1. Monetary Theory and Policy5

2. Chapter Objectives Learn the well-known theories of monetary policy
Review the tradeoffs involved in monetary policy
Learn how analysts monitor and forecast Fed’s monetary policy

3. Monetary Policies How does money affect the real economy?
How does varying money supply growth impact spending?
How does monetary policy in the financial sector impact real economic sector investment and spending?

4. Keynesian Theory Developed by John Maynard Keynes and his students
Initially attempted to explain inadequacy of monetary policy during Great Depression
Effectiveness of monetary policy depends upon the sensitivity (elasticity) of economy to changes in interest rates

5. Keynesian Theory, cont. Advocates fiscal policy
Focused on government deficit/surplus spending to impact economic activity
Monetary policy transmitted slowly via bank credit policy and interest rates
A proactive economic policy

6. Exhibit 5.3 a a Stimulative Monetary Policy T reasury Securities $
Fed T
reasury
Securities $
Investors
Bank Funds
Increase
Interest Rates
Decrease
Aggregate
Spending
Increases
Restrictive Monetary
Policy
Fed T
reasury
Securities $
Investors
Bank Funds
Decrease
Interest Rates
Increase
Aggregate
Spending
Decreases
Inflation
Decreases

7. Monetary Theories Quantity theory Based on equation of exchange
MV = PGQ
M = amount of money in the economy
V = velocity, average number of times each
dollar changes hands during the year
PG = weighted average price level of goods
and services in the economy
Q = quantity of goods and services sold

8. Monetary Theories Quantity theory’s assumptions
PGQ is the total value of goods and services produced
Assume V constant or predictable—changing M impacts total spending
M should grow at rate of output capacity, Q
Faster M growth increases PG or inflation

9. Monetary Theories Monetarists Velocity is affected by
Income levels
Frequency income is received
Use of credit cards
Inflationary expectations
Velocity changes found to be predictable and not related to fluctuations in money supply

10. Monetarist vs. Keynesian Theories
Let economic problems resolve themselves
Low growth reduces borrowing and lowers interest rates
Problem: It takes time
Keynesian
Need to take action to lower interest rates
High money growth to fix a recession by lowering rates
Problem: Might ignite inflation

11. Monetarist vs. Keynesian Theories
Low, stable growth in the money supply
Focus on maintaining low inflation and will tolerate what they call natural unemployment
Keynesian
Actively manage the money supply
Willing to tolerate inflation that helps reduce unemployment

12. Rational Expectations Theory
Households and businesses act in their own self-interest
Individuals anticipate effects of government policy changes
Expansionary monetary policy signals future inflation and interest rates increase (security prices fall)
Rational expectations may nullify intended effects of monetary policy

13. Tradeoff of Monetary Policy Goals
Goals of the Monetary Policy
Steady GDP growth
Low unemployment
Stable price levels
Tradeoffs
Lowering unemployment by stimulating the economy may increase inflation
Lowering inflation by slowing the economy may increase unemployment

14. Economic Indicators Monitored by the Fed
Indicators of economic growth
Gross Domestic Product or GDP
Industrial production
National income
Unemployment
Indicators of Inflation
Producer price indexes
Consumer price Indexes
Other indicators

15. Economic Indicators Monitored by the Fed
How the Fed uses indicators
Fed meets to decide course of monetary policy
Assesses recent reports on indicators of growth and inflation
Uses indicators to anticipate how the economy will change
Decides the appropriate monetary policy given possible conditions

16. Lags in Monetary Policy
Recognition lag
Most economic problems revealed by statistics, not observation
Fed quick to see changes in economy
Implementation lag
Fed acts quickly to implement change in monetary policy
Fiscal policy via Congress takes a long time
Impact Lag
Takes time for monetary changes to have full impact
Fiscal policy tax changes have unpredictable results

17. Assessing the Impact of Monetary Policy
How does the policy change affect financial market participants?
Depends on the kinds of securities you trade
Depends on your expectations about how the changes affect on the economy
Forecasting money supply movements
Financial market participants look at actual growth compared to Fed targets
Growth outside range could signal Fed policy changes

18. Assessing the Impact of Monetary Policy
Improved communication at the Fed
Fed more willing to disclose its intentions since 1999
Immediate feedback to public and financial markets about “bias” on rates
Market reaction to reported money supply levels
Thursday release of money supply data
Try to determine future trends in interest rates

19. Assessing the Impact of Monetary Policy
Anticipating reported money supply levels
Securities and financial market professionals cannot profit on information available to all at the same time
Try to forecast and anticipate changes
Trying to figure out the future course of interest rates and Fed policy
Market reaction to discount rate adjustment

20. Assessing the Impact of Monetary Policy
Market reaction to discount rate adjustment
Monitor changes to determine policy
Some changes are technical or intended to bring the discount rate in line with market rates
Financial market participants try to anticipate changes
Discount rate seems to preceded market interest rate movements since 1980

21. Exhibit 5.9 a Federal Open Market Committee (FOMC) Money Supply T
argets
Supply of
Loanable Funds
Inflationary
Expectations
Demand for
Loanable Funds
Equilibrium
Interest Rates
Cost of
Household Credit
(Including Mortgage
Rates)
Cost of Capital
for Corporations
Household
Consumption
Residential
Construction
Corporate
Expansion
Economic
Growth a

22. Assessing the Impact of Monetary Policy
Forecasting the impact of monetary policy
Even if financial market participants correctly anticipate changes in the money supply there are still problems
Not a stable relationship between money supply and economic variables over time
Examples include the relationship between economic growth and the money supply

23. Integrating Monetary and Fiscal Policies
History
Executive branch usually most concerned with employment and growth
Fed and administration may differ on priorities of price stability or growth needs
Agreement when inflation and unemployment are at relatively low levels

24. Exhibit 5.12 U.S. Monetary Policy U.S. Fiscal Policy U.S. Personal
Income T
ax Rates
U.S.
Budget
Deficit
U.S.
Business T
ax Rates
U.S.
Personal
Income
Level
U.S.
Household
Demand
for Funds
Government
Demand
for Funds
U.S.
Business
Demand
for Funds
Savings
by U.S.
Households
Supply
of Funds
in U.S.
Demand
for Funds
in U.S.
U.S.
Interest
Rate a

25. Integrating Monetary and Fiscal Policies
Combined monetary and fiscal policy effects
Fiscal policy usually has a larger influence on the demand for loanable funds
Monetary policy usually has a larger influence on the supply of loanable funds
Monetizing the debt
Should the Fed help finance a federal budget deficit created by fiscal policy?
Forecasted surpluses, debt reduction, and U.S. Treasury securities

26. Integrating Monetary and Fiscal Policies
Market assessment of integrated policies
Financial markets assess both fiscal and monetary policy
Markets monitor a wide range of information and data
Forecast how loanable funds supply and demand will change

27. Global Effects on Monetary Policy
Impact on the U.S. dollar
Value of the dollar relative to other currencies can affect inflation
A weak dollar stimulates U.S. exports, discourages imports and stimulates the economy
Fed less likely to stimulate the economy if the dollar is weak
Strong dollar
Stimulates imports and economic growth
Encourages capital flows into U.S. and lower interest rates

28. Global Effects on Monetary Policy
Transmission of interest rates
International flow of funds affected by Fed policy
Global capital and money markets are integrated
Capital flows to highest real, after-tax, exchange-rate adjusted rate of return
Financial integration improves with
Decreased governmental regulation in markets
Decreased transaction costs
Improved financial technology
Deficits or surpluses in the U.S. have global implications

29. Global Effects on Monetary Policy
Fed policy during the Asian crisis
Fed realizes the global economy is integrated
U.S. economic conditions affect other countries
Other countries economic conditions affect the U.S.
Fed reaction to Asian crisis shows possible complications that result from economic integration

30. Forecasting Money Supply
Watch weekly federal reserve data releases
Observe changes with announced fed ranges of money growth
Markets attempt to estimate changes in monetary policy direction and . . .
Anticipate interest rate changes

31. Global Effects on Monetary Policy
Exchange Rate Levels
International Funds Flow
Economic Activity of Foreign Countries