Prior to the 1970s, most economists thought fiscal policy was far more important than monetary policy.
See opening quote, page 302. Now the consensus is that monetary policy is more important than fiscal
We now look at how monetary policy works - how changes in monetary policy and the money supply
(MS) affect interest rates, output, employment, ex-rates, inflation and prices.
IMPACT OF MONETARY POLICY
Like the opening quote implies, fiscal policy was once thought to be very potent and monetary policy
was considered less important (Keynesian view), especially when it came to stimulating AD. Starting
in the late 1950s, Milton Friedman and other economists started to depart from the Keynesian view,
and they emphasized the importance of monetary policy, becoming known as the
Monetarists believe that 1) unstable, erratic monetary policy is the main cause of economic fluctuations
(expansions and contractions) and 2) inflation is caused by excess money creation. See Friedman's
quote on page 288 and bio on p. 289. Now the general consensus (even among Keynesians) is that
monetary policy does matter. The modern, consensus view of modern monetary policy is presented in
DEMAND and SUPPLY OF MONEY
Think of money as cash or non-interest checking balances. Money demand (MD) is the amount of
cash/checking that people/businesses are willing to hold at any given time, given our current level of
income and wealth. We all want more income/wealth, but at a given level of income or wealth, the
amount of money we hold is MD.
Why do people hold cash? 1) to carry out transactions (
), 2) to deal with
uncertainties (bail someone out of jail, buy something on Sunday at an estate sale) -
, and 3) to store value, people use money as an asset -
MD is inversely related to the Interest Rate - think of the Interest Rate as the Interest Rate on bonds,
savings accounts or CDs. Interest Rate is the
Opportunity Cost of holding cash balances
. If you hold
$1000 in cash at 0%, you are giving up interest earned from buying a bond, CD or putting cash into a
savings account. Even when you hold money in an interest bearing checking account (1%), you are
still usually giving up a higher interest rate in a CD or savings account (3-4%), so there is still an
opportunity cost to holding cash balances in a checking account.
MD is inversely related to int. rates, see graph page 290, Exhibit 1, Panel a. As interest rates rise, the
opp. cost of holding money increases, so people would minimize MD during periods of high int. rates.
T-bills were 15.5% in 1981, making the opportunity cost of holding cash very high, people
and businesses therefore economized on their cash balances.
MGT 551: BUSINESS ECONOMICS CH – 14