| UNIT FIVE |
CHAPTER 14
Monetary Policy
I. Impact
of Monetary Policy
A.
Evolution of Modern View
1.
Keynesian View: Dominated during the 1950s and 1960s, Keynesians argued
that money supply does not matter much.
2.
Monetarists Challenged Keynesian view during 1960s and 1970s. According
to monetarist, changes in the money supply are the cause of both inflation and
economic instability
3.
Modern view emerged from this debate: While minor
disagreements remain, both modern Keynesians and monetarists agree that
monetary policy exerts an important impact on the economy.
B.
Demand and Supply of Money
1.
The quantity of money people want to hold is inversely related to the
money rate of interest, because higher interest rates make it more costly to
hold money instead of interest-earnings assets like bonds.
2.
The supply of money is vertical because it is determined by the
Fed.
3.
Equilibrium: The money interest rate will gravitate toward the rate where
the quantity of money people want to hold is just equal to the stock of money
the Fed has supplied.
C.
Transmission of Monetary Policy
1.
The impact of a shift in monetary policy is generally transmitted through
interest rates, exchange rates, and asset prices.
2.
Shift to a more expansionary monetary policy—Fed generally buys bonds,
which will both increase bond prices and create additional bank reserves,
placing downward pressure on real interest rates. As a result, an unanticipated
shift to a more expansionary policy will stimulate aggregate demand and
thereby increase output and employment.
3.
Shift to a more restrictive monetary policy—Fed sells bonds, which will
depress bond prices and drain reserves from the banking system. An unanticipated
shift to a more restrictive monetary policy will increase real interest rates
and reduce aggregate demand, output, and employment in the short run.
D.
Proper Timing
1.
Proper timing of monetary policy is not an easy task.
2.
While the Fed can institute policy changes rapidly, there may be a
substantial time lag before the change will exert a significant impact on AD.
II.
Monetary Policy in the Long Run
A. The Quantity
Theory of Money: MV=PY
1.
If V (velocity) and Y (output) are constant, an increase in M (money
supply) would lead to a proportional increase in P (price level).
B.
Long-Run Implications of Modern Analysis
1.
In the long run, the primary impact will be on prices rather than on real
output.
2.
When expansionary monetary policy leads to rising prices, decision makers
eventually anticipate the higher inflation rate and build it into their choices.
As this happens, money interest rates, wages, and incomes will reflect the
expectation of inflation, so real interest rates, wages, and output will return
to their long‑run normal levels.
III.
Monetary Policy When Effects Are Anticipated
A.
When the effects are anticipated prior to their occurrence, the
short‑run impact of an increase in the money supply is similar to its
impact in the long run.
B.
Nominal prices and interest rates rise, but real output remains
unchanged.
IV.
Interest Rates and Monetary Policy
A.
While the Fed can strongly influence short-term interest rates, its
impact on long-term rates is much more limited.
B.
Interest rates can be a misleading indicator of monetary policy.
In the long run, expansionary monetary policy leads to inflation and high
interest rates, rather than low interest rates.
Similarly, restrictive monetary policy when pursued over a lengthy time
period leads to low inflation and low interest rates.
V.
Effects of Monetary Policy: Summary
A. An
unanticipated shift to a more expansionary (restrictive) monetary policy will
temporarily stimulate (retard) output and employment.
B. The stabilizing
effects of a change in monetary policy are dependent upon the state of the
economy when the effects of the policy change are observed.
C.
Persistent growth of the money supply at a rapid rate will cause
inflation.
D.
Money interest rates and the inflation rate will be directly related.
