Monetary policy

Monetary policy

1. Monetary policy is more effective when the interest rate sensitivity of investment is large. Explain why. a) Refer to the IS-LM analysis in your answer. b) Also, refer to changes that take place in the bond and capital markets when the money supply grows.

a) A large elasticity (sensitivity) of investment demand to interest rates results in a flat IS curve because the interest rate parameter is in the denominator of the slope. Increasing the money supply reduces the intercept of the LM curve, shifting it to the right and increasing the equilibrium value of real GDP. The equilibrium value of GDP increases more for any given shift in the LM cure when the IS curve is flat (the policy is more effective when interest sensitivity of investment demand is high).
b) A money supply expansion makes more money available than is needed to purchase the existing level of aggregate production. The excess of money beyond what is needed for transactions is put in the bond market which pushes interest rates lower. The lower interest rates encourage additional investment. When investors are highly sensitive to interest rates, they will increase investment proportionally more for any given decline in interest rates than they will when interest rates are not an important factor in their investment decisions. Thus, greater sensitivity to interest rate changes by investors causes proportionally larger changes in GDP for any given increase in money supply.

2. Explain, from the Keynesian perspective, why the aggregate demand schedule is negatively slope. Your answer should both describe a) what happens in the IS-LM analysis (how does the equilibrium change when prices change) and b) what happens in markets when prices change.

An increase in the price level reduces the real money stock.
a) As a consequence, the LM schedule shifts up because the intercept of LM increases and the equilibrium interest rate rises. The rising interest rate reduces investment and the equilibrium level of real GDP. Thus, the rising price level is associated with falling real GDP.
b) A rising price level means that there is no longer enough money to finance transactions, so money is withdrawn from the bond market to pay for more expensive output. Reducing the supply of loanable funds pushes up the interest rate. The increase in the interest rate reduces investment and, therefore, aggregate demand for GDP.

3. Compare the aggregate supply schedule from the classical perspective with the aggregate supply schedule from the Keynesian view when money wages are flexible but do not change proportionally with price changes. a) Compare the informational and behavioral assumptions that underlie their difference in opinion. b) Explain how these different behaviors affect the slope of aggregate supply.

a) Classical economists assumed that workers and employers had good information (they knew workers’ productivity, the actual level of prices and the money wages earned by workers) and that everyone in the labor market makes rational decisions. Keynes argued that people do not know workers’ productivity and worker base their employment decisions on an expected price level that is not equal to the actual price level. Instead, workers focus on relative wages (what they are paid relative to other workers) and resist money wage cuts that reduce their relative pay. They form contracts to protect their pay in uncertain environments and these implicit and explicit contracts reinforce money wage rigidity.
b) Labor demand is reduced when prices fall. In the classical model, well-informed and rational workers accept money wage reductions that are proportional to the decline in prices. Employment and output are maintained at the full employment level. In the Keynesian model, workers resist money wage changes and labor supply does not fully adjust to falling labor demand caused by the decline in prices. Consequently, money wages fall less than proportionally (to prices) and the impact of decline in labor demand causes employment and real output to decline as well.
4. How did the monetary theories of Milton Friedman and John Keynes differ and what is the significance of their difference in opinion? (20 points)

Keynes believed that people held money for speculative purposes as a hedge against uncertainty. This money demand is inversely related to interest rates so that rising interest rates draws money into capital markets and provides the monetary foundation for additional aggregate demand (the effective velocity of money increases with rising interest rates). Consequently, aggregate demand can fluctuate without any change in the money supply provided by the central bank and commercial banks. Friedman believed that interest rates had little impact on the demand for money. He believed that following interest rates cause financial investors to exit bond markets but that they go into equities, durable goods and other income-earning assets rather than money. In his theory, rising interest rates do not increase aggregate demand (the velocity of money is inelastic with respect to interest-rates). In Friedman’s view, only changes in money supply initiated by the central bank can cause variations in aggregate demand.

5. What is the difference between adaptive expectations and rational expectations? (20 points)

Adaptive expectations occur when people learn over time and change their behavior in response to their experiences. For instance, people may not initially accept wage cuts during a recession. However, if high unemployment persists over a long period, they will eventual learn that they can protect their jobs by being flexible with respect to wage demands. Rational expectations occur when people take into consideration all available information, both past events, the history of government and business reaction to economic conditions and their own evaluation of the current economic climate. In this case, they do not just react to economic changes but anticipate events and react more rapidly to changing economic conditions.

 

 

6. Both Hayek and Keynes thought that uncertainty was the cause of business cycles, yet they came to different conclusions about what this meant. Briefly compare their perspectives and explain the significance of their differences. (20 points)

Keynes believed (along with Frank Knight) that uncertainty meant that the future was not knowable, even in a probabilistic sense. The strategies that people adopt in this environment lead to mistakes that reduce economic activity and require government intervention to correct. Hayek believed that knowledge is dispersed throughout the economy and, while no one person has more than a small fraction of the total information, can be revealed by interpersonal interchange and networking. Hayek believed that the prices in markets were a primary means for knowledge of economic conditions to be revealed and that government was as ignorant as individuals about the true nature of specific economic conditions. Hayek concluded that government intervention in economic activity thwarted the market mechanism (and price adjustments) that would eventually lead to a better understanding of economic conditions.
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