CHAPTER 5 Monetary Theory and Policy

Chapter Objectives n Learn the well-known theories of monetary policy n Review the tradeoffs involved in monetary policy n Learn how analysts monitor and forecast Fed’s monetary policy

Monetary Policies n How does money affect the real economy? n How does varying money supply growth impact spending? n How does monetary policy in the financial sector impact real economic sector investment and spending?

Keynesian Theory n Developed by John Maynard Keynes and his students n Initially attempted to explain inadequacy of monetary policy during Great Depression n Effectiveness of monetary policy depends upon the sensitivity (elasticity) of economy to changes in interest rates

Keynesian Theory, cont. n Advocates fiscal policy n Focused on government deficit/surplus spending to impact economic activity n Monetary policy transmitted slowly via bank credit policy and interest rates n A proactive economic policy

Exhibit 5.3 aa Stimulative Monetary Policy Restrictive Monetary Policy Fed Investors Bank Funds Increase Interest Rates Decrease Aggregate Spending Increases $ Treasury Securities Fed Investors Bank Funds Decrease Interest Rates Increase Aggregate Spending Decreases $ Treasury Securities Inflation Decreases

Monetary Theories n Quantity theory l Based on equation of exchange l MV = P G Q M =amount of money in the economy V =velocity, average number of times each dollar changes hands during the year P G =weighted average price level of goods and services in the economy Q =quantity of goods and services sold

Monetary Theories n Quantity theory’s assumptions l P G Q is the total value of goods and services produced l Assume V constant or predictable—changing M impacts total spending l M should grow at rate of output capacity, Q l Faster M growth increases P G or inflation

Monetary Theories n Monetarists l Velocity is affected by u Income levels u Frequency income is received u Use of credit cards u Inflationary expectations l Velocity changes found to be predictable and not related to fluctuations in money supply

Monetarist vs. Keynesian Theories n Monetarist l Let economic problems resolve themselves l Low growth reduces borrowing and lowers interest rates l Problem: It takes time n Keynesian l Need to take action to lower interest rates l High money growth to fix a recession by lowering rates l Problem: Might ignite inflation

Monetarist vs. Keynesian Theories n Monetarist l Low, stable growth in the money supply l Focus on maintaining low inflation and will tolerate what they call natural unemployment n Keynesian l Actively manage the money supply l Willing to tolerate inflation that helps reduce unemployment

Rational Expectations Theory n Households and businesses act in their own self-interest n Individuals anticipate effects of government policy changes n Expansionary monetary policy signals future inflation and interest rates increase (security prices fall) n Rational expectations may nullify intended effects of monetary policy

Tradeoff of Monetary Policy Goals n Goals of the Monetary Policy l Steady GDP growth l Low unemployment l Stable price levels n Tradeoffs l Lowering unemployment by stimulating the economy may increase inflation l Lowering inflation by slowing the economy may increase unemployment

Economic Indicators Monitored by the Fed n Indicators of economic growth l Gross Domestic Product or GDP l Industrial production l National income l Unemployment n Indicators of Inflation l Producer price indexes l Consumer price Indexes l Other indicators

Economic Indicators Monitored by the Fed n How the Fed uses indicators l Fed meets to decide course of monetary policy l Assesses recent reports on indicators of growth and inflation l Uses indicators to anticipate how the economy will change l Decides the appropriate monetary policy given possible conditions

Lags in Monetary Policy n Recognition lag l Most economic problems revealed by statistics, not observation l Fed quick to see changes in economy n Implementation lag l Fed acts quickly to implement change in monetary policy l Fiscal policy via Congress takes a long time n Impact Lag l Takes time for monetary changes to have full impact l Fiscal policy tax changes have unpredictable results

Assessing the Impact of Monetary Policy n How does the policy change affect financial market participants? l Depends on the kinds of securities you trade l Depends on your expectations about how the changes affect on the economy n Forecasting money supply movements l Financial market participants look at actual growth compared to Fed targets l Growth outside range could signal Fed policy changes

Assessing the Impact of Monetary Policy n Improved communication at the Fed l Fed more willing to disclose its intentions since 1999 l Immediate feedback to public and financial markets about “bias” on rates n Market reaction to reported money supply levels l Thursday release of money supply data l Try to determine future trends in interest rates

Assessing the Impact of Monetary Policy n Anticipating reported money supply levels l Securities and financial market professionals cannot profit on information available to all at the same time l Try to forecast and anticipate changes l Trying to figure out the future course of interest rates and Fed policy n Market reaction to discount rate adjustment

Assessing the Impact of Monetary Policy n Market reaction to discount rate adjustment l Monitor changes to determine policy l Some changes are technical or intended to bring the discount rate in line with market rates l Financial market participants try to anticipate changes l Discount rate seems to preceded market interest rate movements since 1980

Exhibit 5.9 a Federal Open Market Committee (FOMC) Money Supply Targets Inflationary Expectations Demand for Loanable Funds Cost of Capital for Corporations Corporate Expansion Equilibrium Interest Rates Residential Construction Economic Growth Supply of Loanable Funds Cost of Household Credit (Including Mortgage Rates) Household Consumption

Assessing the Impact of Monetary Policy n Forecasting the impact of monetary policy l Even if financial market participants correctly anticipate changes in the money supply there are still problems u Not a stable relationship between money supply and economic variables over time u Examples include the relationship between economic growth and the money supply

Integrating Monetary and Fiscal Policies n History l Executive branch usually most concerned with employment and growth l Fed and administration may differ on priorities of price stability or growth needs l Agreement when inflation and unemployment are at relatively low levels

Exhibit 5.12 a U.S. Monetary Policy U.S. Fiscal Policy U.S. Personal Income Tax Rates U.S. Budget Deficit U.S. Business Tax Rates U.S. Household Demand for Funds Government Demand for Funds U.S. Business Demand for Funds U.S. Personal Income Level Savings by U.S. Households Supply of Funds in U.S. U.S. Interest Rate Demand for Funds in U.S.

Integrating Monetary and Fiscal Policies n Combined monetary and fiscal policy effects l Fiscal policy usually has a larger influence on the demand for loanable funds l Monetary policy usually has a larger influence on the supply of loanable funds n Monetizing the debt l Should the Fed help finance a federal budget deficit created by fiscal policy? l Forecasted surpluses, debt reduction, and U.S. Treasury securities

Integrating Monetary and Fiscal Policies n Market assessment of integrated policies l Financial markets assess both fiscal and monetary policy l Markets monitor a wide range of information and data l Forecast how loanable funds supply and demand will change

Global Effects on Monetary Policy n Impact on the U.S. dollar l Value of the dollar relative to other currencies can affect inflation u A weak dollar stimulates U.S. exports, discourages imports and stimulates the economy u Fed less likely to stimulate the economy if the dollar is weak l Strong dollar u Stimulates imports and economic growth u Encourages capital flows into U.S. and lower interest rates

Global Effects on Monetary Policy n Transmission of interest rates l International flow of funds affected by Fed policy l Global capital and money markets are integrated u Capital flows to highest real, after-tax, exchange-rate adjusted rate of return u Financial integration improves with n Decreased governmental regulation in markets n Decreased transaction costs n Improved financial technology l Deficits or surpluses in the U.S. have global implications

Global Effects on Monetary Policy n Fed policy during the Asian crisis l Fed realizes the global economy is integrated u U.S. economic conditions affect other countries u Other countries economic conditions affect the U.S. l Fed reaction to Asian crisis shows possible complications that result from economic integration

Forecasting Money Supply n Watch weekly federal reserve data releases n Observe changes with announced fed ranges of money growth n Markets attempt to estimate changes in monetary policy direction and... n Anticipate interest rate changes

Global Effects on Monetary Policy n Exchange Rate Levels n International Funds Flow n Economic Activity of Foreign Countries