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Unit 25 — Monetary Policy

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Purpose:

To discuss the relationship between the money supply and economic growth and inflation, and to illustrate some of the reason why choosing the correct monetary policy is so difficult.

Objectives:

  1. Interest rates are affected by the supply and demand for money. The money supply is largely controlled by the Federal Reserve. The demand for money is affected by the level of GDP/GNP (transactions demand) and the level of interest rates.
  2. High interest rates can be due to either an increase in the demand for money or a decrease in the supply of money. Therefore, it is not always possible to determine the proper monetary policy by simply following a money supply rule.
  3. The Fed and other central banks around the world have had relatively good luck with inflation targeting—implicit for the Fed, explicit for some other central banks. Inflation has steadily fallen in the past couple of decades.
  4. Central banks have had less luck in controlling asset bubbles. The U.S. housing bubble of the 2000s is a case in point. By keeping interest rates “too low for too long,” the Fed allowed home prices to rise too much, setting the stage for the subprime crisis.

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Meet the Series Experts

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Milton Friedman

Milton Friedman

Winner of the 1976 Nobel Prize in Economics for “his achievements in the field of consumption analysis, monetary history, and theory, and for his demonstration of the complexity of stabilization policy.”

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Robert C. Holland

Robert C. Holland

Economist appointed to the Federal Reserve Board by President Richard Nixon in 1973, serving as Secretary to the Board of Governors from 1973 to 1976.

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Donald Kohn

Donald Kohn

Vice Chairman of the Board of Governors of the Federal Reserve System, 2006–2010, and Member of the Board of Governors, 2002–2008.

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Henry S. Reuss

Henry S. Reuss

U.S. Congressman from Wisconsin, 1955–1983, a staunch Democrat known for his progressive stands on a wide range of issues.

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Frederick H. Schultz

Frederick H. Schultz

Private Investor, owner of Schultz Investments, Vice Chairman of the Board of Governors of the Federal Reserve System, 1979–1982, and member of the Florida House of Representatives, 1963–1970.

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WHAT’S YOUR
ECONOMICS IQ?

  1. Many economists today agree that major recessions of the twentieth century can be traced to:

    the Fed's efforts to stem inflation by cutting the rate of growth of the money supply.

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  2. Monetarists tend to believe that the principal factor affecting business fluctuations is:

    variation in the quantity of money.

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  3. Assume that Economy X produces only one product: natural gas. Now suppose that the current money in circulation is $10,000 and that nominal NNP for the period is $40,000. Based on these figures, what is the current velocity of money?

    4

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  4. According to the classical view of the equation of exchange, which of the following two factors are constant?

    velocity and output.

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  5. The extent to which an increase in the money supply affects the price level depends MOST heavily on:

    the current level of employment.

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  6. The economic situation experienced by the country in the mid-1970s was different from that in preceding times mainly because:

    we faced high employment coupled with high inflation.

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