Chapter 5

Monetary Theory and Policy

© 2001 South-Western College Publishing Company

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Monetary Theories

Developed by John Keynes and his students Initially tried to explain inadequacy of

monetary policy during great depressionEffectiveness of monetary policy depends

upon The sensitivity (elasticity) of economy to changes In interest rates

Advocates fiscal policy

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Monetary Theories

Keynesian theory continuedFocus on how a government surplus or deficit

can influence the economyAdvocates proactive economic policyCan consider the theory using the framework

of loanable funds

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Monetary Theories

Keynesian theory to correct a weak economyTo stimulate the economy the Fed buys securities

in an open market operationFed’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

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Monetary Theories

Keynesian theory and credit crunchesBanks’ willingness to lend affects monetary policyBanks lend based on evaluation of borrower’s

ability to repay, not just availability of fundsMonetary policy to stimulate the economy works

only if banks find enough qualified borrowers Restrictive monetary policy may magnify credit

crunch

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Monetary Theories

Quantity theoryBased on equation of exchangeMV=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

MonetaristsVelocity 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

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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

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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

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Tradeoff Faced By The Fed

Goals of the FedSteady GDP growthLow unemploymentMaintain low inflation

TradeoffsLowering unemployment may put pressure on

inflationLowering inflation may increase unemployment

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Tradeoff Faced By The Fed

Tradeoffs between employment and inflation make it difficult to solve both problems simultaneously

Impact of other forcesFactors outside the control of the Fed affect

employment and inflationClassic example of the tradeoff is the summer of

1990 with Gulf War and high oil prices but signals pointing to a possible recession

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Economic Indicators Monitored By The Fed

Indicators of economic growthGross Domestic Product or GDP Industrial productionNational incomeUnemployment

Indicators of InflationProducer price indexesConsumer price IndexesOther indicators

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Integrating Monetary And Fiscal Policies

HistoryExecutive branch usually most concerned

with employment and growthFed 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

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Integrating Monetary And Fiscal Policies

Combined monetary and fiscal policy effectsFiscal policy usually has a bigger influence on

the demand for loanable fundsMonetary policy usually has a bigger

influence on the supply of loanable funds

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Global Effects On Monetary Policy

Impact on the dollarValue of the dollar relative to other currencies

can affect inflationFor 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