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.