CHAPTER 27: The Role of Monetary Policy
FOCUS OF THE CHAPTER
This chapter begins with a brief introduction to monetarism and Keynesianism. The
adaptive expectations and rational expectations theories of inflation are discussed.
Short-run and long-run Phillips curves are used to explain the relationship between the
monetary and real sides of the economy. The link between inflation and money stock is
analyzed, as described in the quantity theory of money and the real bills doctrine. The
chapter ends with a discussion of the link between financial development and economic
growth.
Learning Objectives:





Define monetarism and main competing theories of monetary thought
Explain what the Phillips curve represents
Describe the role played by inflation expectations and how they are measured
Determine why there is inconsistency in optimal monetary policy
Explain the roles played by quantity theory and the real bills doctrine in
understanding the influence of monetary policy and what they predict.
 List the channels of monetary transmission mechanism, and discuss what we can
learn from them and why they are varied
 Determine whether monetary policy contributes to economic growth
SECTION SUMMARIES
Why Economists Disagree
Disagreements among economists arise for various reasons, such as differences in focus,
emphasis, and ideology. The issue as to whether the monetary sector influences the real
sector in the economy has produced one of the best-known disagreements between
"monetarists" and Keynesians. However, disagreements about the desirability of low
inflation and the design of monetary policies required to guarantee such an outcome have
narrowed considerably in the recent past.
Monetarism and Competitive Theories
"Classical economics" dominated the science of economics from the late 18th century to
the 1930s. The classical economists believed that the free-market economy is a selfcorrecting mechanism, and that demand and supply forces, free of government
intervention, would ensure full employment and economic growth. They argued against
Page 1 of 8
Copyright © 2004 McGraw-Hill Ryerson Limited
active government intervention in the economy. According to their view, changes in the
money supply directly influence only prices (not output level or employment level).
During the period between the 1930s and the 1970s, Keynesians, who argued in
favour of active government intervention in the economy through regulation and fiscal
policy, dominated the debate. Since the 1970s, monetarists seem to have been
dominating the science of economics. They believe that: a) money is neutral in the long
run; b) the price level and inflation are monetary phenomena; and c) business cycles are
caused by monetary policy. Monetarism was succeeded in popularity by the new
classical economics.
The Neutrality of Money
The neutrality of money is the theory that changes in money (or in monetary policy)
cannot affect the level of employment or output in the long run. According to this view,
the Phillips curve (which shows the relationship between the rate of inflation and the
unemployment rate) is vertical in the long run. A trade-off between the rate of inflation
and the rate of unemployment exists only in the short run (i.e., the short-run Phillips
curve is downward-sloping). Therefore, the unemployment rate can be moved from its
long-run value only in the short run.
Expectations of Inflation in the Short Run: Theories about how individuals form
expectations about future inflation are discussed in this section.
Adaptive Expectations: According to the expectations hypothesis, people form expectations about
inflation by adapting to (extrapolating from) the past behaviour of prices and by continually
revising their forecasts on the basis of their previous errors.
An Algebraic Interpretation of Adaptive Expectations: An adaptive expectations model of
inflation is given by:
Pft = Pft-1 + b(Pt-1 - Pft-1)
where Pft is the forecast for the price level at time t (today), Pft-1 is the forecast for the price level
at time t-1 (last period), Pt-1 is the actual value of the price level at time t-1, and Pt- Pft-1 is the last
period's forecast error. If the coefficient b is zero, then Pft = Pft-1, and if the coefficient b = 1, then
Pft = Pt-1. According to this model, forecast errors rise over time during periods of inflation.
Rational Expectations: This theory postulates that individuals are rational, and that they use all
the information available to them in forming expectations about the future. This implies that, in
effect, individuals have an economic model in their minds in forming expectations, and that
forecast errors in the past are irrelevant to future forecasts.
An Algebraic Interpretation of Rational Expectations: Suppose the public believes the price level
(P) is determined by the past level of the money supply (Mt-1) as follows:
Pt = aMt-1 + vt
Page 2 of 8
Copyright © 2004 McGraw-Hill Ryerson Limited
where vt is the unpredictable component. Assuming that, on average, vt = 0, a forecast of the
future price level (Pft) can be written as:
Pft = aMt-1
The average forecast error can be written as:
Pt - Pft = aMt-1- aMt-1 = 0
Rational expectations forecasts tend to be accurate, unlike those derived from the adaptive
expectations model.
What Does It All Mean? Monetarists argue that the effects of monetary policy occur with
long and variable lags. This view stems largely from the assumption of adaptive
expectations. With rational expectations there is no trade-off (between inflation rate and
unemployment rate) worth considering. Adaptive expectations imply that the public can
be easily fooled. By contrast, rational expectations imply that it is almost impossible to
fool the public. The reality may be a mixture of elements from both of the models.
Rules versus Direction in the Conduct of Monetary Policy
Since monetary policy cannot have long-lasting real effects, it has been argued that the
authorities should follow a monetary policy rule (fixing the money supply according to a
rule) such as the one given by the equation Pt = aMt-1.
The Political Temptation to Stimulate the Economy: Even though the society prefers a
zero inflation rate which corresponds to the natural rate of unemployment (NRU) or the
non-accelerating inflation rate of unemployment (NAIRU), the political temptation of
policy-makers to achieve unemployment rates lower than the natural rate of
unemployment (NRU) or the non-accelerating inflation rate of unemployment (NAIRU),
results in higher inflation rates, both in the short run and in the long run. A decrease in
the unemployment rate increases the rate of inflation (a movement along the short-run
Phillips curve), which in turn increases the expected rate of inflation, causing an upward
shift in the short-run Phillips curve. The result is a higher rate of inflation. (See Figure
27.1 in the text.)
The Time-Inconsistency Problem: The time-inconsistency problem of monetary policy
refers to the argument that policy-makers have an incentive to implement inflationary
monetary policy and, therefore, that their commitment to a given rate of inflation is not
credible. The time-inconsistency problem does not sound like a reasonable depiction of
the facts to everyone.
An Algebraic Interpretation of the Credibility Problem: Many economists believe that the
loss function of monetary policy (which the government wants to minimize) may be an
equation like the one stated below.
L = 1/2 (-e)2 + /2 (u* - u)
Page 3 of 8
Copyright © 2004 McGraw-Hill Ryerson Limited
Where,  and e are actual and expected rates of inflation, respectively, and u* and u are
natural and actual rates of unemployment, respectively. The coefficient  indicates the
importance attached to the unemployment objective. According to this equation,
unemployment rates higher than NRU and inflation rates higher than the expected rate of
inflation are costly. An inflation target that is fully credible might deliver an inflation rate
equal to the expected rate of inflation at all times.
Towards a New Trade-Off: A monetary policy rule called Taylor’s Rule is given by:
Rt = g gap + gyy gap
Where, Rt is the rate of interest,  gap is the difference between actual and desired or
target inflation rate, y gap is the difference between actual and potential levels of real
GDP. The equation shows that volatility in Rt results from changes in  gap and y gap. If
both inflation and GDP are volatile the loss will be larger. Consequently, Taylor
advocates a rule that results in a trade-off between the variability of inflation and the
variability of the output gap.
The Base Drift Problem: Periodic revisions of the money growth target by the monetary
authorities lead to the base drift problem. The base drift problem is the upward revision
of the base from which monetary growth targets are adjusted. In a situation in which the
actual growth rate of the money supply exceeds the target growth rate and authorities
revise money growth targets often, based on the actual level of money supply, the base
drift problem arises. This makes it difficult to accurately predict the money supply and
the price level.
Two Theories of Money: The quantity theory of money and the rejuvenated real bills
doctrine presents two contrasting views about the link between monetary policy and
inflation. The quantity theory holds that “inflation is always and everywhere a monetary
phenomenon,” while the rejuvenated real bills doctrine holds a contrasting view, but sees
a connection between inflation and printing money to cover government debts.
The Quantity Theory of Money: The quantity theory of money is represented by the following
equation:
MV = Py
where M is the stock of money, V is the velocity of circulation, P is price level, and y is real
aggregate income. On the assumption that V and y are fixed, changes in the price level can be
explained only by changes in the stock of money. It is in this sense that inflation is a monetary
phenomenon. The quantity theory endured as a theory of price levels for at least two reasons: 1)
the quantity theorists generally did not take a firm stand on what constitutes money; and 2) the
theory has been a reliable tool for predicting the price level over the business cycle.
The Rejuvenated Real Bills Doctrine: The rejuvenated real bills doctrine argues that the value of
money and its purchasing power can be explained by the value of the assets that back it. As long
as money is backed by assets that have value, there is no need to link a particular money stock
with a particular price level. Unless individuals perceive that government debt eventually will be
financed by printing increasing quantities of money, there is no need for money supply changes to
Page 4 of 8
Copyright © 2004 McGraw-Hill Ryerson Limited
create price level changes. If government budget deficits are financed through printing money
(rather than through the sale of bonds to the public), changes in the money supply will lead to
changes in price levels.
Two Theories of Money: Conclusion: The real bills doctrine can explain both high and low
episodes of inflation, and, therefore, represents an improvement over the quantity theory.
However, the quantity theory has worked well in predicting the price level over the business cycle
and therefore will remain a prominent explanation of price level movements.
Which Transmission Mechanism?
The transmission mechanism refers to the manner in which the monetary side can
influence the real side of the economy. There are four views of the transmission
mechanism:
1) The interest rate channel: less money drives up interest rates which impact
negatively on output.
2) The exchange rate channel: higher interest rates attract capital inflows which
reduce exports and increase imports, thus lowering output.
3) The impact of asset prices more generally: a lower money supply makes stocks
less attractive to hold and lowers investment and, therefore, output.
4) The credit channel: a lower money supply implies fewer bank deposits and
fewer loans, which translates into lower investment and output.
Money, Financial Development, and Growth
At least in the short run, inflation and money growth influence output. Empirical
evidence shows that before the 1973-74 oil shock, during a period of low inflation, the
economic growth rate and the inflation rate were positively related in the G-7 countries.
In the post-oil shock period, a period of high inflation and stagnation, the two rates were
negatively related. Thus the link between inflation and economic growth is not clear.
However, there is clear evidence that the development of the financial sector spurs
overall economic growth.
MULTIPLE-CHOICE QUESTIONS
1. The neutrality of money implies that
a) monetary policy cannot affect the price level in the short run.
b) monetary policy has no effect on the price level in the long run.
c) monetary policy cannot affect the output level in the long run.
d) monetary policy cannot affect the output level in both the long run and short run.
2. The short-run Phillips curve shows the trade-off between
a) the economic growth rate and the unemployment rate.
b) the inflation rate and the unemployment rate.
c) the inflation rate and the economic growth rate.
d) the interest rate and the inflation rate.
3. Monetarists believe that there is
a) a trade-off between the inflation rate and the unemployment rate in the long run.
Page 5 of 8
Copyright © 2004 McGraw-Hill Ryerson Limited
b) no trade-off between the inflation rate and the unemployment rate in the long run.
c) no trade-off between the inflation rate and the unemployment rate in the short run.
d) a trade-off between the inflation rate and the unemployment rate in the long run and in
the short run.
4. If P = price level, Pf = forecast of the price level, M = money supply, and t refers to
time period, which of the following is an adaptive expectations model of inflation?
a) Pf t = Pf t-1 + 0.4(P t-1- Pf t-1)
b) Pt = Pft + 0.5(P t-1- Pf t-1)
c) Pt = Pft + 0.5M t-1
d) Pf t = .75M t-1
5. The natural rate of unemployment is the rate of unemployment that exists when
a) the economy is in recession.
b) the economy is operating at full employment
c) the economy has a negative inflation rate.
d) the economy has only cyclical unemployment.
6.Consider the following equation: t = 2 - 0.40Ut, where  is rate of inflation, U is
unemployment rate, and t refers to time. The non-accelerating inflation rate of
unemployment for this economy is
a) 10%.
b) 20%.
c) 8%.
d) 5%.
7. Policy-makers’ bias towards positive inflation provides the basis
a) for the neutrality of money.
b) for the base drift problem.
c) for high rates of unemployment.
d) for the time-inconsistency problem.
8. Consider the following data for a hypothetical economy: The real income level (y) is
fixed at $200 million and the velocity of circulation is fixed at 4.0. According to the
quantity theory of money, an increase in the nominal stock of money (M) by 100
a) increases the price level by 2.0.
b) decreases the price level by 2.0.
c) increases the price level by 4.0.
d) has no impact on the price level.
9. According to the real bills doctrine
a) there is no link between monetary policy and the price level.
b) the price level is proportional to the money stock.
c) printing money to finance budget deficits is inflationary.
d) the supply of money is negatively related to the price level.
10. During the period before the oil shock of 1973-74, the rate of inflation and the rate of
economic growth in the G-7
Page 6 of 8
Copyright © 2004 McGraw-Hill Ryerson Limited
a) were both zero.
b) were negatively related.
c) were positively related.
d) were neither positively nor negatively related.
PROBLEMS
1. Consider the following data for an economy:
Year
1991
1992
1993
1994
1995
1996
1997
1998
1999
Inflation rate (%)
10.0
9.5
9.5
8.6
8.0
6.0
6.0
5.5
5.2
Unemployment rate (%)
2.0
3.6
3.9
4.1
3.9
4.8
5.0
5.2
5.5
Is there a trade-off between the rate of inflation and the rate of unemployment in this
economy?
2. Consider the following two models:
i) Pf t = Pf t-1 + 0.8(P t-1- Pf t-1)
ii) Pf t = 0.15M t-1
where P = price level, Pf = forecast of the price level, M = money supply, and t refers to
time period.
a) What theories of the forecast of inflation underlie these models?
b) How do the underlying theories differ from each other?
3. What is the basis for the statement that “Inflation is always and everywhere a monetary
phenomenon”? Explain.
4. “Inflation is always detrimental to economic growth.” Does the empirical evidence
support this view?
ANSWER SECTION
Answers to multiple-choice questions:
1.
2.
3.
4.
5.
6.
c
b
b
a
b
d
(see page 509)
(see page 509)
(see page 509)
(see page 510)
(see page 514)
(see page 516)
Page 7 of 8
Copyright © 2004 McGraw-Hill Ryerson Limited
7.
8.
9.
10.
d
a
c
c
(see page 516)
(see page 522)
(see pages 522, 524)
(see page 526)
Answers to problems:
1. Yes, there is a trade-off between the rate of inflation and the rate of unemployment in
this economy. The relationship between the inflation rate and the unemployment rate is
given graphically by the Phillips curve. In general, on a diagram which depicts a Phillips
curve, the rate of inflation is measured along the vertical axis and the rate of
unemployment is measured along the horizontal axis. A plot of the data given in the
problem on such a diagram would produce a scatter diagram with a negative trend. This
shows that there is a trade-off between the inflation rate and the unemployment rate (i.e.,
a negative relationship between the two rates).
2. a) The theories underlying the first and second models are the adaptive expectations
theory and the rational expectations theory, respectively, about how individuals form
expectations about future inflation.
b) According to the adaptive expectations model, individuals form expectations about
future inflation by adapting to the past behaviour of prices and by taking into account
their previous forecast errors. For example, according to this model, the forecast of the
price level for the current period (Pf t ) is the sum of the forecast for the past period
(Pf t-1) and 80% of the forecast error [0.8(P t-1- Pf t-1)]. According to rational expectations
theory, individuals are rational and use all the information available to them in forming
expectations about the price level. This means that they have an economic model, like the
second model given in the question.
3. The basis for this statement is provided by the quantity theory of money. According to
the quantity theory of money, the relationship between the price level and the money
stock is given by the following equation:
MV = Py
where M is the stock of money, V is the velocity of circulation, P is price level, and y is
real aggregate income. On the assumption that V and y are fixed, quantity theorists argue
that changes in the price level can be explained only by changes in the stock of money.
This implies that a change in the quantity of money brings about a proportional change in
the price level.
4. No. The relationship between inflation and economic growth is not a clear. Empirical
evidence on the relationship is mixed. For example, empirical evidence from the G-7
countries indicates that the relationship between the inflation rate and the economic
growth rate was positive during the period before the oil shock of 1973-74. This was a
period of relatively low inflation. However, in the post-oil shock period of relatively high
inflation the relationship was clearly negative. Therefore, it cannot be argued that
inflation is always detrimental to economic growth.
Page 8 of 8
Copyright © 2004 McGraw-Hill Ryerson Limited