2. THE MONEY MARKET
The Demand for Money (Balances): Represents the
inverse relationship between the quantity demanded of
money balances and the price of holding money
balances.
The price of holding money balances is the interest rate.
The interest rate is the opportunity cost of holding
money.
As the interest rate increases, the opportunity cost of
holding money increases, and people choose to hold
less money.
Supply of Money: Determined by the Fed, hence a
vertical line.
4. EQUILIBRIUM IN THE MONEY MARKET
The money supply is not
exclusively determined by
the Fed because both the
banks and the public are
important players the
money supply process.
Equilibrium in the money
market exists when the
quantity demanded of
money equals the quantity
supplied.
No shortages or surpluses,
individuals are holding the
amount of money they
want to hold.
5. TRANSMISSION MECHANISMS
Focus on the following:
The impact that changes in the money market
have on the goods and services market
Whether that impact is direct or indirect
The routes and ripple effects created in the money
market travel to affect the goods and services
market are known as the transmission
mechanism.
6. THE KEYNESIAN TRANSMISSION MECHANISM:
INDIRECT
The Three Markets:
The Money Market
The Investment Goods Market
The Goods and Services Market (AD-AS
Framework)
The Mechanism:
When the money supply increases, the Keynesian
transmission mechanism works as follows: an
increase in the money supply lowers the interest
rate, which causes investment to rise and the AD
curve to shift rightward. Real GDP increases and
the unemployment rate drops.
8. THE KEYNESIAN MECHANISM MAY GET BLOCKED:
INTEREST-INSENSITIVE INVESTMENT
Some Keynesian economists
believe that investment is not
always responsive to interest rates.
The Keynesian transmission
mechanism would be short-
circuited in the investment goods
market, and the link between the
money market and the goods and
services market would be broken.
If fall in interest rate does not lead
to a rise in investment, AD will not
shift, Real GDP and
Unemployment will remain
changed.
9. THE KEYNESIAN MECHANISM MAY GET
BLOCKED: THE LIQUIDITY TRAP
Keynesians have sometimes
argued that the demand curve for
money could become horizontal at
some low interest rate.
At that interest, even if money
supply is increased, individuals
are willing to hold all the additional
money supply at the given interest
rate.
As a result, an increase in Money
supply does not lead to a fall in
interest rate.
The rest of the mechanism does
not occur.
11. BOND PRICES, INTEREST RATES, AND THE
LIQUIDITY
Why did we assume the demand for money becomes
horizontal at some low interest rate?
As the price of a bond decreases, the actual interest
rate return, or simply the interest rate, increases.
The market interest rate is inversely related to the price
of old or existing bonds.
As higher money supply does not lead to a fall in
interest rate because at the low interest rate, bond
prices are too high not a worthwhile investment to
make. Rather they would hold the additional money
supply.
12. THE MONETARIST TRANSMISSION
MECHANISM: DIRECT
In the Monetarist theory, there is a direct link
between the money market and the goods and
services market.
Increased money supply more money in hands
of consumer and businesses C and I increases
AD increases
An increase in the money supply means increased
Aggregate Demand, Increased Real GDP,
increased Prices and a decrease in unemployment.
A decrease in the money supply means decreased
Aggregate Demand, Decreased Real GDP,
decreased Prices and an increase in
unemployment.
14. MONETARY POLICY AND THE PROBLEM OF
INFLATIONARY AND RECESSIONARY GAPS
Expansionary Monetary Policy: The policy by which
the Fed increases money supply.
Shifts AD to the right to remove inflationary gaps
Contractionary Monetary Policy: The policy by
which the Fed decreases money supply.
Shifts AD to the left to remove inflationary gaps
17. KEYNESIANS, RECESSION, AND INFLATION
Most Keynesians believe that the natural forces of
the market economy work much faster and more
assuredly at eliminating an inflationary gap than a
recessionary gap [wages and prices rise more
quickly than falling as they are sticky downwards].
Keynesians are more likely to advocate
expansionary monetary policy to eliminate a
stubborn recessionary gap than contractionary
monetary policy to eliminate a not-so-stubborn
inflationary gap.
It has been argued that Keynesian monetary policy
has an inflationary bias.
18. MONETARY POLICY AND THE ACTIVIST–
NONACTIVIST DEBATE
Activists argue that
monetary and fiscal
policies should be
deliberately used to
smooth out the business
cycle.
They are in favor of
economic fine-tuning,
which is the frequent
use of monetary and
fiscal policies to
counteract even small
undesirable movements
in economic activity.
Nonactivists argue
against the use of
deliberate fiscal and
monetary policies.
They believe the
discretionary policies
should be replaced by a
stable and permanent
monetary and fiscal
framework and the rules
should be established in
place of activist policies.
19. THE CASE FOR ACTIVIST MONETARY POLICY
1. The economy does not always equilibrate quickly
enough at Natural Real GDP. Without intervention, the
economy will stuck at a recessionary gap for too long,
resulting in the economy having to tolerate too much loss
in output and high unemployment in the interim.
2. Activist monetary policy works; it is effective at
smoothing out the business cycle. Data of 1970s
indicates periods of constant money supply growth being
consistent with recession during the same time. Activists
argue this could have been avoided with discretionary
monetary policy.
3. Activist monetary policy is flexible; non-activist
monetary policy, which is based on rules, is not.
Activist monetary policy can be tailored to meet the
demand of an economy, unlike a rule-based policy.
20. THE CASE FOR NON-ACTIVIST MONETARY
POLICY
1. In modern economies, wages and prices
are sufficiently flexible to allow the
economy to equilibrate at reasonable
speed at Natural Real GDP.
2. Activist monetary policies may not work.
3. Activist monetary policies are likely to be
destabilizing rather than stabilizing; they
are likely to make matters worse rather
than better.
21. EXPANSIONARY MONETARY POLICY AND NO
CHANGE IN THE REAL GDP
If expansionary
monetary policy is
anticipated, workers
may bargain for and
receive higher wage
rates. It is possible
that the SRAS curve
will shift leftward to
the degree that
expansionary
monetary policy shifts
the AD curve
rightward. Result: no
change in Real GDP.
22. MONETARY POLICY MAY DESTABILIZE THE
ECONOMY
In this scenario, the
SRAS curve is shifting
rightward, but Fed
officials do not realize
this is happening. They
implement expansionary
monetary policy, and the
AD curve ends up
intersecting SRAS2 at
point 2 instead of SRAS1
at point 1’. Fed officials
end up moving the
economy into an
inflationary gap and thus
destabilizing the
economy
23. NON ACTIVIST MONETARY PROPOSALS
Non-Activists propose the following non-activist (or
rule-based) monetary proposals:
1. Constant-money-growth-rate rule
2. Predetermined-money-growth-rate rule
3. The Taylor Rule
4. Inflation Targeting
