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1、5,Monetary Theory and Policy,Chapter Objectives,Learn the well-known theories of monetary policyReview the tradeoffs involved in monetary policyLearn how analysts monitor and forecast Feds monetary policy,1. Monetary Policies,How does money affect the real economy?How does varying money supply growt
2、h impact spending?How does monetary policy in the financial sector impact real economic sector investment and spending?,1.1 Keynesian Theory,Developed by John Maynard Keynes and his studentsInitially attempted to explain inadequacy of monetary policy during Great DepressionEffectiveness of monetary
3、policy depends upon the sensitivity (elasticity) of economy to changes in interest rates,Keynesian Theory, cont.,Advocates fiscal policyFocused on government deficit/surplus spending to impact economic activityMonetary policy transmitted slowly via bank credit policy and interest ratesA proactive ec
4、onomic policyCorrecting economic recession and high inflation,Exhibit 5.3,a,a,$,$,Effects of a Credit Crunch,An economic condition where investment capital is difficult to obtain. Banks and investors become wary of lending funds to corporations, thereby driving up the price of debt products for borr
5、owers.Credit crunches are usually considered to be an extension of recessions. A credit crunch makes it nearly impossible for companies to borrow because lenders are scaredof bankruptcies or defaults, which results in higher rates. The consequence is a prolonged recession (or slower recovery), which
6、 occurs as a result of the shrinking credit supply.,Effects of a Credit Crunch,A credit crunch may partially offset the desired effects of a simulative monetary policy (need more sufficient qualified borrowers) and magnify the effects of a restrictive monetary policy (prevent potential borrowers fro
7、m obtain loans),1.2 Monetary Theories,Quantity theory (Milton Friedman)Based on equation of exchangeMV = PGQM =amount of money in the economyV =velocity, average number of times eachdollar changes hands during the yearPG =weighted average price level of goodsand services in the economyQ =quantity of
8、 goods and services sold,Monetary Theories,Quantity theorys assumptionsPGQ is the total value of goods and services producedAssume V constant or predictablechanging M impacts total spendingM should grow at rate of output capacity, QFaster M growth increases PG or inflation,Monetary Theories,Monetari
9、stsVelocity is affected byIncome levelsFrequency income is receivedUse of credit cardsInflationary expectationsVelocity changes found to be predictable and not related to fluctuations in money supply,Monetarist vs. Keynesian Theories,MonetaristLet economic problems resolve themselvesLow growth reduc
10、es borrowing and lowers interest ratesProblem: It takes time (too passive),KeynesianNeed to take action to lower interest ratesHigh money growth to fix a recession by lowering ratesProblem: Might ignite inflation,Monetarist vs. Keynesian Theories,MonetaristLow, stable growth in the money supplyFocus
11、 on maintaining low inflation and will tolerate what they call natural unemploymentWithout causing additional problems,KeynesianActively manage the money supplyWilling to tolerate inflation that helps reduce unemployment,1.3 Rational Expectations Theory,Households and businesses act in their own sel
12、f-interestIndividuals anticipate effects of government policy changesExpansionary monetary policy signals future inflation and interest rates increase (security prices fall)Rational expectations may nullify intended effects of monetary policy,2. Tradeoff of Monetary Policy Goals,Goals of the Monetar
13、y PolicySteady GDP growthLow unemploymentStable price levels TradeoffsLowering unemployment by stimulating the economy may increase inflationLowering inflation by slowing the economy may increase unemploymentPhillips Curve,Tradeoff of Monetary Policy Goals,Fed determine whether unemployment or infla
14、tion is the more serious problem Higher inflation: tight-money policy-reduce economic growth-price and sales volume remain stable-workers are not in demand-inflation rate reduced and stagnant economy(sales decrease, inventories accumulate, reduce workforce)-high unemployment rateIn fact, sometimes,
15、neither tight-money policy nor loose-money policy could fully eliminate either problem (unskilled workers, oil prices high),Tradeoff of Monetary Policy Goals,Fed need decide which money policy should be selected under worse condition (both inflation and unemployment are high)-see exhibit 5.5Some out
16、side factors have affected both the variables (oil price, close of training center)-see exhibit 5.6Persian Gulf War,3.1 Economic Indicators Monitored by the Fed,Indicators of economic growthGross Domestic Product or GDP (it measures the total value of goods and services produced during a specific period)Industrial productionNational income (it is the total income earned by firms and individual employees during a specific period)Unemployment Many types of indexes,
