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1、5,Monetary Theory and Policy,Chapter Objectives,Learn the well-known theories of monetary policyReview the tradeoffs involved in monetary policyLearn how analysts monitor and forecast Feds monetary policy,Monetary Policies,How does money affect the real economy?How does varying money supply growth i
2、mpact spending?How does monetary policy in the financial sector impact real economic sector investment and spending?,Keynesian Theory,Developed by John Maynard Keynes and his studentsInitially attempted to explain inadequacy of monetary policy during Great DepressionEffectiveness of monetary policy
3、depends upon the sensitivity (elasticity) of economy to changes in interest rates,Keynesian Theory, cont.,Advocates fiscal policyFocused on government deficit/surplus spending to impact economic activityMonetary policy transmitted slowly via bank credit policy and interest ratesA proactive economic
4、policy,Exhibit 5.3,a,a,$,$,Monetary Theories,Quantity theoryBased on equation of exchangeMV = PGQM =amount of money in the economyV =velocity, average number of times eachdollar changes hands during the yearPG =weighted average price level of goodsand services in the economyQ =quantity of goods and
5、services sold,Monetary Theories,Quantity theorys assumptionsPGQ is the total value of goods and services producedAssume V constant or predictablechanging M impacts total spendingM should grow at rate of output capacity, QFaster M growth increases PG or inflation,Monetary Theories,MonetaristsVelocity
6、 is affected byIncome levelsFrequency income is receivedUse of credit cardsInflationary expectationsVelocity changes found to be predictable and not related to fluctuations in money supply,Monetarist vs. Keynesian Theories,MonetaristLet economic problems resolve themselvesLow growth reduces borrowin
7、g and lowers interest ratesProblem: It takes time,KeynesianNeed to take action to lower interest ratesHigh money growth to fix a recession by lowering ratesProblem: Might ignite inflation,Monetarist vs. Keynesian Theories,MonetaristLow, stable growth in the money supplyFocus on maintaining low infla
8、tion and will tolerate what they call natural unemployment,KeynesianActively manage the money supplyWilling to tolerate inflation that helps reduce unemployment,Rational Expectations Theory,Households and businesses act in their own self-interestIndividuals anticipate effects of government policy ch
9、angesExpansionary monetary policy signals future inflation and interest rates increase (security prices fall)Rational expectations may nullify intended effects of monetary policy,Tradeoff of Monetary Policy Goals,Goals of the Monetary PolicySteady GDP growthLow unemploymentStable price levels Tradeo
10、ffsLowering unemployment by stimulating the economy may increase inflationLowering inflation by slowing the economy may increase unemployment,Economic Indicators Monitored by the Fed,Indicators of economic growthGross Domestic Product or GDPIndustrial productionNational incomeUnemployment Indicators
11、 of InflationProducer price indexesConsumer price IndexesOther indicators,Economic Indicators Monitored by the Fed,How the Fed uses indicatorsFed meets to decide course of monetary policyAssesses recent reports on indicators of growth and inflationUses indicators to anticipate how the economy will c
12、hangeDecides the appropriate monetary policy given possible conditions,Lags in Monetary Policy,Recognition lagMost economic problems revealed by statistics, not observationFed quick to see changes in economyImplementation lagFed acts quickly to implement change in monetary policyFiscal policy via Co
13、ngress takes a long timeImpact LagTakes time for monetary changes to have full impactFiscal policy tax changes have unpredictable results,Assessing the Impact of Monetary Policy,How does the policy change affect financial market participants?Depends on the kinds of securities you tradeDepends on you
14、r expectations about how the changes affect on the economyForecasting money supply movementsFinancial market participants look at actual growth compared to Fed targetsGrowth outside range could signal Fed policy changes,Assessing the Impact of Monetary Policy,Improved communication at the FedFed mor
15、e willing to disclose its intentions since 1999Immediate feedback to public and financial markets about “bias” on ratesMarket reaction to reported money supply levelsThursday release of money supply dataTry to determine future trends in interest rates,Assessing the Impact of Monetary Policy,Anticipa
16、ting reported money supply levelsSecurities and financial market professionals cannot profit on information available to all at the same timeTry to forecast and anticipate changesTrying to figure out the future course of interest rates and Fed policyMarket reaction to discount rate adjustment,Assess
17、ing the Impact of Monetary Policy,Market reaction to discount rate adjustmentMonitor changes to determine policySome changes are technical or intended to bring the discount rate in line with market ratesFinancial market participants try to anticipate changesDiscount rate seems to preceded market int
18、erest rate movements since 1980,Exhibit 5.9,a,Assessing the Impact of Monetary Policy,Forecasting the impact of monetary policyEven if financial market participants correctly anticipate changes in the money supply there are still problemsNot a stable relationship between money supply and economic va
19、riables over timeExamples include the relationship between economic growth and the money supply,Integrating Monetary and Fiscal Policies,HistoryExecutive branch usually most concerned with employment and growthFed and administration may differ on priorities of price stability or growth needs Agreeme
20、nt when inflation and unemployment are at relatively low levels,Exhibit 5.12,a,Integrating Monetary and Fiscal Policies,Combined monetary and fiscal policy effectsFiscal policy usually has a larger influence on the demand for loanable fundsMonetary policy usually has a larger influence on the supply
21、 of loanable fundsMonetizing the debtShould the Fed help finance a federal budget deficit created by fiscal policy?Forecasted surpluses, debt reduction, and U.S. Treasury securities,Integrating Monetary and Fiscal Policies,Market assessment of integrated policiesFinancial markets assess both fiscal
22、and monetary policyMarkets monitor a wide range of information and dataForecast how loanable funds supply and demand will change,Global Effects on Monetary Policy,Impact on the U.S. dollarValue of the dollar relative to other currencies can affect inflationA weak dollar stimulates U.S. exports, disc
23、ourages imports and stimulates the economyFed less likely to stimulate the economy if the dollar is weakStrong dollarStimulates imports and economic growthEncourages capital flows into U.S. and lower interest rates,Global Effects on Monetary Policy,Transmission of interest ratesInternational flow of
24、 funds affected by Fed policyGlobal capital and money markets are integratedCapital flows to highest real, after-tax, exchange-rate adjusted rate of returnFinancial integration improves withDecreased governmental regulation in marketsDecreased transaction costsImproved financial technologyDeficits o
25、r surpluses in the U.S. have global implications,Global Effects on Monetary Policy,Fed policy during the Asian crisisFed realizes the global economy is integratedU.S. economic conditions affect other countriesOther countries economic conditions affect the U.S.Fed reaction to Asian crisis shows possi
26、ble complications that result from economic integration,Forecasting Money Supply,Watch weekly federal reserve data releasesObserve changes with announced fed ranges of money growthMarkets attempt to estimate changes in monetary policy direction and . . .Anticipate interest rate changes,Global Effects on Monetary Policy,Exchange Rate LevelsInternational Funds FlowEconomic Activity of Foreign Countries,
