notes10spring2018wpd.pdf - MACROECONOMICS 201(Spring 2018...

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MACROECONOMICS 201 (Spring 2018) NOTES 10 MONETARY POLICY AND ITS EFFECTS ON AGGREGATE DEMAND AND THE CONSEQUENCES THEREOF A. Banks and the creation of money B. Effect of other financial intermediaries C. Near moneys and money substitutes D. Role of the Federal Reserve System Reading Assignments: Principles of Economics: Chapters: 27 & 28 Madariaga: 29, 30 Introduction Monetary policy, i.e., the manipulation of the amount of money in the economy, the amount of available funds that can be lent, and the level and composition of interest rates, has become, in a reasonably well functioning economy, the stabilization tool of first choice . However, during the 1930's, and as a direct consequence of the depression, the role of monetary policy and interest rates was downplayed. Instead, economists focused on changes in government spending and taxes. In fact, the usual policy recommendation was to increase government spending on public works in order to reduce unemployment. This was largely a consequence of the fact that in times of massive unemployment, monetary policy was not considered particularly effective, since few people wished to incur debt or risk investing money when jobs are not secure and markets are weak. This sounds similar to the situation in the recent great recession as interest rates were pushed down about as far as they could go. You may sometimes hear this described as the “liquidity trap” since interest rates cannot fall enough to encourage enough increased spending/investment to bring the recession to an end. We will, however, reconsider this topic below. However, after WWII, many economists began to re-examine and re-emphasize the importance of monetary policy on AD and/or AE. Remember, any change in AE will also change AD. This made perfect sense given that the economy was quite prosperous, and while unemployment was sometimes a problem, so was inflation beginning to be seen as a problem, and equally importantly, it became obvious that changes in interest rates could have a dramatic effect on spending, both upward and downward. Remember the effects on prices and output as you move along our AS curve. After World War II, the intersection of the AD and AS curve generally led to a high level of employment, and was sometimes close to the region of rapidly increasing prices. Lowering interest rates would often lead to increased investment (by lowering costs of investment) and increased consumer borrowing for homes, cars, and consumer goods, and sometimes could cause a significant increase in inflation. Raising interest rates, of course, would have the opposite effect. In this set of notes, we will discuss the different tools of monetary policy and how it is carried out 1. What is Money? A. Money , narrowly defined , is any commodity that people will readily accept in exchange for goods or services. One long-time definition was that money is defined as checking deposits (we will
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2 consider savings deposits a little later), and paper and metal money held by the nonbank public, i.e., in circulation and not in bank vaults . Note that dollars, considered money in the U.S., will not be counted as
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