Prior to the 1970s, most economists thought fiscal policy was far more important than monetary policy. Now the consensus is that monetary policy is more important than fiscal policy. The current economic expansion is far more because of stable monetary policy than any fiscal stimulus. In fact, Bush and Clinton both RAISED taxes, which would be restrictive or contractionary.

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. 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 320 and bio on p. 321. Now the general consensus (even among Keynesians) is that monetary policy does matter. The modern, consensus view of modern monetary policy is presented in this chapter.

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 (transactions demand), 2) to deal with uncertainties (bail someone out of jail, buy something on Sunday at an estate sale) - precautionary demand, and 3) to store value, people use money as an asset - asset demand.

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 322, Panel a. As interest rates rise, the opp. cost of holding money increases, so people would minimize MD during periods of high int. rates. Example: 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.

MD is also influenced by technology/innovation. Examples: credit cards and ATM machines allow us to carry less cash, has reduced MD over time. Also, income is more predictable now compared to 100 yrs. ago when the economy was more farm-based. Income was received two or three times a year and the timing and the amount was unpredictable. These changes would reduce MD, and would shift the entire MD curve back and to the left. We have seen this happen, for example MD/GDP has gone from 58.5% to 51.8% over the last 40 years due to increased use credit cards, etc.

MS is fixed/determined by the FRS, and is independent of the interest rate, so it is shown as a vertical line on page 322, Panel b.

See graph page 323 - MD, MS and Equilibrium. Just like in the market for goods, the money market will gravitate toward an equilibrium condition where MD = MS. Instead of the price adjusting, now the interest rate adjusts to bring about equilibrium. Market interest rate change daily to bring about a continual balance between MD and MS.

TRANSMISSION OF MONETARY POLICY

Combination of influences by Keynesians and monetarists, the modern view of monetary policy explains the transmission of monetary policy (how changes in the MS affect the economy) as on page 324.

1. Fed increases MS from S1 to S2 - Expansionary Monetary Policy - by buying bonds in an Open Market Operation. This expansion of MS lowers nominal interest rates - Panel a.

2. Banks now have excess reserves and they start making additional loans, increase the supply of credit, or loanable funds - Panel b. In addition, the FRS is supplying credit directly to the credit market by buying bonds, increasing the supply of credit, shifting out the supply curve. The increased supply of credit (from banks and the Fed) lowers real int. rates.

3. The lower interest rates, both nominal and real, stimulate the economy and shift the AD curve out, AD increases from AD1 to AD2 in Panel c.

AD shifts out for 3 reasons:

1. Lower interest rates stimulate consumption spending (houses, cars) by consumers (C) and investment spending (I) by businesses. AD goes up because C and I go up.

2. Lower int. rates in U.S. lead to a capital outflow to other countries (Canada, Europe), which leads to an appreciation of the foreign currency (C$ and ) and a depreciation of the U.S. dollar. The strong foreign currencies lead to an increase in Exports (X). AD goes up.

3. Lower interest rates increase asset/stock prices. Reasons: a) lower interest rates lower the cost of debt (borrowing) and therefore make businesses more profitable, increasing stock prices. b) Also, stock market competes with bond market. As int. rates fall in the bond market, stocks are more attractive, prices get bid up. Wealth effect from rising asset prices increases AD by increasing C.

Lower int. rates stimulate AD - AD1 to AD2. Prices goes up and real GDP goes up, as on page 324, Panel c. See Thumbnail Sketch on page 326.

UNANTICIPATED EXPANSIONARY MONETARY POLICY

Expansionary monetary policy has to be unexpected to really work. For example: see page 326, Panel a. Economy is at Y1 (e1), less than full output/full employment. Fed implements unanticipated expansionary monetary policy to get the economy back to YF by shifting AD1 to AD2. The expansionary policy was unexpected, so Retail Prices rise immediately, costs of production are fixed (wages, leases, contracts, etc.) and rise slowly. Profits are increased in SR to get output to expand to E2. We move along the SRAS from e1 to E2, because the price level is higher than expected, improving profit margins, expanding output. Retail prices are flexible, costs of production are fixed in SR.

Panel b - expansionary monetary policy when the economy is already at full employment (E1, YF) results in temporarily higher output in SR (e2), higher prices and full employment output in the LR (E2).

Possible scenario: Economy is in recession, Fed implements expansionary policy, but the self-correcting mechanisms move the economy back YF and then the expansionary policy impacts the economy (bad timing) and moves the economy into an unnecessary expansion.

UNANTICIPATED RESTRICTIVE MONETARY POLICY

See page 327. MS goes down, from S1 to S2. Fed sells bonds, reduces bank reserves. Lower bank reserves means fewer loans, and the supply of credit shift back, decreases, which raises the real int. rate and lowers AD from AD1 to AD2.

Page 328, Panel a. Use of restrictive monetary policy to control inflation. Restrictive policy shifts AD from AD1 to AD2, output goes from e1 to E2. This restrictive monetary policy generally describes the monetary policy of a few years ago in 1999-2000, the Fed was trying to slow down the economy, to prevent it from inflationary "overheating" by raising interest rates six times to dampen AD slightly.

Panel b - If restrictive policy is mis-timed and takes effect when the economy is already at full output, then the economy would go into a recession - E1 to e2, Y2.

As mentioned, proper timing of monetary policy is critical, and almost impossible due to lags. To be effective, we need expansionary monetary policy during a recession and restrictive policy during an inflationary expansion. However, there is a 12-18 month lag for expansionary policy to affect output and employment, and a 36 month lag to affect prices. Without perfect foresight, it is unlikely to ever have monetary policy timed correctly.

If it is not timed perfectly, expansionary policy that takes affect when the economy is already recovered will be extremely destabilizing. Restrictive policy that takes affect when the economy is already moving toward recession will make the recession much worse, also destabilizing.

Although the monetarists emphasize the importance of money, they have generally been critical of activist, countercyclical monetary policy because they are skeptical of the Fed's ability to achieve correct timing of monetary policy.

MONETARY POLICY IN THE LONG RUN

Start with the Quantity Theory of Money, developed in the early 1900s by economist Irving Fisher. One simple implication of the Quantity Theory is that changes in the MS will be reflected by a proportional change in inflation. If MS increases by 5%, prices will increase by 5% (inflation = 5%).

It is actually a little more complicated, we can start with the equation:

PY = Nominal GDP ($11T) = MV, where

P = Price level Y = Real output (real GDP) PY = Nominal GDP

M = Money Supply, usually M1 V = Velocity or turnover rate of money. The average number of times a dollar is used during the year to purchase final goods/services. MV = Nominal GDP

In 2001, GDP was $9963B, M1 was about $1088B, so Velocity of M1 was 7.8x ($9963/$1088). Velocity of 7.8x means that a single dollar turned over 7.8x during the year, or about every 7 weeks. For example, you spend $100 at Target, and it takes about 7 weeks on average before that same money is spent again on final goods and services.

Velocity = GDP/M1. V is inversely related to MD. If people hold less cash and GDP is the same, then velocity is greater. Velocity increases as technology increases - more efficient financial/banking system - faster check clearing, etc. Also as we use credit cards, ATMs, MD is lower, V is higher. We can get by with less cash, as Velocity increases, and money circulates faster. V has generally been increasing over the last fifty years as we move towards a cashless economy.

If we convert to the previous equation to percentage changes, we get the Equation of Exchange:

%Y + %P (inflation) = %M1 + %V

We can assume that %Y (real output) is "fixed" in SR, and determined by real factors like technology, productivity, resource base, skill of workforce, etc., independent of the MS. Also, we can assume that V is fixed in the short run, or changes very slowly in response to financial innovations, credits cards, ATMs, etc.

If %Y and %V are fixed in the short run, then %P = %M, meaning that increases in the MS lead a corresponding increase in inflation. This is one the important implications of the Quantity Theory, that increases in the MS lead to proportionate increases in the Price Level. "Inflation is always and everywhere a monetary phenomenon."

However, if we more realistically assume a growth in real output of 3%, then an increase in the MS of 3% would lead to 0% inflation. We would need 3% more money for the 3% increase in real output, since MD will increase by 3% because income has increased by 3%. Other possible outcomes using the Equation of Exchange, assuming real output grows at 3%:

%P = %M1 - %Y -3% =0%-3% (3% deflation) 0% = 3-3 (0% inflation as described above) 2% = 5- 3 (2% inflation since money growth > output growth) 20% = 23- 3 (20% inflation since money growth > output growth).

Implication of the Equation of Exchange: "Inflation is caused by too much money chasing too few goods." Or inflation occurs when the growth rate in the MS is greater than the growth rate in real output.

Monetarist have advocated an alternative monetary policy to the activist approach: Passive, Fixed growth rule policy - Fix MS growth at X% per year (3% is usually suggested) so that people would know what to expect.

SUMMARY:

Keynesian view of Money - Emphasized fluctuations in AD as the source of econ instability, policy conclusion - activist, discretionary fiscal policy to stabilize AD. No role for money, monetary policy. Didn't think econ instability, fluctuations were caused by money, Didn't think that monetary policy would stimulate AD. And if M went up, but V went down by the same amount, monetary policy wouldn't do anything.

Monetarists - Led by Milton Friedman, starting in the 1950s. Emphasized: 1) the strong link between MS and inflation and 2) the link between econ instability and monetary instability. Emphasized the strong role that money and monetary policy play in the economy, especially the negative, harmful role of erratic monetary policy. Even though they emphasize the role of monetary policy, they do not advocate activist, discretionary monetary policy. Monetarists generally favor passive policy based on specified rules or formulas - fixed growth rule.

Monetarists emphasized the problems of lags - recognition lag, policy lag, effectiveness lag. With monetary policy, the policy lag is much shorter, but the effectiveness lag is still long. It takes 6-18 months for a change in monetary policy to affect output, and 12-36 months to affect the price level. By the time the policy takes affect, the economy will most likely have already changed. Timing is critical and also practically impossible. Lengthy and unpredictable time lags may prevent activist, discretionary monetary policy from ever working effectively.

MONETARY POLICY WHEN EFFECTS ARE ANTICIPATED

In SR, expansionary monetary policy can temporarily stimulate the econ, increase AD, output and employment. In LR, however, the effects of rapid money growth are higher inflation and higher interest rates. Money growth cannot reduce un or increase real output in the LR. Money is neutral in the long run. Or possibly negative if it is erratic. Money growth/inflation can be like drinking alcohol - the initial result is favorable, but if we consume too much, there is a bad hangover.

Point: For money growth to be expansionary in the SR, it has to be unexpected. People have to be fooled. Only surprise money matters. The expansionary effect is because retail prices rise faster than input prices - wages, rents, leases, supply contracts, int. rates, etc. - increasing profits and expanding output. The rising prices catches workers, landlords, suppliers and lenders off guard, and real wages, real rents, real input prices and real int. rates fall.

If workers, landlords, lenders and suppliers fully anticipate the future inflation, there will be no change in output, employment at all. See page 334. For example, long term contracts such as union contracts may include an "escalator clause" (COLA - cost of living adjustment) that will raise nominal wages or prices automatically as the price level rises. Therefore, monetary policy will be neutral if fully anticipated or if everyone takes measures to counteract the effects of inflation. Retail prices and input/resource prices will both increase by the same amount and the result would be a higher price level, but no real affect on output, employment.

Graph page 334. Expansionary monetary policy shifts AD1 to AD2. Output would expand along SRAS1 if either a) they did not anticipate the policy or b) did not protect themselves with escalator and COLA clauses in contract. But if the expansionary policy is fully anticipated and resource suppliers have fully incorporated inflationary expectations into their decisions, output is not affected even in the short run. The expansionary monetary policy will induce producers to raise prices for inputs and will shift SRAS1 to SRAS2.

For example, retail prices rise by 5% and input prices rise by 5% demonstrating the "Policy ineffectiveness theory." Policy is neutralized, monetary policy is ineffective because output and employment are unaffected. Economy goes from E1 to E2, output (YF) stays the same, at a higher price level, WHEN suppliers either a) correctly anticipate inflation or b) sufficiently protect themselves against inflation with escalator and COLA clauses in their contracts, and adjustable or variable rate loans, etc.

How likely are people to anticipate monetary policy? Topic of Debate. For example, people didn't anticipate the inflation of the 70s very well, but that led to significant increase in the use of COLAs, escalator clauses, ARMs (adjustable rate mortgages), etc. We will come back to this topic in the next chapter.

MAIN POINT: The effects of monetary policy depend critically on whether the policy is expected (no effect) or unexpected (economy is affected).

INTEREST RATES AND MONETARY POLICY

Confusing issue - we have to distinguish between SR and LR and between short term rates and long term rates. In the long run, increases in the MS will lead to higher inflation and higher interest rates for both short and long term rates.

In the SR, increases in MS will usually lower short term rates. Fed conducts OMO, buys T-bills, increases bank reserves, lowers the Fed Funds Rate (FFR), overnight market for banks lending reserves. MS/MD graph shows this (p. 324).

As FFR falls, other short term rates may fall TEMPORARILY - CDs, svgs. accounts, 3 month T-bills, etc. However, the LR effect on short-term rates is usually higher int. rates due to increased inflation.

The effect of monetary policy on long term rates is much less predictable and much less certain. If people expect higher inflation as a result of expansionary monetary policy, long term rates may increase in response to expansionary policy, not fall. People and businesses make major investment decisions based on long term rates, not short term rates - 30 years mortgage rates, 30 year bond rates, etc. If expansionary monetary policy raises long term rates, the policy won't stimulate the economy, it will slow it down, contract it.

MAIN POINTS: 1) Expansionary monetary policy may lower short-term rates (FFR, 3 month T-bills), but RAISE long-term rates (30 year bonds, 30 year mortgages), 2) Investment decisions depend more on long term rates, so the expansionary policy may not stimulate investment and output if long term rates rise, and 3) All interest rates (short and long term) may be higher in the long run as a result of expansionary policy if inflation accelerates (e.g. 1970s).

SUMMARY OF MONETARY POLICY

See page 337 for a Thumbnail Sketch of the effects of monetary policy. It is important to separate the effects: 1) in short run when policy is unanticipated and 2) in short run when anticipated and 3) in long run. If policy is anticipated, the effects in the SR and LR are exactly the same (see Thumbnail Sketch) because the LR adjustment process happens immediately when policy is expected. It is only "surprise money" that affects the economy differently in SR and LR - only "surprise money matters."

In the LR, or in SR if policy is anticipated, the only effects of expansionary monetary policy are higher int. rates and higher inflation. Real int. rates, real output, real employment will be the same, see last column in graph on page 337.

If expansionary monetary policy is a surprise (Column 1 on p. 337), interest rates (nominal and real) and the unemployment rate will decrease temporarily and output will increase. However in the LR after an adjustment period, there will be no LR affect on output, employment or the real interest rate, only higher prices and higher nominal interest rates.

Main point of Thumbnail Sketch on p. 337: "Monetary policy is neutral in the LR" ( and in the SR when expected).

MONETARY POLICY - 5 MAJOR PREDICTIONS:

1. Unexpected expansionary (contractionary) monetary policy will temporarily increase (decrease) output and employment.

2. Expansionary monetary policy will stimulate an economy in recession toward full employment. If the economy is at full employment, expansionary policy will be inflationary. Restrictive policy will result in a recession if it impacts the economy at or below YF.

3. Persistent growth in the MS will cause inflation.

4. Inflation will increase nominal interest rates.

5. Due to lags, it takes time for changes in monetary policy to affect output and prices. 6 months - 3 years. There may not always be a close short-run relationship between changes in monetary policy and changes in output, inflation and interest rates due to lags and due to some prices being set by long term contracts.

EMPIRICAL EVIDENCE

1. Monetary policy and real output - see Exhibit 10, p. 359. There appears to be a strong link between money growth and real output growth. During periods of economic recessions, there is a decrease in money growth, and during economic expansions there is an increase in money growth. Also, there is some evidence of expansionary monetary policy during recessions in 1970, 1974 and 1980.

However, association is not the same as causation. Did monetary policy "cause" output growth to change, or did output growth "cause" monetary policy to change? Higher growth/income raises the demand for money, lower growth lowers the demand for money? We can see a strong link between money and output (supports the Monetarist position), but the direction of causality cannot be determined from the graph.

2. Money Supply and Inflation, see Exhibit 11, p. 340. Fairly close link between M2 growth and inflation three years later. We compare M2 growth in 1960 with inflation in 1963, to allow three years for money to have its full effect on inflation.

1980s - M2 was growing at about 10% and inflation was only growing about 4- 5%. Why? i) Real output was growing very rapidly, as high as 4% and ii) Velocity (V) was falling due to int. on checking. When checking accounts starting paying interest, people were willing to hold more cash. Banking laws from the 1930s prohibited banks from paying interest on checking until 1980.

MV = PY, if M goes up, but V goes down, the effect of M on P is dampened.

3. Inflation rate and Nominal Interest Rates - see Exhibit 12, p. 373. Very strong link between inflation rate and short term nominal int. rates (3 mo. t-bills).

4. International evidence of the link between MS growth and inflation - see Exhibit 13, p. 342. Very close link between MS and inflation over a 19 year period in more than 30 countries supports the Quantity Theory of Money and is one of the most consistent empirical relationships in economics. "Inflation is always and everywhere a monetary phenomenon."