Holt 7525-9 S15_IT

c. The Federal Reserve System will face more inflationary pressures and more challenges
from populist politics than in recent years.
d. Countries will continue to face a trade-off; “…the greater the freedom to compete and the
stronger the rule of law, the greater the material wealth produced. But…the greater the
degree of competition…the greater the degree of stress and anxiety experienced by market
participants.”
Study Guide for Chapter 12
Chapter Summary for Chapter 12
Monetary policy is changes in the money supply to achieve macroeconomic goals. Monetary
policy can be used to try to move the economy toward Natural Real GDP.
Classical economists see a direct relationship between the money supply and the price level.
Velocity of money is the average number of times that a dollar is spent annually. Velocity is equal
to nominal GDP divided by the money supply.
The equation for velocity of money can be restated as the equation of exchange; money supply
times velocity equals price level times Real GDP. Classical theory assumes that velocity is
constant and that Real GDP is constant in the short run. Thus, there is a directly proportional
relationship between the money supply and the price level. Velocity of money has not proven to
be constant in the actual economy.
Monetarism is an economic theory based on classical theory, but with some differences; (1)
velocity is not constant, (2) a change in AD can be caused by a change in the money supply
and/or by a change in the velocity of money, and (3) changes in AD will change both the price
level and Real GDP in the short run. Like classical theory, monetarism holds that AD affects only
the price level in the long run.
Keynesian theory holds that changes in the money supply affect Real GDP through a series of
steps called the Keynesian monetary transmission mechanism. If the Fed wants to trigger an
increase in Real GDP, the steps in the Keynesian monetary transmission mechanism would be:
(1) An increase in the money supply leads to (2) a decrease in interest rates, which leads to (3)
an increase in investment, which leads to (4) an increase in Total Expenditures, which leads to
(5) an increase in Real GDP.
The Keynesian monetary transmission mechanism may fail due to; (1) investment may be
interest-insensitive, or (2) the liquidity trap (interest rates will only fall so low).
The monetarist transmission mechanism is more direct: an increase in the money supply means
increased Total Expenditures and Real GDP.
Monetary policy can be used to attempt to close a recessionary gap or an inflationary gap. To
close a recessionary gap, expansionary monetary policy (increase in the money supply) would be
used. To close an inflationary gap, contractionary monetary policy (decrease in the money
supply) would be used.
Keynesians support the use of both fiscal and monetary policy to improve economic stability, but
put more confidence in fiscal policy.
Monetarists are generally opposed to activist fiscal and monetary policies. Activist policies may
have a destabilizing effect on the economy. Most monetarists favor a monetary rule for monetary
policy. A monetary rule would link money supply growth to Real GDP growth to achieve a stable
price level.
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Monetary Policy 12 - 10