CHAPTER

55Monetary Theory and Policy

© 2003 South-Western/Thomson Learning

Chapter ObjectivesChapter Objectives

Learn the well-known theories of monetary policy

Review the tradeoffs involved in monetary policy

Learn how analysts monitor and forecast Fed’s monetary policy

Monetary PoliciesMonetary Policies

How does money affect the real economy? How does varying money supply growth

impact spending? How does monetary policy in the financial

sector impact real economic sector investment and spending?

Keynesian TheoryKeynesian Theory

Developed by John Maynard Keynes and his students

Initially attempted to explain inadequacy of monetary policy during Great Depression

Effectiveness of monetary policy depends upon the sensitivity (elasticity) of economy to changes in interest rates

Keynesian Theory, cont.Keynesian Theory, cont.

Advocates fiscal policy Focused on government deficit/surplus

spending to impact economic activity Monetary policy transmitted slowly via bank

credit policy and interest rates A proactive economic policy

Exhibit 5.3Exhibit 5.3

Stimulative MonetaryPolicy

Restrictive MonetaryPolicy

Fed

InvestorsBank Funds

IncreaseInterest Rates

Decrease

AggregateSpendingIncreases

$ TreasurySecurities

Fed

InvestorsBank FundsDecrease

Interest RatesIncrease

AggregateSpending

Decreases

$Treasury

Securities

InflationDecreases

Monetary TheoriesMonetary Theories

Quantity theory Based on equation of exchange MV = PGQ

M = amount of money in the economy

V = velocity, average number of times each

dollar changes hands during the year

PG = weighted average price level of goods

and services in the economy

Q = quantity of goods and services sold

Monetary TheoriesMonetary Theories

Quantity theory’s assumptions PGQ is the total value of goods and services

produced Assume V constant or predictable—changing M

impacts total spending M should grow at rate of output capacity, Q Faster M growth increases PG or inflation

Monetary TheoriesMonetary Theories

Monetarists Velocity is affected by

Income levels Frequency income is received Use of credit cards Inflationary expectations

Velocity changes found to be predictable and not related to fluctuations in money supply

Monetarist vs. Keynesian TheoriesMonetarist vs. Keynesian Theories

Monetarist Let economic problems

resolve themselves Low growth reduces

borrowing and lowers interest rates

Problem: It takes time

Keynesian Need to take action to

lower interest rates High money growth to

fix a recession by lowering rates

Problem: Might ignite inflation

Monetarist vs. Keynesian TheoriesMonetarist vs. Keynesian Theories

Monetarist Low, stable growth in

the money supply Focus on maintaining

low inflation and will tolerate what they call natural unemployment

Keynesian Actively manage the

money supply Willing to tolerate

inflation that helps reduce unemployment

Rational Expectations TheoryRational Expectations Theory

Households and businesses act in their own self-interest

Individuals anticipate effects of government policy changes

Expansionary monetary policy signals future inflation and interest rates increase (security prices fall)

Rational expectations may nullify intended effects of monetary policy

Tradeoff of Monetary Policy Goals Tradeoff of Monetary Policy Goals

Goals of the Monetary Policy Steady GDP growth Low unemployment Stable price levels

Tradeoffs Lowering unemployment by stimulating the

economy may increase inflation Lowering inflation by slowing the economy may

increase unemployment

Economic Indicators Monitored by the Economic Indicators Monitored by the FedFed

Indicators of economic growth Gross Domestic Product or GDP Industrial production National income Unemployment

Indicators of Inflation Producer price indexes Consumer price Indexes Other indicators

Economic Indicators Monitored by the Economic Indicators Monitored by the FedFed

How the Fed uses indicators Fed meets to decide course of monetary policy Assesses recent reports on indicators of growth

and inflation Uses indicators to anticipate how the economy

will change Decides the appropriate monetary policy given

possible conditions

Lags in Monetary PolicyLags in Monetary Policy

Recognition lag Most economic problems revealed by statistics, not

observation Fed quick to see changes in economy

Implementation lag Fed acts quickly to implement change in monetary policy Fiscal policy via Congress takes a long time

Impact Lag Takes time for monetary changes to have full impact Fiscal policy tax changes have unpredictable results

Assessing the Impact of Monetary PolicyAssessing the Impact of Monetary Policy

How does the policy change affect financial market participants? Depends on the kinds of securities you trade Depends on your expectations about how the

changes affect on the economy Forecasting money supply movements

Financial market participants look at actual growth compared to Fed targets

Growth outside range could signal Fed policy changes

Assessing the Impact of Monetary PolicyAssessing the Impact of Monetary Policy

Improved communication at the Fed Fed more willing to disclose its intentions since

1999 Immediate feedback to public and financial

markets about “bias” on rates Market reaction to reported money supply

levels Thursday release of money supply data Try to determine future trends in interest rates

Assessing the Impact of Monetary PolicyAssessing the Impact of Monetary Policy

Anticipating reported money supply levels Securities and financial market professionals

cannot profit on information available to all at the same time

Try to forecast and anticipate changes Trying to figure out the future course of interest

rates and Fed policy

Market reaction to discount rate adjustment

Assessing the Impact of Monetary PolicyAssessing the Impact of Monetary Policy

Market reaction to discount rate adjustment Monitor changes to determine policy Some changes are technical or intended to bring

the discount rate in line with market rates Financial market participants try to anticipate

changes Discount rate seems to preceded market interest

rate movements since 1980

Exhibit 5.9Exhibit 5.9

Federal OpenMarket Committee

(FOMC)

Money SupplyTargets

InflationaryExpectations

Demand forLoanable Funds

Cost of Capitalfor Corporations

CorporateExpansion

EquilibriumInterest Rates

ResidentialConstruction

EconomicGrowth

Supply ofLoanable Funds

Cost ofHousehold Credit

(Including MortgageRates)

HouseholdConsumption

Assessing the Impact of Monetary PolicyAssessing the Impact of Monetary Policy

Forecasting the impact of monetary policy Even if financial market participants correctly

anticipate changes in the money supply there are still problems Not a stable relationship between money supply and

economic variables over time Examples include the relationship between economic

growth and the money supply

Integrating Monetary and Fiscal PoliciesIntegrating Monetary and Fiscal Policies

History Executive branch usually most concerned with

employment and growth Fed and administration may differ on priorities of

price stability or growth needs Agreement when inflation and unemployment are

at relatively low levels

Exhibit 5.12Exhibit 5.12

U.S.Monetary

PolicyU.S.

FiscalPolicy

U.S.PersonalIncome

Tax Rates

U.S.BudgetDeficit

U.S.BusinessTax Rates

U.S.HouseholdDemandfor Funds

GovernmentDemandfor Funds

U.S.BusinessDemandfor Funds

U.S.PersonalIncomeLevel

Savingsby U.S.

Households

Supplyof Fundsin U.S.

U.S.Interest

Rate

Demandfor Funds

in U.S.

Integrating Monetary and Fiscal PoliciesIntegrating Monetary and Fiscal Policies

Combined monetary and fiscal policy effects Fiscal policy usually has a larger influence on the

demand for loanable funds Monetary policy usually has a larger influence on

the supply of loanable funds Monetizing the debt

Should the Fed help finance a federal budget deficit created by fiscal policy?

Forecasted surpluses, debt reduction, and U.S. Treasury securities

Integrating Monetary and Fiscal PoliciesIntegrating Monetary and Fiscal Policies

Market assessment of integrated policies Financial markets assess both fiscal and monetary

policy Markets monitor a wide range of information and

data Forecast how loanable funds supply and demand

will change

Global Effects on Monetary PolicyGlobal Effects on Monetary Policy

Impact on the U.S. dollar Value of the dollar relative to other currencies can

affect inflation A weak dollar stimulates U.S. exports, discourages

imports and stimulates the economy Fed less likely to stimulate the economy if the dollar is

weak

Strong dollar Stimulates imports and economic growth Encourages capital flows into U.S. and lower interest

rates

Global Effects on Monetary PolicyGlobal Effects on Monetary Policy

Transmission of interest rates International flow of funds affected by Fed policy Global capital and money markets are integrated

Capital flows to highest real, after-tax, exchange-rate adjusted rate of return

Financial integration improves with Decreased governmental regulation in markets Decreased transaction costs Improved financial technology

Deficits or surpluses in the U.S. have global implications

Global Effects on Monetary PolicyGlobal Effects on Monetary Policy

Fed policy during the Asian crisis Fed realizes the global economy is integrated

U.S. economic conditions affect other countries Other countries economic conditions affect the U.S.

Fed reaction to Asian crisis shows possible complications that result from economic integration

Forecasting Money SupplyForecasting Money Supply

Watch weekly federal reserve data releases Observe changes with announced fed ranges

of money growth Markets attempt to estimate changes in

monetary policy direction and . . . Anticipate interest rate changes

Global Effects on Monetary PolicyGlobal Effects on Monetary Policy

Exchange Rate Levels International Funds Flow Economic Activity of Foreign Countries