Chapter 15 Monetary Policy
Keynesian Transmission Mechanism
wanted to increase money supply
Fine Tuning
- The (usually frequent) use of monetary and fiscal policies to counteract even small undesirable movements in economic activity.
The Monetarist Transmission Mechanism - Short & Direct
1. Changes in the money market directly affect aggregate demand in the goods and services market. ex: an increase in the money supply leaves individuals with an excess supply of money that they spend on a wide variety of goods.
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 are likely to be destabilizing rather than stabilizing; they are likely to make matters worse rather than better.
How demand for and supply of money affect:
1. Interest rates 2. Market for goods and services
Non-activists
1. Persons who argue against the deliberate use of discretionary fiscal and monetary policies. 2. They believe in a permanent, stable, rule-oriented monetary and fiscal framework
The Case for Activist Monetary Policy
1. The economy does not always equilibrate quickly enough at Natural Real GDP. 2. Activist monetary policy works; it is effective at smoothing out the business cycle. 3. Activist monetary policy is flexible; non-activist (rules-based) monetary policy is not.
Explain how the monetarist transmission mechanism works when the money supply rises.
A rise in the money supply brings about an excess supply of money in the money market that flows to the goods and services market, stimulating aggregate demand.
If the economy is stuck in a recessionary gap, does this make the case for activist (expansionary) monetary policy stronger or weaker? Explain your answer.
Being stuck in a recessionary gap makes the case stronger, ceteris paribus. If the economy can't get itself out of a recessionary gap, then the case is stronger for the Fed to take action. However, this is not to say that expansionary monetary policy will work ideally. There may still be problems with the correct implementation of the policy.
According to the Keynesian transmission mechanism, as the money supply rises, there is a direct impact on the goods and services market." Do you agree or disagree with this statement? Explain your answer.
Disagree 1. liquidity trap, a rise in the money supply will not affect interest rates and therefore will not affect investment or the goods and services market. market can affect the goods and services market only indirectly. 2. even if the money market is not in the liquidity trap, a rise in the money supply affects the goods and services market not directly, but indirectly: The rise in the money supply lowers the interest rate, causing investment to rise (assuming investment is not interest insensitive). As investment rises, the AD curve shifts rightward, affecting the goods and services market. In other words, there is an important intermediate market between the money market and the goods and services market in the Keynesian transmission mechanism. Thus, the money market can affect the goods and services market only indirectly.
The Liquidity Trap
If the money market is in the liquidity trap, an increase in the money supply will not lower the interest rate.
Why are Keynesians more likely to advocate expansionary monetary policy to eliminate a recessionary gap than contractionary monetary policy to eliminate an inflationary gap?
Keynesians believe that prices and wages are inflexible downward but not upward. They believe it is more likely that natural forces will move an economy out of an inflationary gap than out of a recessionary gap.
Activists
Persons who argue that monetary and fiscal policies should be deliberately used to smooth out the business cycle.
How might monetary policy destabilize the economy?
Suppose the economy is regulating itself out of a recessionary gap, but this is not known to Fed officials. Thinking that the economy is stuck in a recessionary gap, the Fed increases the money supply. When the money supply is felt in the goods and services market, the AD curve intersects the SRAS curve (that has been moving rightward, unbeknownst to officials) at a point that represents an inflationary gap. In other words, the Fed has moved the economy from a recessionary gap to an inflationary gap instead of from a recessionary gap to long-run equilibrium at the Natural Real GDP level.
Interest
investment and spending does not always react to interest levels