Unformatted text preview: Monetary Policy
Long-term effects: The Money Stock, Velocity of Circulation, and the Economy Expansionary Monetary Policy: Action by the Fed to increase bank reserves and the money stock or the rate of growth of these variables. Short interest rates decline. s Contractionary Monetary Policy: Actions by the Fed to decrease bank reserves and the money stock or the rate of growth of these variables. Short term interest rates rise
s Short run effects of monetary policy:
Short-term interest rates will rise or fall --long-term interest rates depend on inflationary expectations and are not under direct control of the Fed s The supply of credit and money will change albeit with a lag. Sometimes it takes the banking system and the economy several months to respond to change in monetary policy.
s Long-term effects of monetary policy:
Long term effects depend the impact of Fed policies on inflationary expectations. s Long term effects also depend on changes in the equilibrium money stock and its rate of turnover (velocity). s To prevent inflation or recessions the money stock must grow in line with the rate of growth of potential real GDP after adjustment for changes in velocity.
s Income Velocity of Circulation of Money (V):
s V is the number of times per year, on average, a dollar of money is spent on final products or paid out as income s V = Nominal GDP/M1 For 2008, M1=1.5 trillion s 2008 Nominal GDP = 14.3 trillion s For 2008, V = 14.3/1.5= 9.54
s The Equation of Exchange:
Nominal GDP M1 NOMINAL GDP = PQ
Price level Real GDP MV = PQ MV = PQ
The classical economists believed that the economy's self correction mechanism would assure that the economy would achieve equilibrium at potential real GDP s The quantity theory of money assumes that V is constant and Q = Potential real GDP s Modern "monetarists" assume that changes in V are predictable
s Stability of velocity:
From 1960 to 1982 V grew from 3.8 to 7 s From 1982 to 1992 V stabilized within a range of 6 and 7 but since 1992 it has increased to nearly 10. s If V remains stable, and potential real GDP grows at the rate of 3% per year then the equation of exchange, MV=PQ, implies that money stock must increase by 3% per year to achieve economic growth with full employment and zero inflation
s The dilemmas of monetary policy: The Fed cannot simultaneously stabilize interest rates and the money stock. Equilibrium interest rates and money stock depend on the demand and supply for money:
Interest Rate Initial Money Supply 4% Initial Money Demand 1000 M1 During and expansion the demand for money typically increases putting upward pressure on interest rates:
Interest Rate 6% 4% Initial Money Supply New Money Demand Initial Money Demand M1 1000 1100 If the Fed responds by increasing money supply to keep interest rates low and keep the expansion going, it could add to inflationary pressures by increasing equilibrium M1:
Interest Rate 6% 4% Initial Money Supply New Money Supply New Money Demand Initial Money Demand 1000 11001200 M1 If the Fed prevents the money stock from growing during an expansion, interest rates soar which could cause a recession, as was the case in 1982:
Interest Rate 8% 6% 4% New Money Supply Initial Money Supply New Money Demand Initial Money Demand
1000 1100 M1 ...
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