1 Chapter 5 Monetary Theory and Policy Financial Markets and Institutions, 7e, Jeff Madura Copyright 2006 by South-Western, a division of Thomson Learning. All rights reserved. 2 Chapter Outline Monetary theory Tradeoff faced by the Fed Economic indicators monitored by the Fed Lags in monetary policy Assessing the impact of monetary policy Integrating monetary and fiscal policies Global effects of monetary policy 3 Monetary Theory Pure Keynesian Theory One of the most popular theories influencing the Fed Developed by John Maynard Keynes Suggests how the Fed can affect the interaction between the demand for money and the supply of money to influence: Interest rates The aggregate level of spending Economic growth 4 Monetary Theory (contd) Pure Keynesian Theory (contd) Can be explained by using the loanable funds framework Demand for and supply of loanable funds determine the equilibrium interest rate The business investment schedule illustrates the inverse relationship between interest rates on loanable funds and the level of business investment 5 Monetary Theory (contd) Pure Keynesian Theory (contd) Correcting a weak economy The Fed would use open market operations to increase the money supply A higher level of the money supply would reduce interest rates Lower interest rates encourage more borrowing and spending Keynesian philosophy advocates an active role for the government in correcting economic problems 6 Monetary Theory (contd) S2 Correcting a Weak Economy D1 i2 i1 S1 Demand and Supply of Loanable Funds Business Investment Schedule i1 i2 B1B2 7 Monetary Theory (contd) Pure Keynesian Theory (contd) Correcting high inflation The Fed would sell Treasury securities (decrease the money supply) A lower level of the money supply reduces the level of spending Less spending slows economic growth and reduces inflationary pressure (demand-pull inflation) 8 Monetary Theory (contd) S1 Correcting High Inflation D1 i1 i2 S2 Demand and Supply of Loanable Funds Business Investment Schedule i2 i1 B2B1 9 Monetary Theory (contd) Pure Keynesian Theory (contd) Effects of a credit crunch on a stimulative policy The economic impact of monetary policy depends on the willingness of banks to lend funds If banks are unwilling to extend credit despite a stimulative policy, the result is a credit crunch A credit crunch can occur during a restrictive policy since some borrowers will not borrow because of the high interest rates 10 Monetary Theory (contd) Quantity Theory and the Monetarist approach The quantity theory suggests a particular relationship between the money supply and the degree of economic activity in the equation of exchange: Velocity is the average number of times each dollar changes hands per year The right side of the equation is the total value of goods and services produced If velocity is constant, a change in the money supply will produce a predictable change in the total value of goods and services QPMV G 11 Monetary Theory (contd) Quantity Theory and the Monetarist approach (contd) An early form of the theory assumed a constant Q Assumes a direct relationship between the money supply and prices Under the modern quantity theory of money, the constant quantity assumptions has been relaxed A direct relationship exists between the money supply and the value of goods and services 12 Monetary Theory (contd) Quantity Theory and the Monetarist approach (contd) Velocity represents the ratio of money stock to nominal output Velocity is affected by any factor that influences this ratio: Income patterns Factors that change the ratio of households money holdings to income Credit cards Inflationary expectations 13 Monetary Theory (contd) Comparison of the Monetarist and Keynesian Theories The Monetarist approach advocates stable, low growth in the money supply Allows economic problems to resolve themselves Keynesian approach would call for a loose monetary policy to cure a recession 14 Monetary Theory (contd) Comparison of the Monetarist and Keynesian Theories (contd) Monetarists are concerned about maintaining low inflation and are willing to tolerate a natural rate of unemployment Keynesians focus on maintaining low unemployment and are willing to tolerate any inflation that results from stimulative monetary policies 15 Monetary Theory (contd) Theory of Rational Expectations Holds that the public accounts for all existing information when forming its expectations Suggests that households and business will use historical effects of monetary policy to forecast the impact of an existing policy and act accordingly Households spend more with a loose monetary policy to avoid inflation Businesses will increase their investment with a loose monetary policy to avoid higher costs Labor market participants will negotiate higher wages with a loose monetary policy Supports the Monetarist view that changes in monetary policy do not have a sustained impact on the economy 16 Monetary Theory (contd) Which theory is correct