Chapter 26
Monetary Policy
• Key Concepts
• Summary
• Practice Quiz
• Internet Exercises
©2002 South-Western College Publishing
1
What are the three schools
of economic thought?
• Classical
• Keynesian
• Monetarist
2
What is the Keynesian
view of money?
People who hold cash or
checking account
balances incur an
opportunity cost in
foregone interest or profits
3
According to
Keynes, why would
people hold money?
• Transactions demand
• Precautionary demand
• Speculative demand
4
What is the
transactions demand
for money?
The stock of money people
hold to pay everyday
predictable expenses
5
What is the
precautionary demand
for money?
The stock of money
people hold to pay
unpredictable expenses
6
What is the speculative
demand for money?
The stock of money people
hold to take advantage of
expected future changes in
the price of bonds, stocks,
or other nonmoney
financial assets
7
How does a change in
interest rates affect
speculative demand?
As the interest rate falls,
the opportunity cost of
holding money falls, and
people increase their
speculative balances
8
What is the demand for
money curve?
A curve representing the
quantity of money that
people hold at different
possible interest rates,
ceteris paribus
9
How do interest
rates affect the
demand for money?
There is an inverse
relationship between the
quantity of money
demanded and the
interest rate
10
What gives the
demand for money a
downward slope?
The speculative
demand for money at
possible interest rates
11
What determines
interest rates in
the market?
The demand and
supply of money in the
loanable funds market
12
16%
12%
8%
Interest Rate
The Demand for Money Curve
A
B
4%
Billions of dollars
500
MD
1,000 1,500 2,000
13
Increase in the
quantity of money
demanded
Decrease in the
interest rate
14
The Equilibrium Interest Rate
12%
8%
MS
Interest Rate
16%
E
4%
Billions of dollars
500
Surplus
Shortage
MD
1,000 1,500 2,000
15
Bond prices fall
and the interest
rate rises
People sell
bonds
Excess
money
demand
16
Bond prices
rise and the
interest rate
falls
People buy
bonds
Excess
money
supply
17
Why do bond prices fall
as interest rates rise?
Bond sellers have to offer
higher returns (lower
price) to attract potential
bond buyers, or else they
will go elsewhere to get
higher interest returns
18
Why do bond prices rise
as interest rates fall?
Bond sellers are put in a
better bargaining position
as interest rates fall
(higher price); potential
buyers cannot go
elsewhere to get higher
interest returns so easily
19
How can the Fed
influence the
equilibrium
interest rate?
It can increase or decrease
the supply of money
20
16%
12%
8%
Interest Rate
Increase in the Money Supply
MS1 MS2 Surplus
E1
E2
MD
4%
Billions of dollars
500 1,000 1,500 2,000
21
16%
12%
8%
Interest Rate
Decrease in the Money Supply
MS2 MS1
Shortage
E2
E1
MD
4%
Billions of dollars
500 1,000 1,500 2,000
22
Decrease the
interest rate
Money surplus and
people buy bonds
Increase in the
money supply
23
Increase in the
interest rate
Money shortage and
people sell bonds
Decrease in the
money supply
24
In the Keynesian
Model, what do
changes in the money
supply affect?
Interest rates, which in
turn affect investment
spending, aggregate
demand, and real GDP,
employment, and prices
25
Change in
the money
supply
Keynesian Change in
Change in
interest
prices, real GDP, Policy
rates
& employment
Change in
the aggregate
demand curve
Change in
investment
26
16%
12%
8%
Interest Rate
Expansionary Monetary Policy
MS1 MS2 Surplus
E1
E2
MD
4%
Billions of dollars
500 1,000 1,500 2,000
27
16%
12%
8%
Interest Rate
Investment Demand Curve
A
B
I
4%
Billions of dollars
1,000 1,500
28
When will businesses
make an investment?
When the investment
projects for which the
expected rate of profit
equals or exceeds the
interest rate
29
155
150
Price Level
Product Market
AS
E2
E1
full employment
AD2
AD1
Billions of dollars
6.0
6.1
30
What is the Classical
economic view?
The economy is stable in
the long-run at full
employment
31
How did the
Classical
economists view the
role of money?
They believed in the
equation of exchange
32
What is the
equation of exchange?
An accounting number of
times per year a dollar
of the money supply is
spent on final goods and
services
33
What is the
velocity of money?
The average number of
times per year a dollar
of the money supply is
spent on final goods and
services
34
Money
Prices
MV = PQ
Velocity
Quantity
35
What is the
Monetarist Theory?
That changes in the
money supply directly
determine changes in
prices, real GDP, and
employment
36
Change in
the quantity
of money
Change in
Monetarist Change in
the money
prices, real GDP, Policy
supply
& employment
Change in
the aggregate
demand curve
37
What is the Quantity
Theory of Money?
The theory that changes in
the money supply are
directly related to
changes in the price level
38
What is the conclusion
of the Quantity Theory
of Money?
Any change in the money
supply must lead to a
proportional change in
the price level
39
Who are the
Modern Monetarists?
Monetarist argue that
velocity is not
unchanging, but is
nevertheless predictable
40
According to the
Monetarist, how do we
avoid inflation and
unemployment?
We must be sure that
the money supply is
at the proper level
41
Who is
Milton Friedman?
In the 1950’s and
1960’s, he was a leader
in putting forth the
ideas of the modernday monetarists
42
What does Milton
Friedman advocate?
The Federal Reserve
should increase the money
supply by a constant
percentage each year to
enhance full employment
and stable prices
43
How do the
Keynesians view the
velocity of money?
Over long periods of
time, it can be unstable
and unpredictable
44
The Velocity of Money
7
6
5
4
3
2
1
Year
40
50
60
70
80
90
00
45
What is the
conclusion of the
Keynesians?
A change in the money
supply can lead to a
much larger or smaller
change in GDP than the
monetarists would predict
46
What is the crux of the
Keynesian argument?
Because velocity is
unpredictable, a constant
money supply may not
support full employment
and stable prices
47
What is the conclusion of
the Keynesian argument?
The Federal Reserve must
be free to change the
money supply to offset
unexpected changes in
the velocity of money
48
What are the main
points of Classical
economics?
49
• Economy tends toward a full
employment equilibrium
• Prices & wages are flexible
• Velocity of money is stable
• Excess money causes inflation
• Short-run price & wage
adjustments cause
unemployment
• Monetary policy can change
aggregate demand & prices
• Fiscal policies are not necessary
50
What are the main
points of Keynesian
economics?
51
• The economy is unstable at less
than full employment
• Prices & wages are inflexible
• Velocity of money is stable
• Excess demand causes inflation
• Inadequate demand causes
unemployment
• Monetary policy can change
interest rates and level of GDP
• Fiscal policies may be necessary
52
What are the main
points of the
Monetarists?
53
• Economy tends toward a full
employment equilibrium
• Prices & wages are flexible
• Velocity of money is predictable
• Excess money causes inflation
• Short-run price & wage
adjustments cause
unemployment
• Monetary policy can change
aggregate demand & prices
• Fiscal policies are not necessary
54
What is the
crowding-out effect?
Too much government
borrowing can crowd
out consumers and
investors from the
loanable funds market
55
What is the
Keynesian view of the
crowding-out effect?
The investment demand
curve is rather steep
(vertical), so the
crowding-out effect is
insignificant
56
What is the
Monetarist view of the
crowding-out effect?
The investment demand
curve is flatter (horizontal),
so the crowding-out effect
is significant
57
Key Concepts
58
Key Concepts
• What are the three schools of economic
thought?
• What is the Keynesian view of money?
• How can the fed influence the equilibrium
interest rate?
• In the Keynesian model, what do changes
in the money supply effect?
• What is the Classical economic view?
59
Key Concepts cont.
• How did the Classical economists view the
role of money?
• What is the equation of exchange?
• What is the velocity of money?
• What is the quantity theory of money?
• What is the conclusion of the quantity
theory of money?
• Who are the modern monetarists?
60
Key Concepts cont.
• According to the monetarist, how do we
avoid inflation and unemployment?
• Who is Milton Friedman?
• What does Milton Friedman advocate?
• What is Classical economists?
• What is Keynesian economists?
• What is monetarism?
61
Summary
62
The demand for money in the
Keynesian view consists of three
reasons why people hold money:
(1) Transactions demand is money
held to pay for everyday predictable
expenses. (2) Precautionary
demand is money held to pay
unpredictable expenses. (3)
Speculative demand is money held
to take advantage of price changes
in nonmoney assets.
63
The demand for money curve
shows the quantity of money
people wish to hold at various rates
of interest. As the interest rate
rises, the quantity of money
demanded is less than when the
interest rate is lower.
64
16%
12%
8%
Interest Rate
The Demand for Money Curve
A
B
4%
Billions of dollars
500
MD
1,000 1,500 2,000
65
The equilibrium interest rate is
determined in the money market
by the intersection of the
demand for money and the
supply of money curves. The
money supply (M1), which is
determined by the Fed, is
represented by a vertical line.
66
An excess quantity of money
demanded causes households
and businesses to increase their
money balances by selling
bonds. This causes the price of
bonds to fall, thus driving up the
interest rate.
67
16%
12%
8%
Interest Rate
The Equilibrium Interest Rate
MS
E
4%
Billions of dollars
Surplus
Shortage
MD
500 1,000 1,500 2,000
68
An excess quantity of money
supplied causes households and
businesses to reduce their
money balances by purchasing
bonds. The effect is to cause the
price of bonds to rise, and,
thereby, the rate of interest falls.
69
The Keynesian view of the monetary
policy transmission mechanism
operates as follows: First, the Fed
uses its policy tools to change the
money supply. Second, changes in
the money supply change the
equilibrium interest rate, which
affects investment spending. Finally,
a change in investment changes
aggregate demand and determines
the level of prices, real GDP, and
employment.
70
Monetarism is the simpler view that
changes in monetary policy directly
change aggregate demand and
thereby prices, real GDP, and
employment. Thus, monetarists
focus on the money supply, rather
than on the rate of interest.
71
The equation of exchange is an
accounting identity that is the
foundation of monetarism. The
equation (MV = PQ) states that the
money supply multiplied by the
velocity of money is equal to the
price level multiplied by real output.
72
The velocity of money is the
number of times each dollar is
spent during a year. Keynesians
view velocity as volatile but
monetarists disagree.
73
The quantity theory of money is a
monetarist argument that the
velocity of money (V) and the output
(Q) variables in the equation of
exchange are relatively constant.
Given this assumption, changes in
the money supply yield proportionate
changes in the price level.
74
The monetarist solution to an inept
Fed tinkering with the money
supply and causing inflation or
recession would be to have the Fed
simply pick a rate of growth in the
money supply that is consistent
with real GDP growth and stick to it.
75
Monetarists’ and Keynesians’ views
on fiscal policy are also different.
Keynesians believe the aggregate
supply curve is relatively flat, and
monetarists view it as relatively
vertical. Because the crowding out
effect is large, monetarists assert
that fiscal policy is ineffective.
Keynesians argue that crowding
out is small and that fiscal policy is
effective.
76
END
77