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Since monetarism is based on classical theory, it assumes that the economy is self-regulating
and automatically adjusts back to Natural Real GDP. The increases and decreases in Real GDP
caused by changes in AD will not last in the long run. Thus, like classical theory, monetarism
holds that AD affects only the price level in the long run.
Keynesian Monetary Theory
According to Keynesian theory, spending drives the economy. The level of Total Expenditures
determines the level of Real GDP. Monetary policy can be used to increase or decrease Total
Expenditures, in order to increase or decrease Real GDP. Keynesian theory holds that changes
in the money supply affect Real GDP indirectly, through a series of steps called the Keynesian
monetary transmission mechanism. If the Fed wants to trigger an increase in Real GDP, the Fed
would increase the money supply. 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 Fed conducts monetary policy. If the Fed wants to trigger an increase in Real GDP, the Fed
would buy U.S. government securities in the open market. This would cause an increase in the
money supply, beginning the steps in the Keynesian monetary transmission mechanism. If the
Fed wants to trigger a decrease in Real GDP, the Fed would sell U.S. government securities in
the open market. This would cause a decrease in the money supply, leading to an increase in
interest rates, a decrease in investment, a decrease in Total Expenditures, and a decrease in
Real GDP.
Failure of the Keynesian Monetary Transmission Mechanism
The Keynesian monetary transmission mechanism is indirect, with the money supply affecting
Real GDP through a series of steps. A failure may occur in this series of steps to break the link
between the change in the money supply and an eventual change in Real GDP. There are two
reasons why the Keynesian monetary transmission mechanism may fail:
1. Investment may be interest-insensitive. A decrease in interest rates will generally lead to an
increase in investment. But if investors are extremely pessimistic about the future investment
returns, they may be insensitive to a decrease in interest rates. And if a decrease in interest
rates does not increase investment, the change in the money supply has no effect on Real
GDP.
Example 4: In a severe recession, investors may be so pessimistic about future returns that an
interest rate near zero would still not induce them to borrow and invest.
2. The liquidity trap. The liquidity trap means that an increase in the money supply does not
cause a decrease in interest rates. Interest rates will only fall so low. Once they have fallen as
low as they will fall, an increase in the money supply has no effect on interest rates. And if an
increase in the money supply does not decrease interest rates, the change in the money
supply has no effect on Real GDP.
Example 5: In a severe recession, interest rates may fall to near zero percent. Once interest
rates have fallen to near zero percent, they cannot fall any lower. Savers are not going to be
willing to lend at an interest rate of zero percent, and they certainly are not going to be willing to
lend at a negative interest rate. Since December of 2008, the Federal Funds target rate has been
near zero percent. The Fed has resorted to quantitative easing to try to stimulate the economy.
See the appendix on quantitative easing in Chapter 11.
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Monetary Policy 12 - 4