1. ©2005 South-Western College Publishing
Monetary Policy
Key Concepts
Summary
©2005 South-Western College Publishing

2. How is this chapter organized?
The first half explores how Keynesian economists view the relationship between monetary policy and the economy, then the opposing view of the monetarists is discussed.

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. The Demand for Money Curve
16%
12%
Interest Rate A 8% B 4% MD
Billions of dollars
500
1,000
1,500
2,000

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

16. The Equilibrium Interest RateMS
16%
Surplus
12%
Interest Rate E
Shortage 8% 4% MD
Billions of dollars
500
1,500
2,000
1,000

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

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

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. Increase in the Money Supply
MS1
MS2
16%
Surplus
12%
Interest Rate E1 E2 8% MD 4%
Billions of dollars
500
1,000
1,500
2,000

23. Decrease in the Money Supply
MS2
MS1
16%
Shortage
12%
Interest Rate E2 E1 8% MD 4%
Billions of dollars
500
1,000
1,500
2,000

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

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

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

28. Expansionary Monetary Policy
MS1
MS2
16%
Surplus
12%
Interest Rate E1 E2 8% MD 4%
Billions of dollars
500
1,000
1,500
2,000

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

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

31. AS E2 155 E1 AD2 150 AD1 6.0 6.1 Product Market Price Level
full employment
AD1
Billions of dollars
6.0
6.1

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. Money
Prices
MV = PQ
Velocity
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 quantity of money
Change in the money supply
Change in prices, real GDP, & employment
Monetarist
Policy
Change in the aggregate demand curve

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

46. The Velocity of Money 7 6
GDP/M1 5 4 3 2 1
Year 40 50 60 70 80 90 00

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. What are the three schools of economic thought?
What is the Keynesian view of money?
How can the fed influence the equilibrium interest rate?
In the Keynesian model, what do changes in the money supply effect?
What is the Classical economic view?

61. 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?
Who are the modern monetarists?

62. 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. The Demand for Money Curve
16%
12%
Interest Rate A 8% B 4% MD
Billions of dollars
500
1,000
1,500
2,000

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. The Equilibrium Interest RateMS
16%
Surplus
12%
Interest Rate E
Shortage 8% 4% MD
Billions of dollars
500
1,500
2,000
1,000

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.

74. The velocity of money is the number of times each dollar is spent during a year. Keynesians view velocity as volatile but monetarists disagree.

75. 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.

76. 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.

77. Monetarists’ and Keynesians’ views on fiscal policy are also different
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.

78. END