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Monetary Policy

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

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Monetary Policy

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  1. 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 Rate MS 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 moneysupply 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. Product Market AS E2 155 Price Level E1 AD2 150 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 theequation 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 thevelocity 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 theMonetarist Theory? That changes in the money supply directly determine changes in prices, real GDP, and employment

  38. Change in the quantityof 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 theModern 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 isMilton 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 5 GDP/M1 4 3 2 1 Year 60 40 70 80 90 00 50

  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?

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