Economics 374-01A Dr. John F. Olson

Monetary Theory and Policy Spring 2007

Study Guide for Second Test

The second test (Wednesday, April 18^th) will be on Units 3 & 4 with the material from Handa, chapters 10, 2, 13, and 14 plus the supplementary web-documents on the money supply process and the Federal Reserve documents on monetary policy tools.

The bulleted points below are from the end of the chapter “Summary of Critical Conclusions” in the Handa text. See/study the appropriate chapter sections of the text for details. I have inserted my annotations (and some potential test questions) in italics.

Chapter 10 – Money Supply Process

The money stock is not exogenously fixed as is often assumed in basic macroeconomic models to reduce the complexity of the analytical framework. The money supply depends upon the behaviors of the public and the banking system, as well as the direct and indirect influences of the monetary authorities (primarily the Federal Reserve).

The money supply process can be expressed analytically as M ^s = m x Base. The money multiplier (m) is determined, in turn, by the currency-deposit and reserve-deposit ratios. See the course web-document on the money supply process for the derivation of the expression and further details.

What is fundamental to understanding the money supply process is its integration with the process of credit and deposit creation in the banking system. Banks accept deposits, then extend those funds as new credit (loans and/or acquired securities) which, in turn, becomes the source of new, additional deposits.

You should be able to explain how the money supply (and money multiplier) process works in terms of the economic behavior of the public, banks, and the Federal Reserve, as well as how their behaviors are determined and affected by changes in economic variables (interest rates, etc.).

• The private sector affects the money supply, so that the central bank must be able to predict its responses if it is to offset them and control the money supply in the economy.
• The non-bank public influences the money supply through its demand for currency and various forms of its deposits with the banks.

This is measured by the currency-deposit ratio in the money multiplier formula.

• The commercial banks influence the money supply through changes in their demand for reserves.

This is measured by the reserve-deposit ratio in the money multiplier formula.

• The central bank can influence the money supply through open market operations, through changes in the minimum reserve requirements, if any, imposed by it on the commercial banks, and through changes in its discount rate for loans to commercial banks. In some countries, it also does so by shifting government deposits between the commercial banks and itself.

See the Federal Reserve web-pages for each of the three policy tools linked from http://www.federalreserve.gov/policy.htm. How do changes in each of the tools subsequently affect (directly and/or indirectly) the monetary base and/or the money multiplier through the currency-deposit and/or the reserve-deposit ratio?

• Monetary evolution, inducing changes in the currency or deposit ratios, can change the monetary base multiplier. In general, this has been increasing over time.

You can also empirically determine on your own from the course web-site accessible data sets that the currency-deposit and reserve-deposit ratios have been declining over time, which increase the value of the money multiplier.

• Empirical studies support a behavioral approach to the money supply and indicate that the money supply depends on the interest rates in the economy.

Refer to the Handa text sections 10.6 and 10.7 and the tables 10.1 and 10.2 for theory and evidence.

• The estimated money supply functions are very sensitive to the monetary policy and target regimes.

We will discuss the details of this in Unit 5.

Chapter 2 – Money and Prices (reviewed as foundation for material in Chapters 13 & 14)

• The quantity theory consisted of several approaches in its evolutionary history. They asserted that, in equilibrium, a change in the money supply will cause a proportionate change in the price level, but will not affect output and unemployment. These assertions are also implied by the neoclassical and the modern classical approaches—currently the dominant approaches in macroeconomics.

This assertion is the neutrality of money. You should be able to discuss the perspectives of Fisher, the Cambridge approach, Pigou, and Wicksell to the QTM.

• The quantity theory allowed that the changes in the money supply would affect output and employment in disequilibrium. This is consistent with the neoclassical approach. It is a fundamental aspect of Keynesian ideas.

The QTM disequilibrium changes are, of course, short-run adjustment processes in moving to the new long-run equilibrium.

• Wicksell shifted the transmission mechanism (from money to aggregate demand) from the direct transmission one to the indirect one.

Explain the different concepts or views of the transmission mechanism (see the final two bulleted conclusions below).

• Keynes expanded the reasons for holding money to encompass the transactions motive, the precautionary motive and the speculative motive. Keynesians subsequently provided distinctive analyses for each of these motives.

Present and explain the economic reasoning underlying each of the three Keynesian motives for holding money.

• Friedman, although ostensibly claiming to provide a ‘restatement’ of the quantity theory, in fact provided an integrated version of the neoclassical and the Keynesian ideas on the demand for money. However, his replacement of current income by permanent income as the scale determinant of money demand belonged in neither the quantity theory nor the Keynesian traditions.
• Keynes and the Keynesians integrated the analysis of the money market and the price level into the general macroeconomic model, rather than leaving it as an appendage to the analysis of the commodity markets. They also introduced bonds as an alternative asset to money in the demand for money and made the bond market a component of the macroeconomic analysis.

Recall that the classical view assumes there is no money illusion and, thus, there is the classical dichotomy between the real (commodity markets) and nominal (money) economies. Money is primarily a transactions asset with few or no good substitutes. The Keynesian assumptions are contrasting views of the nature of money and its role in the economy.

• There are three potential transmission mechanisms through which the changes in the money supply impact on aggregate demand. These are the direct transmission mechanism, the indirect one and the lending one. The Keynesians and the modern classical macroeconomic schools, following Wicksell and Keynes, have based their IS-LM analysis on the indirect mechanism, with the direct one being ignored for the modern financially developed economies.
• The lending channel has been proposed by some economists. Whether it is distinctive from the indirect one and whether it is also significant for the modern financially developed economies is not generally accepted. Its role for financing investment in financially under-developed economies is likely to be much greater.

Chapter 13 – Neoclassical and Classical Models

In this chapter and the next (14), you are presented with the evolution of macroeconomic thinking over the past two or more centuries. I suggest using a compare/contrast approach in studying the material. What is common among the models in their assumptions about structure and behavior? What is different? And how does that yield similar or different conclusions?

There is also the development and presentation of the IS-LM and AD-AS model(s) with which you should be familiar from ECON 333 (Macroeconomic Theory). You should be able to use these tools to appropriately illustrate your macroeconomic arguments. While the graphs and/or equations are useful illustrative and/or analytical devices, what is most important are the underlying economic (conceptual) arguments.

Keynes and his subsequent followers had different assumptions about the structure and processes of the macro-economy than the classical and neo-classical approaches; thus, they reach different conclusions and results.

The IS curve represents goods market equilibrium, while the LM curve represents money market equilibrium. (Note: by invoking Walras’ Law, goods market equilibrium simultaneously implies credit – savings/investment – market equilibrium, and money market equilibrium simultaneously implies bond market equilibrium.) Combining IS and LM conditions creates an AD (aggregate demand) curve – a negatively-sloped relationship between the price level and level of real expenditure (income, GDP demanded) in the economy. To complete the model, an AS (aggregate supply) curve is constructed to represent the supply-side (factor market equilibrium) of the economy. Just as there are differences in views (assumptions) about how the demand-side of the economy should be modeled, there are differences about the supply-side.

• In the Walrasian general equilibrium of the economy, the economy has full employment, full employment output and the natural rate of unemployment.

Why is this the case; that is, what assumptions and reasoning lead to these conclusions? What do flexible prices and wages, the extent or degree of market competition, and the absence of money illusion have to do with this?

The natural rate of unemployment exists because of normal amounts of frictional and structural unemployment – these can change over the long-run as the demographic composition of the labor force changes, the structure of the labor market and labor search changes, and as the structural composition of labor demand and supply change.

• In the Walrasian general equilibrium of the economy, the quantity of money is neutral and monetary policy cannot be used to increase or decrease the level of output or unemployment. It can only change the nominal value of aggregate demand, the price level and the rate of inflation.

Why is the quantity of money neutral; that is, what assumptions and reasoning lead to these conclusions? See immediately above as well as in Chapter 2 – pure QTM! The implication is that in the long-run, monetary policy can only affect the price level and the rate of inflation.

• The Walrasian economy can at times be in disequilibrium and take time to return to general equilibrium with full employment. In this disequilibrium phase or state, money need not be neutral so that an appropriate monetary policy could speed the recovery to full employment equilibrium.

Is this “disequilibrium” state just the adjustment phase of going from one long-run equilibrium to another? Why and/or how might monetary policy speed the recovery or adjustment to equilibrium?

• While the traditional classical economists and the neoclassical approaches, as well as the 1970s monetarism, envisaged the possibility of the economy at times being in disequilibrium, the modern classical and the new classical approaches assume continuous full employment and the Walrasian general equilibrium in the economy. While money is not always neutral in the former set of approaches, it is always neutral in the latter set. If there is uncertainty, then anticipated monetary policy is neutral.

Section 13.18 discusses the distinguishing features among the different (and evolving) views with the Classical paradigm, while section 13.19 elaborates the Monetarist view. What is it in (the assumptions of) the modern classical and new classical approaches vs. those of traditional classical, neo-classical, and monetarists that creates the difference regarding the neutrality or non-neutrality of money?

• Whether the economy, especially when in recession, is in full employment equilibrium or not, is never certain, so that the particular monetary policy being followed by the monetary authority is usually in dispute among economists.

The theory of Ricardian equivalence is addressed in section 13.17 – this is the proposition that the effects on nominal income of debt-financed vs. tax-financed increases in government expenditures are the same. The proposition largely rests on the recognition by households that debt-financing is merely postponing a subsequent increase in taxes. Thus, with an increase in current taxes, households reduce their current consumption to pay the current taxes or with debt-financing, households increase their saving (and reduce current consumption) to pay future taxes.

Chapter 14 – Keynesian and Neo-Keynesian Approaches

Keynes and his subsequent followers had different assumptions about the structure and processes of the macro-economy than the classical and neo-classical approaches; thus, they reach different conclusions and results.

• Early (1940s and 1950s) Keynesian models were based on nominal wage rigidity or price illusion by labor.
• In the 1960s and 1970s, Keynesian models were often based on the Phillips curve.

The Phillips’ curve is, of course, the inverse relationship between the inflation rate and unemployment rate. The classical and neo-classical views hold that such a relationship might exist only in the short-run; in the long-run the Phillips’ curve is vertical. Why?

• More modern versions of such (Keynesian) models rely on staggered wage contracts with price expectations and the possibility of expectational errors.

Hence, the inflation-expectations augmented short-run Phillips’ curve can be derived and applied. Explain how inflation-expectations can shift the short-run Phillips’ curve, yet still result in a vertical long-run Phillips’ curve (when expectations = actual experience).

• An abiding theme in Keynesian models, originating with Keynes’ The General Theory, is the failure of the economy to attain Walrasian general equilibrium. This is attributed to the absence in the real world of an adequate coordinating mechanism such as tatonnement, auctioneer or recontracting, and the imperfect functioning of the competitive mechanisms that do exist in the modern economy. The Keynesian approach asserts that this failure is especially symptomatic of the labor market, so that involuntary unemployment is a common occurrence in the real-world economies.

Recall how the Walrasian view (classical and neo-classical) assumes the dominance of competition, flexible wages and prices, and the absence of money illusion. How does the Keynesian view differ? What about the modern or new classical approaches?

• The Keynesian model based on this deficiency in the macroeconomic environment is the demand-deficient model. This approach posits that the rational dynamic responses by firms and households to conditions of inadequate demand and involuntary unemployment do not always take the economy to full employment or do so within the acceptable period.

Why not – that is, why don’t these rational dynamic responses take the economy to full employment (or within an acceptable period)? What prevents full-employment equilibrium from being restored?

• The demand-deficient models imply that the responses of output and unemployment with respect to changes in the money supply during periods of demand deficiency are not properly captured in the Phillips curve or the Lucas supply curve relationships.
• The neo-Keynesian theories rely on rational long-run behavior resulting in implicit contracts, staggered wage contracts, sticky prices and menu costs, etc.

Notice here that Handa is presenting and discussing a long-run view – how does this neo-Keynesian view differ from a neo-classical view in not only the assumptions, but also the conclusions?

• There is no logical inconsistency between the Keynesian approach and rational expectations. Further, Keynes’ The General Theory argued strongly for the adequate consideration of both short-run and long-run expectations in the macroeconomic analysis. The Keynesian models can quite legitimately incorporate rational expectations, provided they are defined in a manner consistent with the economy’s effective state – which need not necessarily be the general equilibrium one.
• There is no logical inconsistency between the Keynesian approach and Ricardian equivalence. While incorporation of Ricardian equivalence into the Keynesian models renders fiscal policy ineffective, it enhances the role of monetary policy in stabilizing the economy.

What is Ricardian equivalence? (See Handa 13.17 and above.)

• However, the spirit both of Keynes’ The General Theory and of Keynesian analyses, as well as their policy conclusions, runs counter to Ricardian equivalence. Therefore, while the Keynesian models can be modified to incorporate Ricardian equivalence, doing so is not consistent with the spirit of the Keynesian tradition.

What is the spirit of Keynes’ General Theory, Keynesian analyses, and their policy conclusions? How do these compare with the “spirit” of classical, neo-classical, monetarist, modern classical, and/or new classical views? What specifically accounts for the difference(s) or similarity?