chapter 15 monetary theory-and-policy
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Chapter 15
Monetary Theory and Policy
• Why would people hold money?– Transactions Demand for Money– Precautionary Demand for Money– Speculative Demand for Money
The Demand for Money
• The three motivates for holding money combine to create a demand for money curve.– Def: The demand for money curve represents the
money people hold at different possible interest rates, ceteris paribus.
– Why is it downward sloping?– Example of Graph
The Demand for Money Curve
Example of a Graph
• The supply of money is a vertical line (MS) implying that the quantity of money supplied is independent of the interest rate– Why?– Show equilibrium
The Equilibrium Interest Rate
Example of MS
What happens if the Fed increases the money supply?
• The opportunity cost of holding money falls enough that the public is willing to hold the now larger stock of money
How the Fed Controls the MS?
• The establishment of reserve requirements for banks
• Buying and selling U.S. government securities and other financial assets in the open market
• The volume of loans extended to banks and other institutions
• The interest rate it pays banks on funds held as reserves
http://www.youtube.com/watch?v=HdZnOQp4SmU
Recent Monetary Policy
• Increase in the monetary base from $828 billion at mid-year 2008 to $1.63 trillion in early 2009 to more than $2 trillion in 2010.
• Lower interest rates
http://www.pbs.org/newshour/updates/business/july-dec09/bernanke_07-26.html
http://federalreserve.gov/newsevents/press/monetary/20101103a.htm
Example of lowering the interest rate
Interest Rates and Investment
• Suppose the Fed purchases U.S. government bonds.– What happens to Investment?– What happens to AD?
Example of Investment and Interest Rates
Adding the Short-Run Aggregate Supply Curve
• For a given shift of the aggregate demand curve, the steeper the short-run aggregate supply curve, the smaller the increase in real GDP and the larger the increase in the price level.
Example of Graph of SRAS
• Def: Monetarism is the theory that changes in the money supply directly determine changes in prices, real GDP, and employment– They put the spotlight on the money supply. They
argue that to predict the condition of the economy, you simply look at the money supply.
– Too much money supply = higher inflation– Too less money supply= unemployment and
deflation
The Monetarist View of the Role of Money
• Def: The equation of exchange is an accounting identity that state’s the MS time velocity of money is equal to total spending:
MV=PY
The Equation of Exchange
• It is assumed by classical economists that V and Y(real output) are fairly constant.– Why is this true?
– Def: The Quantity Theory of Money states that changes in the money supply are directly related to changes in the affect of price level.
The Quantity Theory of Money
• Today, we do not think that V is constant and the employment does not always operate at full employment– M& P are correlated, but not perfectly correlated.
Modern Monetarism
Targets Before 1982
• Between World War II and October 1979- the Fed attempted to stabilize interest rates.
• Friedman said this made monetary policy a source of instability in the economy because changes in the money supply reinforced fluctuations in the economy.– He said pay less attention to interest rates and
instead focus on a steady and predictable growth in the money supply
– Monetary rule
Targets After 1982
• Less force on a steady and predictable growth in the money supply.
• The force was on a targeted federal funds rate.