1. Chapter 14 “Monetary Policy and Price Stability”
ECONOMICS: EXPLORE & APPLY by Ayers and Collinge
Chapter 14 “Monetary Policy and Price Stability”

2. Learning Objectives State the goals of monetary policy.
Explain the significance of the money market and the motives for holding money.
Recite the equation of exchange and its role in the conduct of monetary policy.
Discuss the monetarist school of thought and its implications for monetary policy.

3. Learning Objectives
Interpret the relationship between monetary policy and interest rates.
(E&A) Address the importance of central banks staying independent of political pressures.

4. 14.1 A FIRST LOOK AT MONETARY POLICY
The Federal Reserve Act of 1913 established the Fed and it was viewed at that time to be a lender of last resort for troubled banks.
Today, the Fed’s role has expanded greatly.
The 1977 amendment to the act spells out the objective of monetary policy as..
“ to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”

5. Monetary Policy
Federal Reserve monetary policy encompasses three macro goals.
High employment
Low inflation (price stability)
Economic growth
Many economist argue that price stability should be the Fed’s primary goal.

6. Economic Growth and Inflation in the 1960’s

7. Monetary Policy
There are sometimes conflicts and/or tradeoffs involved in pursuing a particular monetary policy.
Bringing down inflation can lead to high higher interest rates and unemployment.
The Fed develops monetary policy surrounded by a whirlpool of considerations.
Debates over appropriate Fed policy can be intense.
Unemployment and inflation exact a toll in human suffering.

8. Monetary Policy
There are two monetary policy instruments that the Fed can influence as part of monetary policy.
By increasing or decreasing the growth rate of the money supply the Fed can attempt to stimulate or slow down the economy.
The Fed can also manipulate short-term interest rates to stimulate or slow down the economy

9. Money and the Macroeconomy
To maintain full employment, the quantity of money must rise to keep pace with the economy’s productive potential.
The Fed strongly influences the money supply buy conducting open market operation, changing the discount rate, and changing the reserve requirement.
An overwhelming amount of evidence shows excessive growth in the money supply to be the root cause of inflation.

10. Money and the Macroeconomy
The quantity of money affects aggregate demand.
An increase in the money supply is associated with expansionary monetary policy (looser monetary policy).
An increase in the money supply shifts aggregate demand to the right, thus allowing more aggregate output to be purchased at each possible price level.

11. Expansionary Monetary Policy
Price
level
A larger money supply shifts aggregate demand because it allows more to be purchased at each price level.
Aggregate
demand
Same
price
level
Real GDP
More
purchasing power

12. Contractionary Monetary Policy
A contractionary monetary policy would have the effect of drying up liquidity and tightening up the economy’s purse strings, and is thus called a tighter monetary policy.
The effect of tighter monetary policy would be just the opposite of the expansionary policy shown in the previous figure.

13. 14.2 THE MONEY MARKET
The demand for money is the quantities of money that people would prefer to hold at various nominal interest rates, ceteris paribus.
The nominal interest reflects the opportunity cost of holding money.
Three motives make people willing to pay the price of holding money.
The transactions motive.
The precautionary motive.
The speculative motive.

14. The Money Market and the Demand for Money
The transactions motive: money is held because of the everyday need to buy goods and services.
The precautionary motive: unforeseen circumstances motivate people to hold more money than called for by their transactions demands.
The speculative motive: People may speculate with some of their money in the sense that they prefer to hold money rather than invest it when financial investments seem unattractive.

15. The Demand for Money Nominal interest rates Lower interest rates
When the interest
rate falls, money
holdings rise.
Lower
interest
rates
More money
holdings
Money
holdings

16. Money Market Equilibrium
The money market is characterized by demand and supply.
The money supply curve is drawn as a vertical line because we are assuming that this is the quantity of money supplied to the economy by the Fed.
A vertical money supply curve implies that the money supply is independent of the interest rate.
The intersection of demand and supply establishes the money market equilibrium.

17. Money Market Equilibrium
Money supply
Nominal
interest rates
Excess
supply
Money demand
Too high
Money market
equilibrium
Equilibrium
Interest rate
Too low
Excess demand
Money
holdings

18. The Substitutability of Money and Bonds
The market interest rate will adjust to the equilibrium interest rate.
A market interest rate that is above the equilibrium interest rate will fall until the equilibrium interest rate is reached.
A market interest rate that is below the equilibrium interest rate will rise until the equilibrium interest rate is reached.
The key to understanding interest rate changes is to realize that money, bonds, and other investments are substitutes for each other.

19. The Substitutability of Money and Bonds
If the
interest is
Quantity of money demanded is
Quantity of money paying asset demand is
Public’s
Response
Interest Rate response to Public’s Action
(1) At
equilibrium
Equal to Qs of money
Equal to Qs of interest paying assets
No change in holdings of money or bonds
Interest rate decreases
(2) Above equilibrium
Less than Qs of money
Greater than the Qs of interest paying assets
Increase the holdings of bonds and decrease the holdings of money
Interest rate decrease
(3) Below
equilibrium
Greater than Qs of money
Less the Qs of interest paying assets
Decrease holdings of bonds and increase holdings of money
Interest rate increases

20. 14.3 GUIDING MONETARY POLICY
The Fed maintains confidentiality when it comes to what economic variables determine monetary.
Transcripts of meetings of the Federal Open Market Committee are not released to the public until five years after those meetings take place.
In recent years observers have speculated that the Fed has followed price rule by which it conducts monetary policy with the aim of keeping price increases among certain basic commodities within a low range.

21. The Equation of Exchange
The equation of exchange reveals that the amount of money people spend must equal the market value of what they purchase…
M x V = P x Q
M = Qs
V= velocity of money,
which is the average
Number of times money
Changes hands in a year.
Price index
Aggregate out of
goods and services

22. The Equation of Exchange
The total amount of spending in an economy is equivalent to the economy’s nominal GDP.
Thus the equation of exchange says that aggregate spending on the left side of the equation, equals nominal GDP on the right side.
Because the value of what is bought is always equal to value of what is sold, the equation of exchange is always true.
M x V [total spending] = P x Q [nominal GDP]

23. The Quantity Theory of Money
The equation of exchange forms the basis of the quantity theory of money.
The quantity theory assumes…
The velocity of money is independent of the quantity of money in the long run. V, in the equation is a constant value.
Aggregate output, Q, is also independent of the quantity of money in the long run. Q, in the equation can also be treated as a constant.

24. The Quantity Theory Aggregate supply Price level The aggregate demand
curve moves higher in
response to a money supply
increase.
Higher
price
level
Aggregate
Demand
Full
employment
GDP
Real GDP

25. The Monetarist Prescription
Monetarism is a school of thought associated with Nobel-winning economist Milton Freidman (1912-).
Monetarist readily agree with the original quantity theory.
However, unlike the original quantity theory, monetarism acknowledges the existence of the short-run.

26. The Monetarist Prescription
According to the monetarist view, the quantity of money may indeed affect velocity and aggregate output in the short run.
Neither V nor Q in the equation of exchange is viewed as constant by monetarist.
A reduction in the growth rate of the money supply may cause a reduction in aggregate output, Q.
The velocity of money can change because of changes in people’s need to hold money, V.

27. The Monetarist Prescription
Expansionary (Looser) Monetary Policy
Increase in the quantity of Money
Increased aggregate spending
Increased nominal GDP
Contractionary (Tighter) Monetary Policy
Decrease in the quantity of Money
Increased aggregate spending
Increased nominal GDP

28. Velocity Year Velocity 1979 1.742 1980 1.748 1981 1.784 1982 1.706
1983
1.662
1984
1.703
1985
1.688
1986
1.630
1987
1.675
Year
Velocity
1988
1.706
1989
1.738
1990
1.771
1991
1.773
1992
1.842
1993
1.907
1994
2.017
1995
2.033
1996
2.05
Year
Velocity
1997
2.06
1998
2.00
1999
1.99
2000
2001
1.87

29. Velocity

30. Velocity
To avoid the recession that could result from too little money, or the inflation that could result from too much money, the monetarist policy recommendation is for the Fed to increase the money supply at a steady rate, equal to or slightly greater than the long-run growth rate in aggregate output.

31. Monetarist Policy
Monetarist recommend growth in the Money supply that just matched the growth in long-run aggregate supply.
To monitor the Fed, the monetarist have established a Shadow Open Market Committee.
The Fed controls the money base.
Consumer pessimism or optimism about the economy can greatly effect the money multiplier, which relates the monetary base to the money supply.

32. Complications in Conducting Monetary Policy
There are a number of possible difficulties the Fed could face in designing an effective monetary policy.
Large unpredictable shifts in the demand for money.
Interest rate insensitivity among consumers and business.
An unresponsive interest rate caused by a liquidity trap.
Lags in the effects of monetary policy
Differential effects of monetary policy.

33. The Monetarist Prescription
Expansionary (Looser) Monetary Policy
Increase in the quantity of Money
Lower interest rates
Increased borrowing
Increased aggregate spending
Increased nominal GDP
Contractionary (Tighter) Monetary Policy
Decrease in the quantity of Money
Higher interest rates
Decreased borrowing
Decreased aggregate spending
Decreased nominal GDP

34. 14.4 THE FEDERAL FUNDS RATE AND MARKET INTEREST RATES
Fed Action
Bank Reserves
Federal Funds Rate
Short-term Interest Rates
Open Market sale of securities to banks
Decrease (reserves go to the Fed to pay for securities)
Increases, as reserves leave the banking system
Increase
Open market purchase of securities from banks
Increase (reserves are received from the Fed in payment for securities
Decreases, as reserves are pumped into the banking system
Decrease

35. 14.5 EXPLORE & APPLY How Independent Should a Central Bank be?
The Fed is relatively independent from political interference from the President and Congress.
The Fed board members serve 14 year non-renewable terms.
The Fed funds itself with interest earned on loans to banks and on holdings of treasury securities.

36. Terms Along the Way expansionary monetary policy
contractionary monetary policy
monetary policy instruments
demand for money
transactions motive
precautionary motive
speculative motive
money market
price rule
equation of exchange
velocity of money
quantity theory of money
monetarism

37. Test Yourself Conflicts in meeting the goals of Fed policymaking
never occur.
occur, but are ignored by the Fed.
occur, and are considered by the Fed in choosing monetary policy actions.
occur only when the President and Congress disagree about the proper course of monetary policy.

38. Test Yourself for transaction purposes only.
2. The demand for money represents the quantities of money that people want to hold
for transaction purposes only.
at different income levels.
at various interest rates.
at banks.

39. Test Yourself 3. The speculative demand for money occurs because
people want to make purchases.
of the need to save for a rainy day.
money that is stolen must be replaced.
sometimes investments are not attractive to people and so they hold money instead.

40. Test Yourself
4. The equation of exchange says that the quantity of money multiplied by _____________ equals total spending.
the price level.
velocity.
GDP.
the equilibrium interest rate.

41. Test Yourself
5. The quantity theory of money assumes that aggregate output is
never at the full-employment level.
always at the full-employment level.
equal to one minus velocity.
unpredictable and unexplainable.

42. Test Yourself 6. Monetarism recommends that monetary policy
focus on low interest rates.
focus on the stock market, aiming to increase stock prices.
expand the money supply at a steady rate.
be turned over to Congress.

43. “Elasticity: Measuring Responsiveness"
The End!
Next Chapter 15
“Elasticity: Measuring Responsiveness"