Final Paper due Monday Midnight/8 pages

Learning Outcomes

By the end of this chapter, you will be able to:

• Explain how monetary policy works both directly and through changes in the interest rate to affect output, employment, and the price level.

• Identify some of the weaknesses in implementing monetary policy.

• Summarize the debate over the appropriate targets for monetary policy.

• Describe the main policy actions of the Fed over the last few decades.

14

Monetary Policy in Theory and Practice

Associated Press

ama80496_14_c14_383-406.indd 383 12/4/12 4:43 PM

CHAPTER 14Pre-Test

Introduction

Look in your wallet and consider the cash you have in there. Those familiar green bills are called Federal Reserve notes. Why? Because the Federal Reserve (the Fed) controls the money supply—it decides when to print more money or change inter- est rates according to what the United States’s economy needs. Monetary policy cannot be understood until you know what the Federal Reserve is and does. The Fed is actually an independent government agency that sets short-term interest rates for the U.S. cen- tral bank. What this means is that the Fed has influence over inflation, unemployment, and every other aspect of the U.S. economy. Ben Bernanke, who took over as chair of the Federal Reserve in 2006, expanded the Fed’s powers in an effort to revitalize the fragile economy of the early 2000s.

Bernanke’s strength is in his experience as a leading scholar of the Great Depression. He used his knowledge of this era and its mistakes to make decisions on what to do about interest rates; he printed more money to infuse into the stalled economy. He assisted with the very public rescue of failing private companies, lowered interest rates, lent money to whatever mutual fund, hedge fund, investment bank, or other borrower asked for it, and tackled stalled credit markets and housing finance. Bernanke did what was not done during the Great Depression—he injected the U.S. economy with more green bills and lowered interest rates to next to nothing in an effort to keep the country running.

Why is monetary policy so important to a country’s economy? Does monetary policy really have that much of an impact on economic activity? This chapter will help you find the answers to these questions.

Pre-Test

1. In the classical view, the demand for money is strongly dependent on income. a. True b. False

2. Monetarists believe the appropriate target of monetary policy is long-term inter- est rates.

a. True b. False

3. The housing market will NOT be affected by tight monetary policy. a. True b. False

4. The Accord makes sure the Fed keeps interest rates lower to help the treasury’s debt.

a. True b. False

ama80496_14_c14_383-406.indd 384 12/4/12 4:43 PM

CHAPTER 14Section 14.1 How Monetary Policy Affects Aggregate Demand

Answers 1. a. True. The answer can be found in Section 14.1. 2. b. False. The answer can be found in Section 14.2. 3. b. False. The answer can be found in Section 14.3. 4. b. False. The answer can be found in Section 14.4.

14.1 How Monetary Policy Affects Aggregate Demand

Economists, politicians, investors, and businesspeople keep a close eye on the Fed because the actions of the Fed change the money supply and interest rates. Changes in money supply and interest rates affect household assets, the amount of funds available to borrow, the return on various assets, and the terms of new loans. Through these changes in the credit market, the Fed influences spending. Changes in planned spending will shift AE and AD and affect output, employment, and the price level.

The Fed’s impact on the economy through the credit market operates through two differ- ent channels. Recall that there are only two things that individuals can do when they have more money than they wish to hold: Spend it or lend it. (If you leave money in a checking or savings account, the bank will lend it for you.) Classical theory puts a strong emphasis on spending as the way to get rid of extra money. Classical economists point to the role of demand for cash balances (transactions demand) and the equilibrium between money supply and money demand. The Keynesian model puts an equally strong emphasis on lending. Economists in the Keynesian tradition emphasize the role of interest rates (asset demand for money), although U.S. monetary policy is now usually described in terms of interest rate decisions such as those made during the Great Recession of 2007–2009. Monetary policy alone may not stimulate the economy directly, so it is often used as a complementary policy to expansionary fiscal policy.

These explanations are not necessarily contradictory. Both mechanisms can be at work to translate changes in the money supply into shifts in aggregate demand, resulting in changes in output, employment, and the price level. However, the impact of mon- etary policy on the economy tends to be stronger through the spending route than the lending route because there are so many more things that can go wrong on the longer lending route.

The Classical View

The classical tradition stressed the effects of monetary policy through excess money bal- ances. In this view, when the Fed engages in open market operations, both bank reserves and the money supply increase. When the Fed buys bonds from banks, there is an increase in bank reserves. When the Fed buys bonds directly from the public rather than from banks, the switch from bonds to money increases the money supply directly. If the public deposits payments from the Fed in checkable deposits, bank reserves will also increase.

According to the quantity theory, when the money supply (Ms) expands, both individu- als and private banks find that they are holding larger money balances than they want. Demand for money to hold for transactions depends mainly on money income. When the

ama80496_14_c14_383-406.indd 385 12/4/12 4:43 PM

CHAPTER 14Section 14.1 How Monetary Policy Affects Aggregate Demand

Fed increases the money supply, then at the current level of money income, money sup- ply will exceed money demand. People attempt to spend their excess cash balances. This increase in planned spending is represented by a rightward shift in the AD curve. Either the price level, real output, or some combination of the two will rise, depending on the slope of the AS curve. Money income, which is P×Y, will rise. This process will continue until people are satisfied with their larger cash balances as a fraction of a larger money income. Thus, classical economists saw changes in the money supply as affecting spend- ing directly, rather than working indirectly through interest rates.

The process of translating money supply changes into changes in demand, output, and the price level happens through many different channels. Figure 14.1 shows the classical view of the process.

Figure 14.1: A classical view of the monetary process

In the classical tradition, an increase in the money supply creates excess money balances. As these bal- ances are spent, the increase in planned spending shifts AD to the right, driving up real output and the price level.

The Keynesian View

In the Keynesian view, the monetary process is longer and more complicated than in the classical view. In a Keynesian model, financial markets are linked to aggregate supply and aggregate demand primarily through changes in planned investment, which is a highly volatile component of aggregate demand. Other borrowing decisions (by households and governments) are also translated into changes in aggregate demand. An increase in the money supply will reduce interest rates, at least initially, because more funds will be avail- able for banks to lend. The lower interest rates will stimulate investment demand (which Keynes emphasized) as well as other kinds of spending that depends on borrowed funds (which is much more important in the 2000s than it was in the 1930s). Changes in both kinds of spending shift the AE and AD curves, causing changes in output and income. Depending on the slope of the AS curve, perhaps there will be an increase in the price level as well. Figure 14.2 shows the Keynesian view of the monetary process.

Changes in money supply

Spending (shifts in AE

and AD) (Influences)(Influence)

Output and

income

ama80496_14_c14_383-406.indd 386 12/4/12 4:43 PM

CHAPTER 14Section 14.1 How Monetary Policy Affects Aggregate Demand

Figure 14.2: A Keynesian view of the monetary process

In the Keynesian tradition, when the Fed buys bonds, the money supply increases, and interest rates fall. Lower interest rates stimulate spending, especially investment, and drive up aggregate expenditure, shifting AD to the right. The result is higher real output and a higher price level.

From Money to Interest Rates When the Fed creates money by buying bonds, the initial effect is to create excess bank reserves. Banks will want to lend these reserves in order to earn interest. To entice borrow- ers, banks may have to offer lower interest rates. In fact, the process of monetary expan- sion itself will tend to lower interest rates, at least in the short run. Consider the relation- ship between bond prices and bond yields. When the Fed uses open market operations to expand the money supply, it buys bonds. The increased demand for bonds drives their prices up and their yields down. As the lower yields on bonds spread to other assets and other financial markets, interest rates in general tend to fall.

Modern macroeconomists have tried to build their theories and models on a solid foun- dation of microeconomics. That is, they have sought to develop models that are firmly anchored in the self-interested behavior of individuals. The response of banks and indi- viduals to money creation is based on how they respond to changes in interest rates as the opportunity cost of holding money.

If open market operations by the Fed result in banks holding more excess reserves than they would like to, bankers will be eager to lend those excess reserves even at lower inter- est rates. If individuals find themselves with larger cash balances than they need, they will make some of them available for lending in order to earn interest. Both of these actions will increase the supply of loanable funds and tend to put downward pressure on the market interest rate.

The lower interest rates brought about by monetary policy may be short-lived, however, because market interest rates reflect expected inflation. If investors, banks, and house- holds think that expansion of the money supply will increase the inflation rate, they will build a higher expected inflation rate into the interest rates that they ask from borrow- ers or are willing to pay on loans. Thus, expectations of higher inflation can weaken the impact of monetary policy at this stage.

Changes in money

supply

Interest rates

Lower interest rates lead to

higher investment.

Higher investment causes output and national income to

rise through the multiplier process,

increasing employment.

(Influence) (Influence) (Influence)Investment Output

and income

ama80496_14_c14_383-406.indd 387 12/4/12 4:43 PM

CHAPTER 14Section 14.1 How Monetary Policy Affects Aggregate Demand

From Interest Rates to Planned Spending The next step in the monetary process is from interest rates to planned spending, espe- cially for investment. Chapter 13 introduced a relationship between investment demand and the interest rate, the ID curve. In Figure 14.3(a), we assume that the ID curve, repre- senting private investment demand, is the only source of demand for borrowing. When the supply of loanable funds increases due to expansion of the money supply, the interest rate falls from 6% to 4% and the quantity of loanable funds demanded for investment purposes increases from $100 billion to $125 billion.

Because investment is an important component of aggregate expenditure, the AE curve will shift from AE1 to AE2 as shown in Figure 14.3(b). The vertical shift will equal the $25 billion increase in investment demand. The upward shift in the AE curve will shift the AD curve to the right in Figure 14.3(c), increasing output and the price level. Thus, in the Keynesian version, monetary policy works through the channels of interest rates and investment demand to influence the levels of output and prices.

Figure 14.3: From loanable funds to aggregate demand

(a) The process of translating changes in the money supply into changes in output begins in the market for loanable funds. An increase in loanable funds depresses the interest rate, increasing investment demand from $100 billion to $125 billion. (b) Increased investment demand shifts aggregate expendi- ture upward, from AE1 to AE2. (c) An increase in aggregate expenditures shifts aggregate demand to the right, from AD1 to AD2, driving up output and the price level.

Problems With the Monetary Process

In the Keynesian view, however, several things could go wrong in translating changes in the money supply into changes in output. Banks may not lend, interest rates may not fall, or borrowers may not respond to lower interest rates. This last issue, how sensitive bor- rowing is to changes in interest rates, was addressed in Chapter 13. The other two issues are examined here.

0

6

4

MEI

100 125

Interest Rate (%)

(a)

45 degrees

(b)

$25 billion

0 Y

C, I, G

0 Y

AS

P

P 1

P 2

Y1

S 1

AE 2

AD 2 AD 1

AE 1

S 2

Y2 Y1 Y2

(c)

Loanable Funds (Billions of Dollars)

ama80496_14_c14_383-406.indd 388 12/4/12 4:43 PM

CHAPTER 14Section 14.1 How Monetary Policy Affects Aggregate Demand

Bank Lending and Excess Reserves Banks might choose to hold excess reserves, especially if the economy is in recession, when interest rates are already low and potential borrowers look risky. If the Fed buys bonds from the public rather than from banks, the individuals who sell the bonds might choose to hold currency instead of depositing the funds from selling the bonds in their checking accounts. If interest rates are low, the opportunity cost of holding money instead of inter- est-bearing assets is also low. Both banks and individuals may hold on to their monetary assets, expecting that interest rates will go back up and not wanting to lock in their assets in bonds at low current interest rates. Thus, currency drains and excess bank reserves can reduce the expansionary effect of open market operations on the money supply.

Keynes believed that banks would be more likely to hold excess reserves and households would be more likely to increase their money holdings when the money supply increase takes place under recessionary conditions of low interest rates and pessimistic expecta- tions. He thought that the demand for excess reserves by banks and for cash balances by households would be very sensitive to interest rates, at least during recessions. This was seen during the Great Recession of 2007–2009, when precrisis levels of excess reserves spiked from $1.5 billion in September 2008 to above $900 billion in January 2009 (Keister & McAndrews, 2009).

Money Demand and Interest Rates Even if banks or individuals lend some of the newly created money in the form of bank loans or purchases of other financial assets, it is possible that the interest rate might not fall very much. Figure 14.4 shows two views of the negative relationship between money demand and interest rates. The demand curve in both cases slopes down from left to right because interest is the opportunity cost of holding money, and when that cost is lower, more money will be demanded. The real issue between Keynesians and monetarists is not the negative slope but the steepness of the money demand curve.

The curve labeled DK is a Keynesian money demand curve, on which the quantity of money demanded is very sensitive to interest rates. The curve labeled DC is a money demand curve in the classical tradition, on which the quantity of money demanded does not respond very much to changes in interest rates. When the money supply expands from Ms1 to Ms2, interest rates fall much more along DC than DK. When money demand is highly sensitive to interest rates, a given expansion of the money supply will bring about a smaller decline in interest rates. A very small drop in interest rates is enough to induce banks and households to hold much more cash and fewer other financial assets, such as loans and bonds.

ama80496_14_c14_383-406.indd 389 12/4/12 4:43 PM

CHAPTER 14Section 14.1 How Monetary Policy Affects Aggregate Demand

Figure 14.4: Money demand, money supply, and interest rates

In the Keynesian view, money demand (DK) is very flat (sensitive); an increase in the money supply from Ms1 to Ms2 only reduces interest rates from i1 to i2 because it only takes a small drop in interest rates to bring about a large change in desired cash balances. In the classical view, money demand (DC) is very steep (insensitive); an increase in money supply from Ms1 to Ms2 reduces interest rates from i1 to i3 because it takes a very large drop in interest rates to bring about the same change in desired cash balances.

The responsiveness of money demand to interest rates is a major point of disagreement between economists in the Keynesian tradition and economists in the classical tradition. Numerous studies have attempted to determine the relative importance of changes in money income and interest in money demand. These test results suggest that both the “spend it” and the “lend it” channels of monetary policy are important channels through which monetary policy can affect output, employment, and prices (Alvarez & Lippi, 2011).

Is Monetary Policy Effective?

Suppose banks do not lend, or the public holds cash, or interest rates do not fall very much, or investment demand does not respond to lower interest rates. If any one of these occurs, a very large increase in the money supply will be needed to bring about much change in aggregate expenditure, output, and employment. Thus, the possibility that money demand is very sensitive to interest rates while investment demand is not is a serious drawback to monetary policy. Keynesians argue that you can lead investors to money, but you cannot make them spend. In their view, monetary policy should play a

0

i

i 1

i 2

i 3

M ,d M s

M s 1 M s 2

Dk

Dc

ama80496_14_c14_383-406.indd 390 12/4/12 4:44 PM

CHAPTER 14Section 14.1 How Monetary Policy Affects Aggregate Demand

Key Ideas: Two Views of Monetary Policy

Economists in the Keynesian tradition believe:

• Money demand is sensitive to interest rates. • The velocity of money is unstable. • Investment is insensitive to interest rates. • Monetary policy is not very effective in changing aggregate demand, output, and employment.

Economists in the classical tradition believe the opposite:

• Money demand is insensitive to interest rates. • The velocity of money is stable. • Investment responds to changes in interest rates. • Monetary policy is effective in influencing aggregate demand, output, and employment in

most cases.

supporting role for fiscal policy, keeping credit available and interest rates low when fiscal policy is expansionary and keeping credit tight when fiscal policy is contractionary. If fis- cal policy is successful in inducing investors and other spenders to borrow, however, then it is important that funds be available to them. Keynesians do not deny that monetary policy is important, but they think it clearly takes a backseat to fiscal policy, especially during recessions. To Keynesians, money matters, but not as much as fiscal policy.

Modern macroeconomists in the classical tradition who focus their attention on monetary policy are called monetarists. This group of economists feels that monetary policy is very important in affecting the level of employment, output, and prices—especially prices. Most monetarists regard recessions and depressions, as well as inflation, as results of bad mon- etary policy rather than some sort of normal, regular fluctuations in a market economy.

Monetarists argue that Keynesians put too much emphasis on the importance of interest rates in money demand and not enough stress on the importance of the interest rate to investment decisions. Keynesians are firmly grounded in microeconomic behavior with respect to money demand and interest rates. But economists in the classical tradition have the solid microeconomic foundation in their view of what determines investment demand. Interest is the price that firms must pay for the use of funds now rather than later. Firms compare that interest rate to the rate of return on the investment, whether they are borrowing funds or using their own funds that could be earning interest.

The debate over the role of interest rates in affecting lending and borrowing has important policy implications. If the Keynesian view is correct, then monetary policy will be rela- tively ineffective, especially during recessions. If monetarists are correct, monetary policy is an important and powerful tool with which to influence the price level and real output.

Economists in the classical tradition, who tend to unite in their doubts about the useful- ness or desirability of activist fiscal policy, are more likely to split on the issue of monetary policy. Some economists in this tradition think that the aggregate supply curve is so close to vertical, even in the short run, that all monetary policy can do is influence the price level, with little impact on real output. Others feel that monetary policy can be an effective tool for influencing output in the short run, but often they argue that in practice monetary policy has done more harm than good.

ama80496_14_c14_383-406.indd 391 12/4/12 4:44 PM

CHAPTER 14Section 14.2 The Choice of Monetary Policy Targets

14.2 The Choice of Monetary Policy Targets

Keynesians argue that monetary policy works mainly through interest rates. As a result, some economists argue that the target of monetary policy should be control-ling interest rates. Monetarists place less emphasis on interest rates and more on the direct effects of changes in the money supply on spending. They believe that the Fed should emphasize controlling the size of the money supply. Interest rates and the money supply are alternative targets for monetary policy, and there has been an ongoing dispute about which policy works better.

This dispute is important for two reasons. First, the Fed’s impact on market interest rates is limited and temporary. If the Fed tries to reduce interest rates by expanding the money supply, there will eventually be upward pressure on the price level. Inflationary expecta- tions will spread. Since these expectations are an important influence on interest rates, market interest rates will rise.

The second reason the dispute is important is that the Fed cannot pursue both targets at once. If the Fed tries to control interest rates, it must adjust the money supply to whatever level is needed to maintain the desired rates. If interest rates rise above the desired level, the Fed must buy bonds and increase bank reserves to stimulate lending and bring inter- est rates back down. If interest rates fall below the desired level, the Fed must cut back on the money supply to try to bring them back up. If the Fed tries to control the money sup- ply, then it cannot control interest rates. When the Fed chooses one target, it loses control of the other.

Monetarists usually favor controlling the size of the money supply and its rate of growth. Keynesians usually prefer an interest rate target. This choice reflects the Keynesian belief that interest rates exert an important influence on business activity. In addition, some Keynesians argue that it is difficult, if not impossible, for the Fed to control the growth of the money supply within narrow limits. This argument is based on the fact that the Fed does not exercise direct control over the money supply. The Fed affects the money sup- ply indirectly through its control of bank reserves and currency (Federal Reserve notes). Banks’ decisions about excess reserves and individuals’ decisions about cash balances will affect how large a money supply a given monetary base supports. For this reason among others, U.S. monetary policy is now typically described in terms of interest rate decisions.

The Monetary Base and the Money Multiplier

The Fed can influence bank lending by influencing bank reserves, but it cannot directly control lending and the money supply. What the Fed does control is the monetary base, which consists of currency in the hands of the public plus reserves held by banks. (Cur- rency in people’s hands is part of the monetary base because it becomes bank reserves if it is deposited in banks.) Thus, the monetary base is used either as cash holdings for the public or as reserves to support bank deposits. The monetary base can support a money supply up to the maximum determined by the deposit multiplier. The actual money sup- ply may be less than that amount, depending on currency withdrawals and bank excess reserves. The measure of the relationship between the monetary base and the actual money supply is given by the money multiplier, m, which is measured by

ama80496_14_c14_383-406.indd 392 12/4/12 4:44 PM

CHAPTER 14Section 14.2 The Choice of Monetary Policy Targets

m 5 Ms B

where B is the monetary base.

Suppose, for example, that the reserve ratio was 12.5%. The deposit multiplier would be 8, and a monetary base of $200 billion could support a maximum money supply of $1,600 billion. The value of m, however, is calculated from the actual money supply and the monetary base. There are different money multipliers that correspond to the different measures of the money supply. For example, suppose M1 5 $400 billion, M2 5 $1,000 bil- lion, and B 5 $200 billion. Then the M1 money multiplier is

m1 5 M1 B

5 $400 billion $200 billion

5 2

and the M2 money multiplier is

m2 5 M2 B

5 $1,000 billion $200 billion

5 5

Both the size and the stability of the money multiplier are important because the Fed can control only the monetary base, not the money supply. Changes in the money supply can result from changes in the monetary base, the money multiplier, or both. The value of m is influenced by the required reserve ratio but is really not under the Fed’s control. Part of an increase in the monetary base could result in increased holdings of currency, with a smaller increase in bank reserves. In this case, the public’s decision to hold more currency and coins instead of checkable deposits would keep Ms from rising as much as it other- wise would. The value of m would fall. If an increase in B goes entirely to reserves, banks could decide not to lend all these reserves, and again there would be a fall in m, partly frustrating the Fed’s attempts to increase the money supply.

If the money multiplier is not constant, changes in its value can affect the money supply even with no change in the monetary base. Suppose B is $200 billion and m is initially 2.5. Then Ms equals $500 billion (2.5 3 $200 billion). A fall in m of only 0.1, to 2.4, means that M becomes $480 billion (2.4 3 $200 billion), a fall of $20 billion. Thus, a very small change in m has a large effect on Ms. If the money multiplier is fairly stable, controlling the monetary base can allow the Fed to control the money supply fairly well.

Figure 14.5 shows the values of m for M1for the period 1984–2012. In each case, m was cal- culated by dividing the money supply by the monetary base. Although m was fairly stable from 1984 to 1994, it has fallen drastically in more recent years. In 1994, the M1 multiplier was 2.77. In 2012, the M1 multiplier hit a low of 0.806. Because the money multiplier is less than perfectly stable, when the Fed is pursuing a money supply target that target is usually set in terms of the growth of the money supply rather than the monetary base. The monetary base is then adjusted to offset undesired changes in the money supply from week to week.

ama80496_14_c14_383-406.indd 393 12/4/12 4:44 PM

CHAPTER 14Section 14.2 The Choice of Monetary Policy Targets

Figure 14.5: M1 money multiplier

The level of the M1 money multiplier was fairly stable from 1984 to 1994, before falling drastically in more recent years.

Source: Federal Reserve Bank of St. Louis, http://research.stlouisfed.org/fred2/graph/?s[1][id]5MULT.

Interest Rates as Target

It is important for the Fed to pay attention to interest rates. Letting interest rates rise too high could discourage investment and cause a recession. The decision to target interest rates instead of the money supply was reinforced by the fact that the treasury has to bor- row by selling U.S. government securities to the public. The government budget deficit is financed through these bond sales, and the treasury prefers low, stable interest rates to high, unstable ones.

When the Fed pursues an interest rate target, the Federal Open Market Committee attempts to keep the federal funds rate (the interest rate banks charge each other when lending and borrowing reserves) within a certain range. If, for example, Bank A needs $1 million in reserves to meet the reserve requirement, it can borrow it from Bank B and pay that bank interest at the federal funds rate. Bank B notifies the Fed to transfer $1 million from its reserve account to Bank A’s account. If banks want to borrow more reserves in the federal funds market than other banks have available to lend, there will be upward pres- sure on the interest rate, the federal funds rate.

1.0

0.5

2.5

2.0

3.5

Ratio

1.5

3.0

1980 1985 19951990 2000 2010 20152005

Shaded areas indicate U.S. recessions.

Year

ama80496_14_c14_383-406.indd 394 12/4/12 4:44 PM

CHAPTER 14Section 14.2 The Choice of Monetary Policy Targets

When the Fed targets interest rates, the normal specific target is a range of values for the federal funds rate, such as 7%–7.5%. If the demand for reserves rises, driving up the fed- eral funds rate to 7.5% or higher, the Fed will buy government bonds. The prices of bonds will rise, and their yields will fall. Lower interest rates spread from bonds to other assets, making bank lending less attractive and banks less anxious to borrow reserves from other banks in order to expand their loans. As a result, the federal funds rate is kept from rising above 7.5%. If demand for reserves falls, and the federal funds rate seems likely to fall below 7%, the Fed will sell government bonds. Open market sales of bonds will depress bond prices and put upward pressure on interest rates.

An interest rate target requires the Fed to keep adjusting the monetary base to whatever is demanded in the market for loanable funds. Thus, the Fed cannot control both the money supply and interest rates at the same time. The Fed was widely criticized by monetar- ists in the 1970s for giving interest rate targets priority over money supply targets. In an abrupt shift, the Fed changed its priorities from interest rates to the money supply in the fall of 1979. This change, under the leadership of chairman Paul Volcker, was regarded as a milestone in monetary policy and a victory for monetarist ideas. The policy of focusing on the money supply remained in place until 1982, but pressure on the Fed during the recession then forced it to moderate that policy. In addition, changes in the banking sys- tem have made it more difficult to forecast and control relationships between the size of the monetary base and the money supply. Finally, the link between both M1 and M2 and GDP has weakened as more substitutes for traditional forms of money have developed, all leading the Fed to focus its monetary policy on interest rate decisions.

Current Debates Over Targets

The Fed has also included GDP targeting in its range of policy tar- gets. This policy calls for the Fed to aim at some level of nominal GDP by influencing a number of vari- ables that affect it. These variables include the measures of the money supply as well as total credit and interest rates. However, even if changing GDP is the ultimate goal, the Fed must choose intermediate targets that are within its control to try to attain that goal (Romer, 2011). Those targets are still some combination of money supply and interest rates.

One such method of monetary policy targeting is called the Taylor rule. Basically, the Taylor rule stip- ulates that for each 1% increase in inflation, the Fed should increase

Associated Press

Federal Reserve Board chairman Alan Greenspan testified before the Senate Banking Committee in Washington, DC, on Thursday, July 22, 1993. He emphasized that the Federal Reserve Board viewed containing inflation as a necessary prerequisite to achieving sustained economic growth.

ama80496_14_c14_383-406.indd 395 12/4/12 4:44 PM

CHAPTER 14Section 14.3 Problems in Implementing Monetary Policy

Key Ideas: Possible Monetary Policy Targets

Interest Rate Targets

Federal funds rate The rate banks charge each other to borrow federal reserves

Real interest rate The federal funds or T-bill rate adjusted for inflation

Money Supply Targets

Monetary base Currency plus bank reserves

M1 or M2 money supply Currency, checkable deposits, traveler’s checks, other items

GDP Target

GDP or growth rate Nominal output

the nominal interest rate by more than 1% (Taylor, 1993). The benefit of such a rule is to reduce uncertainty about how the Fed would choose to respond to inflation, thereby promoting price stability. The practice of creating a specific action by a central bank in response to inflation is called inflation targeting.

Since 1982, the Fed has been using a mix of targets: a range of growth rates for the several measures of the money supply and a range of market interest rates. In 1993, after working with a changing array of targets for 6 years, then-chairman Alan Greenspan announced that the policy of the Fed would emphasize real (inflation-adjusted) interest rates as a pol- icy target. Greenspan’s goal was to slow the growth of bank reserves and put the brakes on bank lending so that the expansion would continue, but not at a pace that would result in accelerating inflation. This choice of targets was partly influenced by a weakening rela- tionship between the M2 money supply and the price level. As both short-term and long- term real interest rates fell sharply in the early 1990s, the real interest rate on Treasury bills was close to zero by 1993 and again in 2010.

14.3 Problems in Implementing Monetary Policy

In addition to theoretical difficulties in how monetary policy affects the economy, and the problems associated with a choice of targets, there are also some practical difficul-ties in implementing monetary policy. Like fiscal policy, monetary policy is subject to lags. Monetary policy impacts a few sectors of the economy more heavily, rather than being spread evenly throughout the economy. And finally, the management of monetary policy has been complicated by the increasing globalization of financial markets. This sec- tion examines each of these problems in turn.

ama80496_14_c14_383-406.indd 396 12/4/12 4:44 PM

CHAPTER 14Section 14.3 Problems in Implementing Monetary Policy

Lags in Monetary Policy

Monetary policy is affected by the same kinds of lags as fiscal policy: recognition, implemen- tation, and impact. The recognition lag is probably about the same length for both monetary and fiscal policy. Unlike fiscal policy, however, monetary policy has a very short implementa- tion lag. The Federal Open Market Committee (FOMC) meets regularly and makes decisions about changes in the money supply. Because of the Fed’s independence from Congress and the executive branch, it can move quickly without asking anyone’s permission.

In discussions of monetary policy, the recognition and implementation lags are combined and known as the inside lag. The time from action to impact—known as the outside lag in monetary policy—can be quite long. The length of the outside lag depends on how quickly people recognize and respond to a change in the money supply. It takes time for banks to increase or decrease their lending or for individuals to adjust their spending. In general, it is estimated that, because of the outside lag, it takes at least two quarters for monetary policy to have half its ultimate impact and 18 to 24 months for the full effect to be felt.

Lags can cause monetary policy to have the wrong effect, just as they can for fiscal policy. Between 1945 and 1982, cycles of economic activity were brief, with the average recession lasting only 11 months. A policy that cannot be implemented quickly and have a rapid impact may be worse than no policy at all.

Domestic Sectoral Effects

Monetary policy does not affect all sectors of the economy equally. When monetary policy is tight, economic activities that depend on borrowing are affected more heavily. Business investment in plants and equipment, housing, consumer durables (especially automo- biles), and state and local government capital projects are very dependent on borrow- ing and sensitive to changes in monetary policy. Consumers, the auto industry, and the construction industry resent being singled out to bear more than their share of the battle against inflation when monetary policy is tightened. Adjustable-rate mortgages (ARMs) and other innovations in home financing have somewhat lessened the impact of monetary policy on housing. However, this and other parts of the private sector are still very sensi- tive to changes in interest rates and the availability of funds.

Monetary Policy in a Global Economy

The monetary process shown in Figures 14.1 and 14.2 (See section 14.1) is based on a closed economy. That is, this model ignores the rest of the world. However, the fraction of U.S. output entering international trade has grown in recent decades. Flows of money and financial assets between countries have also expanded. It has become increasingly clear that neither monetary policy nor fiscal policy can ignore the rest of the world.

Since 1973, when nations switched to floating exchange rates, monetary policy has been more closely tied to changes in the foreign sector. A tight monetary policy that drives up interest rates attracts funds from abroad and drives up the price of the dollar. When the price of the dollar rises, exporters find it harder to sell their goods abroad. Also, import- competing firms find that their foreign competitors can more easily undersell them because

ama80496_14_c14_383-406.indd 397 12/4/12 4:44 PM

CHAPTER 14Section 14.3 Problems in Implementing Monetary Policy

Key Ideas: Lags in Monetary Policy

Monetary policy lags arise from

• recognition, • implementation (combined with recognition to form the inside lag), and • impact (or outside lag).

Unlike fiscal policy, monetary policy has a very short implementation lag.

their goods are cheaper in dollar terms. Thus, the international sector of the economy has become increasingly sensitive to monetary policy.

For example, suppose the Fed is pursuing an expansionary policy. According to the mon- etarist model, there will be an excess supply of money. As people try to spend it, their purchases will drive up both real output and the price level, in some combination. In an open economy, however, some of their purchases will be imported goods rather than domestic products. As the price level starts to rise, sales of exports will fall, and imports of relatively cheaper foreign goods will rise. A fall in exports and a rise in imports mean that the aggregate demand curve shifts to the left. This shift reduces the impact of expansion- ary monetary policy on output and the price level. Some of the extra money is, in effect, exported, increasing demand in the rest of the world as well as at home.

In the Keynesian model, monetary policy works mainly through interest rates. In the international economy, the emphasis shifts from interest rates to yields on assets. Most of the difference between yields and interest rates comes from the fluctuations in exchange rates. For countries with a common currency, or a currency agreement, such as the mem- bers of the European Union that have adopted the euro, yields and interest rates will be the same, as they are among the states of the United States.

As interest rates start to fall in an open economy, domestic firms will want to borrow more in response to the lower rates. Lenders, however, are more likely to want to make loans in other countries where higher yields are offered. Some of the newly created money goes abroad in search of higher yields. In addition, the inflow of funds from abroad shrinks as domestic interest rates fall. The net increase in loanable funds is fairly small, and there is little effect on investment.

The same problems occur with contractionary monetary policy in a Keynesian model. Spending falls, but some of the decline is in spending for imports, rather than domestic goods and services. Thus, there is less impact on aggregate demand, output, and the price level. Higher interest rates will attract an inflow of foreign funds, frustrating any attempts to reduce investment demand.

Thus, although Keynesians and monetarists often disagree about the process, they concur that monetary policy is less effective in an open economy. Regardless of whether mon- etary policy works directly through spending or indirectly through interest rates, it will be less effective in an economy that is very open (has a lot of economic interactions with other countries). Small countries, such as Guyana, Taiwan, the Netherlands, and Costa Rica, will find it virtually impossible to pursue an independent monetary policy because most of the effects may leak out of the economy instead of staying at home.

ama80496_14_c14_383-406.indd 398 12/4/12 4:44 PM

CHAPTER 14Section 14.4 Monetary Policy Under the Fed, 1914–2012

14.4 Monetary Policy Under the Fed, 1914–2012 When the Federal Reserve System was established in 1913, one of its primary functions was to keep the United States in compliance with the international gold standard. The Fed had to allow the size of the U.S. gold stock held by the treasury to set an upper limit on the size of the money supply. Such a requirement severely limited the Fed’s freedom to expand the money supply.

The Fed’s first challenge was helping the treasury finance the budget deficit during and after World War I. The Fed cooperated in keeping interest rates low and buying any gov- ernment bonds that could not find a buyer. These actions were inflationary. When the Fed recognized that the ratio of money to gold was getting too high, it began to contract the money supply. That action played a role in bringing about the 1920–1921 recession.

The Fed and the Depression

The biggest controversy over the Fed’s policy centers on its actions from 1929 to 1937. The money supply fell by 25% from August 1929 to March 1933, in part because of widespread bank failures. Such a wave of failures was exactly what the Fed was intended to pre- vent. The Fed, aided by large inflows of gold, did keep the discount rate low during the early years of the Depression. It was the money supply, not the monetary base, which fell sharply. The monetary base remained stable while the ratio of currency to deposits rose (as people withdrew cash from the banking system) and the ratio of deposits to reserves fell (as banks held more excess reserves). Widespread bank failures led to large cash with- drawals from banks. Thus, the same monetary base supported fewer deposits. Banks saw few good loan prospects, so they chose to hold large excess reserves. Cash withdrawals combined with excess reserves meant that the money multiplier was smaller.

Milton Friedman and Anna Schwartz are the best-known critics of the Fed’s actions in this period. In a thorough study of these actions, Friedman and Schwartz argued that the Fed was too passive, failing to pump up reserves to offset what was happening in the private sector (Friedman & Schwartz, 1963). The Fed did not shrink the monetary base, but did not allow it to expand either. However, the Fed was constrained, with respect to the size of the money supply, by the gold standard until 1934. The most controversial policy decision by the Fed during the Depression took place after the United States went off the gold standard. The Fed chose to raise reserve requirements in 1936, trying to “mop up” excess bank reserves. This contractionary action was widely blamed for sparking an economic downturn in 1937.

However, the money supply can change from either the supply side or the demand side. The return on investment was low during the early years of the Depression. If there is low return on investment and weak consumption demand, interest rates will fall. That fall will lead both individuals and banks to hold more cash and make less available to borrow- ers. The opportunity cost of holding currency and excess reserves will be low because of demand factors, which are largely outside the Fed’s control.

The Fed did not cause the Depression, but perhaps a more aggressive expansionary mon- etary policy would have made it shorter and milder. Bear in mind, however, that the Fed had had only 17 years of experience when the Depression occurred, and monetary theory was nowhere near as well developed as it is today. Also, many of the Fed’s actions prior to 1935 were restricted by its need to comply with the gold standard.

ama80496_14_c14_383-406.indd 399 12/4/12 4:44 PM

CHAPTER 14Section 14.4 Monetary Policy Under the Fed, 1914–2012

Policy Focus: Alan Greenspan Versus Ben Bernanke

The 4-year term of the chair of the Federal Reserve Board of Governors overlaps the term of the presi- dent in a peculiar fashion. About a year and a half before leaving office or running for reelection, the president finally gets to choose the person who controls the nation’s monetary policy. In 1987, Presi- dent Reagan appointed Alan Greenspan, a conservative economist with a strong anti-inflationary bent, as head the Federal Reserve. Greenspan, who was reappointed by President George H. W. Bush in 1991, was only the second economist (after Arthur Burns) to have served as both chair of the Council of Eco- nomic Advisers (under President Ford) and head of the Federal Reserve System.

Greenspan was not an advocate of zero inflation, just inflation low enough so that it is no longer a significant factor in financial decisions. Greenspan felt that this goal required frequent adjustments in the Fed’s goals and targets, a course that earned him much criticism from monetarist supporters of a monetary rule and a steady monetary growth policy. In 2006, Ben Bernanke was appointed as the head of the Federal Reserve by President George W. Bush. In 2012, he presented a new monetary policy framework with an explicit inflation target of 2%. In Bernanke’s opinion, raising the inflation target (an economic policy in which a central bank estimates and makes public a projected, or target, inflation rate and then attempts to steer actual inflation toward the target through the use of interest rate changes and other monetary tools) would lift employment and stimulate the economy. Unlike Greenspan, Ber- nanke felt that raising inflation was the shock to the system that the U.S. economy needed in order to create more jobs and move more of the money supply throughout the economy.

These two men have had two different approaches to how the Fed should manage the U.S. economy. Only time will tell which approach will be more effective.

The Accord

During and after World War II, the Fed’s main task was helping the treasury finance the enormous debt incurred during the war at acceptably low interest rates. The Fed aban- doned monetary targets in order to hold down interest rates. The result was inflation because every time the Fed bought treasury obligations to keep interest rates down, it expanded bank reserves. In 1951, the Fed and the treasury reached an agreement. This agreement, called the Accord, stated that the Fed was no longer obliged to hold interest rates low to assist with the treasury’s debt financing. In 1952, the Fed was finally free to turn its monetary policy in the direction of stabilizing economic activity.

For most of the rest of the 1950s, the Fed used free reserves as its policy target. Free reserves consist of bank excess reserves less bank loans from the Fed. If free reserves were large, the Fed took that as a signal of too much slack in the credit market. The Fed defined its role during this time as “leaning against the wind.” That is, the Fed was assessing the direc- tion of economic activity and trying to steer the economy back toward a middle ground of steady growth, stable prices, and high employment.

ama80496_14_c14_383-406.indd 400 12/4/12 4:44 PM

CHAPTER 14Section 14.4 Monetary Policy Under the Fed, 1914–2012

Monetary Policy in the 1960s and 1970s

The inflation rate began to creep up in the late 1960s and rose faster in the 1970s. From 1965 to 1979, the CPI rose 130%. For most of this period, monetary policy was expansion- ary. The 1970s began with a financial crisis, a sharp drop in the stock market combined with the failure of Penn Central, a railroad that was a major borrower from commercial banks. The Fed earned some of its highest marks ever for monetary policy during this cri- sis. It announced that the discount window was open and lowered reserve requirements.

By the late 1970s, after flip-flopping between targeting the money supply and targeting interest rates, the Fed began to move more in a monetary direction, while keeping an eye on interest rates. An abrupt change of direction in October 1979 was later named the “Saturday night special.” Instead of interest rates, the Fed decided to make the growth of the various measures of the money supply, especially M1, the focus of its policy actions. The Fed cut the monetary growth rate sharply at the end of 1979, which drove interest rates to all-time highs. This action contributed to the recession (and drop in the inflation rate) of the early 1980s. The 1979 shift marked a firm choice of money supply targets over interest rate targets.

Monetary Policy in the 1980s and 1990s

Through most of the 1980s, the Fed, under chairman Paul Volcker, pursued a fairly restric- tive monetary policy. This policy was credited with helping to reduce both the inflation rate and nominal (but not real) interest rates. Part of the decrease in inflation and interest rates, however, was the result of a decline in velocity rather than a slowing of the growth of the money supply. Monetary policy in the 1980s was complicated by rapid growth of the federal debt, an influx of foreign lending, changes in bank regulations, and more numerous bank failures. In 1982, the Fed backed off from its 1979 decision to focus solely on money supply targets and began to pursue interest rate targets as well. In addition, M1 competed with other measures of money and credit for the role of primary money supply target.

In 1987, Volcker was succeeded by Alan Greenspan as chair of the Fed. A combination of changing leadership and experience changed the Fed’s operating style and priorities. The experience of the 1970s and 1980s made the Fed much more concerned about inflation and also much more aware of the effects of high interest rates on the economy. Bank deregu- lation, increasing involvement of foreigners in U.S. money and credit markets, and the gradual weakening of the close link between M1 and GDP have made the Fed much more uncertain about the effects of its actions on the economy. Greenspan held his position as chair of the Fed for 18 years, from 1987 to 2006, when he retired.

Monetary Policy in the 2000s

In February 2006, Ben Bernanke was appointed chairman of the Federal Reserve, ushering in a new era of monetary policy as the credit and housing markets experienced a bubble of previously unseen proportions. One of Bernanke’s first actions was to increase interest rates in an effort to keep inflation in check. Once the housing bubble burst, Bernanke had to over- see the response of the Fed to these financial crises. The 2007–2009 Great Recession particu- larly challenged Bernanke and other economists. There was great disagreement about how

ama80496_14_c14_383-406.indd 401 12/4/12 4:44 PM

CHAPTER 14Section 14.4 Monetary Policy Under the Fed, 1914–2012

to handle the situation. As the debate continued, most economists came to agree that the crisis stemmed from an economic bubble, but neither the classical nor Keynesian schools of macroeconomic thought had considered that such a significant bubble could occur. Because of this, the crisis helped spur all economists to reevaluate their thinking.

In the meantime, the recession that began in 2007 with problems at the Bear Stearns hedge fund continued the next 2 years. When Bear Stearns collapsed in 2008, it was only the beginning of the meltdown of the Wall Street investment bank industry in September 2008 and the subsequent global financial crisis and recession. The collapse of such long- standing giants of the financial world was followed by the filing of bankruptcy by the Lehman Brothers, the takeover of Merrill Lynch by Bank of America, the failure of Wash- ington Mutual bank, and the federal takeover of Fannie Mae and Freddie Mac.

From 2007 to 2010, the Fed used many practices that had never before been seen from the central bank of the United States. First, the Fed extended credit to nonbank financial firms, which was the first time since the Great Depres- sion that entities outside of the Federal Reserve System could bor- row directly from the Fed. The Fed also purchased assets and loans from firms deemed “too big to fail.” The purchases of mortgage- backed securities, loans ranging from millions to billions to finan- cial firms like American Interna- tional Group, and guarantees of the assets of Citigroup and Bank of America were all seen as uncon- ventional practices of the Fed. Armed with a clause in the Fed- eral Reserve Act for practices to

be used in “unusual or exigent circumstances,” the Fed used everything in its power to stabilize the financial system and prevent a more severe downturn in the U.S. economy (Labonte, 2010).

In January 2012, the Federal Open Market Committee claimed the economy had been expanding moderately, with labor market conditions improving and the unemployment rate declining slightly. The housing sector was still depressed, but the committee that steers the Fed expected moderate economic growth. Because of this, the committee is maintaining a “highly accommodative stance for monetary policy,” and plans to keep the target range for the federal funds rate at 0 to 0.25%, at least through 2014 (Board of Gov- ernors of the Federal Reserve System, 2012).

Associated Press

Graffiti seen on the entrance of a Washington Mutual branch. Washington Mutual had been seized by the Federal Deposit Insurance Corporation and then sold to JPMorgan Chase & Co. 1 day earlier.

ama80496_14_c14_383-406.indd 402 12/4/12 4:44 PM

CHAPTER 14Post-Test

Key Ideas: Monetary Policy Response to the Great Recession

During the Great Recession of 2007–2009, the Fed used many unconventional methods to stabilize the economy, like

• lowering the federal funds rate to nearly zero, • expanding the credit market to include direct lending to nonbank financial firms, and • guaranteeing the assets of firms deemed “too big to fail.”

Conclusion

One man can have a tremendous impact on a country and its economy. Ben Ber-nanke ended the “cult of personality” that began with Volcker and Greenspan, choosing instead to take a more relaxed, professorial approach to managing the Fed. Bernanke infused some much-needed cash into the U.S. economy, easing up the 2007–2009 recession and avoiding another Great Depression.

In January 2012, the Federal Open Market Committee noted that the inflation rate of 2% is in line with where the Fed and the economy need to head over the next few years. This inflation goal will help keep longer term inflation expectations firmly anchored, which will foster price stability, moderate long-term interest rates, and enhance the committee’s ability to promote maximum employment. Monetary policy is a key tool in the Fed’s arse- nal to shore up the economy in challenging times.

Post-Test

1. “Monetary policy is really interest rate policy.” This statement describes the view of monetary policy held by

a. monetarist economists. b. Keynesian economists. c. stockbrokers. d. supply siders. e. officials of the United States Treasury.

2. An increase in the interest rate will cause a. an increase in consumption. b. an increase in the price of bonds. c. a rightward shift of aggregate demand, thus increasing output and prices. d. a leftward shift of aggregate demand, thus lowering output and prices.

3. Keynesians believe that the appropriate target of monetary policy is a. the money supply. b. bank reserves. c. interest rates. d. the size of the government deficit. e. MFC.

ama80496_14_c14_383-406.indd 403 12/4/12 4:44 PM

CHAPTER 14Post-Test

4. If there is an increase in the money supply, then in the long run, a. short-term nominal interest rates will fall. b. the price level and nominal interest rates will increase. c. the price level will increase and nominal interest rates will fall. d. the price level and nominal interest rates will fall. e. the price level will increase and nominal interest rates will not change.

5. Compared to fiscal policy, monetary policy has a. no lags. b. a shorter recognition lag, but a longer implementation lag. c. a longer implementation lag, but no impact lag. d. a shorter implementation lag, but a longer impact lag. e. shorter impact lag, but a longer recognition lag.

6. When monetary policy is tight, the sectors most likely to be affected are a. consumer durables and consumer nondurables. b. business investment and consumer nondurables. c. state and local governments. d. business investment, state and local governments, and consumer durables. e. none of these sectors would be affected.

7. In the early years of the Federal Reserve’s existence, its primary function was to a. set the standards for the establishment of new banks. b. act as a participant in currency markets to maintain the value of the dollar rela-

tive to the English pound. c. set an upper limit on the size of the money supply in a fixed ratio to U.S. gold

holdings. d. maintain the interest rate at an artificially high level.

8. Which one of the following is NOT an argument for a monetary rule? a. long and variable lags. b. imperfect information in the marketplace. c. past performance of the Fed. d. the Fed’s lack of control of the monetary base. e. political interference in the Fed’s monetary policy.

Answers 1. b. Keynesian economists. The answer can be found in Section 14.1. 2. d. a leftward shift of aggregate demand, thus lowering output and prices. The answer can be found in

Section 14.1. 3. c. interest rates. The answer can be found in Section 14.2. 4. b. the price level and nominal interest rates will increase. The answer can be found in Section 14.2. 5. d. a shorter implementation lag, but a longer impact lag. The answer can be found in Section 14.3. 6. d. business investment, state and local governments, and consumer durables. The answer can be found

in Section 14.3. 7. c. set an upper limit on the size of the money supply in a fixed ratio to U.S. gold holdings. The answer

can be found in Section 14.4. 8. d. the Fed’s lack of control of the monetary base. The answer can be found in Section 14.4.

ama80496_14_c14_383-406.indd 404 12/4/12 4:44 PM

CHAPTER 14Critical Thinking Questions

Key Ideas

1. Monetarists believe that monetary policy works directly by creating a money supply that exceeds money demand. The excess money is spent, driving up prices or output. The Keynesian view of monetary policy is that it works by lowering interest rates. In turn, lower interest rates stimulate investment and increase aggregate expenditure and aggregate demand. In this case, the effective- ness of monetary policy depends on how sensitive money demand is to interest rates and how responsive investment demand is to changes in interest rates. Keynesians do not think that monetary policy is always very effective at lower- ing interest rates or that lower interest rates are very effective in stimulating investment.

2. The Fed can attempt to control either the money supply or interest rates, but not both. From 1979 until the early 1990s, more emphasis has been placed on target- ing the money supply. More recently, the Fed has been looking at other targets, including real interest rates.

3. Monetary policy suffers from lags, regional effects, and political pressures. Because of these problems with monetary policy, some economists support a monetary rule that would set a fixed rate of growth for the money stock. Mon- etary policy is less effective in a global economy because financial markets are integrated among countries.

4. The Fed used many unconventional methods to stabilize the economy during and after the Great Recession of 2007–2009. By lowering the federal funds rate to nearly zero, expanding the credit market to include direct lending to non-bank financial firms, and guaranteeing the assets of firms deemed “too big to fail,” the Fed likely averted a more serious economic crisis and perhaps another Great Depression.

Critical Thinking Questions

1. The monetarist monetary process accepts “spend it” as the explanation of what happens to an increase in the money supply. The Keynesian monetary process follows the “lend it” route. Explain the difference.

2. Why can the Fed not control both the money supply and interest rates at the same time? Discuss the advantages and disadvantages of each target.

3. Which sectors are most affected by changes in monetary policy? Why? 4. Why did Milton Friedman advocate a monetary rule instead of discretionary fis-

cal policy? 5. What are the inside lag and the outside lag? How do they affect the usefulness of

monetary policy? 6. If MPC 5 0.75, what change in Y would occur if i decreased from 10% to 6%? Use

Figure 14.3 to determine your answer. 7. Let i 5 6% and MPC 5 0.9. Further, suppose the economy is in equilibrium and

Y 5 $2,000 billion. If Y* 5 $2,200 billion, what change in i would be necessary to bring the economy to the full-employment level of national income? Use Figure 14.3 to determine your answer.

ama80496_14_c14_383-406.indd 405 12/4/12 4:44 PM

CHAPTER 14Critical Thinking Questions

8. Let B be $200 billion. If m is 3 and then rises to 3.2, what is the change in Ms? What is the dollar change in Ms if B rises from $200 billion to $225 billion and m is constant at 3?

9. Why do Keynesians think that monetary policy is likely to be less effective than fiscal policy?

10. If money demand is sensitive to changes in interest rates and investment demand is not, how would that affect the relative effectiveness of monetary and fis- cal policy? What if money demand is not sensitive to interest rate changes but investment demand is?

11. If you were in charge of the Fed and concerned about inflation, would you pur- sue an interest rate target or a money supply target? Why?

ama80496_14_c14_383-406.indd 406 12/4/12 4:44 PM