All Terrain Thinking

A Compendium of things I think are Important

Economics: It's not just whats' in your wallet

Answers for the Day
1970s: Money and the Economy

1.  "Inflation is always a monetary phenomenon" because inflation is caused by "too many dollars chasing too few goods." What is the story here? How are these statements related to Friedman's comments that there is a "close, regular, predictable relationship between the quantity of money, national income, and prices...?"

It sounds like monetarists talking and it would seem that they are talking about the quantity theory of money equation: p = m - y + v. The inflation rate (p) is directly related to the growth rate in the money supply (m). This is the relationship that Friedman is talking about.

2. Keynes' identified a speculative demand for money in addition to the transactions demand that had been identified by the Classical economists.   What would happen to the "opportunity cost" of holding money as interest rates rose? What would the money demand curve look like and how would you use the Ms - Md diagram to demonstrate the impact of an increase in the money supply?

Keynes assumed that the amount of money that people would hold would be related to the price of the money.  If you look at the interest rate as the opportunity cost of money - when you hold money you will not get interest income from investing the money - then as interest rates rise the demand for money should fall.   The supply and demand curve for money are presented below.  If there was an increase in the money supply then the S curve would shift out and this would push the equilibrium down and to the right - lower interest rates and higher quantity of money.

Money Market

3. If the US economy found itself in a very severe recession, you can be assured that politicians would be falling over themselves trying to push for their own cure. Please explain how one might justify the use of fiscal and monetary policy to help the economy out of the recession.

The justification would be based on your view of the appropriateness of discretionary monetary and fiscal policy. If you happened to believe that monetary policy could be effective at increasing AD, then you would propose that the money supply be increased which would lower interest rates and increase investment spending. Fiscal policy would be preferred by some who felt that the monetary policy link was weak and that an expansionary policy (tax cut or spending increase) would get the economy moving.

4. What is the significance of the statement: "Long after the Pope is gone, you'll remember this?"  What is the event / change in policy that is being referred to?  Please show the change using a simple Ms-Md diagram that you can use to show the policy dilemma facing the Fed.

The policy refers to the Fed's decision to alter its policy from one of monitoring the interest rates to one of monitoring the money supply.   What we know is that the Fed can control only the interest rate or the money supply. The options are evident in the two graphs below.  in both graphs there is an outward shift in demand and we can now examine the two possible Fed responses. In the left-side diagram we see that the FED reacts to the increase in money demand with an increase in the money supply which allows it to control the interest rate, but it loses control of the money supply. In the right-side diagram we see how the fed could lower the money supply which would raise interest rates, but keep the money supply constant. This is the policy dilemma faced by the Fed.  After the announcement mentioned in the question, the Fed began targeting interest rates.

5. If I discover that consumption of automobiles is more sensitive to changes in the interest rate than previously thought, what impact will this have on policy makers' views of the relative effectiveness of monetary and fiscal policy?

Sound familiar?  Think about all of the car ads that offer interest rate rebates or reductions.  These companies obviously think that the interest rate matters.  By allowing demand for cars to depend on interest rates, this would increase the sensitivity of aggregate demand to interest rates. This would help make monetary policy more effective-for any change in the interest rate caused by the policy, the change in output would be greater. As for fiscal policy, this would increase the crowding out effect which would lower the effectiveness of fiscal policy.

6. Determine, with the aid of the traditional AS-AD diagram (positive and negative slopes), the impact of the following on income and the price level.

a. A Fed open market purchase of securities.

This will increase the money supply which will shift the AD curve out.

b. An increase in bank holdings of excess reserves.

This will decrease the money supply which will shift the AD curve in.

c. A reduction in the discount rate

This will increase the money supply which will shift the AD curve out.

7. Describe the differences between the Monetarists and Keynesians with regard to their views concerning:

a. the AS curve

The Monetarists believe that the AS curve is steeper.

b. the lags in monetary and fiscal policy

The Monetarists believe that the lags are too long and too variable to make stabilization policy useful.

c. the proper targets for the Fed's policies

The monetarists tend to favor money supply targets while Keynesians tend to favor interest rate targets.

d. the extent of crowding out

Monetarists believe it is a substantial problem, while Keynesians tend to emphasize crowding in.

8. Forecasting is always difficult-especially when it is for the future. It made sense when I first heard it. But can we forecast? Can we anticipate? Let's try. Please use the 'model' we discussed in class to explain the impact of the following possible headlines.

• a. "Japan emerges from a long recession"

a. If Japan is emerging from a long recession we will see income in the economy rising. As consumers in Japan begin to spend more, some of their spending will be on American goods-US exports. But exports are part of aggregate demand so an increase in exports should increase equilibrium income. You should be able to forecast an increase in income in the US.

• b. "Fed decides to raise interest rates"

b. If the FED decides to raise interest rates, an issue we will discuss in the next section, then we can expect to see a decline in some components of spending. The impact will be felt most strongly in sectors like homes and autos where people borrow for their purchases. We can also expect, based on the discussion in the book, to see business investment spending fall. The result would be a downward shift in aggregate spending which would suggest that we will be seeing a decline in the economy. Sounds like Greenspan's policy decision in early 1997.

9. Do expectations matter? How does the formation of expectations alter one's perception of the potential effectiveness of macro policy? What are the implications of rational expectations?

Rational expectations change the way we view the effectiveness of monetary policy. If we know that prices will rise if the money supply rises then we will build that into all of our calculations. This will mean that any increase in the money supply will be recognized as inflationary and as people build in the higher inflationary expectations, the policy will not "fool" anyone and the policy will have no effect on demand.

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