Expansionary and contractionary monetary policy.

The Fed is engaging in expansionary

monetary policy when it uses any of its instruments of monetary policy in such a way as to
cause an increase in the supply of money. The Fed is said to engage in contractionary
monetary policy when it uses its instruments to effect a reduction in the supply of money.
Classical view of monetary policy. The classical economists' view of monetary policy is
based on the quantity theory of money. According to this theory, an increase (decrease) in the
quantity of money leads to a proportional increase (decrease) in the price level. The quantity
theory of money is usually discussed in terms of the equation of exchange, which is given
by the expression

In this expression, P denotes the price level, and Y denotes the level of current real GDP.
Hence, PY represents current nominal GDP; M denotes the supply of money over which the
Fed has some control; and V denotes the velocity of circulation, which is the average number
of times a dollar is spent on final goods and services over the course of a year. The equation
of exchange is an identity which states that the current market value of all final goods and
servicesnominal GDPmust equal the supply of money multiplied by the average number
of times a dollar is used in transactions in a given year. The quantity theory of money requires
two assumptions, which transform the equation of exchange from an identity to a theory of
money and monetary policy.
Recall that the classical economists believe that the economy is always at or near the natural
level of real GDP. Accordingly, classical economists assume that Y in the equation of
exchange is fixed, at least in the shortrun. Furthermore, classical economists argue that the
velocity of circulation of money tends to remain constant so that V can also be regarded as
fixed. Assuming that both Y and V are fixed, it follows that if the Fed were to engage in
expansionary (or contractionary) monetary policy, leading to an increase (or decrease) in M,
the only effect would be to increase (or decrease) the price level, P, in direct proportion to the
change in M. In other words, expansionary monetary policy can only lead to inflation, and
contractionary monetary policy can only lead to deflation of the price level.
Keynesian view of monetary policy. Keynesians do not believe in the direct link between
the supply of money and the price level that emerges from the classical quantity theory of
money. They reject the notion that the economy is always at or near the natural level of real
GDP so that Y in the equation of exchange can be regarded as fixed. They also reject the
proposition that the velocity of circulation of money is constant and can cite evidence to
support their case.
Keynesians do believe in an indirect link between the money supply and real GDP. They
believe that expansionary monetary policy increases the supply of loanable funds available
through the banking system, causing interest rates to fall. With lower interest rates, aggregate
expenditures on investment and interestsensitive consumption goods usually increase,
causing real GDP to rise. Hence, monetary policy can affect real GDP indirectly.

Keynesians, however, remain skeptical about the effectiveness of monetary policy. They
point out that expansionary monetary policies that increase the reserves of the banking
system need not lead to a multiple expansion of the money supply because banks can simply
refuse to lend out their excess reserves. Furthermore, the lower interest rates that result from
an expansionary monetary policy need not induce an increase in aggregate investment and
consumption expenditures because firms' and households' demands for investment and
consumption goods may not be sensitive to the lower interest rates. For these reasons,
Keynesians tend to place less emphasis on the effectiveness of monetary policy and more
emphasis on the effectiveness of fiscal policy, which they regard as having a more direct
effect on real GDP.
Monetarist view of monetary policy. Since the 1950s, a new view of monetary policy,
called monetarism, has emerged that disputes the Keynesian view that monetary policy is
relatively ineffective. Adherents of monetarism, called monetarists, argue that the demand
for money is stable and is not very sensitive to changes in the rate of interest. Hence,
expansionary monetary policies only serve to create a surplus of money that households will
quickly spend, thereby increasing aggregate demand. Unlike classical economists,
monetarists acknowledge that the economy may not always be operating at the full
employment level of real GDP. Thus, in the shortrun, monetarists argue that expansionary
monetary policies may increase the level of real GDP by increasing aggregate demand.
However, in the longrun, when the economy is operating at the full employment level,
monetarists argue that the classical quantity theory remains a good approximation of the link
between the supply of money, the price level, and the real GDPthat is, in the longrun,
expansionary monetary policies only lead to inflation and do not affect the level of real GDP.
Monetarists are particularly concerned with the potential for abuse of monetary policy and
destabilization of the price level. They often cite the contractionary monetary policies of the
Fed during the Great Depression, policies that they blame for the tremendous deflation of that
period. Monetarists believe that persistent inflations (or deflations) are purely monetary
phenomena brought about by persistent expansionary (or contractionary) monetary policies.
As a means of combating persistent periods of inflation or deflation, monetarists argue in
favor of a fixed money supply rule. They believe that the Fed should conduct monetary
policy so as to keep the growth rate of the money supply fixed at a rate that is equal to the
real growth rate of the economy over time. Thus, monetarists believe that monetary policy
should serve to accommodate increases in real GDP without causing either inflation or
deflation.