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1. State the goals of monetary policy.
2. Explain the significance of the money market and the motives for holding money.
3. Recite the equation of exchange and its role in the conduct of monetary policy.
4. Discuss the monetarist school of thought and its implications for monetary policy.
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5. Interpret the relationship between monetary policy and interest rates.
6. (E&A) Address the importance of central banks staying independent of political pressures.
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The Federal Reserve Act of 1913 established the Fed and it was viewed at that time to be a lender of last resort for troubled banks.
Today, the Fed’s role has expanded greatly.
The 1977 amendment to the act spells out the objective of monetary policy as..
“ to promote effectively the goals of maximum employment, stable prices, and moderate longterm interest rates.”
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Federal Reserve monetary policy encompasses three macro goals.
High employment
Low inflation (price stability)
Economic growth
Many economist argue that price stability should be the Fed’s primary goal.
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12
10
8
6
4
2
0
1961 1962 1963 1964 1965 1966 1967 1968 1969
Year
Growth Rate in GDP Inflation Rate
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There are sometimes conflicts and/or tradeoffs involved in pursuing a particular monetary policy.
Bringing down inflation can lead to high higher interest rates and unemployment.
The Fed develops monetary policy surrounded by a whirlpool of considerations.
Debates over appropriate Fed policy can be intense.
Unemployment and inflation exact a toll in human suffering.
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•
There are two monetary policy instruments that the Fed can influence as part of monetary policy.
– By increasing or decreasing the growth rate of the money supply the Fed can attempt to stimulate or slow down the economy.
–
The Fed can also manipulate short-term interest rates to stimulate or slow down the economy
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To maintain full employment, the quantity of money must rise to keep pace with the economy’s productive potential.
The Fed strongly influences the money supply buy conducting open market operation, changing the discount rate, and changing the reserve requirement.
An overwhelming amount of evidence shows excessive growth in the money supply to be the root cause of inflation.
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
The quantity of money affects aggregate demand.

An increase in the money supply is associated with expansionary monetary policy (looser monetary policy).

An increase in the money supply shifts aggregate demand to the right, thus allowing more aggregate output to be purchased at each possible price level.
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Price level
Aggregate demand
A larger money supply shifts aggregate demand because it allows more to be purchased at each price level.
Same price level
More purchasing power
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Real GDP
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
A contractionary monetary policy would have the effect of drying up liquidity and tightening up the economy’s purse strings, and is thus called a tighter monetary policy.

The effect of tighter monetary policy would be just the opposite of the expansionary policy shown in the previous figure.
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
The demand for money is the quantities of money that people would prefer to hold at various nominal interest rates, ceteris paribus.

The nominal interest reflects the opportunity cost of holding money.

Three motives make people willing to pay the price of holding money.

The transactions motive.

The precautionary motive.

The speculative motive.
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
The transactions motive: money is held because of the everyday need to buy goods and services.

The precautionary motive: unforeseen circumstances motivate people to hold more money than called for by their transactions demands.

The speculative motive: People may speculate with some of their money in the sense that they prefer to hold money rather than invest it when financial investments seem unattractive.
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Nominal interest rates
When the interest rate falls, money holdings rise.
Lower interest rates
More money holdings
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Money holdings
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
The money market is characterized by demand and supply.

The money supply curve is drawn as a vertical line because we are assuming that this is the quantity of money supplied to the economy by the Fed.

A vertical money supply curve implies that the money supply is independent of the interest rate.

The intersection of demand and supply establishes the money market equilibrium.
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Nominal interest rates
Too high
Excess supply
Money supply
Money market equilibrium
Equilibrium
Interest rate
Too low
Money demand
Excess demand
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Money holdings
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
The market interest rate will adjust to the equilibrium interest rate.

A market interest rate that is above the equilibrium interest rate will fall until the equilibrium interest rate is reached.

A market interest rate that is below the equilibrium interest rate will rise until the equilibrium interest rate is reached.

The key to understanding interest rate changes is to realize that money, bonds, and other investments are substitutes for each other.
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If the interest is
(1) At equilibrium
(2) Above equilibrium
(3) Below equilibrium
Quantity of money demanded is
Quantity of money paying asset demand is
Equal to
Qs of money
Less than
Qs of money
Greater than Qs of money
Equal to Qs of interest paying assets
Greater than the Qs of interest paying assets
Less the Qs of interest paying assets
Public’s
Response
No change in holdings of money or bonds
Increase the holdings of bonds and decrease the holdings of money
Decrease holdings of bonds and increase holdings of money
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Interest Rate response to
Public’s Action
Interest rate decreases
Interest rate decrease
Interest rate increases
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
The Fed maintains confidentiality when it comes to what economic variables determine monetary.

Transcripts of meetings of the Federal Open
Market Committee are not released to the public until five years after those meetings take place.

In recent years observers have speculated that the
Fed has followed price rule by which it conducts monetary policy with the aim of keeping price increases among certain basic commodities within a low range.
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o The equation of exchange reveals that the amount of money people spend must equal the market value of what they purchase…
M x V = P x Q
M = Qs
V= velocity of money, which is the average
Number of times money
Changes hands in a year.
Price index
Aggregate out of goods and services
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•
The total amount of spending in an economy is equivalent to the economy’s nominal GDP.
•
Thus the equation of exchange says that aggregate spending on the left side of the equation, equals nominal GDP on the right side.
•
Because the value of what is bought is always equal to value of what is sold, the equation of exchange is always true.
M x V [total spending] = P x Q [nominal GDP]
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The equation of exchange forms the basis of the quantity theory of money.
The quantity theory assumes…
The velocity of money is independent of the quantity of money in the long run. V , in the equation is a constant value.
Aggregate output, Q , is also independent of the quantity of money in the long run. Q, in the equation can also be treated as a constant.
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Price level
Higher price level
Aggregate supply
The aggregate demand curve moves higher in response to a money supply increase.
Aggregate
Demand
Full employment
GDP
Real GDP
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Monetarism is a school of thought associated with Nobel-winning economist
Milton Freidman (1912-).
Monetarist readily agree with the original quantity theory.
However, unlike the original quantity theory, monetarism acknowledges the existence of the short-run.
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According to the monetarist view, the quantity of money may indeed affect velocity and aggregate output in the short run.
Neither V nor Q in the equation of exchange is viewed as constant by monetarist.
A reduction in the growth rate of the money supply may cause a reduction in aggregate output, Q .
The velocity of money can change because of changes in people’s need to hold money,
V .
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Expansionary (Looser) Monetary Policy
Increase in the quantity of Money Increased aggregate spending
Increased nominal GDP
Contractionary (Tighter) Monetary Policy
Decrease in the quantity of Money Increased aggregate spending
Increased nominal GDP
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Year Velocity
1979 1.742
1980 1.748
1981 1.784
1982 1.706
1983 1.662
1984 1.703
1985 1.688
1986 1.630
1987 1.675
Year Velocity
1988 1.706
1989 1.738
1990 1.771
1991 1.773
1992 1.842
1993 1.907
1994 2.017
1995 2.033
1996 2.05
Year Velocity
1997
1998
1999
2000
2001
2.06
2.00
1.99
2.00
1.87
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2.5
2
1.5
1
0.5
0
1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001
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To avoid the recession that could result from too little money, or the inflation that could result from too much money, the monetarist policy recommendation is for the Fed to increase the money supply at a steady rate, equal to or slightly greater than the long-run growth rate in aggregate output.
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
Monetarist recommend growth in the Money supply that just matched the growth in longrun aggregate supply.

To monitor the Fed, the monetarist have established a Shadow Open Market Committee.

The Fed controls the money base.

Consumer pessimism or optimism about the economy can greatly effect the money multiplier, which relates the monetary base to the money supply.
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
There are a number of possible difficulties the Fed could face in designing an effective monetary policy.
 Large unpredictable shifts in the demand for money.

Interest rate insensitivity among consumers and business.

An unresponsive interest rate caused by a liquidity trap.

Lags in the effects of monetary policy

Differential effects of monetary policy.
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Expansionary (Looser) Monetary Policy
Increase in the quantity of Money
Increased borrowing
Lower interest rates
Increased aggregate spending
Increased nominal GDP
Contractionary (Tighter) Monetary Policy
Decrease in the quantity of Money
Decreased borrowing
Higher interest rates
Decreased aggregate spending
Decreased nominal GDP
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THE FEDERAL FUNDS RATE AND
MARKET INTEREST RATES
Fed Action Bank Reserves
Federal Funds
Rate
Short-term
Interest Rates
Open Market sale of securities to banks
Open market purchase of securities from banks
Decrease (reserves go to the Fed to pay for securities)
Increases, as reserves leave the banking system
Increase (reserves are received from the Fed in payment for securities
Decreases, as reserves are pumped into the banking system
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Increase
Decrease
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How Independent Should a Central Bank be?
o The Fed is relatively independent from political interference from the President and Congress.
o The Fed board members serve 14 year non-renewable terms.
o The Fed funds itself with interest earned on loans to banks and on holdings of treasury securities.
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 expansionary monetary policy
 contractionary monetary policy
 monetary policy instruments
 demand for money
 transactions motive
 precautionary motive
 speculative motive
 money market
 price rule
 equation of exchange
 velocity of money
 quantity theory of money
 monetarism
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1.
Conflicts in meeting the goals of Fed policymaking a.
never occur.
b.
occur, but are ignored by the Fed.
c.
occur, and are considered by the Fed in choosing monetary policy actions.
d.
occur only when the President and Congress disagree about the proper course of monetary policy.
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2.
The demand for money represents the quantities of money that people want to hold a. for transaction purposes only.
b. at different income levels.
c. at various interest rates.
d. at banks.
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3. The speculative demand for money occurs because a. people want to make purchases.
b. of the need to save for a rainy day.
c. money that is stolen must be replaced.
d. sometimes investments are not attractive to people and so they hold money instead.
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4. The equation of exchange says that the quantity of money multiplied by
_____________ equals total spending.
a. the price level.
b. velocity.
c. GDP.
d. the equilibrium interest rate.
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5. The quantity theory of money assumes that aggregate output is a. never at the full-employment level.
b. always at the full-employment level.
c. equal to one minus velocity.
d. unpredictable and unexplainable.
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6. Monetarism recommends that monetary policy a. focus on low interest rates.
b. focus on the stock market, aiming to increase stock prices.
c. expand the money supply at a steady rate.
d. be turned over to Congress.
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The End!
Next Chapter 15
“Into The
International
Marketplace”
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