ECONOMICS U$A
Episode 13

MONETARY POLICY

PURPOSE:
To discuss the relationship between the money supply and economic growth and inflation, and to illustrate some of the reason why choosing the correct monetary policy is so difficult.

OBJECTIVES:
1. Interest rates are affected by the supply and demand for money. The money supply is largely controlled by the Federal Reserve. The demand for money is affected by the level of GNP (transactions demand) and the level of interest rates.

2. High interest rates can be due to either an increase in th dmand for money or a decrease in the supply of money. Therefore, it is not always possible to determine the proper monetary policy by simply following a money supply rule.

3. The quantity of money necessary to support a given level of GNP can change from year to year. Therefore, it is not always possible to determine the proper monetary policy by simply following a money supply rule.

4. The debate between Keynesians and Monetarists has centered on how money affects the economy and whether the Fed should try to target the growth in the money supply or the level of interest rates.

KEY ECONOMIC CONCEPTS:
demand for money,
income velocity of money,
accommodative monetary policy, interest rate versus monetary aggregates targets,
interest sensitivity of investment, housing and consumer durables

Contemporary Issues Monetary Policy

In recent years, the Fed has come under severe criticism for not taking pre-emptive action to prevent the stock market bubble of the late 1990s. Does the Fed’s charter include – either explicitly or implicitly – the mandate to control movements in the stock market or other asset markets? Do rising stock prices have an impact on economic behavior – specifically economic growth and inflation? If so, how successful might the Fed be in controlling the movements in the stock market?

For a complete transcript of this video program download TVpdf#13

Velocity: The Speed of Money
The Federal Reserve Board is responsible for deciding how much money the economy needs to grow. In times of inflation, the Fed tightened the money supply to squeeze excess dollars out of the economy. In times of recession, it increased the money supply to stimulate growth. In 1975, the Fed, under the Chairmanship of Arthur Burns faced a new and troubling dilemma—how to keep the economy on course with persistent inflation and the growing recession.
The Fed during this time stuck to a policy of keeping money tight to combat inflation, which had risen to a staggering 12%. But the Fed’s actions began to have a negative effect when unemployment started to rise in late 1974. Unemployment was the worst since the Great Depression. The pressure was on Washington to act. The Congressional Banking Committees and other representatives began to pressure Fed Chairman Arthur Burns and the Fed to relent and allow the money supply to grow more rapidly.
According to Burns he did not open up the spigot and permit the money supply to increase rapidly because he believed it would not be helping significantly to relieve unemployment and it would be releasing forces that could accelerate dangerous inflation. Burns correctly predicted that the modest easing the Fed had permitted would be sufficient to stimulate the economy, due to an increase in the velocity, or turnover of money.

Comment and Analysis by Richard Gill
Income velocity tells us how many times a year a dollar circulates through the economy to buy final goods and service. Congressional critics were saying that the economy needed a bigger increase in currency to get a bigger increase in quantity of goods produced (jobs, output, employment). Burns was saying that you could get this bigger increase in the quantity of goods without such a large increase in the money supply because velocity would also be going up.
Targeting the Money Supply
By the late 1970’s inflation had taken over again, and there was a widespread feeling that the Fed had to exercise restraint on the economy. Up until this period most economists felt that the best way to cool inflation was to raise interest rates, keeping the price of money high. That would slow down business investment and spending and put inflation back in the box. But others felt it was best to work on the money supply directly and to focus on the long run rather than the short-run.
The Fed was facing enormous criticism, much of it coming from a group of economist called Monetarists.
Paul Volcker, Chairman of the Fed, announced that the Fed would no longer target interest rates, but would focus instead on targeting the money supply itself, restraining it until inflation was broken. The major change in monetary policy was a difference in targeting the money supply.
By the year end, interest rates rose dramatically. Small businessman felt the squeeze. By 1982, the economy had fallen into the deepest recession since the Great Depression. Finally, late in the year, the Fed saw inflation drop substantially and eased the money supply.
Focusing on the money supply appears to have worked but the cost was high. Chronic inflation, which had plagued the economy for more than a decade, was reduced and contained, but at the price of forcing the economy through two deep recessions.

Comment and Analysis by Richard Gill
The Feds were willing to pay the price of keeping the monetary supply tight and forcing the country through two recessions because they saw no alternative. They felt they couldn’t avoid short term difficulties in the economy. The focus was on the long run to eliminate inflation over a period of years.
Greenspan and Wall Street
Alan Greenspan took over as Chairman of the Fed in 1987. His first action was to reaffirm Volcker’s tight money policy. He saw the stock market fall to 508 points more than five times greater than the 1929 drop which precipitated the Great Depression.
The Fed was worried that people had borrowed a lot to finance purchasing stock as the stock market rose. As it crashed a lot of those loans were called in. The Fed was worried that there would be a lot of bankruptcies and a lot of people would be laid off. The unemployment rate would rise, causing a full-scale recession or even a depression.
In 1929, the Fed tightened the money supply. This time Alan Greenspan did the opposite. The end result was that Wall Street bounced back to the largest rally in big Boards history.
Monetary policy was also an effective factor in holding down inflation in the booming '90,. including limiting the damage done by the Russian debt default of 1998 and the terrorist attack of September 11th 2001. In both instances the Fed flooded the banking system with liquidity to make sure U.S. financial markets did not freeze up.
Comment and Analysis by Richard Gill
There are times when human judgement and discretion are crucial. Theories of long run steadiness gave way immediately to an appreciation of crisis in 1987. If the banking system needed more resources then the Federal Reserve, under the leadership of Chairman Alan Greenspan would provide it. It was clearly a notice to all that when it came to establishing monetary policy, it was better to leave the immediate decisions in the hands of those men and women best equipped to make them.