The Fed manages Inter-bank Interest Rates and Regulates Banks…but does it control money supply?

The Federal Reserve has a dual mandate to:Maintain stable prices (fight inflation/deflation)Maintain full employment (monetary policy to manage macroeconomic conditions)

The Fed manages Inter-bank Interest Rates and Regulates Banks…but does it control money supply?

Monetary Policy "Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output... A steady rate of monetary growth at a moderate level can provide a framework under which a country can have little inflation and much growth. It will not produce perfect stability; it will not produce heaven on earth; but it can make an important contribution to a stable economic society." --Milton Friedman The Bank [of Canada] gave it a college try, it really did. It just doesn't work that way. --John Crow, former governor of the Bank of Canada, on implementing Friedman's theories;

What Is Monetary Policy? • Central bank (as representative of government) manipulation of the • money supply, • interest rates • credit conditions with an objective of achieving macroeconomic goals.

Monetarist Theory History – The Classical School Strikes Back at Keynesianism

Three Theories of Monetary Policy • Strict Monetarist • Neo-classical/New Keynesian • Modern Monetary Theory (MMT)

Equation of Exchange • M x V = P x Y • M: money supply • V: Velocity • (how fast money is spent) • P: Price Level • Y: Real Income • Note: sometimes shown as M * V = P * Q same concept, different notation • Identity: Must be true for any period of time

Both Monetarist and Neo-Classical/New Keynesian Theories: • Trade-off between unemployment and inflation exists • Controlling Inflation is higher priority

Money supply concept: (Classical or Milton Friedman Monetarist version) Money supply is ‘exogenous’ • more bank reserves —> • more lending by banks –> • increased money supply –> • lower interest rates –> • borrowing by consumers/firms –> • more C and I spending –> • faster GDP growth & inflation

Interest rates concept: (Neoclassical version) • central bank open market purchases of bonds –> • higher bond prices = lower interest rates –> • more borrowing by consumers/firms –> • more spending on C and I –> • faster GDP growth –>

But, the Equation of Exchange • M x V = P x Y • M: money supply • V: Velocity (how fast money is spent) • P: Price Level • Y: Real Income • Note: sometimes shown as M V = P Q • same concept, different notation • Equation of Exchanges is an Identity: Must be true for any period of time after the fact..

Quantity theory of money (QTM): • Based on equation of exchange with added assumptions about the behavior of variables. • assume V is constant • Conclusions: • Money supply growth is solely responsible for determining Inflation

‘Crowding Out’ Theory • Assumptions: • Fixed amount of money in economy • QTM holds true • Theory: Gov borrowing takes $ away/raises interest rate for firm and household borrowers –> will reduce C and I unless • Central Bank increases M to fund deficit  inflation • Absolutely not supported by evidence or data in modern real world.

Current Neoclassical and New Keynesian Views on monetary policy • Support for ad hoc policy (policy makers should make it up as they go)

Modern Monetary Theory (MMT) • Money growth (M1 – bank credit) is largely endogenous • Key is base money growth, not M1 • government deficits enable the private sector (firms and households) to grow and yet still accumulate net financial assets

MMT Foundation: Fiat money system with floating exchange rates eliminates government budget constraint • Deficits effective in fighting unemployment • no financing constraint on deficits • deficits are limited by the availability of real, unemployed resources for the government to purchase • Inflation threat is at/near full employment is reached (AD- LRAS model)

Limitations of Monetary Policy: ‘Pushing on string’ • Central bank cannot force banks to make loans

Limitations of Monetary Policy: Endogenous money supply • Banks, not central bank really determine supply of money and credit

Limitations of Monetary Policy: Fiscal Policy Coordination • Fiscal and Monetary policy could work at cross-purposes • could expect ‘other’ to do it

Limitations of Monetary Policy: Liquidity trap • At ‘zero lower bound’ • when interest rates approach zero but the economy is still weak, monetary policy is largely ineffective.

Limitations of Monetary Policy: Globalization • If interest rates too low or inflation too high, then value of currency drops –> capital inflow drops and M drops, even though X rises

The Fed manages Inter-bank Interest Rates and Regulates Banks…but does it control money supply?