CHAPTER 5
MONETARY THEORY AND POLICY
Dr. David P. Echevarria
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1
[Keynesian] Model of Money and Interest Rates
P
(i)
M-supply
M-Demand
Q
Dr. David P. Echevarria
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2
MONETARY THEORY
• Pure Keynesian Theory
1.Money demand inversely related to interest rate (More
money demanded as rates go down)
2.Interest rates directly related to the money supply (As
interest rates rise, more money is supplied)
3.Capital investment directly related to Money supply ( and
inversely to interest rates)
4.Role of government is to
a.Adjust the money supply (to lower interest rates)
b.Provide public demand (for capital goods) when private demand
is absent.
Dr. David P. Echevarria
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3
MONETARY THEORY
B. Quantity Theory of Money: Monetarist
Approach
1.Money supply and economic activity directly related.
2.Key variable is the velocity of exchange: MV = PQ.
a.As households hold more money, velocity decreases.
b.Variables affecting the amount of money held; frequency of
receipts, credit.
3.Increases in Money supply leads to an increase in output.
4.Monetarists favor steady gradual increases in money
supply
Dr. David P. Echevarria
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MONETARY THEORY
C.
Theory of Rational Expectations
1.Households use historical experience to adjust behavior ahead of
government policy
2.Changes in government policy unlikely to achieve desired effects
D.
Integrating Monetary Theories
1.Congress appears trapped in Keynesian policy initiatives
2.Federal Reserve appears to be attempting to minimize effects of government
policy
Dr. David P. Echevarria
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RELATIONSHIP OF MONEY SUPPLY
AND ECONOMY
• Decline in real growth of money supply tends to lead recessions
• Increase in real growth tends to accompany recoveries
• What is not evident: effects of expansionary fiscal policy…
1.Timing of results
2.Magnitude
Dr. David P. Echevarria
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RELATIONSHIP OF MONEY SUPPLY
AND ECONOMY
D. The lag between changes in Money supply and
changes in output
E. Trade-Off Faced By the Fed
1.The Phillips Curve
a.Increases in wages directly related to unemployment.
b.Government policies to reduce unemployment ends up creating
more
2.The Policy Paradox
a.Fighting inflation results in increased unemployment
b.Easy money reduces unemployment but spurs inflationary
pressures
c.Changes in technology creates additional pressures
Dr. David P. Echevarria
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INTEGRATING MONETARY AND
FISCAL POLICY
• Managing Money supply and economic growth
• Assessing the role of government and regulation of the market place
1.Determining minimum necessary to maintain viable economy
2.Determining the maximum level of involvement in recovery
3.Government Fiscal Policy and Fed Accommodation - monetizing the debt
Dr. David P. Echevarria
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8
INTERNATIONAL CONSIDERATIONS OF
MONETARY POLICY
• Assessing impact of global economy on US economic growth
• Adam Smith's international trade imperative
1.Is trade free?
2.If not, what is the cost?
• Role of the US Dollar as official reserve currency
Dr. David P. Echevarria
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HOMEWORK QUESTIONS
• How do Keynesians treat the supply of money?
• How do Monetarists treat the supply of money?
• Why is velocity important?
• What does the Theory of Rational Expectations say
about the effectiveness of government policy
initiatives?
• What policy tools can the Federal Reserve use to
control inflation?
Dr. David P. Echevarria
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