ECON 201 ch 13

Taylor rule:

A rule for the federal funds target that suggests that the target is equal to 2% + Current Inflation Rate + 1/2(Inflation Gap) + 1/2(Output Gap). Alternatively, it is equal to 2% plus the current inflation rate plus 1/2 times the difference between the current inflation rate and the Fed's inflation target rate plus 1/2 times the output gap (current GDP minus potential GDP).

Monetary theories

Classical (long run) - Equation of exchange • Keynesian (short run) • Monetarist (long and short run)

Monetarist View

Crowding out makes fiscal policy ineffective. • Consumption based on permanent income not current income. • Changes in money supply lead to changes in nominal GDP as predicted by equation of exchange. Monetary policy impacts interest rates, spending and aggregate demand in short run, effecting price & output in short run, but only price in long run. • Money supply should increase at long run rate of growth of output.

Goals of monetary policy

Each country's central bank charter or legislative directive specifies the goals upon which it must focus. - U.S.: Both inflation and employment - Eurozone: Inflation only

Taylor Rule

FFTR = 2 + CIR + ½ (IG) + ½ (OG) FFTR = Federal Funds Target Rate CIR = Current inflation rate IG = Inflation gap which is (CIR - Fed's inflation target) OG = Output gap which is (current GDP - full-employment GDP) as a % of current GDP

contractionary monetary policy

Fed actions designed to decrease excess reserves and the money supply to shrink income and employment, usually to fight inflation. Tight money - Restrictive policy

tight money or restrictive monetary policy

Fed actions designed to decrease excess reserves and the money supply to shrink income and employment, usually to fight inflation. See also contractionary monetary policy.

expansionary monetary policy

Fed actions designed to increase excess reserves and the money supply to stimulate the economy (expand income and employment) Loose money - Quantitative easing - "Printing" money Often undertaken to expand employment and stimulate an economy.

easy money, quantitative easing, or accommodative monetary policy

Fed actions designed to increase excess reserves and the money supply to stimulate the economy (expand income and employment). See also expansionary monetary policy. Often undertaken to control inflation or reduce incomes

what happens when you Increase M1

Interest rates fall, investment spending rises, purchases made with borrowed funds rise. - Lower interest rates attract fewer savings from abroad and domestic savers move funds abroad, causing currency to depreciate; net exports rise. - Aggregate demand rises.

what happens when you Decrease M1

Interest rates rise, investment spending falls, purchases made with borrowed funds fall. - Higher interest rates attract more savings from abroad and domestic savers bring funds home, causing currency to appreciate; net exports fall. - Aggregate demand falls.

monetary rule

Keeps the growth of money stocks such as M1 or M2 on a steady path, following the equation of exchange (or quantity theory), to set a long-run path for the economy that keeps inflation in check.

Inflation targeting

Long-run goal of a low inflation rate (usually 2%). Policy adjusted to achieve goal.

Equation of Exchange

MV = PY MV= Total amount of expenditures in a year PQ = Nominal GDP or P x Q for all things produced

Keynesian View

Monetary policy is less effective than fiscal policy. • If used, it should be used in countercyclical manner to stabilize economy in short run. • Monetary policy not helpful in times of deep recession when expansionary money policies lead to very low interest rates.

Classical view

Quantity of money in economy affects price (long run) & employment levels (short run only). Long run is only time period that matters, so policy impacts only price level.

Monetary policy and demand/supply shocks

Shocks are short run shifts in aggregate demand and supply curves.

inflation targeting:

The central bank sets a target on the inflation rate (usually around 2% per year) and adjusts monetary policy to keep inflation in that range.

equation of exchange

The heart of classical monetary theory uses the equation M x V = P x Q, where M is the supply of money, V is the velocity of money (the average number of times per year a dollar is spent on goods and services, or the number of times it turns over in a year), P is the price level, and Q is the economy's output levelThe heart of classical monetary theory uses the equation M x V = P x Q, where M is the supply of money, V is the velocity of money (the average number of times per year a dollar is spent on goods and services, or the number of times it turns over in a year), P is the price level, and Q is the economy's output level

liquidity trap

When interest rates are so low that people believe rates can only rise, they hold on to money rather than investing in bonds and suffering the expected capital loss

What is the connection between the money supply and interest rates?

When the money supply shrinks, interest rates will rise. When the money supply increases, interest rates will fall.

twin goals of monetary policy

economic growth, low unemployment, stable prices, long-term moderate interest rates

Monetarist or monetary targeting

increase money supply at long-run rate of growth of output

Classical

short run: Does not exist, economy always self adjusts long run: Economy self-adjusts due to flexible prices. Money supply impacts only price level.

Keynesian

short run: Fiscal policy is effective; monetary policy is ineffective in times of deep recession. long run: Economy adjusts to long-run equilibrium; increased money leads to higher prices.

monetarist

short run: Fiscal policy is ineffective because government spending crowds out consumption and investment, while monetary policy is effective. long run: Economy adjusts to long-run equilibrium; increased money supply leads to higher prices.

demand shock

this shock moves output and price in the same direction as the shock.

supply shock

this shock shifts SRAS and move price and output in opposite directions.

Discretion-based approach

which approach is - Favors addressing specific situations - More off-setting than preventative

Rule-based approach

which approach is More preventive than off-setting - Reduces time lags, political bias, long-run inflatio