1 Chapter 26 Monetary Policy ©2000 South-Western College Publishing Key Concepts Key Concepts Summary Summary Practice Quiz Internet Exercises Internet Exercises

2 In this chapter, you will learn to solve these economic puzzles: Why do people wish to hold money balances? What is a monetary policy transmission mechanism? Why would a Nobel Laureate economist suggest replacing the Federal Reserve with an intelligent horse?

3 What are the Three Schools of Economic Thought? Classical Keynesian Monetarist

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

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

6 What is the Transactions Demand for Money? The stock of money people hold to pay everyday predictable expenses

7 What is the Precautionary Demand for Money? The stock of money people hold to pay unpredictable expenses

8 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

9 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

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

11 How do Interest Rates affect the Demand for Money? There is an inverse relationship between the quantity of money demanded and the interest rate

12 What gives the Demand for Money a Downward Slope? The speculative demand for money at possible interest rates

13 What determines Interest Rates in the Market? The demand and supply of money in the loanable funds market

14 16% 12% 8% 4% 5001,0001,5002,000 A B The Demand for Money Curve MD Interest Rate Billions of dollars

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

16 16% 12% 8% 4% 5001,5002,000 E The Equilibrium Interest Rate MD MS Surplus Shortage 1,000 Interest Rate Billions of dollars

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

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

19 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

20 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

21 How can the Fed influence the Equilibrium Interest Rate? It can increase or decrease the supply of money

22 16% 12% 8% 4% 5002,000 E1E1 Increase in the Money Supply MD MS 1 Surplus 1,000 MS 2 E2E2 1,500 Interest Rate Billions of dollars

23 16% 12% 8% 4% 5002,000 E1E1 Decrease in the Money Supply MD MS 1 1,000 MS 2 E2E2 1,500 Shortage Interest Rate Billions of dollars

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

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

26 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

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

28 16% 12% 8% 4% 5002,000 E1E1 Expansionary Monetary Policy MD MS 1 Surplus 1,000 MS 2 E2E2 1,500 Interest Rate Billions of dollars

29 16% 12% 8% 4% A Investment Demand Curve I 1,000 B 1,500 Interest Rate Billions of dollars

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

E2E2 AD Product Market E1E1 Price Level AS AD 2 Full Employment Billions of dollars

32 What is the Classical Economic View? The economy is stable in the long-run at full employment

33 How did the Classical Economists view the Role of Money? They believed in the equation of exchange

34 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

35 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

36 MV = PQ Money Velocity Prices Quantity

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

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

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

40 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

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

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

43 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

44 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

45 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 Year GDP/M1

47 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

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

49 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

50 What are the main points of Classical Economics?

51 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

52 What are the main points of Keynesian Economics?

53 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

54 What are the main points of the Monetarists?

55 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

56 What is the Crowding-Out Effect? Too much government borrowing can crowd out consumers and investors from the loanable funds market

57 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

58 What is the Monetarist View of the Crowding- Out Effect? The investment demand curve is flatter (horizontal), so the crowding-out effect is significant

59 Key Concepts

60 Key Concepts What are the Three Schools of Economic Thought?What are the Three Schools of Economic Thought? What is the Keynesian View of Money? How can the Fed influence the Equilibrium Interest Rate?How can the Fed influence the Equilibrium Interest Rate? In the Keynesian Model, what do changes in the Money Supply effect?In the Keynesian Model, what do changes in the Money Supply effect? What is the Classical Economic View?

61 Key Concepts cont. How did the Classical Economists view the Role of Money?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?What is the Conclusion of the Quantity Theory of Money? Who are the Modern Monetarists?

62 Key Concepts cont. According to the Monetarist, how do we avoid Inflation and Unemployment?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?

63 Summary

64 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.

65 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.

66 16% 12% 8% 4% 5001,0001,5002,000 A B The Demand for Money Curve MD Interest Rate Billions of dollars

67 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.

68 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.

69 16% 12% 8% 4% 5001,5002,000 E The Equilibrium Interest Rate MD MS Surplus Shortage 1,000 Interest Rate Billions of dollars

70 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.

71 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.

72 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.

73 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.

74 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.

75 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.

76 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.

77 Chapter 26 Quiz ©2000 South-Western College Publishing

78 1. Keynes gave which of the following as a motive for people holding money? a. Transactions demand. b. Speculative demand. c. Precautionary demand. d. All of the above. D. These are the three motives for holding currency and checkable deposits (M1) rather than stocks, bonds, or other nonmoney forms of wealth.

79 2. A decrease in the interest rate, other things being equal, causes a (an) a. upward movement along the demand curve for money. b. downward movement along the demand curve for money. c. rightward shift of the demand curve for money. d. leftward shift of the demand curve for money. B. At a lower interest rate, money is demanded because the opportunity cost of holding money is lower.

80 3. Assume the demand for money curve is stationary and the Fed increases the money supply. The result is that people a. increase the supply of bonds, thus driving up the interest rate. b. increase the supply of bonds, thus driving down the interest rate. c. increase the demand for bonds, thus driving up the interest rate. d. increase the demand for bonds, thus driving down the interest rate. D.

81 16% 12% 8% 4% 5002,000 E1E1 Expansionary Monetary Policy MD MS 1 Surplus 1,000 MS 2 E2E2 1,500 Interest Rate Billions of dollars

82 4. Assume the demand for money curve is fixed and the Fed decreases the money supply. The result is a temporary a. excess quantity of money demanded. b. excess quantity of money supplied. c. increase in the price of bonds. d. increase in the demand for bonds. A.

83 16% 12% 8% 4% 5002,000 E1E1 Decrease in the Money Supply MD MS 1 1,000 MS 2 E2E2 1,500 Shortage Interest Rate Billions of dollars

84 5. Assume the demand for money curve is fixed and the Fed increases the money supply. The result is that the price of bonds a. rises. b. remains unchanged. c. falls. d. none of the above. A. The result is an excess beyond the amount people wish to hold and they buy bonds which drives the price of bonds upward.

85 6. Using the aggregate supply and demand model, assume the economy is in equilibrium on the intermediate portion of the aggregate supply curve. A decrease in the money supply will decrease the price level and a. lower both the interest rate and the real GDP. b. raise both the interest rate and real GDP. c. lower the interest rate and raise real GDP. d. raise the interest rate and lower real GDP. D. The decrease in money supply increases the interest rate which decreases investment. Since investment is a component of aggregate demand, the aggregate demand curve shifts leftward and real GDP declines.

86 7. Based on the equation of exchange, the money supply in the economy is calculated as a. M = V/PQ. b. M = V(PQ). c. MV = PQ. d. M = PQ - V. C. The equation of exchange is MV = PQ rewritten, M = PQ/V

87 8. The V in the equation of exchange represents the a. variation in the GDP. b. variation in the CPI. c. variation in real GDP. d. average number of times per year a dollar is spent on final goods and services. D. In the equation of exchange, GDP is defined as PQ and the CPI is an index to measure the price level (P).

88 9. Which of the following is not an issue in the Keynesian-monetarist debate? a. The importance of monetary vs. fiscal policy. b. The importance of a change in the money supply. c. The importance of a crowding-out effect. d. All of the above are part of the debate. D. Monetarists believe the effects of monetary policy are more powerful than fiscal policy. They view the shape of the investment demand curve as less steep, so the crowding- out effect is significant. Keynesians disagree.

Keynesians reject the influence of monetary policy on the economy. One argument supporting this Keynesian view is that the a. money demand curve is horizontal at any interest rate. b. aggregate demand curve is nearly flat. c. investment demand curve is nearly vertical. d. money demand curve is vertical. C. If the investment demand curve is nearly vertical, changes in money supply and resulting changes in interest rate have little effect on investment and aggregate demand.

90 8% 6% 4% 2% E1E1 Expansionary Monetary Policy MD MS MS 2 E2E2 600 Interest Rate Billions of dollars

Starting from an equilibrium at E 1 in Exhibit 12, a rightward shift of the money supply curve from MS 1 to MS 2 would cause an excess a. demand for money, leading people to sell bonds. b. supply of money, leading people to buy bonds. c. supply of money, leading people to sell bonds. d. demand for money, leading people to buy bonds. B. An excess quantity of money supplied causes people to buy bonds. The greater demand for bonds causes the price of bonds to increase and the interest rate to decrease.

Beginning from an equilibrium at E 2 in Exhibit 12, a decrease in the money supply from $600 billion to $400 billion causes people to a. sell bonds and drive the price of bonds down. b. buy bonds and drive the price of bonds up. c. buy bonds and drive the price of bonds down. d. sell bonds and drive the price of bonds up. A. An excess quantity of money demanded causes people to sell. The greater supply of bonds on the market causes the price of bonds to decrease and the interest rate to increase.

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