Ch. 14: Monetary Policy
James R. Russell, Ph.D., Professor of Economics & Management, Oral Roberts University
©2005 Thomson Business & Professional Publishing, A Division of Thomson Learning
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The Money Market
The Demand for Money




Demand for Money (Balances):
represents the inverse relationship between
the quantity demanded of money balances
and the price of holding money balances.
The price of holding money balances is the
interest rate.
The interest rate is the opportunity cost of
holding money.
As the interest rate increases, the
opportunity cost of holding money
increases, and people choose to hold less.
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The Money Market
The Supply of Money
Perfectly Inelastic (Vertical).
 Determined largely by the Fed.
 Banks and the public are also
important players.

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Exhibit 1: The Demand for
and Supply of Money
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Equilibrium in The Money
Market
Occurs when quantity demanded
equals quantity supplied.
 No shortages (excess demand).
 No surpluses (excess supply).

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Exhibit 2: Equilibrium in
the Money Market
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Transmission Mechanism
The routes or channels
that ripple effects
created in the money
market travel to affect
the goods and services
market (represented by
the aggregate demand
and supply curves in
the AD-AS framework).
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The Keynesian
Transmission Mechanism




The Money Market
The Investment Goods Market
The Goods and Services Market (AD-AS
Framework)
Keynesian transmission mechanism:
– an increase in the money supply
– lowers the interest rate
– which causes investment to rise and the AD
curve to shift rightward
– Real GDP increases and the unemployment rate
drops.
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Exhibit 3: The Keynesian
Transmission Mechanism
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The Keynesian Mechanism
May Get Blocked


Interest-Insensitive Investment: other
factors involved in making investment
decisions.
Liquidity Trap:
– Horizontal portion of the demand curve
for money.
– Interest rates have become so low that
many believe they have bottomed or are
close to bottoming.
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Exhibit 4: Breaking the Link between the
Money Market and the Goods and
Services Market: Interest-Insensitive
Investment and the Liquidity Trap
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Bond Prices and Interest
Rates


The market interest rate is inversely related
to the price of existing bonds.
Consider the Liquidity Trap: the reason an
increase in the money supply does not
result in an excess supply of money at a low
interest rate is that individuals believe bond
prices are so high that an investment in
bonds is likely to turn out to be a bad deal.
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Exhibit 5: The Keynesian View of
Monetary Policy
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The Monetarist Transmission
Mechanism: Direct


Increase in the money supply
– increased Aggregate Demand
– increased Real GDP
– increased prices
– a decrease in unemployment.
A decrease in the money supply
– decreased Aggregate Demand
– decreased Real GDP
– decreased prices
– an increase in unemployment.
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Exhibit 6: The Monetarist
Transmission Mechanism
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Self-Test



Explain the inverse relationship between
bond prices and interest rates.
“According to the Keynesian transmission
mechanism, as the money supply rises,
there is a direct impact on the goods and
services market.” Do you agree or disagree
with this statement. Explain your answer.
Explain how the monetarist transmission
mechanism works when the money supply
rises.
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Exhibit 7: Monetary Policy and a
Recessionary Gap
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Exhibit 8: Monetary Policy and an
Inflationary Gap
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Monetary Policy and the
Activist–Nonactivist Debate


Activists: argue that monetary and fiscal
policies should be deliberately used to
smooth out the business cycle.
Nonactivists: argue against the
deliberate use of fiscal and monetary
policies. They believe in a permanent,
stable, rules-oriented monetary and fiscal
framework.
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The Case for Activist (or
Discretionary) Monetary Policy
1.
2.
3.
The economy does not always
equilibrate quickly enough at Natural
Real GDP.
Activist monetary policy works; it is
effective at smoothing out the
business cycle.
Activist monetary policy is flexible;
nonactivist (rules-based) monetary
policyis not.
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The Case for Nonactivist (or
rules-based) Monetary Policy
1.
2.
3.
In modern economies, wages and prices
are sufficiently flexible to allow the
economy to equilibrate at reasonable
speed at Natural Real GDP.
Activist monetary policies may not work
(Exhibit 9).
Activist monetary policies are likely to be
destabilizing rather than stabilizing; they
are likely to make matters worse rather
than better (Exhibit 10).
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Exhibit 9: Expansionary Monetary
Policy and No Change in Real
GDP
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Exhibit 10: Monetary Policy May
Destabilize the Economy
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Self-Test



Why are Keynesians more likely to advocate
expansionary monetary policy to eliminate a
recessionary gap than contractionary monetary
policy to eliminate an inflationary gap?
How might monetary policy destabilize the
economy?
If the economy is stuck in a recessionary gap,
does this make the case for activist monetary
policy stronger or weaker? Explain your
answer.
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Nonactivist Monetary (rules
–based) Proposals


Constant-Money-Growth-Rate Rule:
the annual money supply growth rate will
be constant at the average annual
growth rate of Real GDP.
Predetermined-Money-Growth-Rate
Rule: the annual growth rate in the
money supply will be equal to the
average annual growth rate in Real GDP
minus the growth rate in velocity.
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Middle-Ground Monetary
Proposals (Taylor Rule)


Monetary authorities should use a rule in
making discretionary decisions.
Federal funds rate target = inflation +
equilibrium real federal funds rate +
½(inflation gap) + ½ (output gap)
– Inflation: current inflation rate.
– Equilibrium real federal funds rate: nominal
federal funds rate adjusted for inflation
– Inflation gap: the difference between the actual
inflation rate and the target inflation rate
– Output gap: percentage difference between
actual Real GDP and its full-employment level. 26
Self-Test
Would a
monetary
rule produce
price
stability?
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Coming Up (Ch. 15):
Expectations Theory and the
Economy
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