Jim’s Notes

Monetary Policy

What Is Monetary Policy?


Central bank (as representative of government) manipulation of the money supply, credit conditions, and interest rates with an objective of achieving macroeconomic goals of cyclical stability, full employment, and price level stability.


Money supply concept: (Classical or Milton Friedman Monetarist version)

increased money supply –> more bank reserves —>more lending by banks –> lower interest rates –> borrowing by consumers/firms –> more C and I spending –> faster GDP growth
decreased money supply –> reduced bank reserves –> less lending –> higher interest rates –> less borrowing and spending by consumers/firms –> lower (slower growth in) C and I –> slower GDP growth

Interest rates concept: (Neoclassical version)

central bank open market purchases of bonds –> higher bond prices = lower interest rates –> more borrowing by consumers/firms (loans are more attactive) –> more spending on C and I –> faster GDP growth –> lower unemployment and higher inflation
central bank open market sales of bonds –>lower bond prices = higher interest rates –> less borrowing by consumers/firms (loans become unattractive) –> less (or slower increases in) C and I –> slower GDP growth –> higher unemployment and lower inflation

‘The Fed’ Dual Mandate

Maintain stable prices (fight inflation/deflation)

Maintain full employment (monetary policy to manage macroeconomic conditions)

Monetarist Theory (strict Classical version associated with Milton Friedman)

Money supply is ‘exogenous’ (controlled by Central Bank)

Central bank ‘manages’ or controls the money supply

‘demand for money’ by the public for use in transactions, etc. is very stable (can also be stated as ‘velocity’ which is the number of times a dollar is spent or changes hands each year)

interest rates are the ‘price of money’ – set by market forces of stable money demand and Central-bank changes in money supply

Equation of Exchange

M x V = P x Y

M: money supply
V: Velocity (how fast money is spent)
P: Price Level
Y: Real Income

Note: sometimes shown as M V = P Q

same concept, different notation


M x V, the left side of equation, represents the monetary side of all GDP activity. It’s the money we as a nation had (M) times how often we spent it (V).
P x Y (also written as P x Q by some authors), represents total nominal GDP – it’s the price level (P) times real GDP.

Equation of Exchanges is an Identity: Must be true for any period of time after the fact..

Quantity theory of money (QTM):

Based on equation of exchange with added assumptions about the behavior of variables.

If we assume V is constant, then:
P can stay unchanged (no inflation) if and only M increases at the same rate as Q (real GDP growth)
If M increases faster than Q (real GDP growth) and V is constant, then P must increase (inflation)


Money supply growth (increase M) is solely responsible for determining Inflation (increase in P)

BUT the assumption of constant velocity is CRITICAL to the theory

not supported by empirical evidence
Velocity is, in fact, highly variable and erratic


Monetary policy should target a stable rate of growth of M1 to match the long-run growth rate of real GDP

‘Crowding Out’ Theory

Govt borrowing takes $ away/raises interest rate for firm and household borrowers –> could reduce C, I unless Central Bank increases M to fund government deficit

government deficits will supposedly force up interest rates and ‘crowd out’ private borrowers competing for a limited money supply of loanable funds

If Fed creates $, it can ‘finance’ the deficit, but will create inflation

therefore, the theory says government deficits are inflationary

Crowding out is absolutely not supported by evidence or data in modern real world.

Monetarist Theory History:

Emerged as a restatement of Classical Theory to counter Keynesian criticisms

Milton Friedman (leading proponent of monetarism) and monetarist theory gained significant adherents in 1970’s as simple Keynesian theory appeared unable to explain or handle the stagflation of 1970’s

Monetarist and re-stated Classical (now called New Classical) theories came to dominate graduate schools of economics in 1970’s and 1980’s

Central banks, including The Fed, adopted monetarist theory and approaches in late 1970’s but abandoned them in late 1980’s

Monetarist theory failed totally to explain:

Stock market crash in 1987 and subsequent lack of real economic decline
failure of money supply growth to track and explain inflation in 1990’s-present
slow recovery of economy and lack of inflation in 2000’s decade
financial crisis and Great Recession in 2007-09, including the deflationary pressures
failure of inflation to happen or rapid growth after central bank easy money policies following Great Recession (2008 to present)
failure of government deficits in 2009-10 to result in inflation
doesn’t explain the existence of financial ‘bubbles’

Monetarist theory is still strongly supported at so-called ‘freshwater’ (New Classical or Austrian) schools of economics and by many banking economists on TV and ‘conservative’ politicians

Current Neoclassical and New Keynesian Views on monetary policy

Support for ad hoc policy (policy makers should make it up as they go)

Current mainstream theory is presently ad hoc – basically it’s a weakened, less strong version of Classical Monetarism with an emphasis on interest rates and the interest rate mechanism instead of money supply management.

Adopted and used by central banks around the world since late 1980’s


velocity and money demand is variable in short-run as a response to business cycle

but in some unspecified long-run the equation of exchange, quantity theory of money, and crowding out all hold true

Calls for monetary policy and interest rates management as the primary policy tool

Fiscal policy is recommended only for very large recessions – considered too blunt and difficult to implement

Monetary policy and interest rates management is preferred for ‘fine-tuning’ and as primary policy tool


set targets for Fed Funds interest rates as key monetary policy

when economy is near full employment, raise interest rates to prevent inflation

when economy has high unemployment, lower interest rates as long as inflation is still low

Liquidity Trap and Keynesian Theory

Keynesian and New Keynesian Theories generally support the use of monetary policy as effective tool

Exception: when there’s a Liquidity Trap or zero lower bound

Liquidity Trap

Modern Monetary Theory (MMT)

Monetary policy is largely ineffective except to extent it supports fiscal policy

Money growth (M1 – bank credit) is largely endogenous

Key is base money growth

government deficits enable the private sector (firms and households) to grow and yet still accumulate net financial assets

Foundation: Fiat money system with floating exchange rates eliminates government budget constraint

National Saving – Investment Identity: therefore: C + I + G + (X-M) = C + S + T

Simplifing and rearranging: (S-I) = (G-T) + (X-M)
rephrased: net private savings (accumulation of financial assets) = government budget balance + foreign trade balance
in other words, the private sector cannot as a whole get financially wealthier unless government runs a budget deficit and/or a trade deficit.

Government deficits are effective in fighting unemployment

no financing or budget constraint on deficits

deficits are limited by the availability of real, unemployed resources for the government to purchase

expanding government deficits when full employment exists will produce inflation
no inflation threat until full employment is reached (AD- LRAS model)

Limits on Monetary Policy

‘Pushing on string’ – can’t force banks to lend

Central bank can make lending possible and keep interest rates low, but they cannot force banks to make loans

banks may have unhealthy balance sheets (possible unrecognized bad loans) and may choose to hold excess reserves instead of lending them
banks choose to keep large reserves as a safety cushion
households and firms may not want to borrow (no demand for loans)

Endogenous money supply

money supply is mostly determined by bank lending practices (creates M1) and government deficits/surpluses (creates base money), not really central bank policies

if central bank tries to restrict money supply, it tends to push large banks into trouble, which then forces the central bank to abandon tight money as it rescues TBTF banks

Fiscal Policy and Monetary Policy

could work at cross-purposes

could expect ‘other’ to do it

Liquidity trap

monetary policy will be completely ineffective

Monetary policy is more effective when interest rates are already relatively high

Zero lower bound

when interest rates hit or approach zero but the economy is still weak and needs stimulus, monetary policy is largely ineffective.


If interest rates too low or inflation too high, then value of dollar drops –> X rises but M and capital inflow drops