Economics

Chapter 15 – Monetary Policy

Transmission Mechanisms

- The routes, or channels traveled by the ripple effects that the money market creates and that affect the goods
and service market (represented by the aggregate demand and aggregate supply curves in the AD-AS framework)

A. Money Market in the Keynesian Transmission Mechanism

Two sides in the money market system:

1. Demand for Money
o Vertical Axis: Price of holding money balances
 Is the opportunity cost of holding money  represented by the interest rate
 By holding money, individuals forfeit the opportunity to hold that portion of their wealth
in other forms
 Interest rate increases  Opportunity cost increases  Demand for money decreases
 Interest rate decreases  Opportunity cost decreases  Demand for money increases
o Horizontal Axis: Quantity of Money
2. Supply for Money
o Illustrated as a vertical line
o Quantity of money is largely determined by the
Fed
 Largely, not exclusively because both
banks and public are important players
in the money supply process
 E.g. when banks do not lend
their excess reserves, the
money supply is not as large as
it is when they do

Equilibrium in the Money Market – when quantity

demand of money equals quantity supplied

The Keynesian Transmission Mechanism: Indirect

- The Keynesian route between the money market and the goods and services market is an indirect one
o Money Market
 Fed increases bank reserves though open market purchase  Increase in money supply  Money
supply curve shifts right  Reserves of banks increases  More loans made  Interest rate
decreases
o Investment Goods Market
 Fall in interest rates  Increase in investment
o Goods and Services Market
 Increase in Investment  Increase in total spending  AD increases/ shifts right AS (Real GDP)
increases from Q1 to Q2  no change in price level
o In summary:
 𝑀𝑜𝑛𝑒𝑦 𝑆𝑢𝑝𝑝𝑙𝑦 ↑  𝑖 ↓  𝐼 ↑  𝐴𝐷 ↑  𝑄 ↑, 𝑝̅
 𝑀𝑜𝑛𝑒𝑦 𝑆𝑢𝑝𝑝𝑙𝑦 ↑  𝑖 ↑  𝐼 ↓  𝐴𝐷 ↓  𝑄 ↓, 𝑝̅
- Implications:
o Changes in money market do not directly affect the goods and services market (and thus Real GDP)
because the investment goods market stands between the two markets
o The link between the money market and the goods and services market could be broken in the investment
goods market.
1. Interest-insensitive Investment – investment is not always responsive to interest rates
 E.g. when business firms are pessimistic about future economic activity, a decrease in
interest rate will do little to increase investment
 When investment is completely insensitive to changes in interest rates, the investment
demand curve is vertical
o If investment demand curve is vertical, a fall in interest rates will not increase it,
nor will aggregate demand and Real GDP
 𝑀𝑜𝑛𝑒𝑦 𝑆𝑢𝑝𝑝𝑙𝑦 ↑ → 𝑖 ↓
𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑖𝑛𝑠𝑒𝑛𝑠𝑖𝑡𝑖𝑣𝑒 𝑡𝑜 𝑐ℎ𝑎𝑛𝑔𝑒𝑠 𝑖𝑛 𝑖 → 𝐼 → 𝐴𝐷 → 𝑄, 𝑃
2. The Liquidity Trap – horizontal portion of the demand curve for money
 Demand curve for money could become horizontal at some low interest rate
o The market interest rate is inversely related to the price of old or existing bonds
 When interest rates are very low, bond prices are very high, so individuals
would rather hold all the additional money supply than use it to buy
bonds
 Effect: interest rate does not change as money supply is
increased
 If interest rates do not change; investment, aggregate demand, and Real GDP remains
constant
 𝑀𝑜𝑛𝑒𝑦 𝑆𝑢𝑝𝑝𝑙𝑦 ↑
𝐿𝑖𝑞𝑢𝑖𝑑𝑖𝑡𝑦 𝑡𝑟𝑎𝑝 → 𝑖 → 𝐼 → 𝐴𝐷 → 𝑄, 𝑃
o Conclusion: At times, monetary policy will be unable to increase Real GDP and decrease unemployment

B. The Monetarist Transmission Mechanism: Direct

- Proposes a direct link between the money market and the goods and services market
o 𝑀𝑜𝑛𝑒𝑦 𝑆𝑢𝑝𝑝𝑙𝑦 ↑→ 𝐴𝐷 ↑→ 𝑄 ↑ 𝑃 ↑
o 𝑀𝑜𝑛𝑒𝑦 𝑆𝑢𝑝𝑝𝑙𝑦 ↓→ 𝐴𝐷 ↓→ 𝑄 ↓ 𝑃 ↓
- An increase in the money supply leaves individuals with an excess supply of money, and as a result they increase
their spending and the aggregate demand curve shifts to the right in the short run
Monetary Policy and the Problem of Inflationary and Recessionary Gaps

- Expansionary Monetary Policy – the policy by which the Fed increases the money supply
- Contractionary Monetary Policy – the policy by which the Fed decreases the money supply

- Keynesian View:
o Inflationary Gap – Market forces work much faster and more assuredly in eliminating an inflationary gap
than in eliminating a recessionary gap
 SRAS is more likely to shift leftward to eliminate an inflationary gap than shift rightward to
eliminate a recessionary gap
 Why?? Because wages and prices rise more quickly than they fall as they are inflexible in
a downward direction
o Recessionary Gap – Advocate for expansionary monetary policy
Patterns of Sustainable Specialization and Trade (PSST)

- Proposed by Economist Arnold Kling

- A decline in economic activity may have nothing to do with a decrease in aggregate demand
o Economic activity should not be viewed solely as stemming from spending in the economy
- Economic activity is best viewed by focusing on specialization and trade
o Sales decline because businesses and labor are out of sync with what buyers want to buy
o The job of an entrepreneur is to reconfigure specializations and trade so that both are sustainable – they
are consistent with what buyers want to buy
- From the PSST perspective of the economy, a fiscal and monetary stimulus that is designed to boost aggregate
demand sometimes does not work at reviving the economy
o If recession is due to buyers and sellers being out of sync with each other, greater aggregate demand is
not the solution
o If the stimulus is directed at propping up unsustainable specializations and trade, then it sends a wrong
signal to some workers, telling them that their current specializations will continue to be in demand, when
they may not be

Monetary Policy and the Activist-Nonactivist Debate

- Activists – argue that monetary and fiscal policies should be deliberately used to smooth out the business cycle
o In favor of fine-tuning – the (usually frequent) use of monetary and fiscal policies to counteract even small
undesirable movements in economic activity
o Activist or discretionary monetary policy – monetary policy that activists advocate
- Nonactivists – argue against the use of activist or discretionary monetary policy
o Propose a rules-based monetary policy – a permanent, stable, rule-oriented monetary fiscal framework
o Nonactivist or rule-based monetary policy – monetary policy that nonactivists advocate

The Case for Activist or Discretionary Monetary Policy

- The case for activist monetary policy rests on three major claims:
1. The economy does not always equilibrate quickly enough at Natural Real GDP
o Economy takes too long to heal itself and that in the interim, too much output is lost and too high an
unemployment rate must be tolerated
2. Activist monetary works; it is effective at smoothing out the business cycle
3. Activist monetary policy is flexible; nonactivists (rule-based) monetary policy is not
o The more closely monetary policy can be designed to meet the particulars of a given economic
environment, the better

The Case for Nonactivist or Rule-Based Monetary Policy

1. In modern economies, wages and prices are sufficiently flexible to allow the economy to equilibrate at
reasonable speed at Natural Real GDP
o A laissez-faire, hands-off approach by government promotes speedy wage and price adjustments and thus
a quick return to Natural Real GDP
2. Activist monetary policies may not work
o There are two types of monetary policy:
a. Monetary policy anticipated by the public
b. Monetary policy not anticipated by the public
o A correctly anticipated increase in the money supply will be ineffective at raising Real GDP
3. Activist monetary policies are likely to be destabilizing rather than stabilizing; they are likely to make matters
worse, not better
o Why? Because of lags – Data, wait-and-see, legislative, transmission, and effectiveness lag
Nonactivist Monetary Proposals

1. Constant-money-growth-rate rule
o Nonactivists argue that the sole objective of monetary policy is to stabilize the price level
o The annual money supply growth rate will be constant at the average annual growth rate of Real GDP
 Economists predict that a constant-money-growth-rate rule will bring about a stable price level
over time because of the equation of exchange (MV=PQ)
o In some years, the growth rate in Real GDP will be below or above its average rate, causing the price level
to increase or decrease; but over time price level will be stable
2. Predetermined-money-growth-rate rule
o Assumptions:
 Velocity is constant
 The money supply is defined correctly
o The annual growth rate in the money supply will be equal to the average annual growth rate in Real GDP
minus the growth rate in velocity
%ΔM = %ΔQ − %ΔV
o With this rule, growth rate of the money supply is not fixed but it is predetermined in that it is dependent
on the growth rates of Real GDP and velocity
%ΔM + %ΔV = %ΔP + %ΔQ
3. The Taylor rule
o Economist John Taylor proposed that monetary authorities use a rule to guide them in making their
discretionary decisions
o There is a federal funds rate target that is consistent with stabilizing inflation around a low inflation rate
and stabilizing Real GDP around its full-employment level
o The federal funds rate target should be one-and-a-half times the inflation rate plus one-half times the
GDP gap plus one
𝐹𝑒𝑑𝑒𝑟𝑎𝑙 𝑓𝑢𝑛𝑑𝑠 𝑟𝑎𝑡𝑒 𝑡𝑎𝑟𝑔𝑒𝑡 = 1.5(𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒) + 0.5(𝐺𝐷𝑃 𝑔𝑎𝑝) +1
4. Inflation Targeting
o Targeting that requires the Fed to keep the inflation rate near a predetermined level
o Major Issues:
a. Should it be a specific percentage rate or a narrow range?
b. What should the specific percentage rate or range be?
c. Whether the inflation rate target should be announced or not
o Arguments against: Such policy constrains the Fed when it might need to overlook the target to deal with
a financial crisis
5. (Nominal) GDP targeting
o Developed by market monetarists
o Argues that the optimal monetary policy is for the Fed to set a nominal GDP target and then to adjust the
money supply growth as to hit the target
o If monetary policy leads to a decline in nominal GDP, nominal income also declines and aggregate demand
in the economy declines