©2005 South-Western College Publishing Monetary Policy Key Concepts Summary ©2005 South-Western College Publishing

How is this chapter organized? The first half explores how Keynesian economists view the relationship between monetary policy and the economy, then the opposing view of the monetarists is discussed.

What are the three schools of economic thought? Classical Keynesian Monetarist

What is the Keynesian view of money? People who hold cash or checking account balances incur an opportunity cost in foregone interest or profits

According to Keynes, why would people hold money? Transactions demand Precautionary demand Speculative demand

What is the transactions demand for money? The stock of money people hold to pay everyday predictable expenses

What is the precautionary demand for money? The stock of money people hold to pay unpredictable expenses

What is the speculative demand for money? The stock of money people hold to take advantage of expected future changes in the price of bonds, stocks, or other nonmoney financial assets

How does a change in interest rates affect speculative demand? As the interest rate falls, the opportunity cost of holding money falls, and people increase their speculative balances

What is the demand for money curve? A curve representing the quantity of money that people hold at different possible interest rates, ceteris paribus

How do interest rates affect the demand for money? There is an inverse relationship between the quantity of money demanded and the interest rate

What gives the demand for money a downward slope? The speculative demand for money at possible interest rates

What determines interest rates in the market? The demand and supply of money in the loanable funds market

The Demand for Money Curve 16% 12% Interest Rate A 8% B 4% MD Billions of dollars 500 1,000 1,500 2,000

Increase in the quantity of money demanded Decrease in the interest rate

The Equilibrium Interest Rate MS 16% Surplus 12% Interest Rate E Shortage 8% 4% MD Billions of dollars 500 1,500 2,000 1,000

Bond prices fall and the interest rate rises People sell bonds Excess money demand

Bond prices rise and the interest rate falls People buy bonds Excess money supply

Why do bond prices fall as interest rates rise? Bond sellers have to offer higher returns (lower price) to attract potential bond buyers, or else they will go elsewhere to get higher interest returns

Why do bond prices rise as interest rates fall? Bond sellers are put in a better bargaining position as interest rates fall (higher price); potential buyers cannot go elsewhere to get higher interest returns so easily

How can the Fed influence the equilibrium interest rate? It can increase or decrease the supply of money

Increase in the Money Supply MS1 MS2 16% Surplus 12% Interest Rate E1 E2 8% MD 4% Billions of dollars 500 1,000 1,500 2,000

Decrease in the Money Supply MS2 MS1 16% Shortage 12% Interest Rate E2 E1 8% MD 4% Billions of dollars 500 1,000 1,500 2,000

Decrease the interest rate Money surplus and people buy bonds Increase in the money supply

Increase in the interest rate Money shortage and people sell bonds Decrease in the money supply

In the Keynesian Model, what do changes in the money supply affect? Interest rates, which in turn affect investment spending, aggregate demand, and real GDP, employment, and prices

Change in the money supply Keynesian Policy Change in interest rates Change in prices, real GDP, & employment Change in the aggregate demand curve Change in investment

Expansionary Monetary Policy MS1 MS2 16% Surplus 12% Interest Rate E1 E2 8% MD 4% Billions of dollars 500 1,000 1,500 2,000

Investment Demand Curve 16% A 12% Interest Rate B 8% I 4% Billions of dollars 1,000 1,500

When will businesses make an investment? When the investment projects for which the expected rate of profit equals or exceeds the interest rate

AS E2 155 E1 AD2 150 AD1 6.0 6.1 Product Market Price Level full employment AD1 Billions of dollars 6.0 6.1

What is the Classical economic view? The economy is stable in the long-run at full employment

How did the Classical economists view the role of money? They believed in the equation of exchange

What is the equation of exchange? An accounting number of times per year a dollar of the money supply is spent on final goods and services

What is the velocity of money? The average number of times per year a dollar of the money supply is spent on final goods and services

Money Prices MV = PQ Velocity Quantity

What is the Monetarist Theory? That changes in the money supply directly determine changes in prices, real GDP, and employment

Change in the quantity of money Change in the money supply Change in prices, real GDP, & employment Monetarist Policy Change in the aggregate demand curve

What is the Quantity Theory of Money? The theory that changes in the money supply are directly related to changes in the price level

What is the conclusion of the Quantity Theory of Money? Any change in the money supply must lead to a proportional change in the price level

Who are the Modern Monetarists? Monetarist argue that velocity is not unchanging, but is nevertheless predictable

According to the Monetarist, how do we avoid inflation and unemployment? We must be sure that the money supply is at the proper level

Who is Milton Friedman? In the 1950’s and 1960’s, he was a leader in putting forth the ideas of the modern-day monetarists

What does Milton Friedman advocate? The Federal Reserve should increase the money supply by a constant percentage each year to enhance full employment and stable prices

How do the Keynesians view the velocity of money? Over long periods of time, it can be unstable and unpredictable

The Velocity of Money 7 6 GDP/M1 5 4 3 2 1 Year 40 50 60 70 80 90 00

What is the conclusion of the Keynesians? A change in the money supply can lead to a much larger or smaller change in GDP than the monetarists would predict

What is the crux of the Keynesian argument? Because velocity is unpredictable, a constant money supply may not support full employment and stable prices

What is the conclusion of the Keynesian argument? The Federal Reserve must be free to change the money supply to offset unexpected changes in the velocity of money

What are the main points of Classical economics?

Economy tends toward a full employment equilibrium Prices & wages are flexible Velocity of money is stable Excess money causes inflation Short-run price & wage adjustments cause unemployment Monetary policy can change aggregate demand & prices Fiscal policies are not necessary

What are the main points of Keynesian economics?

The economy is unstable at less than full employment Prices & wages are inflexible Velocity of money is stable Excess demand causes inflation Inadequate demand causes unemployment Monetary policy can change interest rates and level of GDP Fiscal policies may be necessary

What are the main points of the Monetarists?

Economy tends toward a full employment equilibrium Prices & wages are flexible Velocity of money is predictable Excess money causes inflation Short-run price & wage adjustments cause unemployment Monetary policy can change aggregate demand & prices Fiscal policies are not necessary

What is the crowding-out effect? Too much government borrowing can crowd out consumers and investors from the loanable funds market

What is the Keynesian view of the crowding-out effect? The investment demand curve is rather steep (vertical), so the crowding-out effect is insignificant

What is the Monetarist view of the crowding-out effect? The investment demand curve is flatter (horizontal), so the crowding-out effect is significant

Key Concepts

What are the three schools of economic thought? What is the Keynesian view of money? How can the fed influence the equilibrium interest rate? In the Keynesian model, what do changes in the money supply effect? What is the Classical economic view?

How did the Classical economists view the role of money? What is the equation of exchange? What is the velocity of money? What is the quantity theory of money? What is the conclusion of the quantity theory of money? Who are the modern monetarists?

According to the monetarist, how do we avoid inflation and unemployment? Who is Milton Friedman? What does Milton Friedman advocate? What is Classical economists? What is Keynesian economists? What is monetarism?

Summary

The demand for money in the Keynesian view consists of three reasons why people hold money: (1) Transactions demand is money held to pay for everyday predictable expenses. (2) Precautionary demand is money held to pay unpredictable expenses. (3) Speculative demand is money held to take advantage of price changes in nonmoney assets.

The demand for money curve shows the quantity of money people wish to hold at various rates of interest. As the interest rate rises, the quantity of money demanded is less than when the interest rate is lower.

The Demand for Money Curve 16% 12% Interest Rate A 8% B 4% MD Billions of dollars 500 1,000 1,500 2,000

The equilibrium interest rate is determined in the money market by the intersection of the demand for money and the supply of money curves. The money supply (M1), which is determined by the Fed, is represented by a vertical line.

An excess quantity of money demanded causes households and businesses to increase their money balances by selling bonds. This causes the price of bonds to fall, thus driving up the interest rate.

The Equilibrium Interest Rate MS 16% Surplus 12% Interest Rate E Shortage 8% 4% MD Billions of dollars 500 1,500 2,000 1,000

An excess quantity of money supplied causes households and businesses to reduce their money balances by purchasing bonds. The effect is to cause the price of bonds to rise, and, thereby, the rate of interest falls.

The Keynesian view of the monetary policy transmission mechanism operates as follows: First, the Fed uses its policy tools to change the money supply. Second, changes in the money supply change the equilibrium interest rate, which affects investment spending. Finally, a change in investment changes aggregate demand and determines the level of prices, real GDP, and employment.

Monetarism is the simpler view that changes in monetary policy directly change aggregate demand and thereby prices, real GDP, and employment. Thus, monetarists focus on the money supply, rather than on the rate of interest.

The equation of exchange is an accounting identity that is the foundation of monetarism. The equation (MV = PQ) states that the money supply multiplied by the velocity of money is equal to the price level multiplied by real output.

The velocity of money is the number of times each dollar is spent during a year. Keynesians view velocity as volatile but monetarists disagree.

The quantity theory of money is a monetarist argument that the velocity of money (V) and the output (Q) variables in the equation of exchange are relatively constant. Given this assumption, changes in the money supply yield proportionate changes in the price level.

The monetarist solution to an inept Fed tinkering with the money supply and causing inflation or recession would be to have the Fed simply pick a rate of growth in the money supply that is consistent with real GDP growth and stick to it.

Monetarists’ and Keynesians’ views on fiscal policy are also different Monetarists’ and Keynesians’ views on fiscal policy are also different. Keynesians believe the aggregate supply curve is relatively flat, and monetarists view it as relatively vertical. Because the crowding out effect is large, monetarists assert that fiscal policy is ineffective. Keynesians argue that crowding out is small and that fiscal policy is effective.

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