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Financial markets and institutions, 7e, jeff madura ch05

Chapter 5
Monetary Theory and Policy

Financial Markets and Institutions, 7e, Jeff Madura
Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.

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Chapter Outline








Monetary theory
Tradeoff faced by the Fed
Economic indicators monitored by the Fed

Lags in monetary policy
Assessing the impact of monetary policy
Integrating monetary and fiscal policies
Global effects of monetary policy

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Monetary Theory


Pure Keynesian Theory
 One

of the most popular theories influencing the Fed
 Developed by John Maynard Keynes
 Suggests how the Fed can affect the interaction
between the demand for money and the supply of
money to influence:




Interest rates
The aggregate level of spending
Economic growth

3


Monetary Theory (cont’d)


Pure Keynesian Theory (cont’d)


Can be explained by using the loanable funds framework

Demand for and supply of loanable funds
determine the equilibrium interest rate
 The business investment schedule illustrates the
inverse relationship between interest rates on
loanable funds and the level of business
investment


4


Monetary Theory (cont’d)


Pure Keynesian Theory (cont’d)
 Correcting








a weak economy

The Fed would use open market operations to increase the
money supply
A higher level of the money supply would reduce interest
rates
Lower interest rates encourage more borrowing and
spending
Keynesian philosophy advocates an active role for the
government in correcting economic problems

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Monetary Theory (cont’d)
Correcting a Weak Economy
S1

S2

i1

i1

i2

i2
D1

Demand and Supply of Loanable Funds

B1
B2
Business Investment Schedule
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Monetary Theory (cont’d)


Pure Keynesian Theory (cont’d)


Correcting high inflation

The Fed would sell Treasury securities (decrease
the money supply)
 A lower level of the money supply reduces the
level of spending
 Less spending slows economic growth and
reduces inflationary pressure (demand-pull
inflation)


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Monetary Theory (cont’d)
Correcting High Inflation
S2

S1

i2

i2

i1

i1
D1

Demand and Supply of Loanable Funds

B2
B1
Business Investment Schedule
8


Monetary Theory (cont’d)


Pure Keynesian Theory (cont’d)
 Effects






of a credit crunch on a stimulative policy

The economic impact of monetary policy depends on the
willingness of banks to lend funds
If banks are unwilling to extend credit despite a stimulative
policy, the result is a credit crunch
A credit crunch can occur during a restrictive policy since
some borrowers will not borrow because of the high interest
rates

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Monetary Theory (cont’d)


Quantity Theory and the Monetarist approach


The quantity theory suggests a particular relationship
between the money supply and the degree of economic
activity in the equation of exchange:

MV = PGQ




Velocity is the average number of times each dollar
changes hands per year
The right side of the equation is the total value of goods
and services produced
If velocity is constant, a change in the money supply will
produce a predictable change in the total value of goods
and services
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Monetary Theory (cont’d)


Quantity Theory and the Monetarist approach
(cont’d)
 An


early form of the theory assumed a constant Q
Assumes a direct relationship between the money supply
and prices

 Under

the modern quantity theory of money,
the constant quantity assumptions has been
relaxed


A direct relationship exists between the money supply
and the value of goods and services
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Monetary Theory (cont’d)


Quantity Theory and the Monetarist approach
(cont’d)
 Velocity

represents the ratio of money stock to
nominal output
 Velocity is affected by any factor that influences
this ratio:






Income patterns
Factors that change the ratio of households’ money
holdings to income
Credit cards
Inflationary expectations
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Monetary Theory (cont’d)


Comparison of the Monetarist and Keynesian
Theories
 The

Monetarist approach advocates stable, low
growth in the money supply


Allows economic problems to resolve themselves

 Keynesian

approach would call for a loose
monetary policy to cure a recession

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Monetary Theory (cont’d)


Comparison of the Monetarist and Keynesian
Theories (cont’d)
 Monetarists

are concerned about maintaining low
inflation and are willing to tolerate a natural rate of
unemployment
 Keynesians focus on maintaining low
unemployment and are willing to tolerate any
inflation that results from stimulative monetary
policies

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Monetary Theory (cont’d)


Theory of Rational Expectations



Holds that the public accounts for all existing information
when forming its expectations
Suggests that households and business will use historical
effects of monetary policy to forecast the impact of an
existing policy and act accordingly






Households spend more with a loose monetary policy to avoid
inflation
Businesses will increase their investment with a loose monetary
policy to avoid higher costs
Labor market participants will negotiate higher wages with a
loose monetary policy

Supports the Monetarist view that changes in monetary
policy do not have a sustained impact on the economy

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Monetary Theory (cont’d)


Which theory is correct?
 The

FOMC recognizes the virtues and limitations
of each theory




The FOMC adjusts monetary growth targets to control
economic growth, inflation, and unemployment
Recognizing the Monetarist view, the FOMC is
concerned about the inflation resulting from a loose
monetary policy

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Tradeoff Faced by the Fed


Ideally, the Fed would like:
 Low

inflation
 Steady GDP growth
 Low unemployment


There is a negative relationship between
unemployment and inflation
 Phillips

curve
 A tight money policy can curb inflation but increase
unemployment and vice versa

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Tradeoff Faced by the Fed (cont’d)


Impact of other forces on the tradeoff


Cost factors such as energy costs and insurance costs can
influence the tradeoff



When both inflation and unemployment are high, Fed members
may disagree as to the type of monetary policy that should be
implemented

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Tradeoff Faced by the Fed (cont’d)


Impact of other forces on the tradeoff (cont’d)


How the Fed’s focus shifted during the Persian Gulf War






There were numerous indications of a possible recession in the
summer of 1990
The abrupt increase in oil prices placed upward pressure on U.S.
inflation

How the Fed’s emphasis shifted during 2001–2004





The focus shifted from high inflation to the weak economy over time
From January to December 2001, the FOMC reduced the targeted
federal funds rate ten times
In 2002 and 2003, the Fed reduced the federal funds target rate
twice

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Economic Indicators Monitored by
the Fed


Indicators of economic growth


Gross domestic product (GDP)

Measures the total value of goods and services
produced
 Measured each month
 The most direct indicator of economic growth




Level of production


A high level indicates strong economic growth and
can result in increased demand for labor

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Economic Indicators Monitored by
the Fed (cont’d)


Indicators of economic growth (cont’d)
 National



income

The total income earned by firms and individual employees
A strong demand for goods and services results in a large
amount of income

 Unemployment



rate

Does not necessarily indicate the degree of economic growth
Can decrease in weak economic growth periods if new jobs
are created

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Economic Indicators Monitored by
the Fed (cont’d)


Indicators of economic growth (cont’d)


Industrial production index



Retail sales index



Home sales index



Composite index



Consumer confidence surveys

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Economic Indicators Monitored by
the Fed (cont’d)


Indicators of inflation


Producer and consumer price indexes

The PPI measures prices at the wholesale level
 The CPI measures prices on the retail level
 Both indexes are used to forecast inflation
 Agricultural and housing price indexes also exist




Other indicators


Wages, oil prices, transportation costs, the price of
gold, indicators of economic growth

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Economic Indicators Monitored by
the Fed (cont’d)


How the Fed uses indicators


The Fed uses indicators to anticipate how economic conditions
will change and then determines what monetary policy would be
appropriate

Weak economic conditions suggest an
expansionary monetary policy
 High productivity and employment suggest a
restrictive monetary policy


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Economic Indicators Monitored by
the Fed (cont’d)


Index of Leading Economic Indicators
 The

Conference Board publishes indexes of leading,
coincident, and lagging economic indicators


Leading economic indicators are used to predict future
economic activity






Three consecutive monthly changes in the same direction
suggest a turning point in the economy

Coincident economic indicators reach their peaks and
troughs at the same time as business cycles
Lagging economic indicators tend to rise or fall a few
months after business-cycle expansions and contractions

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