Monetary Theory and Macro Policy

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Learning Objectives Upon completion of this unit, students should be able to:

1. Describe the relationship between the demand and supply of money. 2. Explain how changes in the money supply affect aggregate demand in

the short run. 3. Explain how changes in the money supply affect aggregate demand in

the long run. 4. Evaluate targets for monetary policy. 5. Compare an active policy and a passive policy. 6. Explain the Phillips curve.

Written Lecture Monetary theory is concerned with the effects of the quantity of money on the economy's price level and the level of real output. There is considerable debate among economists concerning what these effects are. One difficulty in determining the effects is that monetary policy changes and fiscal policy changes often occur at the same time, so it is difficult to sort out the effects of one from those of the other. This chapter describes two views of how money affects the economy: a short-run view and a long-run view. The Demand and Supply of Money A person's demand for money is not the same as the person's desire for a greater income. When economists speak of a demand for money, they are referring to the desire to hold a particular amount of money, either in checking accounts or as cash. That is, the demand for money is a demand to hold a stock of money at a particular time. Since money is used to facilitate exchange of goods and services and people engage in exchange on a regular basis, people hold money balances. The demand for money is greater the greater the number of transactions (as measured by real GDP) and the higher the average price at which each good is sold, that is, the greater nominal GDP. Money also competes with other financial assets as a store of wealth. Compared with other financial assets, money has one major advantage and one major disadvantage. Money's advantage is its liquidity—it can be directly exchanged for goods and services. Its disadvantage is that it earns either no interest or substantially less interest than other financial assets. The opportunity cost of holding money is the additional interest that could have been earned by using the money to buy alternative interest-bearing financial assets. Consequently, the cost of holding money increases with the real interest rate, and we expect the demand for money to vary inversely with the real interest rate, other things being constant. That is, the demand curve for money slopes downward when real interest rates are on the vertical axis.

Reading Assignments Chapter 16: Monetary Theory and Policy Chapter 17: Macro Policy Debate: Active or Passive?

Supplemental Reading Click here to access a PDF of the Chapter 16 Presentation. Click here to access a PDF of the Chapter 17 Presentation.

Learning Activities (Non-Graded) See information below.

Key Terms 1. Decision-making lag 2. Demand for money 3. Effectiveness lag 4. Equation of exchange 5. Implementation lag 6. Long-run Phillips

curve 7. Natural rate

hypothesis 8. Phillips curve 9. Quantity theory of

money 10. Rational expectations

UNIT VII STUDY GUIDE

Monetary Theory and Macro Policy

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The supply of money in the economy is determined primarily by the Fed, so we make the simplifying assumption that the quantity of money supplied is constant no matter what the interest rate is. Hence, the supply curve for money is a vertical line at whatever quantity of money the Fed has determined. Exhibit 1 illustrates the money market. The demand for money slopes down, as mentioned, and the supply curve for money is perfectly inelastic. Suppose that the supply of money is indicated initially by supply curve S. The intersection of the two curves determines the equilibrium interest rate, 10 percent. An increase in the supply of money shifts the supply curve to S´ and generates a lower equilibrium interest rate, 6 percent; an increase in the demand for money generates a higher interest rate. Money and Aggregate Demand in the Short Run If money is to affect aggregate demand, it must do so by affecting one of several things: consumption spending, investment spending, government spending, or net exports. As we have just seen, changes in the supply of money cause changes in interest rates. In the model that emphasizes the short run then, monetary policy affects aggregate demand indirectly by influencing the market rate of interest, which affects the level of planned investment. Suppose the Fed wants to pursue a tight monetary policy and reduce the supply of money. The Fed can reduce the money supply by raising the discount rate, selling government securities, or raising the required reserve ratio. Regardless of which method is used, the money supply curve shifts to the left and the market rate increases. In Exhibit 2, the higher interest rate causes a movement along the demand curve for investment and the level of investment falls. As a result, aggregate demand shifts to the left, as shown in Exhibit 3.

(McEachern, W. A., 2012)

11. Recognition lag 12. Short-run Phillips

curve 13. Time-inconsistency

problem 14. Velocity of money

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(McEachern, W. A., 2012)

(McEachern, W. A., 2012)

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The shifts in the curves in Exhibit 3 are not the end of the story. The aggregate supply curve slopes upward, so the ultimate effects of a change in the money supply are partially determined by the shape of the aggregate supply curve. Exhibit 4 shows the bottom part of Exhibit 3 with a short-run aggregate supply curve added. At the original price level, 100, there is an excess supply after the aggregate demand curve shifts from AD to AD´. The excess supply causes prices to fall until equilibrium is reached at price level 90 and real GDP of $4 trillion. Thus, the reduction of the money supply has generated a reduced level of GDP and a lower price level. Money and the Aggregate Demand in the Long Run Monetarists use the equation of exchange to analyze the effects of changes in the money supply. Monetarists argue that an increase in the money supply leaves individuals with larger money balances than they desire. Individuals reduce their money balances by increasing their spending on all goods, not just other financial assets. The increased spending on all goods has a direct effect on aggregate demand. The equation of exchange is a tautology—that is, it is true by definition. Nominal income equals real output, Y, times the price level, P. Since money is used in exchange, nominal income must be equal to the quantity of money in the economy, M, multiplied by the average number of times per year money changes hands to purchase final goods and services, V. Hence, M x V = P x Y. The average number of times money changes hands in a year, V, is called the velocity of money. The quantity theory of money states that velocity is predictable and stable. Consequently M = (P x Y)/V, and changes in the money supply cause predictable changes in nominal income. Whether the change in nominal income is due to changes in the price level or to changes in real output depends on the shape of the aggregate supply curve. In the short run, the aggregate supply curve slopes upward, so an increase in aggregate demand induced by an increase in the supply of money leads to increased real output

(McEachern, W. A., 2012)

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and higher prices. In the long run, the aggregate supply curve is vertical, and an increase in aggregate demand leads only to an increase in the price level. Those who focus on the short-run effects of monetary policy do not accept the monetarist belief that velocity is stable. Instead, they believe that velocity varies with the interest rate. According to this view, an increase in the interest rate increases the opportunity cost of holding money, so the quantity of money held falls and the velocity of money rises. To the extent that a change in interest rates affects velocity, changes in the money supply are offset by changes in velocity. Targets for Monetary Policy Given the differences in their views of the effects of money on the economy, it should not be surprising that the policy prescriptions of those who focus on the short run differ from the prescriptions of those who focus on the long run. The first group argues that monetary policy should focus on interest rates. Monetarists believe that money has a more direct effect on nominal income, so they argue that monetary authorities should focus more on money supply targets. For most of the postwar period, monetary authorities have focused on interest-rate targets rather than on monetary growth-rate targets. In recent years there have been large movements of funds into and out of the United States in response to interest-rate differentials between the United States and other countries. These flows affect the exchange rate and the level of imports and exports. Consequently, the Fed has been forced to give greater consideration to the international effects of its monetary policy decisions. Active Policy Versus Passive Policy The federal government is very concerned with economic policy questions. The Employment Act of 1946 makes the federal government responsible for maintaining full employment. Even without such a law, politicians would be interested in economic policy. Incumbents find it easier to be reelected when the economy is functioning well than when inflation is high and rising, or unemployment rates are high. Thus, the question of interest is which policy is the best policy. Unfortunately for policymakers, the answer to the question remains unclear, and the topic is hotly debated among economists. Some economists advocate an active role for the federal government. An active policy is one in which policymakers make use of discretionary stabilization policies to keep the economy running at or near potential output while maintaining relatively stable prices. Discretionary fiscal and monetary policies tend to focus on shifting the aggregate demand curve to achieve full employment. An expansionary monetary policy is used to stimulate spending when real GDP is below potential, and a restrictive monetary policy is used to reduce spending when the economy is overheated. Fiscal policy can also be used to stimulate or reduce aggregate demand. Advocates of an active policy tend to argue that the private economy is basically unstable and private spending cannot be counted upon to maintain aggregate demand at the full employment level. According to this view, by implementing the correct discretionary policies the government can stabilize the economy around potential output. Other economists disagree and advocate a passive role for the government. They believe the private economy is inherently stable and self-correcting. Deviations from potential GDP tend to be short-lived because self-correcting market forces push the economy toward its potential output. Since the economy is basically stable, there is no need for discretionary stabilization policy. In fact, according to this view, government stabilization policies are inherently destabilizing because there are various time lags between the

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recognition of a problem, the selection and implementation of a policy to correct it, and the impact of a policy change on the economy. During the time lags, the economy's self-correcting mechanisms return the economy to its full employment level. Consequently, when the discretionary policy takes effect, it may generate a new problem, since the problem it was designed to alleviate has already corrected itself. Role of Expectations Individuals make economic decisions on the basis of their experiences; the information they have about prices, inflation, and the like; and their expectations, which are based on information about future economic conditions. This information comes from many sources. For example, a possible change in government tax policy is discussed and debated in public for a considerable time before it is implemented. Money supply figures are published regularly, as are unemployment rates and numerous other measures of economic activity. By affecting short-run aggregate supply, the expectations of economic actors play a crucial role in determining whether a particular discretionary policy will be effective. The rational expectations school of thought holds that people form expectations on the basis of all relevant information, including information about how government stabilization policy operates and is implemented. Consequently, if policymakers attempt to stimulate the economy by increasing the rate of growth of the money supply and people correctly anticipate that the Fed is going to do this, then the monetary growth will not have any short-run effect on output. Instead, the only effect will be a long-run increase in the inflation rate. Exhibit 1 illustrates the views of the rational expectations school. Potential output is $5 trillion, and the current equilibrium is at e*. Suppose the Fed announces a restrictive monetary policy in an effort to reduce the price level to 95, and it initially pursues the restrictive monetary policy. Aggregate demand shifts to AD´, real GDP falls to $4 trillion, and the price level falls to 100. Once the public perceives the new conditions and they adjust their decisions about

(McEachern, W. A., 2012)

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supplying resources in the light of their new information, the short-run aggregate supply curve shifts to SRAS(95), and the new long-run equilibrium is at e´. Suppose, however, that the Fed abandons its restrictive monetary policy before the public adjusts its price expectations to 95. If the public is unaware of this change, aggregate demand returns to AD* at the same time that the short- run aggregate supply curve shifts to SRAS(95), and real GDP increases to $6 trillion. The public gets caught by surprise. Eventually, people will realize the true state of the economy, and the short-run aggregate supply will shift back to SRAS(105). By failing to implement its announced policy, the Fed loses its credibility with the public. If the Fed now announces a restrictive monetary policy to combat inflation, the public will be less likely to believe the announcement. Consequently, people will not change their price expectations, and the short- run aggregate supply curve will not shift. The Fed would have to pursue its restrictive monetary policy for a longer period of time to convince the public that it was serious. During this time, however, real GDP would be below potential output, and unemployment would be above the natural rate of unemployment. Policy Rules Versus Discretion Since advocates of a passive policy believe the government's use of discretionary policy tends to destabilize the economy, they advocate the use of monetary policy rules. A monetary policy rule specifies the relationship between a policy instrument and a policy objective. Some economists support rules on the grounds that the government cannot effectively control the economy because it is so complex and the lags involved in discretionary policies are too long and variable. Those who favor the rational expectations approach advocate rules because they believe the public is sophisticated enough in forming its expectations that discretionary policy tends to affect only the level of prices. By making policy on the basis of a rule, the Fed makes it possible for the public to formulate expectations about the future with greater certainty and permits the economy to achieve the natural rate of output. The Phillips Curve The Phillips curve is a graphical representation of a tradeoff between inflation and unemployment. The tradeoff shown by a Phillips curve is between low unemployment rates and low inflation rates; it is not possible to have both. That is, if the government wants to lower the unemployment rate, it must be willing to accept a higher inflation rate. Exhibit 2 illustrates two possible Phillips curves. During the 1960s, policymakers acted on the belief that there was a stable, long-run tradeoff between inflation and unemployment for the economy. As inflation became a greater problem in the late 1960s and early 1970s, however, this view became suspect. Critics of an active policy argued that the tradeoff is a short-run, not a long-run, phenomenon. According to this view, the government may be able to trade greater inflation for lower unemployment in the short run. Once the public realizes the true state of the economy, however, unemployment will return to its natural rate. In Exhibit 2, the natural rate of unemployment is 6 percent. Suppose the economy is at point a. The government can temporarily reduce unemployment by creating inflation; in that case, the economy moves to point b. Once the public perceives the new economic situation, people adjust their expectations, and the economy returns to the natural rate of unemployment (point c). Now the natural rate of unemployment is associated with a higher inflation rate, and there is a new short-run Phillips curve. The long-run Phillips curve is vertical at the natural rate of unemployment.

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Learning Activities (Non-Graded) Click on the following link to watch a video on Inflation and the Money Supply: http://www.swlearning.com/economics/abcvideos/TMG00051601.html Non-graded learning activities are provided to aid students in their course of study. This is a non-graded activity, so you do not have to submit it.

(McEachern, W. A., 2012)