Transcript Chapter 5
Chapter 5 Monetary Theory and Policy © 2001 South-Western College Publishing Company Monetary Theories Developed by John Keynes and his students Initially tried to explain inadequacy of monetary policy during great depression Effectiveness of monetary policy depends upon The sensitivity (elasticity) of economy to changes In interest rates Advocates fiscal policy 2 Monetary Theories Keynesian theory continued Focus on how a government surplus or deficit can influence the economy Advocates proactive economic policy Can consider the theory using the framework of loanable funds 3 Monetary Theories Keynesian theory to correct a weak economy To stimulate the economy the Fed buys securities in an open market operation Fed’s actions increase the supply of loanable funds Interest rates drop and business investment goes up Keynesian theory to correct high inflation Government policy to reduce spending 4 Monetary Theories Keynesian theory and credit crunches Banks’ willingness to lend affects monetary policy Banks lend based on evaluation of borrower’s ability to repay, not just availability of funds Monetary policy to stimulate the economy works only if banks find enough qualified borrowers Restrictive monetary policy may magnify credit crunch 5 Monetary Theories Quantity theory Based on equation of exchange MV=PGQ M = amount of money in the economy V = velocity, average number of times each dollar changes hands during the year PG = weighted average price level of goods and services in the economy Q = quantity of goods and services sold 6 Monetary Theories Monetarists Velocity is affected by • Income levels • Frequency income is received • Use of credit cards • Inflationary expectations Velocity changes found to be predictable and not related to fluctuations in money supply 7 Monetary Theories Monetarist Let economic problems resolve themselves Low growth reduces borrowing and lowers interest rates Problem: takes time Keynesian Need to take action to lower interest rates High money growth to fix a recession by lowering rates Problem: Might ignite inflation 8 Monetary Theories Monetarist Low, stable growth in the money supply Focus on maintaining low inflation and will tolerate what they call natural unemployment Keynesian Actively manage the money supply Willing to tolerate inflation that helps reduce unemployment 9 Tradeoff Faced By The Fed Goals of the Fed Steady GDP growth Low unemployment Maintain low inflation Tradeoffs Lowering unemployment may put pressure on inflation Lowering inflation may increase unemployment 10 Tradeoff Faced By The Fed Tradeoffs between employment and inflation make it difficult to solve both problems simultaneously Impact of other forces Factors outside the control of the Fed affect employment and inflation Classic example of the tradeoff is the summer of 1990 with Gulf War and high oil prices but signals pointing to a possible recession 11 Economic Indicators Monitored By The Fed Indicators of economic growth Gross Domestic Product or GDP Industrial production National income Unemployment Indicators of Inflation Producer price indexes Consumer price Indexes Other indicators 12 Integrating Monetary And Fiscal Policies History Executive branch usually most concerned with employment and growth Fed and administration may differ on whether or not inflation or growth needs the most emphasis Agreement when inflation and unemployment are at relatively low levels 13 Integrating Monetary And Fiscal Policies Combined monetary and fiscal policy effects Fiscal policy usually has a bigger influence on the demand for loanable funds Monetary policy usually has a bigger influence on the supply of loanable funds 14 Global Effects On Monetary Policy Impact on the dollar Value of the dollar relative to other currencies can affect inflation For example, a weak dollar stimulates U.S. exports, discourages imports and stimulates the economy Fed less likely to stimulate the economy if the dollar is weak 15