1. Monetary Policy

2. Purpose Monetary policy attempts to establish a stable environment so the economy achieves high levels of output and employment. How changes in money supply affect interest rates, output, and prices.

3. Monetarists Group of economists who believe that 1.monetary instability is the major cause of fluctuations in real GDP 2.rapid growth of money supply is the major cause of inflation Erratic monetary policy leads to business instability and inflation

4. Demand for money There is an opportunity cost to holding money balances (foregone interest) Inverse relationship between interest rate and quantity of money demanded

5. Supply of money Quantity of money supplied is determined by the Fed Fed uses its control over reserve requirements, discount rate, and open market operations to set money supply Changes in interest rate do not alter Fed’s determination of money supply

6. Money equilibrium

7. Expansionary monetary policy Fed buys bonds, lowers reserve requirements, or lowers discount rate Real interest rates decrease Stimulates AD (investment and consumption) Lower interest rates lead to capital outflow, so dollar depreciates, and exports stimulated (higher AD) Asset prices increase (housing)

8. Restrictive monetary policy Fed sells bonds, raises reserve requirements, or raises discount rate Real interest rates increase Decreases AD (investment and consumption) Higher interest rates lead to capital inflow, so dollar appreciates, and exports decrease (lower AD) Asset prices decrease

9. Timing As with fiscal policy, timing when to use monetary policy is critical, and hard to plan. Desired effects usually occur in the short term, but then can turn out different. Monetary policy is effective, but must be monitored carefully.

10. Monetary policy in the long run Excessive money growth over time leads to inflation. Quantity theory of money indicates that an increase in the supply of money will cause a proportional increase in price level. PY=GDP=MV P (price level), Y (real GDP or real income), M (existing money stock), V (velocity of money)

11. Velocity of money Average number of times a dollar is used to purchase a final product or service during the year Equals nominal GDP divided by money stock Closely related to demand for money MV=PY indicates that an increase in money supply leads to proportional increase in price level