MONETARY THEORY AND POLICY 1

Monitoring Indicators of Economic Growth: The Fed monitors indicators of economic growth:  GDP - measures the total value of goods and services produced during a specific period  National Income - the total income earned by firms and individual employees during a specific period  Unemployment rate - maintain a low of unemployment rate in the U.S.  Other indexes - Industrial production index, a retail sales index, and a home sales index 2

Monitoring Indicators of Economic Growth Indexes of Economic Indicators include:  Leading economic indicators which predict future economic activity.  Coincident economic indicators which tend to reach their peaks and troughs at the same time as business cycles.  Lagging economic indicators which tend to rise or fall a few months after business-cycle expansions and contractions. 3

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Monitoring Indicators of Inflation a.Producer and consumer price indexes: Producer price index represents prices at the wholesale level, and the consumer price index represents prices paid by consumers (retail level). b.Other inflation indicators i.Wage rates are periodically reported in various regions. ii.Oil prices can signal future inflation because they affect the costs of some forms of production as well as transportation costs and the prices paid by consumers for gasoline. iii.The price of gold is closely monitored because gold prices tend to move in tandem with inflation. iv.In some cases, indicators of economic growth are also used to indicate inflation. 5

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Pure Keynesian Theory 1.Money demand inversely related to interest rate 2.Interest rates directly related to the money supply 3.Capital investment directly related to Money supply 4.Role of government is to a.Adjust the money supply b.Provide demand when economy is contracting 7

B.Quantity Theory of Money: Monetarist Approach 1.Money supply and economic activity directly related. 2.Key variable is the velocity of exchange: MV = PQ. a.As households hold more money, velocity decreases. b.Variables affecting the amount of money held; frequency of receipts, credit. 3.Increases in Money supply leads to an increase in output. 4.Monetarists favor steady gradual increases in money supply 8

C.Theory of Rational Expectations 1.Households use historical experience to adjust behavior ahead of government policy 2.Changes in government policy unlikely to achieve desired effects D.Integrating Monetary Theories 1.Congress appears trapped in Keynesian policy initiatives 2.Federal Reserve appears to be attempting to minimize effects of government policy 9

Decline in real growth of money supply tends to lead recessions Increase in real growth tends to accompany recoveries What is not evident: effects of expansionary fiscal policy… 1.Timing of results 2.Magnitude 10

D.The lag between changes in Money supply and changes in output E.Trade-Off Faced By the Fed 1.The Phillips Curve a.Increases in wages directly related to unemployment. b.Government policies to reduce unemployment ends up creating more 2.The Policy Paradox a.Fighting inflation results in increased unemployment b.Easy money reduces unemployment but spurs inflationary pressures c.Changes in technology creates additional pressures 11

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Managing Money supply and economic growth Assessing the role of government and regulation of the market place 1.Determining minimum necessary to maintain viable economy 2.Determining the maximum level of involvement in recovery 3.Government Fiscal Policy and Fed Accommodation - monetizing the debt 13

3. Transmission of Interest Rates  Global interest rates will vary between countries.  Countries with higher rates will attract investors from countries with lower rates.  If investors leave due to U.S. falling rates, the Fed may believe it should act to prevent rates from falling lower.  Given the international integration in money and capital markets, a government’s budget deficit can affect interest rates of various countries, referred to as global crowding out. 14

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1.In the spring of 2010, Greece experienced a weak economy and a large budget deficit. 2.Creditors were less willing to lend the Greece government funds because they feared that the government may be unable to repay the loans. 3.The European Central Bank (ECB) used a more stimulative monetary policy in a failed attempt to ease concerns about the Greek crisis, which also ended up raising other concerns about potential inflation in the eurozone. 16

Assessing impact of global economy on US economic growth Adam Smith's international trade imperative 1.Is trade free? 2.If not, what is the cost? Role of the US Dollar as official reserve currency 17

How do Keynesians treat the supply of money? How do Monetarists treat the supply of money? What does the Theory of Rational Expectations say about the effectiveness of government policy initiatives? What policy tools can the Federal Reserve use to control inflation? How effective are supply or demand solutions to the current economic recession? Q&A: 1, 2,6,11,16, Interpreting: a, b, c 18