Chapter 15: Monetary Policy Flashcards
Transmission Mechanism
The routes or channels, traveled by the ripple effects that the money market creates and that affect the goods and services market.
Represented by the aggregate demand and aggregate supply curves in the AD-AS framework.
Demand for Money (Balances)
The inverse relationship between the quantity demanded of money balances and the price of money balances.
Why is the Keynesian transmission mechanism considered indirect
Changes in the money market do not directly affect the goods and services market (Real GDP) as the investment goods market stands between the two markets.
Liquidity Trap
The horizontal portion of the demand curve for money.
Keynesians believe this happens at some low interest rate
2 Ways in which the Keynesian Mechanism may get blocked
- Interest-insensitive investment
- The liquidity trap
Explain Interest-insensitive investment
Some Keynesian economists believe that investment is not always responsive to interest rates.
For example, when business firms are pessimistic a decrease in interest rates will do little to increase investment.
Monetarist Transmission Mechanism
Monetarist theory proposes a direct link between the money market and the goods and services market.
Expansionary Monetary Policy
The policy by which the Fed increases the money supply
Contractionary Monetary Policy
The policy by which the Fed decreases the money supply.
Keynesian belief on monetary policy and the problem of inflationary and recessionary gaps
Most Keynesians believe that the natural forces of the market economy work much faster and more assurely in eliminating an inflationary gap than in eliminating a recessionary gap.
Therefore they will rather advocate expansionary monetary policy to eliminate a stubborn recessionary gap than advocate contractionary monetary policy to eliminate a not-so-stubborn inflationary gap.
Activists
Persons who argue that monetary and fiscal policies should be deliberately used to smooth out the business cycle.
Fine-tuning
The (usually frequent) use of monetary and fiscal policies to counteract even small undesirable movements in economic activity.
Nonactivists
Persons who argue against the deliberate use of discretionary fiscal and monetary policies. They believe in a permanent, stable, rule-oriented monetary and fiscal framework.
The case for activist (or discretionary) monetary policy rests on 3 major claims:
- The economy does not always equilibrate quickly enough at Natural Real GDP
- Activist monetary policy work; it is effective at smoothing out the business cycle
- Activist monetary policy is flexible, nonactivist (rules-based) monetary policy is not
The case for nonactivist (or rule-based) monetary policy also rests on 3 major claims:
- In modern economics, wages and prices are sufficiently flexible to allow the economy to equilibrate at reasonable speed at Natural Real GDP
- Activist monetary policies may not work
- Activist monetary policies are likely to be destabilizing rather than stabilizing, they are likely to make matters worse, not better.
Keynesian Transmission Mechanism: 3 Markets
- The money market
- The investment goods market
- The goods and services market
3 Steps in which the Keynesian Transmission mechanism operates given an increase in the money supply
- An increase in the money supply brings on a lower interest rate
- As a result, investment increases
- As investment increases, total expenditures rise and the aggregate demand curve shifts rightward. Real GDP rises.
2 Steps in which the monetarist transmission mechanism operates
- An increase in the money supply leaves individuals with an excess supply of money.
- As a result, they increase their spending on a wide variety of goods.
4 Nonactivist monetary proposals
- Constant-money-growth-rate rule
- Predetermined-money-growth-rate rule
- Taylor rule
- Inflation targeting
Constant-money-growth-rate rule
The annual money supply growth rate will be constant at the average annual growth rate of Real GDP.
Predetermined-Money-Growth-Rate rule
The annual growth rate in the money supply will be equal to the average annual growth rate in Real GDP minus the growth rate in velocity.
%∆M = %∆Q - %∆V
Criticism of the constant-money-growth-rate rule, argue that it makes 2 assumptions:
- Velocity is constant
- The money supply is defined correctly.
Taylor rule
Federal Funds Target = 1.5 (Inflation rate) + 0.5 (GDP gap) + 1
GDP gap measures
The percentage deviation of Real GDP from its potential level.
Inflation targeting
Targeting that requires the Fed to keep the inflation rate near a predetermined level.
Criticism of Inflation targeting
The policy would constrain the Fed at times, such as when it might need to overlook the target to deal with a financial crisis.
Praise of Inflation targeting
The policy is more in line with the Fed’s objective of maintaining near price stability.
