Chapter 14
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Discuss Milton Friedman’s contribution to
modern economic thought.
Evaluate appropriately timed monetary policy
and its impacts on interest rates and
aggregate demand.
Distinguish appropriately timed from ill timed
policy and list its consequences.

1950s and 1960s: economists thought
monetary policy
◦ Could control inflation
◦ Could not stimulate AD
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Today: Most economists believe that
monetary policy impacts
◦ Output in the short run, but not the long run
◦ Prices in the short run and the long run
◦ Can be a source of economic instability
Every major contraction in this
country has been either produced by
monetary disorder or greatly
exacerbated by monetary disorder.
Every major inflation episode has
been produced by monetary
expansion.
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Demand for money balances is not the same
as the demand for wealth
Reasons to hold money
◦ Buy stuff now
◦ In case of emergency
◦ Buy stuff later
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Demand for money – Illustrates the
relationship between the interest rate and
quantity of money people want to hold
Downward sloping: the opportunity cost of
holding money is the nominal interest rate
Shifts right: when nominal GDP rises
Shifts left
◦ When nominal GDP falls
◦ As people use more electronic transactions
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The Fed controls the supply of money
through
◦
◦
◦
◦
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Reserve requirement
Open market operations (federal funds rate)
Discount-rate
Interest paid on excess reserves
Vertical: changes in the interest rate do not
impact the Fed’s ability to control the money
supply
Nominal Interest Rate
Money Supply
Equilibrium – the
quantity of money
demanded equals
the quantity
supplied
i1
Money Demand
Quantity of Money
Qs
When the Fed buys bonds
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◦
◦
◦
Supply of money increases
Supply of loanable funds increases
AD shifts right
Aggregate demand will increase because
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◦
◦
A lower interest rate makes current investment and
consumption cheaper
A lower interest rate causes financial assets to
move abroad, the dollar will depreciate, and net
exports will increase
A lower interest rate increases asset prices (stocks,
houses) which also increases investment and
consumption (aggregate demand)
Nominal Interest Rate
S1
S2
The fed buys bonds
to increase the
money supply and
the interest rate will
fall
i1
i2
Money Demand
Quantity of Money
Q1
Q2
Increases supply
of loanable funds
as banks make
more loans, real
interest rate falls
Real Interest Rate
S1
S2
r1
r2
D
Q1
Q2
Loanable Funds
Expansionary
Monetary policy
shifts AD right as
spending by
consumers and
businesses increases.
Price Level
SRAS1
P2
P1
AD2
AD1
Y1
Y2
In the short run
output increases
Goods and Services
(real GDP)
Price Level
LRAS1
SRAS1
P2
P1
If the economy was
initially at less than
full employment, no
further adjustments
take place
E2
e1
Y1 YF
AD2
AD1
Goods and Services
(real GDP)
Price Level
LRAS1
P3
P2
E2
P1
E1
SRAS2
SRAS1
If the economy was
initially at (or greater
than) full
employment, SRAS
shifts left and
inflation occurs
e2
AD2
AD1
YF
Y2
Goods and Services
(real GDP)
When the Fed sells bonds
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◦
◦
◦
Supply of money decreases
Supply of loanable funds decreases
AD shifts left
Aggregate demand will decrease because
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◦
◦
◦
A higher interest rate makes current investment
and consumption more expensive
A higher interest rate causes financial assets to
flow the U.S., the dollar will appreciate, and net
exports will fall
A higher interest rate decreases asset prices
(stocks, houses) which also decreases investment
and consumption (aggregate demand)
Nominal Interest Rate
S2
S1
i2
The fed sells bonds
to decrease the
money supply and
the interest rate will
rise
i1
Money Demand
Quantity of Money
Q2
Q1
Decreases supply
of loanable funds
as banks make
fewer loans, real
interest rate rises
Real Interest Rate
S2
S1
r2
r1
D
Q2
Q1
Loanable Funds
Restrictive Monetary
policy shifts AD left
as spending by
consumers and
businesses
decreases.
Price Level
SRAS1
P1
P2
AD1
AD2
Y2
Y1
In the short run
output decreases
Goods and Services
(real GDP)
Price Level
LRAS1
SRAS1
P1
If the economy was
initially at greater
than full
employment, no
further adjustments
take place
e1
P2
E2
AD2
YF
Y1
AD1
Goods and Services
(real GDP)
Price Level
LRAS1
SRAS1
P1
P2
If the economy was
initially at full
employment, the
policy will cause a
recession
E1
e2
AD1
AD2
Y2 YF
Eventually, self-correction will
occur as resource prices adjust
downward (this is not pictured)
Goods and Services
(real GDP)
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Timed correctly
◦ Will help mitigate a recession
◦ Will help control / prevent inflation
◦ Will lead to economic stability
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Timed incorrectly
◦ Will make a recession even worse
◦ Will lead to massive inflation
◦ Will lead to economic instability
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Quantity theory of money – a theory that says
a change in the money supply will cause a
proportional change in the price level
Velocity of money – average number of times
a dollar is use to purchase final goods and
services during a year
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P ~ price level
Y ~ real GDP
M ~ money supply
V ~ velocity of money
PY ~ nominal GDP
Equation of
Exchange
PY  MV
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Can be written in terms of growth rates
Rate of inflation + Growth rate of real output
=
Growth rate of money supply + Growth rate of velocity
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In the short-run, monetary policy will impact
real output and employment
◦ Expansionary will increase output
◦ Restriction will reduce output

In the long-run, expansionary monetary
policy will only lead to inflation
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Fed can easily change policy, but
After policy change
◦ 6 – 15 months to impact real output
◦ 12 – 30 months to impact price level and inflation
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Implementing monetary policy in a stabilizing
way is difficult
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Expansionary monetary policy cannot
promote long term economic growth
Economists have limited forecasting abilities
Price stability is a key to economic prosperity
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Explains the housing boom (2002-2006), bust
(2008) and subsequent slow recovery:
Austrians believe:
◦ Expansionary monetary policy pushes the interest
rate to an artificial low.
◦ The low interest rates will induce entrepreneurs to
undertake long-term investments. This will
generate an economic boom.
Austrians believe:
◦ But, the boom will be unsustainable because
savings are too low to purchase these new assets.
◦ The boom turns to bust and a large share of the
newly constructed assets end up unoccupied.
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Austrian economists refer to this as
malinvestment.
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Monetary policy variable over the past decade
Likely to increase economic instability
Hard for monetary policy-makers to institute stopgo policy in a stabilizing manner



Discuss Milton Friedman’s contribution to
modern economic thought.
Evaluate appropriately timed monetary policy
and its impacts on interest rates and
aggregate demand.
Distinguish appropriately timed from ill timed
policy and list its consequences.