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Chapter 26 Monetary Policy
©2002 South-Western College Publishing
• Key Concepts• Summary
• Practice Quiz• Internet Exercises
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What are the three schoolsof economic thought?
• Classical• Keynesian
• Monetarist
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What is the Keynesianview of money?
People who hold cash or checking accountbalances incur an
opportunity cost inforegone interest or profits
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According toKeynes, why wouldpeople hold money?• Transactions demand• Precautionary demand• Speculative demand
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What is the
transactions demandfor money?
The stock of money peoplehold to pay everydaypredictable expenses
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What is the
precautionary demandfor money?
The stock of moneypeople hold to pay
unpredictable expenses
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What is the speculative
demand for money?The stock of money people
hold to take advantage of expected future changes inthe price of bonds, stocks,or other nonmoneyfinancial assets
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How does a change ininterest rates affect
speculative demand?
As the interest rate falls,the opportunity cost of
holding money falls, andpeople increase their speculative balances
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What is the demand for money curve?
A curve representing thequantity of money thatpeople hold at different
possible interest rates,ceteris paribus
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How do interestrates affect thedemand for money?
There is an inverserelationship between thequantity of moneydemanded and theinterest rate
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What gives thedemand for money a
downward slope?
The speculativedemand for money at
possible interest rates
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What determines
interest rates inthe market?
The demand andsupply of money in the
loanable funds market
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16%
12%
8%
4%
500 1,000 1,500 2,000
AB
The Demand for Money Curve
MD
Interest
Rate
Billions of dollars
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Decrease in theinterest rate
Increase in thequantity of money
demanded
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16%
12%
8%
4%
500 1,500 2,000
E
The Equilibrium Interest Rate
MD
MS Surplus
Shortage
1,000
Interest
Rat e
Billions of dollars
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Excessmoney
demand
People sellbonds
Bond prices falland the interest
rate rises
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Excessmoney
supply
People buybonds
Bond prices
rise and theinterest ratefalls
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Why do bond prices fallas interest rates rise?
Bond sellers have to offer
higher returns (lower price) to attract potential
bond buyers, or else theywill go elsewhere to gethigher interest returns
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Why do bond prices rise
as interest rates fall?Bond sellers are put in a
better bargaining positionas interest rates fall (higher price); potential buyers
cannot go elsewhere to gethigher interest returns so
easily
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How can the Fed
influence theequilibrium
interest rate?It can increase or decreasethe supply of money
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16%
12%
8%
4%
500 2,000
E1
Increase in the Money Supply
MD
MS1 Surplus
1,000
MS2
E2
1,500
Interest
Rat e
Billions of dollars
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16%
12%
8%
4%
500 2,000
E1
Decrease in the Money Supply
MD
MS1
1,000
MS2
E2
1,500
Shortage
Interest
Rat e
Billions of dollars
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Increase in themoney supply
Money surplus andpeople buy bonds
Decrease theinterest rate
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Decrease in themoney supply
Money shortage andpeople sell bonds
Increase in theinterest rate
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In the Keynesian
Model, what dochanges in the moneysupply affect?
Interest rates, which inturn affect investment
spending, aggregatedemand, and real GDP,employment, and prices
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Change in
interestrates
Change inthe money
supply
Change ininvestment
Change inthe aggregatedemand curve
Change in
prices, real GDP,& employment
Keynesian
Policy
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16%
12%
8%
4%
500 2,000
E1
Expansionary Monetary Policy
MD
MS1 Surplus
1,000
MS2
E2
1,500
Interest
Rat e
Billions of dollars
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16%
12%
8%
4%
A
Investment Demand Curve
I
1,000
B
1,500
Inte
rest
Rat
e
Billions of dollars
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When will businessesmake an investment?
When the investmentprojects for which theexpected rate of profit
equals or exceeds theinterest rate
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155
150
E2
AD1
6.0 6.1
Product Market
E1
PriceLe
vel
AS
AD2full employment
Billions of dollars
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What is the Classicaleconomic view?
The economy is stable inthe long-run at fullemployment
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How did the
Classicaleconomists view therole of money?
They believed in theequation of exchange
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What is theequation of exchange?
An accounting number of times per year a dollar of the money supply is
spent on final goods andservices
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What is thevelocity of money?
The average number of times per year a dollar of the money supply is
spent on final goods andservices
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MV = PQ
Money
Velocity
Prices
Quantity
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What is theMonetarist Theory?
That changes in themoney supply directlydetermine changes in
prices, real GDP, andemployment
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Change in
the moneysupply
Change inthe quantity
of money
Change inthe aggregatedemand curve
Change in
prices, real GDP,& employment
Monetarist
Policy
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What is the QuantityTheory of Money?
The theory that changes inthe money supply aredirectly related to changesin the price level
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What is the conclusionof the Quantity Theory
of Money?
Any change in the moneysupply must lead to a
proportional change inthe price level
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Who are theModern Monetarists?
Monetarist argue thatvelocity is notunchanging, but isnevertheless predictable
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According to theMonetarist, how do we
avoid inflation and
unemployment?We must be sure that
the money supply isat the proper level
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Who isMilton Friedman?
In the 1950’s and 1960’s,he was a leader inputting forth the ideas
of the modern-daymonetarists
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What does Milton
Friedman advocate?The Federal Reserve should
increase the money supplyby a constant percentageeach year to enhance fullemployment and stableprices
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How do theKeynesians view thevelocity of money?
Over long periods of time, it can be unstable
and unpredictable
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40 50 60 70 80 90 00
1
2
34
56
The Velocity of Money7
Year
G D P / M 1
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What is the
conclusion of theKeynesians?A change in the moneysupply can lead to a muchlarger or smaller change
in GDP than themonetarists would predict
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What is the crux of theKeynesian argument?Because velocity isunpredictable, a constantmoney supply may not
support full employmentand stable prices
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What is the conclusion of
the Keynesian argument?The Federal Reserve mustbe free to change themoney supply to offset
unexpected changes inthe velocity of money
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What are the mainpoints of Classical
economics?
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• Economy tends toward a fullemployment equilibrium
• Prices & wages are flexible• Velocity of money is stable• Excess money causes inflation
• Short-run price & wageadjustments cause unemployment
• Monetary policy can change
aggregate demand & prices• Fiscal policies are not necessary
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What are the mainpoints of Keynesian
economics?
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• The economy is unstable at lessthan full employment
• Prices & wages are inflexible• Velocity of money is stable•
Excess demand causes inflation• Inadequate demand causesunemployment
• Monetary policy can changeinterest rates and level of GDP• Fiscal policies may be necessary
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What are the mainpoints of theMonetarists?
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• Economy tends toward a fullemployment equilibrium
• Prices & wages are flexible• Velocity of money is predictable• Excess money causes inflation
• Short-run price & wageadjustments cause unemployment
• Monetary policy can change
aggregate demand & prices• Fiscal policies are not necessary
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What is thecrowding-out effect?Too much government
borrowing can crowdout consumers and
investors from theloanable funds market
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What is theKeynesian view of thecrowding-out effect?
The investment demandcurve is rather steep
(vertical), so thecrowding-out effect isinsignificant
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What is the
Monetarist view of thecrowding-out effect?
The investment demandcurve is flatter (horizontal),
so the crowding-out effectis significant
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Key Concepts
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Key Concepts
• What are the three schools of economic though• What is the Keynesian view of money?
• How can the fed influence the equilibrium intere
• In the Keynesian model, what do changes in the• What is the Classical economic view?
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Key Concepts cont.
• How did the Classical economists view the rol• What is the equation of exchange?
• What is the velocity of money?
• What is the quantity theory of money?• What is the conclusion of the quantity theory o
• Who are the modern monetarists?
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Key Concepts cont.• According to the monetarist, how do we avoid i
• Who is Milton Friedman?
• What does Milton Friedman advocate?
• What is Classical economists?• What is Keynesian economists?
• What is monetarism?
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Summary
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The demand for money in the
Keynesian view consists of threereasons why people hold money:(1) Transactions demand is moneyheld to pay for everyday predictableexpenses. (2) Precautionarydemand is money held to payunpredictable expenses. (3)
Speculative demand is money heldto take advantage of price changesin nonmoney assets.
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The demand for money curveshows the quantity of moneypeople wish to hold at various rates
of interest. As the interest raterises, the quantity of moneydemanded is less than when theinterest rate is lower.
Th D d f M C
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16%
12%
8%
4%
500 1,000 1,500 2,000
AB
The Demand for Money Curve
MD
Interest
Rate
Billions of dollars
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The equilibrium interest rate isdetermined in the money marketby the intersection of the
demand for money and thesupply of money curves. Themoney supply (M1), which isdetermined by the Fed, isrepresented by a vertical line.
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An excess quantity of moneydemanded causes householdsand businesses to increase their
money balances by sellingbonds. This causes the price of bonds to fall, thus driving up theinterest rate.
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16%
12%
8%
4%
500 1,500 2,000
E
The Equilibrium Interest Rate
MD
MS Surplus
Shortage
1,000
Inte
rest
Rat
e
Billions of dollars
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An excess quantity of moneysupplied causes households andbusinesses to reduce their money balances by purchasingbonds. The effect is to cause theprice of bonds to rise, and,thereby, the rate of interest falls.
The Keynesian view of the monetary
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The Keynesian view of the monetarypolicy transmission mechanism
operates as follows: First, the Feduses its policy tools to change themoney supply. Second, changes inthe money supply change theequilibrium interest rate, whichaffects investment spending. Finally,a change in investment changes
aggregate demand and determinesthe level of prices, real GDP, andemployment.
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Monetarism is the simpler view thatchanges in monetary policy directlychange aggregate demand and
thereby prices, real GDP, andemployment. Thus, monetaristsfocus on the money supply, rather than on the rate of interest.
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The equation of exchange is anaccounting identity that is thefoundation of monetarism. Theequation (MV = PQ) states that themoney supply multiplied by thevelocity of money is equal to theprice level multiplied by real output.
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The velocity of money is thenumber of times each dollar isspent during a year. Keynesiansview velocity as volatile butmonetarists disagree.
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The quantity theory of money is amonetarist argument that thevelocity of money (V) and the output(Q) variables in the equation of
exchange are relatively constant.Given this assumption, changes inthe money supply yield proportionate
changes in the price level.
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The monetarist solution to an ineptFed tinkering with the moneysupply and causing inflation or recession would be to have the Fedsimply pick a rate of growth in themoney supply that is consistentwith real GDP growth and stick to it.
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Monetarists’ and Keynesians’ viewson fiscal policy are also different.Keynesians believe the aggregatesupply curve is relatively flat, andmonetarists view it as relatively
vertical. Because the crowding outeffect is large, monetarists assertthat fiscal policy is ineffective.
Keynesians argue that crowdingout is small and that fiscal policy iseffective.
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Chapter 26 Quiz
©2002 South-Western College Publishing
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1. Keynes gave which of the following as a
motive for people holding money?a. Transactions demand.b. Speculative demand.c. Precautionary demand.d. All of the above.
D. These are the three motives for holding currency and checkabledeposits (M1) rather than stocks,bonds, or other nonmoney forms of wealth.
2 A decrease in the interest rate other
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2. A decrease in the interest rate, other things being equal, causes a (an)a. upward movement along the demand
curve for money.b. downward movement along the demand
curve for money.
c. rightward shift of the demand curve for money.d. leftward shift of the demand curve for
money.
B. At a lower interest rate, money isdemanded because the opportunity costof holding money is lower.
3 Assume the demand for money curve is
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3. Assume the demand for money curve isstationary and the Fed increases themoney supply. The result is that people
a. increase the supply of bonds, thusdriving up the interest rate.
b. increase the supply of bonds, thusdriving down the interest rate.
c. increase the demand for bonds, thusdriving up the interest rate.
d. increase the demand for bonds, thus
driving down the interest rate.D.
E i M t P li
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16%12%
8%
4%
500 2,000
E1
Expansionary Monetary Policy
MD
MS1 Surplus
1,000
MS2
E2
1,500
Inte
rest
Rat
e
Billions of dollars
4 Assume the demand for money curve is
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4. Assume the demand for money curve isfixed and the Fed decreases the moneysupply. The result is a temporarya. excess quantity of money demanded.b. excess quantity of money supplied.c. increase in the price of bonds.
d. increase in the demand for bonds.
B.
D i th M S l
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16%12%
8%
4%
500 2,000
E1
Decrease in the Money Supply
MD
MS1
1,000
MS2
E2
1,500
Shortage
Inte
rest
Rat
e
Billions of dollars
5. Assume the demand for money
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ycurve is fixed and the Fed increasesthe money supply. The result is that
thea. price of bonds rises.b. price of bonds remains
unchanged.
c. price of bonds falls.d. none of the above.
A. The result is an excess beyond theamount people wish to hold and theybuy bonds which drives the price of bonds upward.
6. Using the aggregate supply and demand model,assume the economy is in equilibrium on the
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y qintermediate portion of the aggregate supplycurve. A decrease in the money supply will
decrease the price level anda. lower the interest rate and the real GDP.b. raise both the interest rate and real GDP.c. lower the interest rate and raise real GDP.
d. raise the interest rate and lower real GDP.
D. The decrease in money supply increases theinterest rate which decreases investment.Since investment is a component of aggregate demand, the aggregate demandcurve shifts leftward and real GDP declines.
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7. Based on the equation of exchange, themoney supply in the economy is
calculated asa. M = V/PQ.b. M = V(PQ).
c. M = PQ/V.d. M = PQ - V.
C. The equation of exchange is
MV = PQ rewritten,M = PQ/V
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8. The V in the equation of exchange
represents thea. variation in the GDP.b. variation in the CPI.c. variation in real GDP.
d. average number of times per year adollar is spent on final goods andservices.
D. In the equation of exchange, GDP isdefined as PQ and the CPI is an indexto measure the price level (P).
9. Which of the following is not an issue inthe Keynesian-monetarist debate?
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t e ey es a o eta st debatea. The importance of monetary vs. fiscal
policy.b. The importance of a change in the
money supply.c. The importance of a crowding-out
effect.d. All of the above are part of the debate.
D. Monetarists believe the effects of monetary policy are more powerful thanfiscal policy. They view the shape of theinvestment demand curve as less steep,so the crowding-out effect is significant. Keynesians disagree.
10. Keynesians reject the influence of t li th O
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monetary policy on the economy. Oneargument supporting this Keynesian view
is that thea. money demand curve is horizontal atany interest rate.
b. aggregate demand curve is nearly flat.
c. investment demand curve is nearlyvertical.
d. money demand curve is vertical.
C. If the investment demand curve isnearly vertical, changes in moneysupply and resulting changes in interestrate have little effect on investment andaggregate demand.
Expansionary Monetary Policy
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90
8%
6%
4%
2%
200 800
E1
Expansionary Monetary Policy
MD
MS1
400
MS2
E2
600
Inte
rest
Rat
e
Billions of dollars
11. Starting from an equilibrium at E1 inE hibit 12 i ht d hift f th
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Exhibit 12, a rightward shift of the moneysupply curve from MS1 to MS2 would cause
an excessa. demand for money, leading people to sell
bonds.b. supply of money, leading people to buy
bonds.c. supply of money, leading people to sell
bonds.d. demand for money, leading people to
buy bonds.B. A decrease in interest rates will cause the
price of bonds to increase, making them abetter asset to sell and the quantity of
money to increase.
12. Beginning from an equilibrium at E1 inE hibit 12 i i th
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Exhibit 12, an increase in the moneysupply from $400 billion to $600 billion
causes people toa. sell bonds and drive the price of bondsdown.
b. buy bonds and drive the price of bonds
down.c. buy bonds and drive the price of bonds
down.d. sell bonds and drive the price of bonds
up.A. As people sell more bonds because of the
higher price, the greater supply of bonds on themarket will cause the price of bonds to decrease.
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END