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Chapter 12 Monetary Policy
The basic economic problem is scarcity. Human wants are unlimited. Resources are limited. The
basic goal in dealing with scarcity is to produce as much consumer satisfaction as possible with
the limited resources available. Achieving each of the three macroeconomic goals (price level
stability, full employment, and economic growth) will contribute toward reaching this basic goal.
The ideal quantity of total output is Natural Real GDP. Natural Real GDP is the quantity of total
output that results in the natural unemployment rate (full employment). The economy may
produce at Natural Real GDP, or may suffer from a recessionary gap or an inflationary gap. One
of the major tools that the federal government can use to try to move the economy out of a
recessionary gap or an inflationary gap and toward Natural Real GDP is fiscal policy. Fiscal policy
(see Chapter 9) is changes in government expenditures and taxation to achieve macroeconomic
goals. The other major tool that the federal government can use to try to move the economy
toward Natural Real GDP is monetary policy.
Monetary policy – changes in the money supply to achieve macroeconomic goals.
We saw in Chapter 11 that the Federal Reserve System controls the money supply. The Fed
conducts monetary policy. The Fed controls the money supply primarily through the use of open
market operations, which is buying (or selling) U.S. government securities in the open market.
When the Fed buys U.S. government securities in the open market, the money supply increases.
When the Fed sells U.S. government securities in the open market, the money supply decreases.
When the Fed changes the money supply, the overall economy (price level, Real GDP, and
unemployment rate) is affected. There are different theories about how changes in the money
supply affect the economy. In this chapter, we will examine classical monetary theory,
monetarism, and Keynesian monetary theory.
Classical Monetary Theory
Classical economists see a direct relationship between the money supply and the price level.
According to classical monetary theory, if the money supply increases by 10% in a short period of
time, the price level will increase by 10%. If the money supply decreases by 10% in a short period
of time, the price level will decrease by 10%.
To understand why this direct relationship between the money supply and the price level exists,
according to classical monetary theory, we must understand a measure called the velocity of
money.
Velocity of money (V) – the average number of times that a dollar is spent annually.
Velocity of money is calculated by dividing the dollar value of market transactions (nominal GDP)
by the money supply.
V = Nominal GDP ÷ M
(M is the money supply)
Example 1: In Year 1, nominal GDP was $16,000 billion and the average money supply was
$2,000 billion. The velocity of money was 8 ($16,000 billion ÷ $2,000 billion).
We can adjust the velocity formula to focus on the relationship between the money supply and
the price level. We multiply both sides of the equation by M. This restates the equation as:
M x V = NominalGDP
FOR REVIEW ONLY - NOT FOR DISTRIBUTION
Then we break nominal GDP into price level (P) and Real GDP (Q). This gives us an equation
known as the equation of exchange:
M x V = P x Q
12 - 1 Monetary Policy