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MONETARY POLICY

POLICIES AIMED AT CONTROLLING THE MONEY SUPPLY TO TARGET INTEREST RATES IN AN ECONOMY The twin goals of monetary policy are: 1)economic growth with low unemployment. 2)stable prices with moderate long-term interest rates.

PRICE STABILIT Y

PRICE STABILIT Y IS THE FED'S FOCUS IN THE LONG RUN. BUT HOW SHOULD THE FED RESPOND TO SHORT-RUN SHOCKS?

THE EQUATION OF EXCHANGE

The quantity theory of money is defined by the equation of exchange:M×V= P×Q -M is the supply of money. -Vis velocity of money. -P is the price level. -Q is the economy's real output level. Classical economists assume V and Q are fixed, so expansionary monetary policy only creates inflation.

FED ACTIONS TO STEM THE CRISIS

-It used normal monetary policy tools and some it hadn't used since the 1930s. -By December 2008, the Fed had lowered the federal funds target rate to essentially zero percent. -The Fed then turned to extraordinary measures when it began making massive loansto banks and buying large amounts of risky assets.

THE CLASSICAL MODEL

In the classical model, the economy is at full employment. An increase in aggregate demand only results in higher prices at the same output.

A SUMMARY OF MONETARY POLICY

In the long run, increases in the money supply lead to inflation. -Classical economists believe this happens immediately, so monetary and fiscal policies are ineffective. -Keynesians believe that in the short run, fiscal policy is effective. -Monetarists believe that in the short run, monetary policy is effective.

THE KEYNESIAN MODEL

Keynes argued that economies can get stuck out of equilibrium. -Wages and prices are sticky in the short run. An increase in the money supply would lower interest rates, leading to increased investment and AD

MONEY ILLUSION

MONEY ILLUSION IS THE PERCEPTION THAT WEALTH RISES WHEN THE MONEY SUPPLY GROWS. THE DELAYED REACTION IN WAGES AND PRICES MAKES THEM STICKY.

types of monetary rules

1.monetary growth rule. 2.inflation targeting. 3.the Taylor rule.

liquidity trap

A liquidity trap occurs when interest rates are so low that monetary policy becomes ineffective.

SUPPLY SHOCKS & MONETARY POLICY

A negative supply shock reduces output and raises prices. Monetary policy is not effective in combatting supply shocks. If AD shifts to the right, the price level rises further. If AD shifts to the left, output worsens.

MONETARIST MODEL

An increase in the money supply results in higher output in the short run.In the long run, as prices adjust, SRAS shifts left and the economy returns to long-run output at a higher price level. In the long run, as prices adjust, SRAS shifts left and the economy returns to long-run output at a higher price level.

THE MONETARIST MODEL

Associated with the work of Milton Friedman. -Consumption depends on income and wealth: permanent income hypothesis. -Monetarists believe that the crowding out effect makes fiscal policy ineffective. -Monetarists believe an increase in money supply will increase spending in the short run but leads only to inflation in the long run.

THE LONG RUN: CLASSICAL THEORY

Classical economists focus on long-run adjustments in economic activity: -They assume that wages, prices, and interest rates are flexible. -As a result, labor, product, and capital markets are expected to adjust to keep the economy at full employment. A product of the classical theory is the quantity theory of money.

CONTRACTIONARY MONETARY POLICY

Contractionary monetary policy raises interest rates, which leads to lower aggregate demand, shifting the AD curve to the left.

EXPANSIONARY MONETARY POLICY

Expansionary monetary policy reduces interest rates, which leads to greater aggregate demand, shifting the AD curve to the right.

Keynesians and fiscal policy

KEYNESIANS BELIEVE FISCAL POLICY (SUCH AS GOVERNMENT SPENDING) IS EFFECTIVE DURING ECONOMIC DOWNTURNS.

THE TAYLOR RULE

To address both inflation and output, the Fed can follow the Taylor rule :Fed funds target rate = target inflation rate + current inflation rate + ½(inflation gap) + ½(output gap) The target inflation rate is typically 2%. How close is the Fed funds target rate to the actual rate?

DEMAND SHOCKS & MONETARY POLICY

When a demand shock pushes output below long-run equilibrium...... monetary policy can shift AD back to the right to restore long-run output and prices.