Prior to the 1970s, most economists thought fiscal policy was far more important than

monetary policy. Now the consensus is that monetary policy is more important than
fiscal policy. The current economic expansion is far more because of stable monetary
policy than any fiscal stimulus. In fact, Bush and Clinton both RAISED taxes, which
would be restrictive or contractionary.
We now look at how monetary policy works - how changes in monetary policy and
the money supply (MS) affect interest rates, output, employment, ex-rates, inflation
and prices.
IMPACT OF MONETARY POLICY
Like the opening quote implies, fiscal policy was once thought to be very potent and
monetary policy was considered less important (Keynesian view), especially when it
came to stimulating AD. Starting in the late 1950s, Milton Friedman and other
economists started to depart from the Keynesian view, and they emphasized the
importance of monetary policy, becoming known as the Monetarists. Monetarists
believe that 1) unstable, erratic monetary policy is the main cause of economic
fluctuations (expansions and contractions) and 2) inflation is caused by excess money
creation. See Friedman's quote on page 320 and bio on p. 321. Now the general
consensus (even among Keynesians) is that monetary policy does matter. The
modern, consensus view of modern monetary policy is presented in this chapter.
DEMAND and SUPPLY OF MONEY
Think of money as cash or non-interest checking balances. Money demand (MD) is
the amount of cash/checking that people/businesses are willing to hold at any given
time, given our current level of income and wealth. We all want more income/wealth,
but at a given level of income or wealth, the amount of money we hold is MD.
Why do people hold cash? 1) to carry out transactions (transactions demand), 2) to
deal with uncertainties (bail someone out of jail, buy something on Sunday at an
estate sale) - precautionary demand, and 3) to store value, people use money as an
asset - asset demand.
MD is inversely related to the Interest Rate - think of the Interest Rate as the Interest
Rate on bonds, savings accounts or CDs. Interest Rate is the Opportunity Cost of
holding cash balances. If you hold $1000 in cash at 0%, you are giving up interest
earned from buying a bond, CD or putting cash into a savings account. Even when
you hold money in an interest bearing checking account (1%), you are still usually

giving up a higher interest rate in a CD or savings account (3-4%), so there is still an

opportunity cost to holding cash balances in a checking account.
MD is inversely related to int. rates, see graph page 322, Panel a. As interest rates rise,
the opp. cost of holding money increases, so people would minimize MD during
periods of high int. rates. Example: T-bills were 15.5% in 1981, making the
opportunity cost of holding cash very high, people and businesses therefore
economized on their cash balances.
MD is also influenced by technology/innovation. Examples: credit cards and ATM
machines allow us to carry less cash, has reduced MD over time. Also, income is
more predictable now compared to 100 yrs. ago when the economy was more farmbased. Income was received two or three times a year and the timing and the amount
was unpredictable. These changes would reduce MD, and would shift the entire MD
curve back and to the left. We have seen this happen, for example MD/GDP has gone
from 58.5% to 51.8% over the last 40 years due to increased use credit cards, etc.
MS is fixed/determined by the FRS, and is independent of the interest rate, so it is
shown as a vertical line on page 322, Panel b.
See graph page 323 - MD, MS and Equilibrium. Just like in the market for goods, the
money market will gravitate toward an equilibrium condition where MD = MS.
Instead of the price adjusting, now the interest rate adjusts to bring about equilibrium.
Market interest rate change daily to bring about a continual balance between MD and
MS.
TRANSMISSION OF MONETARY POLICY
Combination of influences by Keynesians and monetarists, the modern view of
monetary policy explains the transmission of monetary policy (how changes in the
MS affect the economy) as on page 324.
1. Fed increases MS from S1 to S2 - Expansionary Monetary Policy - by buying
bonds in an Open Market Operation. This expansion of MS lowers nominal interest
rates - Panel a.
2. Banks now have excess reserves and they start making additional loans, increase
the supply of credit, or loanable funds - Panel b. In addition, the FRS is supplying
credit directly to the credit market by buying bonds, increasing the supply of credit,
shifting out the supply curve. The increased supply of credit (from banks and the Fed)
lowers real int. rates.

3. The lower interest rates, both nominal and real, stimulate the economy and shift the
AD curve out, AD increases from AD1 to AD2 in Panel c.
AD shifts out for 3 reasons:
1. Lower interest rates stimulate consumption spending (houses, cars) by consumers
(C) and investment spending (I) by businesses. AD goes up because C and I go up.
2. Lower int. rates in U.S. lead to a capital outflow to other countries (Canada,
Europe), which leads to an appreciation of the foreign currency (C$ and ) and a
depreciation of the U.S. dollar. The strong foreign currencies lead to an increase in
Exports (X). AD goes up.
3. Lower interest rates increase asset/stock prices. Reasons: a) lower interest rates
lower the cost of debt (borrowing) and therefore make businesses more profitable,
increasing stock prices. b) Also, stock market competes with bond market. As int.
rates fall in the bond market, stocks are more attractive, prices get bid up. Wealth
effect from rising asset prices increases AD by increasing C.
Lower int. rates stimulate AD - AD1 to AD2. Prices goes up and real GDP goes up, as
on page 324, Panel c. See Thumbnail Sketch on page 326.
UNANTICIPATED EXPANSIONARY MONETARY POLICY
Expansionary monetary policy has to be unexpected to really work. For example: see
page 326, Panel a. Economy is at Y1 (e1), less than full output/full employment. Fed
implements unanticipated expansionary monetary policy to get the economy back to
YF by shifting AD1 to AD2. The expansionary policy was unexpected, so Retail Prices
rise immediately, costs of production are fixed (wages, leases, contracts, etc.) and rise
slowly. Profits are increased in SR to get output to expand to E 2. We move along the
SRAS from e1 to E2, because the price level is higher than expected, improving profit
margins, expanding output. Retail prices are flexible, costs of production are fixed in
SR.
Panel b - expansionary monetary policy when the economy is already at full
employment (E1, YF) results in temporarily higher output in SR (e 2), higher prices and
full employment output in the LR (E 2).
Possible scenario: Economy is in recession, Fed implements expansionary policy, but
the self-correcting mechanisms move the economy back YF and then the expansionary
policy impacts the economy (bad timing) and moves the economy into an unnecessary

expansion.
UNANTICIPATED RESTRICTIVE MONETARY POLICY
See page 327. MS goes down, from S1 to S2. Fed sells bonds, reduces bank reserves.
Lower bank reserves means fewer loans, and the supply of credit shift back,
decreases, which raises the real int. rate and lowers AD from AD 1 to AD2.
Page 328, Panel a. Use of restrictive monetary policy to control inflation. Restrictive
policy shifts AD from AD1 to AD2, output goes from e1 to E2. This restrictive monetary
policy generally describes the monetary policy of a few years ago in 1999-2000, the
Fed was trying to slow down the economy, to prevent it from inflationary
"overheating" by raising interest rates six times to dampen AD slightly.
Panel b - If restrictive policy is mis-timed and takes effect when the economy is
already at full output, then the economy would go into a recession - E 1 to e2, Y2.
As mentioned, proper timing of monetary policy is critical, and almost impossible due
to lags. To be effective, we need expansionary monetary policy during a recession and
restrictive policy during an inflationary expansion. However, there is a 12-18 month
lag for expansionary policy to affect output and employment, and a 36 month lag to
affect prices. Without perfect foresight, it is unlikely to ever have monetary policy
timed correctly.
If it is not timed perfectly, expansionary policy that takes affect when the economy is
already recovered will be extremely destabilizing. Restrictive policy that takes affect
when the economy is already moving toward recession will make the recession much
worse, also destabilizing.
Although the monetarists emphasize the importance of money, they have generally
been critical of activist, countercyclical monetary policy because they are skeptical of
the Fed's ability to achieve correct timing of monetary policy.
MONETARY POLICY IN THE LONG RUN
Start with the Quantity Theory of Money, developed in the early 1900s by economist
Irving Fisher. One simple implication of the Quantity Theory is that changes in the
MS will be reflected by a proportional change in inflation. If MS increases by 5%,
prices will increase by 5% (inflation = 5%).
It is actually a little more complicated, we can start with the equation:

PY = Nominal GDP ($11T) = MV, where

P = Price level
Y = Real output (real GDP)
PY = Nominal GDP
M = Money Supply, usually M1
V = Velocity or turnover rate of money. The average number of times a dollar is used
during the year to purchase final goods/services.
MV = Nominal GDP
In 2001, GDP was $9963B, M1 was about $1088B, so Velocity of M1 was 7.8x
($9963/$1088). Velocity of 7.8x means that a single dollar turned over 7.8x during
the year, or about every 7 weeks. For example, you spend $100 at Target, and it takes
about 7 weeks on average before that same money is spent again on final goods and
services.
Velocity = GDP/M1. V is inversely related to MD. If people hold less cash and GDP is
the same, then velocity is greater. Velocity increases as technology increases - more
efficient financial/banking system - faster check clearing, etc. Also as we use credit
cards, ATMs, MD is lower, V is higher. We can get by with less cash, as Velocity
increases, and money circulates faster. V has generally been increasing over the last
fifty years as we move towards a cashless economy.
If we convert to the previous equation to percentage changes, we get the Equation of
Exchange:
%Y + %P (inflation) = %M1 + %V
We can assume that %Y (real output) is "fixed" in SR, and determined by real factors
like technology, productivity, resource base, skill of workforce, etc., independent of
the MS. Also, we can assume that V is fixed in the short run, or changes very slowly
in response to financial innovations, credits cards, ATMs, etc.
If %Y and %V are fixed in the short run, then %P = %M, meaning that increases in
the MS lead a corresponding increase in inflation. This is one the important
implications of the Quantity Theory, that increases in the MS lead to proportionate
increases in the Price Level. "Inflation is always and everywhere a monetary
phenomenon."
However, if we more realistically assume a growth in real output of 3%, then an
increase in the MS of 3% would lead to 0% inflation. We would need 3% more

money for the 3% increase in real output, since MD will increase by 3% because
income has increased by 3%. Other possible outcomes using the Equation of
Exchange, assuming real output grows at 3%:
%P = %M1 - %Y
-3% = 0% - 3%
0% = 3 - 3
2% = 5 - 3
20% = 23 - 3

(3% deflation)
(0% inflation as described above)
(2% inflation since money growth > output growth)
(20% inflation since money growth > output growth).

Implication of the Equation of Exchange: "Inflation is caused by too much money

chasing too few goods." Or inflation occurs when the growth rate in the MS is greater
than the growth rate in real output.
Monetarist have advocated an alternative monetary policy to the activist approach:
Passive, Fixed growth rule policy - Fix MS growth at X% per year (3% is usually
suggested) so that people would know what to expect.
SUMMARY:
Keynesian view of Money - Emphasized fluctuations in AD as the source of econ
instability, policy conclusion - activist, discretionary fiscal policy to stabilize AD. No
role for money, monetary policy. Didn't think econ instability, fluctuations were
caused by money, Didn't think that monetary policy would stimulate AD. And if M
went up, but V went down by the same amount, monetary policy wouldn't do
anything.
Monetarists - Led by Milton Friedman, starting in the 1950s. Emphasized: 1) the
strong link between MS and inflation and 2) the link between econ instability and
monetary instability. Emphasized the strong role that money and monetary policy play
in the economy, especially the negative, harmful role of erratic monetary policy. Even
though they emphasize the role of monetary policy, they do not advocate activist,
discretionary monetary policy. Monetarists generally favor passive policy based on
specified rules or formulas - fixed growth rule.
Monetarists emphasized the problems of lags - recognition lag, policy lag,
effectiveness lag. With monetary policy, the policy lag is much shorter, but the
effectiveness lag is still long. It takes 6-18 months for a change in monetary policy to
affect output, and 12-36 months to affect the price level. By the time the policy takes
affect, the economy will most likely have already changed. Timing is critical and also
practically impossible. Lengthy and unpredictable time lags may prevent activist,

discretionary monetary policy from ever working effectively.

MONETARY POLICY WHEN EFFECTS ARE ANTICIPATED
In SR, expansionary monetary policy can temporarily stimulate the econ, increase AD,
output and employment. In LR, however, the effects of rapid money growth are higher
inflation and higher interest rates. Money growth cannot reduce un or increase real
output in the LR. Money is neutral in the long run. Or possibly negative if it is
erratic. Money growth/inflation can be like drinking alcohol - the initial result is
favorable, but if we consume too much, there is a bad hangover.
Point: For money growth to be expansionary in the SR, it has to be unexpected.
People have to be fooled. Only surprise money matters. The expansionary effect is
because retail prices rise faster than input prices - wages, rents, leases, supply
contracts, int. rates, etc. - increasing profits and expanding output. The rising prices
catches workers, landlords, suppliers and lenders off guard, and real wages, real rents,
real input prices and real int. rates fall.
If workers, landlords, lenders and suppliers fully anticipate the future inflation, there
will be no change in output, employment at all. See page 334. For example, long term
contracts such as union contracts may include an "escalator clause" (COLA - cost of
living adjustment) that will raise nominal wages or prices automatically as the price
level rises. Therefore, monetary policy will be neutral if fully anticipated or if
everyone takes measures to counteract the effects of inflation. Retail prices and
input/resource prices will both increase by the same amount and the result would be a
higher price level, but no real affect on output, employment.
Graph page 334. Expansionary monetary policy shifts AD 1 to AD2. Output would
expand along SRAS1 if either a) they did not anticipate the policy or b) did not protect
themselves with escalator and COLA clauses in contract. But if the expansionary
policy is fully anticipated and resource suppliers have fully incorporated inflationary
expectations into their decisions, output is not affected even in the short run. The
expansionary monetary policy will induce producers to raise prices for inputs and will
shift SRAS1 to SRAS2.
For example, retail prices rise by 5% and input prices rise by 5% demonstrating the
"Policy ineffectiveness theory." Policy is neutralized, monetary policy is ineffective
because output and employment are unaffected. Economy goes from E 1 to E2, output
(YF) stays the same, at a higher price level, WHEN suppliers either a) correctly
anticipate inflation or b) sufficiently protect themselves against inflation with

escalator and COLA clauses in their contracts, and adjustable or variable rate loans,
etc.
How likely are people to anticipate monetary policy? Topic of Debate. For example,
people didn't anticipate the inflation of the 70s very well, but that led to significant
increase in the use of COLAs, escalator clauses, ARMs (adjustable rate mortgages),
etc. We will come back to this topic in the next chapter.
MAIN POINT: The effects of monetary policy depend critically on whether the
policy is expected (no effect) or unexpected (economy is affected).
INTEREST RATES AND MONETARY POLICY
Confusing issue - we have to distinguish between SR and LR and between short term
rates and long term rates. In the long run, increases in the MS will lead to higher
inflation and higher interest rates for both short and long term rates.
In the SR, increases in MS will usually lower short term rates. Fed conducts OMO,
buys T-bills, increases bank reserves, lowers the Fed Funds Rate (FFR), overnight
market for banks lending reserves. MS/MD graph shows this (p. 324).
As FFR falls, other short term rates may fall TEMPORARILY - CDs, svgs. accounts,
3 month T-bills, etc. However, the LR effect on short-term rates is usually higher int.
rates due to increased inflation.
The effect of monetary policy on long term rates is much less predictable and much
less certain. If people expect higher inflation as a result of expansionary monetary
policy, long term rates may increase in response to expansionary policy, not fall.
People and businesses make major investment decisions based on long term rates, not
short term rates - 30 years mortgage rates, 30 year bond rates, etc. If expansionary
monetary policy raises long term rates, the policy won't stimulate the economy, it will
slow it down, contract it.
MAIN POINTS: 1) Expansionary monetary policy may lower short-term rates (FFR,
3 month T-bills), but RAISE long-term rates (30 year bonds, 30 year mortgages),
2) Investment decisions depend more on long term rates, so the expansionary policy
may not stimulate investment and output if long term rates rise, and
3) All interest rates (short and long term) may be higher in the long run as a result of
expansionary policy if inflation accelerates (e.g. 1970s).

SUMMARY OF MONETARY POLICY

See page 337 for a Thumbnail Sketch of the effects of monetary policy. It is
important to separate the effects: 1) in short run when policy is unanticipated and 2)
in short run when anticipated and 3) in long run. If policy is anticipated, the effects in
the SR and LR are exactly the same (see Thumbnail Sketch) because the LR
adjustment process happens immediately when policy is expected. It is only "surprise
money" that affects the economy differently in SR and LR - only "surprise money
matters."
In the LR, or in SR if policy is anticipated, the only effects of expansionary monetary
policy are higher int. rates and higher inflation. Real int. rates, real output, real
employment will be the same, see last column in graph on page 337.
If expansionary monetary policy is a surprise (Column 1 on p. 337), interest rates
(nominal and real) and the unemployment rate will decrease temporarily and output
will increase. However in the LR after an adjustment period, there will be no LR
affect on output, employment or the real interest rate, only higher prices and higher
nominal interest rates.
Main point of Thumbnail Sketch on p. 337: "Monetary policy is neutral in the LR"
( and in the SR when expected).
MONETARY POLICY - 5 MAJOR PREDICTIONS:
1. Unexpected expansionary (contractionary) monetary policy will temporarily
increase (decrease) output and employment.
2. Expansionary monetary policy will stimulate an economy in recession toward full
employment. If the economy is at full employment, expansionary policy will be
inflationary. Restrictive policy will result in a recession if it impacts the economy at
or below YF.
3. Persistent growth in the MS will cause inflation.
4. Inflation will increase nominal interest rates.
5. Due to lags, it takes time for changes in monetary policy to affect output and prices.
6 months - 3 years. There may not always be a close short-run relationship between
changes in monetary policy and changes in output, inflation and interest rates due to

lags and due to some prices being set by long term contracts.
EMPIRICAL EVIDENCE
1. Monetary policy and real output - see Exhibit 10, p. 359. There appears to be a
strong link between money growth and real output growth. During periods of
economic recessions, there is a decrease in money growth, and during economic
expansions there is an increase in money growth. Also, there is some evidence of
expansionary monetary policy during recessions in 1970, 1974 and 1980.
However, association is not the same as causation. Did monetary policy "cause"
output growth to change, or did output growth "cause" monetary policy to change?
Higher growth/income raises the demand for money, lower growth lowers the demand
for money? We can see a strong link between money and output (supports the
Monetarist position), but the direction of causality cannot be determined from the
graph.
2. Money Supply and Inflation, see Exhibit 11, p. 340. Fairly close link between M2
growth and inflation three years later. We compare M2 growth in 1960 with inflation
in 1963, to allow three years for money to have its full effect on inflation.
1980s - M2 was growing at about 10% and inflation was only growing about 4- 5%.
Why? i) Real output was growing very rapidly, as high as 4% and ii) Velocity (V) was
falling due to int. on checking. When checking accounts starting paying interest,
people were willing to hold more cash. Banking laws from the 1930s prohibited banks
from paying interest on checking until 1980.
MV = PY, if M goes up, but V goes down, the effect of M on P is dampened.
3. Inflation rate and Nominal Interest Rates - see Exhibit 12, p. 373. Very strong link
between inflation rate and short term nominal int. rates (3 mo. t-bills).
4. International evidence of the link between MS growth and inflation - see Exhibit
13, p. 342. Very close link between MS and inflation over a 19 year period in more
than 30 countries supports the Quantity Theory of Money and is one of the most
consistent empirical relationships in economics. "Inflation is always and everywhere a
monetary phenomenon."