Chapter
15 Monetary Theory and Policy
Monetary
policy is the Fed.’s role in supplying money to the economy to influence
aggregate economic performance.
Monetary
theory is the study of the effect of money on the economy.
Economists
believe that a change in the money supply affects the economy through two
channels:
1.
Indirect channel – Changes in the money
supply affect AD through changes in the interest rate.
2.
Direct channel – Changes in the money
supply directly affect how much people want to spend.
I.
Money and the Economy: The
Indirect Channel
Demand
for Money –
The relationship between how much money people want to hold and the interest
rate
Money
here is a stock variable. We are not talking about people demanding more income
(flow variable). The demand for income is represented by how much labor and
other resources people are willing to sell. People demand money to carry out
market transactions. The demand for money is represented by the desire of
people to hold money rather than other
assets that could earn more interest.
A.
The Demand for Money
Money
allows people to carry out their economic transactions more easily.
-
The
greater the value of transactions people want to make in a given period, the
greater the demand for money. (level of real output)
-
The
higher the price level, the greater the demand for money.
People
can store their purchasing power in two ways:
1.
money
2.
other
financial assets (bonds, stocks, etc…)
Money
is liquid, but it earns no interest. (If a checkable deposit earns interest, it
is generally lower than other assets.) The interest forgone is the
opportunity cost of holding money.
B.
Money Demand and Interest
Rates
When
the market rate of interest is low, the cost of holding money is low.
When
the market rate of interest is high, the cost of holding money is high.
The quantity
of money demanded varies inversely with the market rate of interest.
Demand
for Money (price level and real GDP constant)
Graph
pg. 318 Exhibit 1
Price Level à Demand for money à Demand curve for money shifts to the right
GDP à Demand for money à Demand curve for money shifts to the right
C.
Supply of Money and the
Equilibrium Interest Rate
The
stock of money in the economy at a given time is determined primarily by the
Fed. The supply of money is depicted as a vertical straight line (independent
of the interest rate).
The
intersection of the supply of money and the demand for money determines the
equilibrium rate of interest.
Graph
pg. 319 Exhibit 2
If
the Fed increases the money supply, the money supply curve shifts to the right.
-
At
the original interest rate, demand for money is less than the supply. More
money is out there to hold, but people are not willing to hold it at the
current rate of interest.
-
People
exchange money for other assets. As they try to exchange money for assets the
interest rate falls on those assets because issuers can pay less interest and
still attract buyers.
-
As
the interest rate decreases, people are willing to hold more money.
-
The
interest rate falls until quantity demanded just equals the quantity supplied.
For
a given demand for money curve, increases in the supply of money drive down the
market interest rate, and decreases in the supply of money drive up the market
interest rate.
II.
Money and Aggregate Demand
Monetary
policy influences the money supply, which influences the market interest rate,
which affects the level of planned investment, which is a component of
aggregate demand.
A.
Interest Rates and Planned
Investment
Example:
The Fed thinks the economy is operating below its potential output. They decide
to increase the money supply to stimulate output and employment.
They
can expand the money supply by 1. Purchasing U.S. government bonds, 2. Lowering
the discount rate, or 3. Lowering the reserve requirement.
Graph:
pg. 321 Exhibit 3
a.
Supply
and Demand for Money
b.
Demand
for investment
c.
Aggregate
Expenditure
d.
Aggregate
demand
Summary
of events:
M à i ¯à I à AE à AD
If
the Fed increases interest rates:
M¯ à i à I ¯ à AE ¯ à AD ¯
As
long as the interest rate is sensitive to changes in the money supply, and as
long as the quantity of investment is sensitive to changes in the interest
rate, changes in the supply of money affect planned investment.
B.
Adding Aggregate Supply
For
a given shift in the AD curve, the
steeper the short-run aggregate supply curve, the smaller the increase in real
GDP and the larger the increase in the price level.
The
indirect effect of an increase in the money supply is to reduce the market
interest rate, resulting in an increase in planned investment and a consequent
increase in aggregate demand. As long as the short-run aggregate supply curve
slopes upward, the short-run effect of an increase in the money supply is an
increase in both real output and the price level.
Graph:
pg. 323 Exhibit 4
C.
Fiscal Policy with Money
If
the government increases government purchases to stimulate AD (leading to both
greater output and higher prices in the short run), the increase in real output
and the price level increase the demand for money.
For
a given money supply, an increase in the demand for money leads to higher
interest rates. Higher interest rates reduce investment spending. The reduction
in investment dampens the effects of the increase in AD.
The
inclusion of money in the fiscal framework introduces another reason why the
simple spending multiplier overstates the increase in real output arising from
any given fiscal stimulus.
III.
Money and the Economy: The
Direct Channel
Another
view of the effect of money sees a more direct relationship between money
supply and AD.
In
this view, people hold their money in financial
assets and REAL ASSETS (real estate, cars, etc…). IF the money supply
increases, at the original interest rate, the supply of money exceeds the
amount demanded. People are holding more of their wealth in money than they
want to, so they increase their demand for financial
assets and REAL ASSETS. The increased demand for REAL ASSETS, increases AD.
A.
The Equation of Exchange
Equation
of Exchange
– The quantity of money, M, multiplied by its velocity, V, equals nominal GDP,
which is the product of the Price level, P, and real GDP, Y.
M X
V = P X Y
P –
price level
Y –
real output
V –
Velocity of Money - the average number of times per year a dollar is
used to purchase final goods and resources
M –
quantity of money in the economy
The
quantity of money in circulation, M, multiplied by the number of times the
money turns over, V, is equal to the average price level times the total
output.
**
Every transaction involves a swap between a seller and a buyer.
B.
Quantity Theory of Money
Monetarists
emphasize the direct relationship between money and AD, and claim that V is
relatively stable (or predictable and not related to money supply)
Quantity Theory of Money – If the velocity of money
is stable or at least predictable, then changes in the money supply have
predictable effects on nominal GDP.
P X
Y = M X V
If
M is increased by 10%, and V is constant, P X Y must increase by 10%.
M à spending à higher nominal GDP
In
the short run, changes in nominal GDP are divided between changes in real GDP
and changes in the price level.
In
the long run, increases in the money supply result only in higher prices.
Money
à Inflation
C.
What Determines the Velocity
of Money?
1.
Customs
and Conventions of Commerce: The velocity of money has increases over time as a
variety of commercial innovations have facilitated exchange. (charge accounts,
credit cards, ATMs, debit cards)
2.
Frequency
with which workers get paid. More frequent à greater velocity
3.
The
better money serves as a store of value, the more people hold and the less the
velocity.
4.
Inflation
increases, velocity increases.
D.
How Stable is Velocity
-
Between
1973 and 1979, velocity grew each year at a rate between 3-4.3 percent. Late
1970s were a high point for monetarists.
-
After
1979, the velocity of M1 became more erratic.
-
Velocity
of M1 has continued to be unpredictable in the 1990s. The equation of exchange is less reliable.
-
In
1987, the Fed switched to velocity of M2 in setting objectives for monetary
growth.
-
In
1993, the Fed announced that monetary aggregates are not reliable guides for
monetary policy.
IV.
Money Supply v. Interest
Rate Targets
Indirect
channel à Monetary authorities should
worry about interest rates when considering monetary policy.
Monetarists
à Monetary authorities should focus on the
money supply.
The
Fed lacks the tools to do both at the same time.
A.
Contrasting Policies
(Example)
B.
Targets until 1982
WWII
– October 1979, the Fed attempted to stabilize interest rates.
Milton Friedman, monetarist,
argued that focusing on interest rates contributed to instability.
Debate
raged through the 1970s.
October
1979, the Fed announced they would stop targeting interest rates and focus on
targeting the growth of monetary aggregates. Interest rates became more
volatile, and some economists believed that a sharp reduction in the money
supply caused the recession of 1982. The Fed, under pressure, announced they would
focus on interest rates and the money supply.
C.
Targets after 1982
Measurement of the money
supply had become more difficult.
The
relationship between M1 and economic activity had begun to break down.
Alan
Greenspan said that changes in the money supply were not closely enough linked
to nominal income to justify focusing only on the money supply. The Fed.’s
focus has become short-term interest rates (in particular the federal funds
rate.)
The Fed now tracks a variety
of indicators of inflationary pressure (growth in real GDP and the unemployment
rate), and target short-term interest rates.