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many graphs in the next few chapters. Most of them, how-
ever, repeat diagrams with which you are already familiar.
Our attention now turns from building a theory to using that
theory to address several important policy issues.
The next three chapters take up a trio of controversial
policy debates that surface regularly in the media: the de-
bate over the conduct of stabilization policy (Chapter 14),
the continuing debate over budget deficits and the effects of
fiscal and monetary policy on growth (Chapter 15), and the
controversy over the trade-off between inflation and unem-
ployment (Chapter 16).



| SUMMARY |
1. A central bank is bank for banks. lending policy to banks. But only open-market opera-
tions are used frequently.
2. The Federal Reserve System is America™s central bank.
There are 12 Federal Reserve banks, but most of the 5. The Fed increases the supply of bank reserves by pur-
power is held by the Board of Governors in Washington chasing government securities in the open market.
and by the Federal Open Market Committee. When it pays banks for such purchases by creating new
reserves, the Fed lowers interest rates and induces a
3. The Federal Reserve acts independently of the rest of the
multiple expansion of the money supply. Conversely,
government. Over the past 20 to 25 years, many coun-
open-market sales of securities take reserves from banks,
tries have decided that central bank independence is a
raise interest rates, and lead to a contraction of the
good idea and have moved in this direction.
money supply.
4. The Fed has three major monetary policy weapons:
open-market operations, reserve requirements, and its



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Chapter 13 275
Managing Aggregate Demand: Monetary Policy



6. When the Fed buys bonds, bond prices rise and interest 10. Monetary policy works in the following way in the Key-
rates fall. When the Fed sells bonds, bond prices fall and nesian model: Raising the supply of bank reserves leads
interest rates rise. to lower interest rates; the lower interest rates stimulate
investment spending; and this investment stimulus, via
7. The Fed can also pursue a more expansionary monetary
the multiplier, then raises aggregate demand.
policy by allowing banks to borrow more reserves, per-
haps by reducing the interest rate it charges on such loans 11. Prices are likely to rise as output rises. The amount of in-
(the discount rate) or by reducing reserve requirements. flation caused by expansionary monetary policy de-
pends on the slope of the aggregate supply curve. Much
8. None of these weapons, however, gives the Fed perfect
inflation will occur if the supply curve is steep, but little
control over the money supply in the short run, because it
inflation if it is flat.
cannot predict perfectly how far the process of deposit cre-
ation or destruction will go. The Fed can, however, control 12. The main reason why the aggregate demand curve
the interest rate paid to borrow bank reserves, which is slopes downward is that higher prices increase the de-
called the federal funds rate, much more tightly. mand for bank deposits, and hence for bank reserves.
Given a fixed supply of reserves, this higher demand
9. Investment spending (I), including business investment
pushes interest rates up, which, in turn, discourages
and investment in new homes, is sensitive to interest
investment.
rates (r). Specifically, I is lower when r is higher.


| KEY TERMS |
Monetary policy 261 Open-market operations 265 Federal Reserve lending to
banks 269
Central bank 263 Equilibrium in the market for bank
reserves 265 Discount rate 270
Federal Reserve System 263
Federal funds rate 266 Reserve requirements 270
Federal Open Market Committee
(FOMC) 264 Bond prices and interest Why the aggregate demand curve
rates 268 slopes downward 273
Central bank independence 264


| TEST YOURSELF |
1. Suppose there is $120 billion of cash and that half of this c. (More difficult) Now generalize this example. Let
cash is held in bank vaults as required reserves (that is, P be the price of the bill and r be the interest rate. De-
banks hold no excess reserves). How large will the velop an algebraic formula expressing r in terms of P.
(Hint: The interest earned is $1,000 2 P. What is the
money supply be if the required reserve ratio is 10 per-
percentage interest rate?) Show that this formula illus-
cent? 12 1„2 percent? 16 2„3 percent?
trates the point made in the text: Higher bond prices
2. Show the balance sheet changes that would take place if
mean lower interest rates.
the Federal Reserve Bank of New York purchased an office
building from Citigroup for a price of $100 million. Com- 5. Explain what a $5 billion increase in bank reserves will
pare this effect to the effect of an open-market purchase of do to real GDP under the following assumptions:
securities shown in Table 1. What do you conclude? a. Each $1 billion increase in bank reserves reduces the
3. Suppose the Fed purchases $5 billion worth of govern- rate of interest by 0.5 percentage point.
ment bonds from Bill Gates, who banks at the Bank of b. Each 1 percentage point decline in interest rates
America in San Francisco. Show the effects on the bal- stimulates $30 billion worth of new investment.
ance sheets of the Fed, the Bank of America, and Gates.
c. The expenditure multiplier is 2.
(Hint: Where will the Fed get the $5 billion to pay
d. The aggregate supply curve is so flat that prices do
Gates?) Does it make any difference if the Fed buys
not rise noticeably when demand increases.
bonds from a bank or an individual?
6. Explain how your answers to Test Yourself Question 5
4. Treasury bills have a fixed face value (say, $1,000) and
would differ if each of the assumptions changed.
pay interest by selling at a discount. For example, if a
Specifically, what sorts of changes in the assumptions
one-year bill with a $1,000 face value sells today for
would weaken the effects of monetary policy?
$950, it will pay $1,000 2 $950 5 $50 in interest over its
life. The interest rate on the bill is therefore $50/$950 5 7. (More difficult) Consider an economy in which govern-
0.0526, or 5.26 percent. ment purchases, taxes, and net exports are all zero, the
consumption function is
a. Suppose the price of the Treasury bill falls to $925.
What happens to the interest rate?
C 5 300 1 0.75Y
b. Suppose, instead, that the price rises to $975. What is
the interest rate now?



Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Part 3
276 Fiscal and Monetary Policy



and investment spending (I) depends on the rate of in- Find the equilibrium GDP if the Fed makes the rate of
terest (r) in the following way: interest (a) 2 percent (r = 0.02), (b) 5 percent, and (c) 10
percent.
I 5 1,000 2 100r


| DISCUSSION QUESTIONS |
1. Why does a modern industrial economy need a central 5.25 percent to 2.0 percent. How did the Fed reduce the fed-
bank? eral funds rate? Illustrate your answer on a diagram.
2. What are some reasons behind the worldwide trend 5. Explain why both business investments and purchases
toward greater central bank independence? Are there of new homes rise when interest rates decline.
arguments on the other side? 6. In the early years of this decade, the federal govern-
3. Explain why the quantity of bank reserves supplied nor- ment™s budget deficit rose sharply because of tax cuts
mally is higher and the quantity of bank reserves and increased spending. If the Federal Reserve wanted
demanded normally is lower at higher interest rates. to maintain the same level of aggregate demand in the
face of large increases in the budget deficit, what should
4. From September 2007 through April 2008, the Fed believed
it have done? What would you expect to happen to
that interest rates needed to fall and took steps to reduce
interest rates?
them, eventually cutting the federal funds rate from




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Licensed to:




The Debate over Monetary
and Fiscal Policy
The love of money is the root of all evil.
T H E N EW TE S TA M E N T

Lack of money is the root of all evil.
GEORGE BERNARD SHAW



U p to now, our discussion of stabilization policy has been almost entirely objective
and technical. In seeking to understand how the national economy works and
how government policies affect it, we have mostly ignored the intense economic and
political controversies that surround the actual conduct of monetary and fiscal policy.
Chapters 14 through 16 are precisely about these issues.
We begin this chapter by introducing an alternative theory of how monetary policy
affects the economy, known as monetarism. Although the monetarist and Keynesian the-
ories seem to contradict one another, we will see that the conflict is more apparent than
real. However, important differences do arise among economists over the appropriate
design and execution of monetary policy. These differences are the central concern of
the chapter. We will learn about the continuing debates over the nature of aggregate
supply, over the relative virtues of monetary versus fiscal policy, and over whether the
Federal Reserve should try to control the money stock or interest rates. As we will see,
the resolution of these issues is crucial to the proper conduct of stabilization policy and,
indeed, to the decision of whether the government should try to stabilize the economy
at all.




CONTENTS
DEBATE: SHOULD WE RELY ON FISCAL DIMENSIONS OF THE RULES-VERSUS-
ISSUE: SHOULD WE FORSAKE STABILIZATION
POLICY? OR MONETARY POLICY? DISCRETION DEBATE
How Fast Does the Economy™s Self-Correcting
VELOCITY AND THE QUANTITY THEORY DEBATE: SHOULD THE FED CONTROL THE
Mechanism Work?
OF MONEY MONEY SUPPLY OR INTEREST RATES?
How Long Are the Lags in Stabilization Policy?
Some Determinants of Velocity Two Imperfect Alternatives
How Accurate Are Economic Forecasts?
Monetarism: The Quantity Theory Modernized What Has the Fed Actually Done?
The Size of Government
FISCAL POLICY, INTEREST RATES, DEBATE: THE SHAPE OF THE AGGREGATE Uncertainties Caused by Government Policy
AND VELOCITY SUPPLY CURVE A Political Business Cycle?
Application: The Multiplier Formula Revisited
DEBATE: SHOULD THE GOVERNMENT ISSUE REVISITED: WHAT SHOULD BE DONE?
Application: The Government Budget
INTERVENE?
and Investment
Lags and the Rules-versus-Discretion Debate




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Licensed to:
Part 3
278 Fiscal and Monetary Policy



ISSUE: SHOULD WE FORSAKE STABILIZATION POLICY?
We have suggested several times in this book that well-timed changes in fiscal or
monetary policy can mitigate fluctuations in inflation and unemployment. For
example, when the U.S. economy sagged after the terrorist attacks in September
2001, both fiscal policy and monetary policy turned more expansionary. Con-
gress cut taxes and the Federal Reserve cut interest rates. These actions might be
called “textbook responses” to the threat of recession. Similarly, when the finan-
cial crisis of 2007“2008 threatened to throw the economy into recession, the Fed cut
interest rates again and the government enacted a large “stimulus package.” These pol-
icy decisions were all consistent with the lessons you have learned in Chapters 11 and 13.
But some economists argue that these lessons are best forgotten. In practice, they
claim, attempts at macroeconomic stabilization are likely to do more harm than good.
Policy makers are therefore best advised to follow fixed rules rather than use their best
judgment on a case-by-case basis.
Nothing we have said so far leads to this conclusion. But we have not yet told the
whole story. By the end of the chapter you will have encountered several arguments in
favor of rules, and so you will be in a better position to make up your own mind.




VELOCITY AND THE QUANTITY THEORY OF MONEY
In the previous chapter, we studied the Keynesian view of how monetary policy influences
real output and the price level. But another, older model provides a different way to look
at these matters. This model, known as the quantity theory of money, will be easy to under-
stand once we introduce one new concept: velocity.
Velocity indicates the
number of times per In Chapter 12, we learned that because barter is so cumbersome, virtually all economic
year that an “average transactions in advanced economies use money. Thus, if there are $10 trillion worth of
dollar” is spent on
transactions in an economy during a particular year, and there is an average money stock
goods and services. It
of $2 trillion during that year, then each dollar of money must have been used an average
is the ratio of nominal
of five times during the year.
gross domestic product
The number 5 in this example is called the velocity of circulation, or velocity for short,
(GDP) to the number
because it indicates the speed at which money circulates. For example, a particular dollar
of dollars in the money
stock. That is: bill might be used to buy a haircut in January; the barber might use it to purchase a
sweater in March; the storekeeper might then use it to pay for gasoline in May; the gas sta-
Nominal GDP

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