The Federal Reserve has a dual mandate to:Maintain stable prices (fight inflation/deflation)Maintain full employment (monetary policy to manage macroeconomic conditions)

Created:Jan 2008by Jim Luke.

The Fed manages Inter-bank Interest Rates and Regulates Banks…but does it control money supply?

Created:Jan 2008by Jim Luke.

Monetary Policy

"Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output... A steady rate of monetary growth at a moderate level can provide a framework under which a country can have little inflation and much growth. It will not produce perfect stability; it will not produce heaven on earth; but it can make an important contribution to a stable economic society."

--Milton Friedman

The Bank [of Canada] gave it a college try, it really did. It just doesn't work that way.

--John Crow, former governor of the Bank of Canada, on implementing Friedman's theories;

What Is Monetary Policy?

Central bank (as representative of government) manipulation of the • money supply,• interest rates• credit conditionswith an objective of achieving macroeconomic

goals.

Monetarist Theory History – The Classical School Strikes Back at Keynesianism

Three Theories of Monetary Policy

Strict Monetarist

Neo-classical/New Keynesian

Modern Monetary Theory (MMT)

Created:Jan 2008by Jim Luke.

Equation of Exchange

M x V = P x Y M: money supply V: Velocity

(how fast money is spent) P: Price Level Y: Real Income Note: sometimes shown as

M * V = P * Q same concept, different notation

Identity: Must be true for any period of time

Both Monetarist and Neo-Classical/New Keynesian Theories:

Trade-off between unemployment and inflation exists Controlling Inflation is higher priority

04/19/23

Money supply concept: (Classical or Milton Friedman Monetarist version)

Money supply is ‘exogenous’

more bank reserves —>more lending by banks –>

increased money supply –> lower interest rates –>

borrowing by consumers/firms –> more C and I spending –>

faster GDP growth & inflation

Interest rates concept: (Neoclassical version)

central bank open market purchases of bonds –>higher bond prices = lower interest rates –>

more borrowing by consumers/firms –>more spending on C and I –>

faster GDP growth –>

But, the Equation of Exchange

M x V = P x Y• M: money supply• V: Velocity (how fast money is spent)• P: Price Level• Y: Real Income

Note: sometimes shown as M V = P Q • same concept, different notation

Equation of Exchanges is an Identity: Must be true for any period of time after the fact..

Quantity theory of money (QTM):

Based on equation of exchange with added assumptions about the behavior of variables.

• assume V is constantConclusions:

• Money supply growth is solely responsible for determining Inflation

‘Crowding Out’ Theory

Assumptions: • Fixed amount of money in economy• QTM holds true

Theory: Gov borrowing takes $ away/raises interest rate for firm and household borrowers –> will reduce C and I unless

Central Bank increases M to fund deficit inflation

Absolutely not supported by evidence or data in modern real world.

Current Neoclassical and New Keynesian Views on monetary policy

Support for ad hoc policy (policy makers should make it up as they go)

Modern Monetary Theory (MMT)

Money growth (M1 – bank credit) is largely endogenous

Key is base money growth, not M1government deficits enable the private

sector (firms and households) to grow and yet still accumulate net financial assets

MMT Foundation: Fiat money system with floating exchange rates eliminates government budget constraint

Deficits effective in fighting unemploymentno financing constraint on deficitsdeficits are limited by the availability of

real, unemployed resources for the government to purchase

Inflation threat is at/near full employment is reached (AD- LRAS model)

04/19/23

Limitations of Monetary Policy: ‘Pushing on string’

Central bank cannot force banks to make loans

Limitations of Monetary Policy: Endogenous money supply

Banks, not central bank really determine supply of money and credit

Limitations of Monetary Policy: Fiscal Policy Coordination

Fiscal and Monetary policy could work at cross-purposes

could expect ‘other’ to do it

Limitations of Monetary Policy: Liquidity trap

At ‘zero lower bound’when interest rates approach zero but the

economy is still weak, monetary policy is largely ineffective.

Limitations of Monetary Policy: Globalization

If interest rates too low or inflation too high, then value of currency drops –> capital inflow drops and M drops, even though X rises