The Federal Reserve has a dual mandate to:
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The Fed manages Inter-bank Interest Rates and Regulates Banks…but does it control money supply? PowerPoint PPT Presentation


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The Federal Reserve has a dual mandate to: Maintain stable prices (fight inflation/deflation) Maintain full employment (monetary policy to manage macroeconomic conditions). The Fed manages Inter-bank Interest Rates and Regulates Banks…but does it control money supply?. Monetary Policy.

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The Fed manages Inter-bank Interest Rates and Regulates Banks…but does it control money supply?

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The Federal Reserve has a dual mandate to:Maintain stable prices (fight inflation/deflation)Maintain full employment (monetary policy to manage macroeconomic conditions)


The Fed manages Inter-bank Interest Rates and Regulates Banks…but does it control money supply?


Monetary Policy

"Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output... A steady rate of monetary growth at a moderate level can provide a framework under which a country can have little inflation and much growth. It will not produce perfect stability; it will not produce heaven on earth; but it can make an important contribution to a stable economic society."

--Milton Friedman

The Bank [of Canada] gave it a college try, it really did. It just doesn't work that way.

--John Crow, former governor of the Bank of Canada, on implementing Friedman's theories;


What Is Monetary Policy?

  • Central bank (as representative of government) manipulation of the

    • money supply,

    • interest rates

    • credit conditions

      with an objective of achieving macroeconomic goals.


Monetarist Theory History – The Classical School Strikes Back at Keynesianism


Three Theories of Monetary Policy

  • Strict Monetarist

  • Neo-classical/New Keynesian

  • Modern Monetary Theory (MMT)


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

  • Identity: Must be true for any period of time


Both Monetarist and Neo-Classical/New Keynesian Theories:

  • Trade-off between unemployment and inflation exists

  • Controlling Inflation is higher priority


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

Money supply is ‘exogenous’

  • more bank reserves —>

  • more lending by banks –>

  • increased money supply –>

  • lower interest rates –>

  • borrowing by consumers/firms –>

  • more C and I spending –>

  • faster GDP growth & inflation


Interest rates concept: (Neoclassical version)

  • central bank open market purchases of bonds –>

  • higher bond prices = lower interest rates –>

  • more borrowing by consumers/firms –>

  • more spending on C and I –>

  • faster GDP growth –>


But, the 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

  • 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.

    • assume V is constant

  • Conclusions:

    • Money supply growth is solely responsible for determining Inflation


‘Crowding Out’ Theory

  • Assumptions:

  • Fixed amount of money in economy

  • QTM holds true

  • Theory: Gov borrowing takes $ away/raises interest rate for firm and household borrowers –> will reduce C and I unless

  • Central Bank increases M to fund deficit  inflation

  • Absolutely not supported by evidence or data in modern real world.


Current Neoclassical and New Keynesian Views on monetary policy

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


Modern Monetary Theory (MMT)

  • Money growth (M1 – bank credit) is largely endogenous

  • Key is base money growth, not M1

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


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

  • Deficits effective in fighting unemployment

    • no financing constraint on deficits

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

  • Inflation threat is at/near full employment is reached (AD- LRAS model)


Limitations of Monetary Policy: ‘Pushing on string’

  • Central bank cannot force banks to make loans


Limitations of Monetary Policy: Endogenous money supply

  • Banks, not central bank really determine supply of money and credit


Limitations of Monetary Policy: Fiscal Policy Coordination

  • Fiscal and Monetary policy could work at cross-purposes

  • could expect ‘other’ to do it


Limitations of Monetary Policy: Liquidity trap

  • At ‘zero lower bound’

    • when interest rates approach zero but the economy is still weak, monetary policy is largely ineffective.


Limitations of Monetary Policy: Globalization

  • If interest rates too low or inflation too high, then value of currency drops –> capital inflow drops and M drops, even though X rises


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