The Federal Reserve has a dual mandate to: Maintain stable prices (fight inflation/deflation) Maintain full employment (monetary policy to manage macroeconomic conditions)

Created: Jan 2008 by Jim Luke. The Fed manages Inter-bank Interest Rates and Regulates Banks…but does it control money supply?

Created: Jan 2008 by Jim Luke. Monetary Policy "Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output... A steady rate of monetary growth at a moderate level can provide a framework under which a country can have little inflation and much growth. It will not produce perfect stability; it will not produce heaven on earth; but it can make an important contribution to a stable economic society." --Milton Friedman The Bank [of Canada] gave it a college try, it really did. It just doesn't work that way. --John Crow, former governor of the Bank of Canada, on implementing Friedman's theories;

What Is Monetary Policy? Central bank (as representative of government) manipulation of the money supply, interest rates credit conditions with an objective of achieving macroeconomic goals.

Monetarist Theory History – The Classical School Strikes Back at Keynesianism

Three Theories of Monetary Policy Strict Monetarist Neo-classical/New Keynesian Modern Monetary Theory (MMT)

Created: Jan 2008 by Jim Luke. Equation of Exchange M x V = P x Y  M: money supply  V: Velocity  (how fast money is spent)  P: Price Level  Y: Real Income  Note: sometimes shown as M * V = P * Q same concept, different notation Identity: Must be true for any period of time

Both Monetarist and Neo-Classical/New Keynesian Theories: Trade-off between unemployment and inflation exists Controlling Inflation is higher priority 8/10/2015

Money supply concept: (Classical or Milton Friedman Monetarist version) Money supply is ‘exogenous’ more bank reserves —> more lending by banks –> increased money supply –> lower interest rates –> borrowing by consumers/firms –> more C and I spending –> faster GDP growth & inflation

Interest rates concept: (Neoclassical version) central bank open market purchases of bonds –> higher bond prices = lower interest rates –> more borrowing by consumers/firms –> more spending on C and I –> faster GDP growth –>

But, the Equation of Exchange  M x V = P x Y M: money supply V: Velocity (how fast money is spent) P: Price Level Y: Real Income  Note: sometimes shown as M V = P Q same concept, different notation  Equation of Exchanges is an Identity : Must be true for any period of time after the fact..

Quantity theory of money (QTM):  Based on equation of exchange with added assumptions about the behavior of variables. assume V is constant  Conclusions: Money supply growth is solely responsible for determining Inflation

‘Crowding Out’ Theory Assumptions: Fixed amount of money in economy QTM holds true Theory: Gov borrowing takes $ away/raises interest rate for firm and household borrowers –> will reduce C and I unless  Central Bank increases M to fund deficit  inflation Absolutely not supported by evidence or data in modern real world.

Current Neoclassical and New Keynesian Views on monetary policy  Support for ad hoc policy (policy makers should make it up as they go)

Modern Monetary Theory (MMT)  Money growth (M1 – bank credit) is largely endogenous  Key is base money growth, not M1  government deficits enable the private sector (firms and households) to grow and yet still accumulate net financial assets

MMT Foundation: Fiat money system with floating exchange rates eliminates government budget constraint  Deficits effective in fighting unemployment  no financing constraint on deficits  deficits are limited by the availability of real, unemployed resources for the government to purchase  Inflation threat is at/near full employment is reached (AD- LRAS model) 8/10/2015

Limitations of Monetary Policy: ‘Pushing on string’  Central bank cannot force banks to make loans

Limitations of Monetary Policy: Endogenous money supply  Banks, not central bank really determine supply of money and credit

Limitations of Monetary Policy: Fiscal Policy Coordination  Fiscal and Monetary policy could work at cross-purposes  could expect ‘other’ to do it

Limitations of Monetary Policy: Liquidity trap  At ‘zero lower bound’  when interest rates approach zero but the economy is still weak, monetary policy is largely ineffective.

Limitations of Monetary Policy: Globalization  If interest rates too low or inflation too high, then value of currency drops –> capital inflow drops and M drops, even though X rises