Monetary Policy

1. Monetary Policy Monetary policy � changes in the money supply to achieve macroeconomic goals. The Fed increases (or decreases) the money supply primarily by buying (or selling) U.S. government securities in the open market. There are different theories about how changes in the money supply affect the economy.

2. Classical Monetary Theory Classical economists see a direct relationship between the money supply and the price level. Velocity of money (V) � the average number of times a dollar is spent annually. V = Nominal GDP � M See Example 1 on page 12-2.

3. The Equation of Exchange M x V = P x Q M is the money supply. V is the velocity of money. P is the price level. Q is Real GDP.

4. The Equation of Exchange M x V = P x Q Classical theory assumes that velocity is constant and that Real GDP is constant in the short run. Thus, there is a directly proportional relationship between the money supply and the price level. See Example 2A on page 12-2.

5. In the actual economy, velocity has not been constant. If velocity is not constant, there will not be a directly proportional relationship between the money supply and the price level. See Example 2B on page 12-3. The Equation of Exchange

6. Monetarism Monetarism is an economic theory based on classical theory, but with some differences. Monetarism holds that: 1. Velocity is not constant. 2. Changes in the money supply and/or in velocity can change AD. 3. Changes in AD will change both the price level and Real GDP in the short run.

7. Monetarism � Changes in AD

8. Classical � Changes in AD

9. Monetarism Monetarism assumes that the economy is self-regulating and automatically adjusts back to Natural Real GDP. Thus, like classical theory, monetarism holds that, in the long run, AD affects only the price level.

10. Keynesian Monetary Theory According to Keynesian theory, monetary policy can be used to change TE, in order to change Real GDP. Keynesian theory holds that changes in the money supply affect Real GDP indirectly, through a series of steps called the Keynesian monetary transmission mechanism.

11. Keynesian Monetary Transmission Mechanism 1. An increase in the money supply leads to 2. a decrease in interest rates, which leads to 3. an increase in investment, which leads to 4. an increase in TE, which leads to 5. an increase in Real GDP.

12. 1. Investment may be interest-insensitive. If investors are extremely pessimistic about future returns, they may be insensitive to a decrease in interest rates. See Example 4 on page 12-5. The Keynesian monetary transmission mechanism may fail because:

13. 2. The liquidity trap. The liquidity trap means that an increase in the money supply does not cause a decrease in interest rates. Interest rates will only fall so low. See Example 5 on page 12-6. The Keynesian monetary transmission mechanism may fail because:

14. Monetarist Transmission Mechanism The monetarist transmission mechanism is more direct: 1. An increase in the money supply means increased Total Expenditures and Real GDP. 2. A decrease in the money supply means decreased Total Expenditures and Real GDP.

15. Monetary Policy and Closing Gaps Monetary policy can be used to attempt to close a recessionary gap or an inflationary gap. Expansionary monetary policy (an increase in the money supply) would be used to close a recessionary gap. Contractionary monetary policy would be used to close an inflationary gap.

16. Keynesian Theory and the Proper Policies Keynesians support the use of both fiscal and monetary policy to move the economy toward Natural Real GDP. Keynesians put more confidence in fiscal policy than in monetary policy.

17. Monetarist Theory and the Proper Policies Monetarists are generally opposed to activist fiscal and monetary policies. Activist policies may have a destabilizing effect on the economy rather than a stabilizing effect. Monetarists favor an annually balanced budget for fiscal policy and a monetary rule for monetary policy.

18. Monetary Rule A monetary rule would link money supply growth to Real GDP growth in order to achieve a stable price level. See Example 6 on page 12-7.

19. The Great Depression No downturn in American history was as severe as the Great Depression. Between 1929 and 1933: a. Real GDP decreased by 27%. b. Investment spending collapsed. c. The CPI fell by 24%. d. The unemployment rate increased from 3.2% to 24.9%. See Example 8 on page 12-8.

20. Great Depression � Keynesian Explanation When investors became extremely pessimistic following the stock market crash of 1929, investment spending collapsed. The decrease in investment spending led to a multiplied decrease in Real GDP. The federal government failed to implement expansionary fiscal and monetary policy.

21. With the coming of World War II, the government�s fiscal and monetary policy became strongly expansionary. See Example 9 on page 12-9. Great Depression � Keynesian Explanation

22. Great Depression � Classical Explanation What began as a normal business downturn was turned into a collapse by two government policy mistakes: 1. The Fed allowed a decrease in the money supply which caused deflation and led to a collapse in investment spending. See Example 10 on page 12-9.

23. 2. The Smoot-Hawley Tariff led to retaliatory tariffs and a collapse in international trade. See the appendix at the end of Chapter 7. Great Depression � Classical Explanation

24. �The Age of Turbulence� In 2007, Alan Greenspan published �The Age of Turbulence: Adventures in a New World�. Greenspan�s tenure as Chairman of the Federal Reserve Board of Governors was marked by a number of historic events. See the list on page 12-10.

25. During Greenspan�s tenure as Fed Chairman, the economy enjoyed a remarkable run of economic stability , with only two mild recessions (in 1991 and 2001). The annual rate of inflation averaged only 3.1% from 1988 through 2005, after having averaged 6.5% from 1970 through 1987. �The Age of Turbulence�

26. Greenspan puts forth observations in the second half of the book. See the list on pages 12-10 and 12-11. �The Age of Turbulence�