Monetary PolicyCh.15, Macroeconomics, R.A. Arnold

The Money MarketDemand for money: The inverse relationship between the quantity demanded of money (i.e. demand for holding money) and the price of holding money (i.e. interest rate). Interest rate is the price we have to pay for holding money (i.e. keeping money in our wallets and homes) since we could have earned interest payment if we had not demanded the money and kept it in a commercial bank.Hence, if the interest rate increases, demand for (holding) money decreases…therefore the money demand curve is downward sloping.The supply of money is determined by the central bank and it does not depend on the interest rate and thus the money supply curve is vertical. Exhibit 2 p. 336.

Transmission Mechanisms

If the supply or demand for money changes in the money market then it affects the economy. How? There are two theories to explain the phenomenon. The channel by which the change affects the economy are called transmission mechanisms.1) The Keynesian Transmission Mechanism: Indirect (Exhibit 3 p. 337. Important)Case 1 (as in the text book). The central bank conducts an open market purchase (ch. 13) this increases the reserves of commercial banks. The banks loan out the excess reserves (i.e. the supply of loanable funds increase) which causes the interest rate to decrease. A fall in interest rate stimulates investment (i.e. investment increases) and hence AD increases (shifts right). Case 2. The central bank conducts an open market sale…(the remaining analysis is just the opposite case i.e. all changes are just the opposite. This is left to you as an exercise which you can show me during my office hours or discuss with your class-mates).

The second theory…2) The Monetarist Transmission Mechanism: Direct (Exhibit 6 p. 341)The monetarists propose a direct link between the money market and the goods and service market. Increase in money supply leaves individuals with an excess supply of money which they use to consume and/or invest hence AD increases (shifts right).

As evident from the discussion so far, changes in money supply i.e. monetary policy can affect the aggregate demand and if the economy is not self-regulatory, it could be used to bring it out of a recessionary or an inflationary gap. Similar to - how we used fiscal policy for the same purpose (Ch. 10).

Monetary Policy and the Problems of Inflationary and Recessionary GapIn a recessionary gap the real GDP < natural real GDP. Hence to bring the economy back to the LR equilibrium where real GDP = Natural real GDP, we must stimulate (increase) aggregate demand. As we have already seen that can be done by increasing the money supply i.e. by conducting expansionary monetary policy. Exhibit 7 (c) p. 342.In an inflationary gap real GDP > natural real GDP. Hence to bring it back to the long run equilibrium we need to decrease aggregate demand which can be done using contractionary monetary policy. Exhibit 8 (c) p. 343.

Consolidation

Classical economists believed that the economy is self-regulatory and hence Laissez-Faire (not interfering with the economy) is the best policyKeynesians argue that the economy is not self-regulatory since the wages and prices are not flexible and hence the government should interfere with the economy (using fiscal policy)Monetarists believe that monetary policy (conducted by central bank) may also be used to address the issue of recessionary and inflationary gapAs we can see the government and the central bank are two very important institutions who may work together to achieve the economics goals of: low unemployment, stable prices & economic growth

Some ideas from Ch. 17But as we can see neither fiscal policy nor monetary policy can increase the Real GDP (total output) in the long run…that is only possible if we can increase the long run aggregate supply (i.e. shift the LRAS right). How? Output is produced using inputs (ch. 1). Hence, to increase the total output in the economy the total input needs to be increased i.e. capital and labour or the technology and human capital needs to be improved (both of which increases the productivity of inputs). In that case LRAS curve shifts right and the economy may be able to produce a higher Real GDP in the long run. So the goal of - economic growth (increasing real GDP) - can be achieved by improving technology, human capital* (which we are trying to do in NSU) and or increasing the capital stock, number of labour etc.*The knowledge and skills a person acquires through education, training and experience

Some ideas from Ch. 22Comparative Advantage: The advantage a country (or a business firm) has when it can produce a good at a lower opportunity cost than another country (or a business firm).E.g. Bangladesh has a comparative advantage over U.S.A in producing RMG.Countries specialize in producing the goods in which they have a comparative advantage. Hence, BD produces RMG and USA produces air-crafts and satellites.Countries (or individuals) trade to make themselves better-off. USA imports RMG from BD and we import air-crafts from USA. But international trade may be restricted due to tariff (a tax on imports) and import quota (a legal limit imposed on the amount of a good that may be imported).