Monetary Theory and Policy

Monetary Theory and Policy

How Monetary Policy Affects Economy

Lags in Monetary Policy

n     Recognition lag

l      Most economic problems revealed by statistics, not observation

l      Fed quick to see changes in economy

n     Implementation lag

l      Fed acts quickly to implement change in monetary policy

l      Fiscal policy via Congress takes a long time

n     Impact Lag

l      Takes time for monetary changes to have full impact

l      Fiscal policy tax changes have unpredictable results

Tradeoff of Monetary Policy Goals

n     Goals of the Monetary Policy

l      Steady GDP growth

l      Low unemployment

l      Stable price levels

n     Tradeoffs

l      Lowering unemployment by stimulating the economy may increase inflation

l      Lowering inflation by slowing the economy may increase unemployment

Assessing the Impact of Monetary Policy

n     How does the policy change affect financial market participants?

l      Depends on the kinds of securities you trade

u   Value of bonds inversely related to interest rates

u   Value of stocks depends on expectations about how the changes affect on the economy

u   Value of foreign currencies inversely related to interest rates

Assessing the Impact of Monetary Policy

n     Financial market participants look at actual growth compared to Fed targets

l      Hires economists to assess impact on portfolios

l      Even if changes in the money supply are correctly anticipated, there are still problems

u   Not a stable relationship between money supply and economic variables over time

Integrating Monetary and Fiscal Policies

n     Combined monetary and fiscal policy effects

l      Fiscal policy usually has a larger influence on the demand for loanable funds

l      Monetary policy usually has a larger influence on the supply of loanable funds

n     “Monetizing” the debt

l      The Fed help finance a federal budget deficit created by fiscal policy

Global Effects on Monetary Policy

n     Impact of the U.S. dollar

l      Value of the dollar relative to other currencies can affect inflation

l      A weak dollar stimulates U.S. exports, discourages imports and stimulates the economy

l      A strong dollar stimulates imports and economic growth, and encourages capital flows into U.S. and lower interest rates

Global Effects on Monetary Policy

n     Transmission of interest rates

l      International flow of funds affected by Fed policy, and vice versa

l      Budget deficits or surpluses in the U.S. have global implications

u   “Global crowding out”

u   That’s why other countries can be very concerned with USA’s deficit!