CHAPTER 5 MONETARY THEORY AND POLICY Dr. David P. EchevarriaAll Rights Reserved1

[Keynesian] Model of Money and Interest Rates Dr. David P. EchevarriaAll Rights Reserved2 P (i) Q M-supply M-Demand

MONETARY THEORY Pure Keynesian Theory 1.Money demand inversely related to interest rate (More money demanded as rates go down) 2.Interest rates directly related to the money supply (As interest rates rise, more money is supplied) 3.Capital investment directly related to Money supply ( and inversely to interest rates) 4.Role of government is to a.Adjust the money supply (to lower interest rates) b.Provide public demand (for capital goods) when private demand is absent. Dr. David P. EchevarriaAll Rights Reserved3

MONETARY THEORY 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 Dr. David P. EchevarriaAll Rights Reserved4

MONETARY THEORY 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 Dr. David P. EchevarriaAll Rights Reserved5

RELATIONSHIP OF MONEY SUPPLY AND ECONOMY 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 Dr. David P. EchevarriaAll Rights Reserved6

RELATIONSHIP OF MONEY SUPPLY AND ECONOMY 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 Dr. David P. EchevarriaAll Rights Reserved7

INTEGRATING MONETARY AND FISCAL POLICY 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 Dr. David P. EchevarriaAll Rights Reserved8

INTERNATIONAL CONSIDERATIONS OF MONETARY POLICY 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 Dr. David P. EchevarriaAll Rights Reserved9

HOMEWORK QUESTIONS How do Keynesians treat the supply of money? How do Monetarists treat the supply of money? Why is velocity important? 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? Dr. David P. EchevarriaAll Rights Reserved10