Ch.15, Macroeconomics, R.A. Arnold Monetary Policy Ch.15, Macroeconomics, R.A. Arnold

Prologue (Intro) In this chapter we study two more theories that explain how a change in money supply affects the economy. And how monetary policy may be used to address the problem of recessionary gap and inflationary gap. Expansionary monetary policy: The policy by which the central bank increases money supply. Contractionary monetary policy: The policy by which the central bank decreases money supply

The Money Market (Figure Next Slide) Demand for money: The inverse relationship between the quantity demanded of money (i.e. demand for holding money) and the price of holding money (i.e. interest rate). Interest rate is the price we have to pay for demanding or holding money (i.e. keeping money in our wallets and homes) - we could have earned interest payment if we had not demanded the money and kept it in a commercial bank. Hence, if the interest rate increases, demand for (holding) money decreases…therefore the money demand curve is downward sloping. The supply of money is determined by the central bank and it does not depend on the interest rate and thus the money supply curve is vertical.

Transmission Mechanisms If the supply or demand for money changes in the money market then it affects the economy. How? There are two theories to explain the phenomenon. The channel by which the change affects the economy are called transmission mechanisms. The Keynesian Transmission Mechanism: Indirect (p. 337) The central bank uses expansionary monetary policy to increase the money supply. The banks loan out the excess supply (i.e. the supply of loanable funds increase) which causes the interest rate to decrease. A fall in interest rate stimulates investment (i.e. investment increases) and hence AD increases (shifts right). Figure next slide.

The second theory… 2) The Monetarist Transmission Mechanism: Direct (p The second theory… 2) The Monetarist Transmission Mechanism: Direct (p. 341) The monetarists propose a direct link between the money market and the goods and service market. Increase in money supply leaves individuals with an excess supply of money which they use to consume and/or invest hence AD increases (shifts right). As evident from the discussion so far, changes in money supply i.e. monetary policy can affect the aggregate demand. And if the economy is not self-regulatory, it could be used to bring it out of a recessionary or an inflationary gap. Similar to - how we used fiscal policy for the same purpose (Ch. 10).

Monetary Policy and the Problems of Inflationary and Recessionary Gap In a recessionary gap the real GDP < natural real GDP. Hence to bring the economy back to the LR equilibrium where real GDP = Natural real GDP, we must stimulate (increase) aggregate demand. As we have already seen this can be done by increasing the money supply i.e. by conducting expansionary monetary policy. Figure (c) next slide. In an inflationary gap real GDP > natural real GDP. Hence to bring it back to the long run equilibrium we need to decrease aggregate demand which can be done using contractionary monetary policy. Figure next slide.

Summary Classical economists believed that the economy is self-regulatory and hence Laissez-Faire (not interfering with the economy) is the best policy Keynesians argue that the economy is not self-regulatory since the wages and prices are not flexible and hence the government and the central bank should interfere with the economy (using fiscal and monetary policy) Monetarists believe that monetary policy (conducted by central bank) may also be used to address the issue of recessionary and inflationary gap The government and the central bank are two very important institutions who may work together to achieve the economics goals of: low unemployment, stable prices & economic growth