Transcript Monetary Policies

CHAPTER
5
© 2003 South-Western/Thomson Learning
Monetary Theory
and Policy
Chapter Objectives
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Learn the well-known theories of monetary
policy
Review the tradeoffs involved in monetary
policy
Learn how analysts monitor and forecast Fed’s
monetary policy
Monetary Policies
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How does money affect the real economy?
How does varying money supply growth
impact spending?
How does monetary policy in the financial
sector impact real economic sector investment
and spending?
Keynesian Theory
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Developed by John Maynard Keynes and his
students
Initially attempted 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
Keynesian Theory, cont.
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Advocates fiscal policy
Focused on government deficit/surplus
spending to impact economic activity
Monetary policy transmitted slowly via bank
credit policy and interest rates
A proactive economic policy
Exhibit 5.3
Stimulative Monetary
Policy
Fed
Treasury
Securities
$
Investors
Bank Funds
Increase
Interest Rates
Decrease
Aggregate
Spending
Increases
Bank Funds
Decrease
Interest Rates
Increase
Aggregate
Spending
Decreases
Restrictive Monetary
Policy
Fed
Treasury
Securities
$
Investors
Inflation
Decreases
Monetary Theories
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Quantity theory
Based on equation of exchange
l 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
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Monetary Theories
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Quantity theory’s assumptions
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PGQ is the total value of goods and services
produced
Assume V constant or predictable—changing M
impacts total spending
M should grow at rate of output capacity, Q
Faster M growth increases PG or inflation
Monetary Theories
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Monetarists
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Velocity is affected by
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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
Monetarist vs. Keynesian Theories
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Monetarist
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Let economic problems
resolve themselves
Low growth reduces
borrowing and lowers
interest rates
Problem: It takes time
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Keynesian
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Need to take action to
lower interest rates
High money growth to
fix a recession by
lowering rates
Problem: Might ignite
inflation
Monetarist vs. Keynesian Theories
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Monetarist
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Low, stable growth in
the money supply
Focus on maintaining
low inflation and will
tolerate what they call
natural unemployment
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Keynesian
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Actively manage the
money supply
Willing to tolerate
inflation that helps
reduce unemployment
Rational Expectations Theory
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Households and businesses act in their own
self-interest
Individuals anticipate effects of government
policy changes
Expansionary monetary policy signals future
inflation and interest rates increase (security
prices fall)
Rational expectations may nullify intended
effects of monetary policy
Tradeoff of Monetary Policy Goals
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Goals of the Monetary Policy
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Steady GDP growth
Low unemployment
Stable price levels
Tradeoffs
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Lowering unemployment by stimulating the
economy may increase inflation
Lowering inflation by slowing the economy may
increase unemployment
Economic Indicators Monitored by the
Fed
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Indicators of economic growth
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Gross Domestic Product or GDP
Industrial production
National income
Unemployment
Indicators of Inflation
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Producer price indexes
Consumer price Indexes
Other indicators
Economic Indicators Monitored by the
Fed
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How the Fed uses indicators
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Fed meets to decide course of monetary policy
Assesses recent reports on indicators of growth
and inflation
Uses indicators to anticipate how the economy
will change
Decides the appropriate monetary policy given
possible conditions
Lags in Monetary Policy
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Recognition lag
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Implementation lag
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Most economic problems revealed by statistics, not
observation
Fed quick to see changes in economy
Fed acts quickly to implement change in monetary policy
Fiscal policy via Congress takes a long time
Impact Lag
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Takes time for monetary changes to have full impact
Fiscal policy tax changes have unpredictable results
Assessing the Impact of Monetary Policy
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How does the policy change affect financial
market participants?
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Depends on the kinds of securities you trade
Depends on your expectations about how the
changes affect on the economy
Forecasting money supply movements
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Financial market participants look at actual growth
compared to Fed targets
Growth outside range could signal Fed policy
changes
Assessing the Impact of Monetary Policy
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Improved communication at the Fed
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Fed more willing to disclose its intentions since
1999
Immediate feedback to public and financial
markets about “bias” on rates
Market reaction to reported money supply
levels
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Thursday release of money supply data
Try to determine future trends in interest rates
Assessing the Impact of Monetary Policy
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Anticipating reported money supply levels
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Securities and financial market professionals
cannot profit on information available to all at the
same time
Try to forecast and anticipate changes
Trying to figure out the future course of interest
rates and Fed policy
Market reaction to discount rate adjustment
Assessing the Impact of Monetary Policy
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Market reaction to discount rate adjustment
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Monitor changes to determine policy
Some changes are technical or intended to bring
the discount rate in line with market rates
Financial market participants try to anticipate
changes
Discount rate seems to preceded market interest
rate movements since 1980
Exhibit 5.9
Federal Open
Market Committee
(FOMC)
Money Supply
Targets
Supply of
Loanable Funds
Inflationary
Expectations
Demand for
Loanable Funds
Equilibrium
Interest Rates
Cost of
Household Credit
(Including Mortgage
Rates)
Household
Consumption
Cost of Capital
for Corporations
Residential
Construction
Economic
Growth
Corporate
Expansion
Assessing the Impact of Monetary Policy
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Forecasting the impact of monetary policy
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Even if financial market participants correctly
anticipate changes in the money supply there are
still problems
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Not a stable relationship between money supply and
economic variables over time
Examples include the relationship between economic
growth and the money supply
Integrating Monetary and Fiscal Policies
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History
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Executive branch usually most concerned with
employment and growth
Fed and administration may differ on priorities of
price stability or growth needs
Agreement when inflation and unemployment are
at relatively low levels
Exhibit 5.12
U.S.
Monetary
Policy
U.S.
Fiscal
Policy
U.S.
Personal
Income
Tax Rates
U.S.
Budget
Deficit
U.S.
Business
Tax Rates
U.S.
Personal
Income
Level
U.S.
Household
Demand
for Funds
Government
Demand
for Funds
Savings
by U.S.
Households
Supply
of Funds
in U.S.
Demand
for Funds
in U.S.
U.S.
Interest
Rate
U.S.
Business
Demand
for Funds
Integrating Monetary and Fiscal Policies
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Combined monetary and fiscal policy effects
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Fiscal policy usually has a larger influence on the
demand for loanable funds
Monetary policy usually has a larger influence on
the supply of loanable funds
Monetizing the debt
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Should the Fed help finance a federal budget
deficit created by fiscal policy?
Forecasted surpluses, debt reduction, and U.S.
Treasury securities
Integrating Monetary and Fiscal Policies
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Market assessment of integrated policies
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Financial markets assess both fiscal and monetary
policy
Markets monitor a wide range of information and
data
Forecast how loanable funds supply and demand
will change
Global Effects on Monetary Policy
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Impact on the U.S. dollar
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Value of the dollar relative to other currencies can
affect inflation
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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
Strong dollar
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Stimulates imports and economic growth
Encourages capital flows into U.S. and lower interest
rates
Global Effects on Monetary Policy
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Transmission of interest rates
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International flow of funds affected by Fed policy
Global capital and money markets are integrated
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Capital flows to highest real, after-tax, exchange-rate
adjusted rate of return
Financial integration improves with
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Decreased governmental regulation in markets
Decreased transaction costs
Improved financial technology
Deficits or surpluses in the U.S. have global
implications
Global Effects on Monetary Policy
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Fed policy during the Asian crisis
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Fed realizes the global economy is integrated
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U.S. economic conditions affect other countries
Other countries economic conditions affect the U.S.
Fed reaction to Asian crisis shows possible
complications that result from economic
integration
Forecasting Money Supply
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Watch weekly federal reserve data releases
Observe changes with announced fed ranges
of money growth
Markets attempt to estimate changes in
monetary policy direction and . . .
Anticipate interest rate changes
Global Effects on Monetary Policy
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Exchange Rate Levels
International Funds Flow
Economic Activity of Foreign Countries