Chapter 14
Modern Macroeconomics and Monetary Policy
OUTLINE
I. The Impact of Monetary Policy: A Brief Historical Background
A. A Brief Historical Background
2. Monetarists challenged Keynesian view during 1960s and 1970s. According to
II. Demand and Supply of Money
A. The quantity of money people want to hold is inversely related to the money rate of
interest, because higher interest rates make it more costly to hold money instead of
interest-earnings assets like bonds.
III. How Does Monetary Policy Affect the Economy?
A. The impact of a shift in monetary policy is generally transmitted through interest rates,
exchange rates, and asset prices.
B. Shift to a more expansionary monetary policy Fed generally buys bonds, which will
D. Effects of an Unanticipated Expansionary Monetary Policy
1. When instituting a more expansionary monetary policy, the Fed generally increases
E. Effects of an Unanticipated Restrictive Monetary Policy
1. When instituting a more restrictive monetary policy, the Fed drains reserves from
IV. Monetary Policy in the Long Run
A. The Quantity Theory of Money: MV=PY
B. Long-Run Impact of Monetary Policy: The Modern View
2. When expansionary monetary policy leads to rising prices, decision makers
eventually anticipate the higher inflation rate and build it into their choices. As this
C. Money and Inflation
1. Countries with persistently low rates of growth in their money supply tend to
experience low rates of inflation.
D. Time Lags, Monetary Shifts, and Economic Stability
1. While the Fed can institute policy changes rapidly, there will be a time lag before
V. The Potential and Limitations of Monetary Policy
A. Two Important Points About Monetary Policy
1. Expansionary monetary policy cannot loosen the bonds of scarcity and therefore it
2. Shifts in monetary policy will influence the general level of prices and real output
only after time lags that are long and variable.
B. Why Proper Timing of Monetary Policy Changes is Difficult
1. The long and variable time lags between a monetary policy shift and their impact on
3. If monetary policy makers are constantly shifting back and forth, policy errors will
occur. Thus, constant policy shifts are likely to generate instability rather than
stability. Historically this has been the case.
VI. Recent Monetary Policy of the United States
A. Three Key Indicators of Monetary Policy
1. Short-term interest rates,
3. The growth rate of the monetary base
Chapter 14/Modern Macroeconomics and Monetary Policy 145
A. Monetary Policy 1990-2013
1. 1990s: Monetary policy was relatively stable and it kept the inflation rate low.
2. 2002-2004: Monetary policy pushed interest rates to historic lows and M2 grew
3. 2005-2007: As the inflation rate rose in 2005, the Fed shifted to a more restrictive
2. There were other causal factors of the 2008 crisis including:
a. government regulations that eroded lending standards and promoted the
purchase of housing with little or no down payment government regulations
B. Fed Policy During and Following the 2008 Financial Crisis
1. Fed response to 2008 financial crisis:
2. But the demand for investment was weak and therefore, expansion in credit was
3. The Fed now faces a dilemma: when the economy begins to recover, banks will use
their excess reserves to extend loans, which will expand the money supply.
4. We are in the middle of another great monetary policy experiment.
B. Impact of Stop-Go Monetary Policy
1. Monetary policy has been on a stop-go path throughout most of the past decade. As
146 Chapter 14/Modern Macroeconomics and Monetary Policy
OBJECTIVES
This chapter integrates money into our basic aggregate demand/aggregate supply model. The
evolution of the modern view of monetary policy including the quantity theory of money and the
early Keynesian view is presented. The modern view of money indicates that monetary policy
may be transmitted to the goods and services market by changing consumption and investment
spending, exchange rates, asset prices, and credit rationing. These mechanisms are illustrated.
The modern view of monetary policy also stresses the importance of whether a change in
monetary policy is anticipated or unanticipated. Only the latter will exert an impact on real interest
rates, output, and employment. Similarly, the impact of monetary policy in the long run may differ
from its impact in the short run. This chapter focuses on each of these issues and discusses recent
Federal Reserve policy.
IMPORTANT POINTS AND TEACHING SUGGESTIONS
1. To give the student a historical perspective, review the positions of both classical and early
Keynesian economists on the quantity theory of money before presenting the modern view.
2. Students tend to confuse fiscal and monetary policy. Instructors should indicate clearly that
fiscal policy involves the altering of tax rates and the level of government expenditures. On the
3. Students also easily confuse the issuing and sale of bonds by the Treasury to the public (which
will not change the money supply) and the sale of bonds by the Fed to the public (which will
have a restrictive effect on the money supply). Point out that U.S. bonds are always issued by
5. Exhibits 7 and 8 will help students grasp the interrelationships among the basic macroeconomic
markets and the importance of expectations. Be sure to note the relationship between inflation
6. Modern macroeconomics stresses the importance of whether the effects of a monetary change
are anticipated or unanticipated. As Exhibit 9 illustrates, expansionary monetary policy will
7. The Thumbnail Sketch illustrates the expected effects of monetary policy under alternative
9. In presenting monetary transmission mechanisms, an interesting classroom discussion topic is
10.
interest rates affects the quantity of money demanded include asking the class what effect the
11. It is useful to mention to students that the equation of exchange will be closely linked to the
12. Although the effects on real variables of reducing the money supply or reducing the growth
13. Remind students that stable monetary policy and prices are important ultimately because it
HINTS FOR ANSWERING CRITICAL ANALYSIS QUESTIONS
5. Expansionary monetary will reduce interest rates in the short run. However, in the long run,
