Economics Online Tutor
| Using Monetary Policy Tools to Achieve Policy Goals |
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| OTHER PAGES IN THIS SECTION: FISCAL & MONETARY POLICIES: MAIN PAGE FISCAL POLICY: AN OVERVIEW THE EFFECTIVENESS OF DISCRETIONARY FISCAL POLICY MONETARY POLICY TOOLS |
Alternative title for this page: The Relationship Between
the Money Supply, Output, and the Price Level
This is a continuation of the discussion that begins on the page entitled
"Monetary Policy Tools". The focus for this part of the discussion is on the
banking and monetary system of the United States, and the role of the Federal
Reserve System (the Fed).
The tools of monetary policy used by the Fed are designed to control the money
supply. But the goal of monetary policy is to influence the level of real output
(real GDP) and the price level. How does the money supply affect these primary
goals? The answer is that the size and growth of the money supply is an
intermediate target.
The relationship between the intermediate target of the money supply and the
goals of output and stable prices can be explained by showing how changes in
the money supply affect the aggregate demand / aggregate supply model.
Start with the demand for money. People hold money balances in order to pay
for transactions (the transaction demand for money); to be prepared for
emergencies (the precautionary demand for money); and as a hedge against
price changes in other financial assets (the speculative demand for money).
the Money Supply, Output, and the Price Level
This is a continuation of the discussion that begins on the page entitled
"Monetary Policy Tools". The focus for this part of the discussion is on the
banking and monetary system of the United States, and the role of the Federal
Reserve System (the Fed).
The tools of monetary policy used by the Fed are designed to control the money
supply. But the goal of monetary policy is to influence the level of real output
(real GDP) and the price level. How does the money supply affect these primary
goals? The answer is that the size and growth of the money supply is an
intermediate target.
The relationship between the intermediate target of the money supply and the
goals of output and stable prices can be explained by showing how changes in
the money supply affect the aggregate demand / aggregate supply model.
Start with the demand for money. People hold money balances in order to pay
for transactions (the transaction demand for money); to be prepared for
emergencies (the precautionary demand for money); and as a hedge against
price changes in other financial assets (the speculative demand for money).
The amount of money that people want to hold for these purposes depends on the interest rate and
nominal income. When interest rates increase, so does the value of holding assets that pay more in
income than money deposits. The opportunity cost of holding money increases. Therefore, an inverse
relationship exists between interest rates and the demand for money.
A direct relationship exists between nominal income and the demand for money. Money is needed to
finance transactions, and at higher nominal levels the value of transactions increases. Either the higher
nominal income will mean higher real income, in which case consumers will purchase more goods and
services in order to increase their standard of living; or higher nominal income will mean higher prices,
in which case consumers will spend more income for the same amount of goods and services.
A graph showing the demand for money will be a downward sloping curve with the interest rate on the
price (vertical) axis and the quantity of money demanded on the horizontal axis. As interest rates
change, the quantity of money demanded will move up and down the money demand curve. As nominal
income changes, the quantity of money demanded will change at every interest rate level, and the money
demand curve will shift.
The supply of money is controlled by the Fed. The money supply curve is a vertical line at the level of
the money supply set by the Fed. When the money demand curve and the money supply curve are
combined on one graph, equilibrium will be at the point where these two curves intersect. The
equilibrium quantity of money will be the quantity set by the Fed. The equilibrium interest rate will be the
interest rate where the money demand curve crosses the equilibrium quantity of money.
Finally, all of this information can be incorporated int the aggregate demand / aggregate supply model to
show the relationship between the money supply, output, and the price level.
Notice from the explanation that with different monetary policy tools, an inverse relationship exists
between the money supply and the interest rate. Also, an inverse relationship exists between the
interest rate and the level of private investment. Since private investment is a portion of aggregate
demand, a positive relationship exists between the money supply and aggregate demand.
The larger the money supply, the higher the aggregate demand. This relationship is what the Fed relies
on when it decides to use its monetary policy tools.
As aggregate demand increases, equilibrium real output (real GDP) increases and the equilibrium price
level increases. The magnitude of each increase is subject to debate, and depends on the slopes of the
aggregate demand and aggregate supply curves.
Some economic schools of thought argue that an increase in the money supply is mostly inflationary.
Other schools of thought argue that an increase in the money supply will mostly increase real output.
Evidence is unclear, but seems to suggest that an increase in the money supply becomes more
inflationary as equilibrium real GDP increases, and nears potential real GDP. This involves the
relationship between inflation and unemployment.
Also, large increases in the money supply in a short period of time can possibly cause a jolt to the
economy and become inflationary as well.
nominal income. When interest rates increase, so does the value of holding assets that pay more in
income than money deposits. The opportunity cost of holding money increases. Therefore, an inverse
relationship exists between interest rates and the demand for money.
A direct relationship exists between nominal income and the demand for money. Money is needed to
finance transactions, and at higher nominal levels the value of transactions increases. Either the higher
nominal income will mean higher real income, in which case consumers will purchase more goods and
services in order to increase their standard of living; or higher nominal income will mean higher prices,
in which case consumers will spend more income for the same amount of goods and services.
A graph showing the demand for money will be a downward sloping curve with the interest rate on the
price (vertical) axis and the quantity of money demanded on the horizontal axis. As interest rates
change, the quantity of money demanded will move up and down the money demand curve. As nominal
income changes, the quantity of money demanded will change at every interest rate level, and the money
demand curve will shift.
The supply of money is controlled by the Fed. The money supply curve is a vertical line at the level of
the money supply set by the Fed. When the money demand curve and the money supply curve are
combined on one graph, equilibrium will be at the point where these two curves intersect. The
equilibrium quantity of money will be the quantity set by the Fed. The equilibrium interest rate will be the
interest rate where the money demand curve crosses the equilibrium quantity of money.
Finally, all of this information can be incorporated int the aggregate demand / aggregate supply model to
show the relationship between the money supply, output, and the price level.
Notice from the explanation that with different monetary policy tools, an inverse relationship exists
between the money supply and the interest rate. Also, an inverse relationship exists between the
interest rate and the level of private investment. Since private investment is a portion of aggregate
demand, a positive relationship exists between the money supply and aggregate demand.
The larger the money supply, the higher the aggregate demand. This relationship is what the Fed relies
on when it decides to use its monetary policy tools.
As aggregate demand increases, equilibrium real output (real GDP) increases and the equilibrium price
level increases. The magnitude of each increase is subject to debate, and depends on the slopes of the
aggregate demand and aggregate supply curves.
Some economic schools of thought argue that an increase in the money supply is mostly inflationary.
Other schools of thought argue that an increase in the money supply will mostly increase real output.
Evidence is unclear, but seems to suggest that an increase in the money supply becomes more
inflationary as equilibrium real GDP increases, and nears potential real GDP. This involves the
relationship between inflation and unemployment.
Also, large increases in the money supply in a short period of time can possibly cause a jolt to the
economy and become inflationary as well.
| This concludes the section on fiscal and monetary policies. Return to home page |
| This page, along with additional commentary, was posted on the "Economics Online Tutor" Facebook page's timeline on September 14, 2012. |
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