Macro Chapter 14

Modern Macroeconomics and Monetary Policy

3 Learning Goals

1) Analyze the impact monetary policy has on the economy

2) Investigate the claim that a rapid increase in the money supply leads to inflation

3) Confirm the ideas presented in the chapter with data from various countries

Daniel Thornton & David Wheelock:

“The conventional wisdom once held that money doesn’t matter. Now there is wide agreement that monetary policy can significantly affect real economic activity in the short run, though only price level in the long run.”

Main points of the chapter:

1) Unanticipated changes in the money supply can change AD

2) Anticipated changes and long run changes do NOT change AD; only prices are affected

3) A more rapid increase in the quantity of money than in the quantity of goods and services available for purchase will produce inflation, raising prices in terms of that money

The Impact of Monetary Policy on Output and Inflation

Review Questions:

(1) What is the primary way the Fed increases the money supply?

(2) What is the primary way the Fed decreases the money supply?

(3) Draw the loanable funds market. Show what happens when the Fed increases the money supply.

When the Fed increases the money supply

Interest rates fall

Consumption and Investment increase

The dollar will depreciate, causing

Exports to rise, imports to fall, and net exports to rise

When the Fed decreases the money supply

Interest rates rise

Consumption and Investment decrease

The dollar will appreciate, causing

Exports to fall, imports to rise, and net exports to fall

Unanticipated changes in the money supply:

Refer back to Chapter 10 regarding the details of what happens when AD increases and decreases

The same “story” is told, the only difference now is the variable that changed AD

What if AD surprisingly increases?(1) Firms will increase production (move along SRAS)– Actual output > potential output– Actual unemployment < natural rate

(2) Resources prices will begin to rise(3) Interest rates will rise as demand for loanable funds increases(4) Foreigners will purchase more US assets; the dollar will appreciate(5) SRAS will begin to fall (shift left) and consumers will buy less (move along AD)(6) The economy will return to long run equilibrium

What if AD surprisingly decreases?(1) Firms will decrease production (move along SRAS)– Actual output < potential output– Actual unemployment > natural rate

(2) Resources prices will begin to fall(3) Interest rates will fall as demand for loanable funds decreases(4) Foreigners will purchase fewer US assets; the dollar will depreciate(5) SRAS will begin to rise (shift right) and consumers will buy more (move along AD)(6) The economy will return to long run equilibrium

Q14.1 If the Federal Reserve increases its bond purchases, the short-run effects will be

1. an increase in the money supply and lower real interest rates.

2. a decrease in the money supply and lower real interest rates.

3. an increase in the money supply and higher real interest rates.

4. a decrease in the money supply and higher real interest rates.

Q14.2 If the Federal Reserve wanted to expand the money supply in order to increase output, it should

1. sell government bonds, which will increase the money supply; this will cause interest rates to fall and aggregate demand to rise.

2. buy government bonds, which will increase the money supply; this will cause interest rates to fall and aggregate demand to rise.

3. increase the discount rate, which will raise the market rate of interest; this will cause both costs and prices to rise.

4. decrease taxes, which will reduce costs and cause prices to fall.

Monetary Policy in the Long Run

Milton Friedman:

“Inflation is always and everywhere a monetary phenomenon”“Inflation occurs when the quantity of money rises appreciably more rapidly than output, and the more rapid the rise in the quantity of money per unit of output, the greater the rate of inflation.”

If your income doubled and the price level doubled, would anything really change?

The Quantity Theory of Money is used to support the hypothesis that a rapid increase in the money supply causes inflation

Equation of exchange: M V = P Y

M = money supply

V = velocity, how quickly $1 passes through the economy

P = price level

Y = GDP = output

M V = Total spending

P Y = Total receipts

Implications:

In the short run, Y and V are assumed to be constant (or change slowly)

Therefore an increase in M causes an increase in P

The long run effects:

↑M → ↑AD → ↑resource prices → ↓SRASThen↑M → ↑AD → ↑resource prices → ↓SRASThen↑M → ↑AD → ↑resource prices → ↓SRASThen …

Q14.3 Suppose the economy is in long-run equilibrium at the level of potential output. What will be the long-run effect of an expansionary monetary policy?1. a higher price level

2. a higher level of real output

3. both a higher price level and a higher level of real output

4. a lower price level

5. a lower level of real output

Do the theories hold up in the real world?

Watch video: Free to Choose-inflation

Q14.4 In the long-run, the primary effect of rapid monetary growth is

1. lower nominal interest rates.

2. reduced unemployment.

3. inflation.

4. an increase in real output.

Question Answers

14.1 = 1

14.2 = 2

14.3 = 1

14.4 = 3