This document discusses monetary theory and policy. It covers the demand for money, how the Federal Reserve controls the money supply through tools like reserve requirements and open market operations, and how changes in the money supply can affect interest rates, investment, aggregate demand, inflation, and economic output. The quantity theory of money and equation of exchange are introduced, as well as the monetarist view that changes in the money supply directly impact prices and economic activity. The document also discusses the Federal Reserve's historical approach to targeting money supply growth versus interest rates.

1. Chapter 15
Monetary Theory and Policy

2. • Why would people hold money?
– Transactions Demand for Money
– Precautionary Demand for Money
– Speculative Demand for Money
The Demand for Money

3. • The three motivates for holding money
combine to create a demand for money curve.
– Def: The demand for money curve represents the
money people hold at different possible interest
rates, ceteris paribus.
– Why is it downward sloping?
– Example of Graph
The Demand for Money Curve

4. Example of a Graph

5. • The supply of money is a vertical line (MS)
implying that the quantity of money supplied
is independent of the interest rate
– Why?
– Show equilibrium
The Equilibrium Interest Rate

6. Example of MS

7. What happens if the Fed increases the
money supply?
• The opportunity cost of holding money falls
enough that the public is willing to hold the
now larger stock of money

8. How the Fed Controls the MS?
• The establishment of reserve requirements
for banks
• Buying and selling U.S. government securities
and other financial assets in the open market
• The volume of loans extended to banks and
other institutions
• The interest rate it pays banks on funds held
as reserves

9. http://www.youtube.com/watch?v=HdZnOQ

10. Recent Monetary Policy
• Increase in the monetary base from $828
billion at mid-year 2008 to $1.63 trillion in
early 2009 to more than $2 trillion in 2010.
• Lower interest rates

11. http://www.pbs.org/newshour/updates/business/ju

12. http://federalreserve.gov/newsevents/press/monet

13. Example of lowering the interest rate

14. Interest Rates and Investment
• Suppose the Fed purchases U.S. government
bonds.
– What happens to Investment?
– What happens to AD?

15. Example of Investment and Interest
Rates

16. Adding the Short-Run Aggregate
Supply Curve
• For a given shift of the aggregate demand
curve, the steeper the short-run aggregate
supply curve, the smaller the increase in real
GDP and the larger the increase in the price
level.

17. Example of Graph of SRAS

18. • Def: Monetarism is the theory that changes in
the money supply directly determine changes
in prices, real GDP, and employment
– They put the spotlight on the money supply. They
argue that to predict the condition of the
economy, you simply look at the money supply.
– Too much money supply = higher inflation
– Too less money supply= unemployment and
deflation
The Monetarist View of the Role of
Money

19. • Def: The equation of exchange is an
accounting identity that state’s the MS time
velocity of money is equal to total spending:
MV=PY
The Equation of Exchange

20. • It is assumed by classical economists that V
and Y(real output) are fairly constant.
– Why is this true?
– Def: The Quantity Theory of Money states that
changes in the money supply are directly related
to changes in the affect of price level.
The Quantity Theory of Money

21. • Today, we do not think that V is constant and
the employment does not always operate at
full employment
– M& P are correlated, but not perfectly correlated.
Modern Monetarism

22. Targets Before 1982
• Between World War II and October 1979- the Fed
attempted to stabilize interest rates.
• Friedman said this made monetary policy a
source of instability in the economy because
changes in the money supply reinforced
fluctuations in the economy.
– He said pay less attention to interest rates and
instead focus on a steady and predictable growth in
the money supply
– Monetary rule

23. Targets After 1982
• Less force on a steady and predictable growth
in the money supply.
• The force was on a targeted federal funds
rate.