Chapter 14

 Discuss Milton Friedman’s contribution to modern economic thought.  Evaluate appropriately timed monetary policy and its impacts on interest rates and aggregate demand.  Distinguish appropriately timed from ill timed policy and list its consequences.

 1950s and 1960s: economists thought monetary policy ◦ Could control inflation ◦ Could not stimulate AD  Today: Most economists believe that monetary policy impacts ◦ Output in the short run, but not the long run ◦ Prices in the short run and the long run ◦ Can be a source of economic instability

Every major contraction in this country has been either produced by monetary disorder or greatly exacerbated by monetary disorder. Every major inflation episode has been produced by monetary expansion.

 Demand for money balances is not the same as the demand for wealth  Reasons to hold money ◦ Buy stuff now ◦ In case of emergency ◦ Buy stuff later

 Demand for money – Illustrates the relationship between the interest rate and quantity of money people want to hold  Downward sloping: the opportunity cost of holding money is the nominal interest rate  Shifts right: when nominal GDP rises  Shifts left ◦ When nominal GDP falls ◦ As people use more electronic transactions

 The Fed controls the supply of money through ◦ Reserve requirement ◦ Open market operations (federal funds rate) ◦ Discount-rate ◦ Interest paid on excess reserves  Vertical: changes in the interest rate do not impact the Fed’s ability to control the money supply

Money Supply Quantity of Money QsQs Equilibrium – the quantity of money demanded equals the quantity supplied i1i1 Money Demand Nominal Interest Rate

 When the Fed buys bonds ◦ Supply of money increases ◦ Supply of loanable funds increases ◦ AD shifts right

 Aggregate demand will increase because ◦ A lower interest rate makes current investment and consumption cheaper ◦ A lower interest rate causes financial assets to move abroad, the dollar will depreciate, and net exports will increase ◦ A lower interest rate increases asset prices (stocks, houses) which also increases investment and consumption (aggregate demand)

S1S1 Q1Q1 The fed buys bonds to increase the money supply and the interest rate will fall i1i1 Money Demand Nominal Interest Rate S2S2 Q2Q2 i2i2 Quantity of Money

Real Interest Rate D r1r1 Q1Q1 S1S1 Loanable Funds Increases supply of loanable funds as banks make more loans, real interest rate falls r2r2 Q2Q2 S2S2

Expansionary Monetary policy shifts AD right as spending by consumers and businesses increases. Price Level Goods and Services (real GDP) AD 2 Y2Y2 P2P2 P1P1 SRAS 1 AD 1 Y1Y1 In the short run output increases

Price Level Goods and Services (real GDP) AD 2 YFYF P2P2 P1P1 SRAS 1 AD 1 Y1Y1 If the economy was initially at less than full employment, no further adjustments take place LRAS 1 E2E2 e1e1

Price Level Goods and Services (real GDP) AD 1 YFYF P1P1 P2P2 SRAS 1 AD 2 Y2Y2 If the economy was initially at (or greater than) full employment, SRAS shifts left and inflation occurs LRAS 1 E2E2 e2e2 E1E1 P3P3 SRAS 2

 When the Fed sells bonds ◦ Supply of money decreases ◦ Supply of loanable funds decreases ◦ AD shifts left

 Aggregate demand will decrease because ◦ A higher interest rate makes current investment and consumption more expensive ◦ A higher interest rate causes financial assets to flow the U.S., the dollar will appreciate, and net exports will fall ◦ A higher interest rate decreases asset prices (stocks, houses) which also decreases investment and consumption (aggregate demand)

S1S1 Quantity of Money Q1Q1 i1i1 Money Demand Nominal Interest Rate S2S2 Q2Q2 i2i2 The fed sells bonds to decrease the money supply and the interest rate will rise

Real Interest Rate D r2r2 Q2Q2 S2S2 Loanable Funds Decreases supply of loanable funds as banks make fewer loans, real interest rate rises r1r1 Q1Q1 S1S1

Restrictive Monetary policy shifts AD left as spending by consumers and businesses decreases. Price Level Goods and Services (real GDP) AD 1 Y1Y1 P1P1 P2P2 SRAS 1 AD 2 Y2Y2 In the short run output decreases

Price Level Goods and Services (real GDP) AD 2 YFYF P2P2 P1P1 SRAS 1 AD 1 Y1Y1 If the economy was initially at greater than full employment, no further adjustments take place LRAS 1 E2E2 e1e1

Price Level Goods and Services (real GDP) AD 1 YFYF P1P1 SRAS 1 AD 2 Y2Y2 If the economy was initially at full employment, the policy will cause a recession LRAS 1 e2e2 E1E1 P2P2 Eventually, self-correction will occur as resource prices adjust downward (this is not pictured)

 Timed correctly ◦ Will help mitigate a recession ◦ Will help control / prevent inflation ◦ Will lead to economic stability  Timed incorrectly ◦ Will make a recession even worse ◦ Will lead to massive inflation ◦ Will lead to economic instability

 Quantity theory of money – a theory that says a change in the money supply will cause a proportional change in the price level  Velocity of money – average number of times a dollar is use to purchase final goods and services during a year

 P ~ price level  Y ~ real GDP  M ~ money supply  V ~ velocity of money  PY ~ nominal GDP Equation of Exchange

 Can be written in terms of growth rates Rate of inflation + Growth rate of real output = Growth rate of money supply + Growth rate of velocity

 In the short-run, monetary policy will impact real output and employment ◦ Expansionary will increase output ◦ Restriction will reduce output  In the long-run, expansionary monetary policy will only lead to inflation

 Fed can easily change policy, but  After policy change ◦ 6 – 15 months to impact real output ◦ 12 – 30 months to impact price level and inflation  Implementing monetary policy in a stabilizing way is difficult

 Expansionary monetary policy cannot promote long term economic growth  Economists have limited forecasting abilities  Price stability is a key to economic prosperity

 Explains the housing boom ( ), bust (2008) and subsequent slow recovery:  Austrians believe: ◦ Expansionary monetary policy pushes the interest rate to an artificial low. ◦ The low interest rates will induce entrepreneurs to undertake long-term investments. This will generate an economic boom.

Austrians believe: ◦ But, the boom will be unsustainable because savings are too low to purchase these new assets. ◦ The boom turns to bust and a large share of the newly constructed assets end up unoccupied.  Austrian economists refer to this as malinvestment.

 Monetary policy variable over the past decade  Likely to increase economic instability  Hard for monetary policy-makers to institute stop- go policy in a stabilizing manner

 Discuss Milton Friedman’s contribution to modern economic thought.  Evaluate appropriately timed monetary policy and its impacts on interest rates and aggregate demand.  Distinguish appropriately timed from ill timed policy and list its consequences.