All Terrain Thinking

A Compendium of things I think are Important

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

1970s:Money and the economy

The setting

"close, regular, predictable relationship between the quantity of money, national income, and prices..." _{Milton Friedman}

"long after the Pope is gone, you'll remember this."  _{Fed Public Affairs Director statement to the media on the announcement of the Fed's policy shift on October 6, 1979}

"I agonized over what to do with these ...money numbers.  In fact, it was very hard to determine whether we were implementing a very tight monetary policy or a rather accommodative one."  _{Lyle Gramley, Fed governor 1982}

"monetarism's powerful simplicity easily and quickly won legions of converts.... After all, orthodox Keynesian precepts, which guided the economy relatively well in the 1950s and much of the 1960s, could neither explain nor cure the complex disease of stagflation."  _{Robert Giordano, Financial Market Perspectives, September-October 1991}

Questions of the day

• 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...?"
• 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?
• 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.
• 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.
• 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?
• 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.
  • b. An increase in bank holdings of excess reserves.
  • c. A reduction in the discount rate
• 7. Describe the differences between the Monetarists and Keynesians with regard to their views concerning:
  • a. the AS curve
  • b. the lags in monetary and fiscal policy
  • c. the proper targets for the Fed's policies
  • d. the extent of crowding out
• 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 on the US economy. More specifically, I am interested in forecasts of output and inflation. 
  • a. "Japan emerges from a long recession"
  • b. "Fed decides to raise interest rates"
• 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?

Outline

• Classical Quantity Theory of money

• Keynesian monetary transmission mechanism

  • money supply and interest rate

  • interest rate and aggregate demand

  • aggregate demand and output / prices

• Fiscal policy in keynesian model

• Policy dilemma

• Expectations and the Phillips curve

  • adaptive

  • rational

• Monetary policy

Overview of money and the economy

Diagram 1

Diagram 2
Impact of Increase in Money Supply

Diagram 3
Monetary Policy Transmission Mechanism

The success of monetary policy depends upon 4 critical factors:

• the ability to anticipate the appropriate policy choice (0)
• the impact of policy choices on money supply and interest rates (1)
• the impact of the money supply and interest rate changes on aggregate demand (2)
• the allocation of the increased demand between higher prices and greater output (3)

(0)

Recognition lag:

Implementation lag:

(1) Liquidity Trap

Diagram 4
Potential Impact on Interest Rates of Increase in Money Supply

(2)

Diagram 5
Interest Rate Responsiveness of Investment Spending

(3)

Diagram 6
Monetary Policy and Aggregate Supply

Diagram 7

Policy dilemma of the Fed

Diagram 2

Diagram 3
Alternative Fed Strategies

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