Chapter 15: Monetary Policy

Monetary policy is the manipulation of the money supply with the objective of affecting macroeconomic outcomes such as GDP growth, inflation, unemployment, and exchange rates. Monetary policy in the United States is conducted by the Federal Reserve, in particular, by the FOMC.

In the chapter we take a closer look at monetary policy by examining how money supply, and thus the Fed, affects aggregate demand. We also compare the effectiveness of monetary and fiscal policy.

I. The Money Market

To understand the role of money in the macroeconomy we first need to look at money demand and money supply. By money supply we are usually referring to M1 or M2.

The Demand for Money

Keynes (yes, him again) believed the demand for money came from 3 sources:

1. Transactions demand. People hold money to buy stuff.
2. Precautionary demand. People hold money for emergencies (cash for a tow truck, savings for unexpected job loss).
3. Speculative demand. People hold money to take advantage of a financial opportunity at a later date.

The decision to hold money involves a tradeoff. Holding M1 is advantageous in buying goods and services, however assets in M1 (cash, checking accounts) earn very little, if any, interest. Holding assets with a competitive interest rate, like bonds is not convenient for buying goods and services. We can think of the interest rate as the opportunity cost or price of holding money. The demand for money (M1) is downward-sloping with respect to interest rates:

An increase in national income will shift the money demand curve to the right, because people buy more stuff. Also, technology like ATM/debit cards will shift the money demand curve to the left because people do not have to hold as much M1 since it is easier to access a savings account.

Money Supply

As seen above, we assume that money supply is set by the Federal Reserve at the level they choose, so money supply is vertical at the quantity chosen by the Fed.

By shifting the money supply, the Fed can change equilibrium interest rates. Suppose the Fed buys bonds on the open market. This increases the money supply, shifting the MS curve to the right, causing interest rates to fall:

II. Money and Aggregate Demand: A Keynesian View

A change in interest rates will in turn affect the spending decisions of consumers and firms. With lower interest rates it is cheaper for firms to invest and for consumers to buy durable goods, and this will shift the aggregate demand curve to the right, increasing output:

Similarly, decreasing the money supply would raise interest rates, decrease investment and consumption, and decrease aggregate demand:

III. Monetary Policy: Keynesian vs. Monetarist Views

In the Keynesian model above, interest rates & investment are the transmission mechanism of monetary policy, i.e. that is the way monetary policy affects macroeconomic outcomes. However, there are other points of view.

The Monetarists believe that monetary policy affects prices, but not real GDP or unemployment. The impact of monetary policy can be expressed using the equation of exchange.

MV = PQ

Where M= the quantity of money in circulation, V = the velocity of money, P = the price level, and Q = real GDP. Velocity is the number of times a dollar is used to purchase goods and services in a given year.

If we assume that V is stable (it doesn’t change very often), the a change in the money supply, M must change P or Q. So no matter what happens to interest rates, total spending changes. If we assume the Q is near full capacity (the vertical part of the AS curve) then changes in M only affect P (see figure 15.5, page 301).

This difference in the Keynesian and Monetarists views also leads to different remedies for fighting inflation and unemployment

Fighting Inflation

Keynesians would advocate a decrease in the money supply (contractionary monetary policy), which would increase interest rates, decrease spending, decrease AD, and decrease prices and real output.

Monetarists would argue that if inflation is too high, then interest rates are already high:

nominal interest rate = real interest rate + anticipated inflation rate

So Monetarists believe that decreasing the money supply will cause nominal interest rates to FALL (not rise) because the anticipated inflation rate will fall eventually. Monetarists advocate steady, predictable money growth to keep anticipated inflation and nominal interest rates low.

Note that both Keynesians and Monetarists advocate a decrease in the money supply to fight inflation, but they expect it to work for different reasons.

Fighting Unemployment

Keynesians would advocate an increase in the money supply (expansionary monetary policy), which would decrease interest rates, increase spending, increase AD, increase prices and output, and decrease unemployment.

But monetarists believe that an increase in the money supply will affect mostly prices, not output. This would raise inflationary expectations and actually INCREASE nominal interest rates. Monetarists do not believe that expansionary monetary policy is effective, unless the economy is WAY below full-employment (on the horizontal part of the AS curve).

In general, Monetarists believe in fixed money supply targets, or a rule for how much to change the money supply. Keynesians disagree, and believe in more flexibility or discretion, with the Fed adjusting money supply to respond to economic conditions. This debate is known as rules vs. discretion.

Tables 15.2 and 15.3 summarize the differences between Keynesians and Monetarists on the efficacy of fiscal and monetary policy.

FYI: Related Links

The History of Economic Thought Website This site offers more information about Keynesians, Monetarists, and other schools of thought in economics.

Milton Friedman Visit the homepage of the leader of modern Monetarism.

EconDebate: Should the Fed pursue a fixed policy rule? An introduction to the debate over rules vs. discretion, complete with links to arguments on either side.

EconDebate: Should the Fed aim at a zero-inflation policy? This debate deals with whether low inflation is just as good as no inflation, or at least close enough.

United States Monetary Policy A primer from the Minneapolis Federal Reserve Bank.