MONETARY THEORY AND POLICY
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Monitoring Indicators of Economic Growth:
The Fed monitors indicators of economic growth:
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
GDP - measures the total value of goods and services
produced during a specific period

National Income - the total income earned by firms and
individual employees during a specific period

Unemployment rate - maintain a low of unemployment
rate in the U.S.

Other indexes - Industrial production index, a retail sales
index, and a home sales index
Monitoring Indicators of Economic Growth
Indexes of Economic Indicators include:
 Leading economic indicators which predict future
economic activity.
 Coincident economic indicators which tend to reach their
peaks and troughs at the same time as business cycles.
 Lagging economic indicators which tend to rise or fall a
few months after business-cycle expansions and
contractions.
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Monitoring Indicators of Inflation
a. Producer and consumer price indexes: Producer price index
represents prices at the wholesale level, and the consumer price
index represents prices paid by consumers (retail level).
b. Other inflation indicators
i. Wage rates are periodically reported in various regions.
ii. Oil prices can signal future inflation because they affect the
costs of some forms of production as well as transportation
costs and the prices paid by consumers for gasoline.
iii. The price of gold is closely monitored because gold prices
tend to move in tandem with inflation.
iv. In some cases, indicators of economic growth are also used
to indicate inflation.
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
Pure Keynesian Theory
1. Money demand inversely related to interest rate
2. Interest rates directly related to the money supply
3.Capital investment directly related to Money supply
4.Role of government is to
a. Adjust the money supply
b.Provide demand when economy is contracting
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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
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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
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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
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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
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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
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3.
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Transmission of Interest Rates

Global interest rates will vary between countries.

Countries with higher rates will attract investors from
countries with lower rates.

If investors leave due to U.S. falling rates, the Fed may believe
it should act to prevent rates from falling lower.

Given the international integration in money and capital
markets, a government’s budget deficit can affect interest
rates of various countries, referred to as global crowding out.
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1.
In the spring of 2010, Greece experienced a weak economy
and a large budget deficit.
2. Creditors were less willing to lend the Greece government
funds because they feared that the government may be
unable to repay the loans.
3. The European Central Bank (ECB) used a more stimulative
monetary policy in a failed attempt to ease concerns about
the Greek crisis, which also ended up raising other concerns
about potential inflation in the eurozone.
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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
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How do Keynesians treat the supply of money?
How do Monetarists treat the supply of money?
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? How effective are supply or demand solutions to
the current economic recession?
Q&A: 1, 2,6,11,16, Interpreting: a, b, c
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