Macro Chapter 14 Modern Macroeconomics and Monetary Policy

3 Learning Goals 1) 1)Analyze the impact monetary policy has on the economy 2) 2)Investigate the claim that a rapid increase in the money supply leads to inflation 3) 3)Confirm the ideas presented in the chapter with data from various countries

Daniel Thornton & David Wheelock: “The conventional wisdom once held that money doesn’t matter. Now there is wide agreement that monetary policy can significantly affect real economic activity in the short run, though only price level in the long run.”

Main points of the chapter: 1) Unanticipated changes in the money supply can change AD 2) Anticipated changes and long run changes do NOT change AD; only prices are affected 3) A more rapid increase in the quantity of money than in the quantity of goods and services available for purchase will produce inflation, raising prices in terms of that money

The Impact of Monetary Policy on Output and Inflation

When the Fed increases the money supply Interest rates fall Consumption and Investment increase The dollar will depreciate, causing Exports to rise, imports to fall, and net exports to rise

When the Fed decreases the money supply Interest rates rise Consumption and Investment decrease The dollar will appreciate, causing Exports to fall, imports to rise, and net exports to fall

Unanticipated changes in the money supply: Refer back to Chapter 10 regarding the details of what happens when AD increases and decreases The same “story” is told, the only difference now is the variable that changed AD

What if AD surprisingly increases? (1) Higher prices will increase profits (2) Firms will increase production (move along SRAS) –Actual output > potential output –Actual unemployment < natural rate (3) Resources prices will begin to rise (4) Interest rates will rise as demand for loanable funds increases (5) Foreigners will purchase more US assets; the dollar will appreciate (6) SRAS will begin to fall (shift left) and consumers will buy less (move along AD) (7) The economy will return to long run equilibrium

Q14.1 In the short run, an unanticipated increase in the money supply will exert its primary impact on 1.output and employment rather than on prices. 2.prices; output and employment will be largely unaffected. 3.interest rates; rising interest rates will stimulate additional saving. 4.prices, if the economy operates at an output level below its long-run supply constraint.

Q14.2 The short run sequence of events following an unanticipated shift to restrictive monetary policy would be higher interest rates followed by dollar 1.depreciation, higher exports, and lower imports. 2.depreciation, lower exports, and higher imports. 3.appreciation, lower exports, and higher imports. 4.appreciation, higher exports, and lower imports.

Monetary Policy in the Long Run

Milton Friedman: “Inflation is always and everywhere a monetary phenomenon” “Inflation occurs when the quantity of money rises appreciably more rapidly than output, and the more rapid the rise in the quantity of money per unit of output, the greater the rate of inflation.”

If your income doubled and the price level doubled, would anything really change? The Quantity Theory of Money is used to support the hypothesis that a rapid increase in the money supply causes inflation

Equation of exchange: M V = P Y M = money supply V = velocity, how quickly $1 passes through the economy P = price level Y = GDP = output M V = Total spending P Y = Total receipts

Implications: In the short run, Y and V are assumed to be constant Therefore an increase in M causes an increase in Y

The long run effects: ↑M → ↑AD → ↑resource prices → ↓SRAS Then Then Then …

Q14.3 In an economy in which velocity is constant and real output grows at an average rate of 3 percent per year, a 5 percent average rate of growth in the money supply would result in a 1.constant price level. 2.low (approximately 2 percent) rate of inflation. 3.decline in the general level of prices at an annual rate of approximately 2 percent. 4.rate of inflation of approximately 8 percent.

Q14.4 (PMA) Equilibrium in the loanable funds market is initially present at a stable price level (zero inflation) and a nominal (and real) interest rate of 4 percent. If a shift to expansionary monetary policy eventually leads to actual and expected inflation of 6 percent, 1) 1)The nominal interest rate will rise to 10 percent. 2) 2)The nominal interest rate will stay at 4 percent. 3) 3)The nominal interest rate will rise to 6 percent. 4) 4)The real interest rate will rise to 10 percent. 5) 5)The real interest rate will stay at 4 percent. 6) 6)The real interest rate will rise to 6 percent.

Do the theories hold up in the real world? Watch video: Free to Choose-inflation

Time Lags, Monetary Shifts, and Economic Stability

You may skip the Taylor Rule

Q14.5 In the long-run, the primary effect of rapid monetary growth is 1.lower nominal interest rates. 2.reduced unemployment. 3.inflation. 4.an increase in real output.

Question Answers: 14.1 = = = = 1 & = 3