Section 6

Monetary Policy

Key Terms Cyclically Adjusted Budget Balance Classical Model of the price level Quantity Theory of Money Short-Run Phillips Curve Velocity of Money Government Debt Nonaccelerating Inflation Rate of Unemployment Natural Rate Hypothesis Fiscal Year Political Business Cycle Public Debt New Keynesian Macroeconomics Debt-GDP Ratio Long-Run Phillips Curve Debt Deflation Implicit Liabilities Rational Expectations Target Federal Funds Rate Zero Bound New Keynesian Economics Liquidity Trap Expansionary Monetary Policy Keynesian Economics Real Business Cycle Theory Macroeconomic Policy Activism Contractionary Monetary Policy Cost-Push Inflation Monetarism Demand-Pull Inflation Taylor Rule Discretionary Monetary Policy Inflation Targeting Monetary Neutrality Monetary Policy Rule

Key Formulas Velocity of Money M*V = P*Y Money supply*Velocity of Money = Nominal GDP

Monetary Policy

Key Graphs

Increase in Money Supply

Decrease in Money Supply

Classical Model Vertical Supply Curve – even in the short run.

Short-Run Phillips Curve

Long-Run Phillips Curve

Demand Pull Inflation

Cost Push Inflation

Supply Side Economics

Economic Schools of Thought Classical macroeconomics Keynesian macroeconomics Monetarism Modern consensus Is expansionary monetary policy helpful in fighting recessions? No Not very Yes Yes, except in special circumstances Is expansionary fiscal policy effective in fighting recessions? Can monetary and/or fiscal policy reduce unemployment in the long run? Should fiscal policy be used in a discretionary way? No, except in special circumstances Should monetary policy be used in a discretionary way? Still in dispute

AP Exam Tips Budget balance is the difference between gov’t tax revenue and gov’t spending (including transfers) in a given year. A budget deficit occurs when the gov’t revenue is less than its spending in a given year. The budget deficit almost always rises when the unemployment rises and falls when the unemployment falls. Don’t confuse the federal funds rate with the discount rate. The Fed can only target the federal funds rate because it is set through the interaction of supply and demand. AD curve shifts same way as the MS : Increase in MS = increase in AD. Decrease in MS = decrease in AD. Be specific on the exam. If asked what policy the central bank should use to correct a particular problem, “expansionary” or “contractionary” monetary policy isn’t good enough. You must identify one of the three tools – OMO, DR, or RR – and usually the best answer is an OMO – buy or sell gov’t bonds. Classical economists believe that prices and wages are flexible and adjust quickly – this means a vertical AS curve even in the Short Run. The Keynesian model believes prices and wages are sticky, leading to an upward sloping SRAS curve. Be able to graph and explain both cost push and demand pull inflation.