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.

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

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

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
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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

Monetary Theory (contd)

Correcting a Weak Economy
S1 i1 i2 D1 S2 i1 i2

Demand and Supply of Loanable Funds

B1 B2 Business Investment Schedule

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)
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Monetary Theory (contd)

Correcting High Inflation
S2 i2 i1 D1 S1 i2 i1

Demand and Supply of Loanable Funds

B2 B1 Business Investment Schedule

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

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:

MV PGQ

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

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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
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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
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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

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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

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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

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Monetary Theory (contd)

Which theory is correct?

The

FOMC recognizes the virtues and limitations of each theory

The FOMC adjusts monetary growth targets to control economic growth, inflation, and unemployment Recognizing the Monetarist view, the FOMC is concerned about the inflation resulting from a loose monetary policy

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Tradeoff Faced by the Fed

Ideally, the Fed would like:

Low

inflation Steady GDP growth Low unemployment

There is a negative relationship between unemployment and inflation

Phillips

curve A tight money policy can curb inflation but increase unemployment and vice versa

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Tradeoff Faced by the Fed (contd)

Impact of other forces on the tradeoff

Cost

factors such as energy costs and insurance costs can influence the tradeoff When both inflation and unemployment are high, Fed members may disagree as to the type of monetary policy that should be implemented

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Tradeoff Faced by the Fed (contd)

Impact of other forces on the tradeoff (contd)

How the Feds focus shifted during the Persian Gulf War

There were numerous indications of a possible recession in the summer of 1990 The abrupt increase in oil prices placed upward pressure on U.S. inflation The focus shifted from high inflation to the weak economy over time From January to December 2001, the FOMC reduced the targeted federal funds rate ten times In 2002 and 2003, the Fed reduced the federal funds target rate twice

How the Feds emphasis shifted during 20012004

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Economic Indicators Monitored by the Fed

Indicators of economic growth

Gross

domestic product (GDP)

Measures the total value of goods and services produced Measured each month The most direct indicator of economic growth
Level

of production

A high level indicates strong economic growth and can result in increased demand for labor

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Economic Indicators Monitored by the Fed (contd)

Indicators of economic growth (contd)

National

income

The total income earned by firms and individual employees A strong demand for goods and services results in a large amount of income

Unemployment

rate

Does not necessarily indicate the degree of economic growth Can decrease in weak economic growth periods if new jobs are created

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Economic Indicators Monitored by the Fed (contd)

Indicators of economic growth (contd)

Industrial

production index Retail sales index Home sales index Composite index Consumer confidence surveys

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Economic Indicators Monitored by the Fed (contd)

Indicators of inflation
Producer

and consumer price indexes

The PPI measures prices at the wholesale level The CPI measures prices on the retail level Both indexes are used to forecast inflation Agricultural and housing price indexes also exist
Other

indicators

Wages, oil prices, transportation costs, the price of gold, indicators of economic growth
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Economic Indicators Monitored by the Fed (contd)

How the Fed uses indicators

The

Fed uses indicators to anticipate how economic conditions will change and then determines what monetary policy would be appropriate
Weak economic conditions suggest an expansionary monetary policy High productivity and employment suggest a restrictive monetary policy

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Economic Indicators Monitored by the Fed (contd)

Index of Leading Economic Indicators

The

Conference Board publishes indexes of leading, coincident, and lagging economic indicators
Leading economic indicators are used to predict future economic activity

Three consecutive monthly changes in the same direction suggest a turning point in the economy

Coincident economic indicators reach their peaks and troughs at the same time as business cycles Lagging economic indicators tend to rise or fall a few months after business-cycle expansions and contractions

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Lags in Monetary Policy

The recognition lag is the lag between the time a problem arises and the time it is recognized The implementation lag is the lag between the time a serious problem is recognized and the time the Fed implements a policy to resolve it The impact lag is the lag between the a policy is implemented and the time the policy has its full impact on the economy
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Lags in Monetary Policy (contd)

Lags hinder the Feds control of the economy

By

the time a policy is implemented, economic conditions may have reversed Without monetary policy lags, implemented policies would have a higher rate of success

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Assessing the Impact of Monetary Policy

Financial market participants will not all react to monetary policy in the same manner
Different

securities are affected differently

Participants trading the same securities may still be affected differently

Expectations

about the policys impact on economic variables may differ

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Assessing the Impact of Monetary Policy (contd)

Forecasting money supply movements

Periodicals sometimes specify the weekly ranges of M1 and M2 based on the Feds disclosure of target ranges When the actual money supply falls outside the target range, a change in the Feds range has not yet been publicly announced Improved communication from the Fed

Uncertainty about FOMC meeting results prior to 1999 caused volatile price movements Since 1999, the Fed has been more willing to disclose its conclusions (federal funds rate target changes and possible future tightening or loosening of the money supply)

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Assessing the Impact of Monetary Policy (contd)

Forecasting the impact of monetary policy

Even

if market participants correctly anticipate changes in the money supply, they may not be able to predict future economic conditions

The historic relationship between the money supply and economic variables has not been stable Impact of monetary policy across financial markets

Monetary policy affects the securities traded in all financial markets due to its effect on interest rates and economic growth

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Integrating Monetary and Fiscal Policies

The Feds monetary policy is commonly influenced by the administrations fiscal policies The Fed and the administration often use complementary policies to resolve economic problems Fiscal policy typically influences the demand for loanable funds, while monetary policy normally has a larger impact on the supply of loanable funds
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Integrating Monetary and Fiscal Policies (contd)

History
Presidential

administrations have been more concerned with maintaining strong economic growth and low unemployment

The Fed shared the same concerns in the early 1970s By 1980, there was high inflation and unemployment

The administration cut taxes to stimulate the economy The Fed used a tight monetary policy to reduce inflation

The Fed ultimately loosened the money supply in 1983

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Integrating Monetary and Fiscal Policies (contd)

Monetizing the debt

Should

the Fed help finance the federal budget deficit that has been created from fiscal policy?
Loosening the money supply in response to a higher budget deficit is called monetizing the debt If the Fed does not monetize the debt, a weak economy may be more likely If the Fed monetizes the debt, higher money supply growth is required

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Integrating Monetary and Fiscal Policies (contd)

Market assessment of integrated policies

Market

participants must consider both fiscal and monetary policies when assessing future economic conditions

The supply of loanable funds can be affected by the Feds adjustment of the money supply or changes in tax policies The demand for loanable funds is affected by changes in the money supply or government expenditures and possibly tax revisions Once the supply and demand for loanable funds has been forecasted, interest rate movements can be forecast

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Global Effects of Monetary Policy

Impact of the dollar

A

weak dollar stimulates exports and discourages imports, which stimulates the economy The Fed is less likely to use a stimulative monetary policy when the dollar is weak

Impact of global economic conditions

When

global economic conditions are strong, foreign countries purchase more U.S. products, which stimulates the U.S. economy
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Global Effects of Monetary Policy (contd)

Transmission of interest rates

Upward

pressure on U.S. interest rates may be offset by foreign inflows of funds A high U.S. budget deficit may lead to higher interest rates in other countries

Global crowding out

Fed policy during the Asian Crisis

The

Fed may have lowered interest rates more than it would have without the crisis
Offset the lower demand for U.S. exports and helped to sustain U.S. demand for foreign exports

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