1) What policy rule do monetarists believe the Fed should follow? What are the m
ID: 1181512 • Letter: 1
Question
1) What policy rule do monetarists believe the Fed should follow? What are the major assumptions underlying this policy prescription?
2) What average annual inflation rate would a monetarist expect if the Fed maintained a growth rate of M2 = 10% per year for a three year period? (Assume that the monetarist felt that the long run average growth rate of RGDP was 3%)
3) Why would you expect the velocity of circulation of a monetary aggregate such as M1 or M2 to rise during periods of high interest rates and to decline during periods of low interest rates?
4) Suppose that long term interest rates in the economy were increasing due to strong economic growth and demand for loans in the world economy. Meanwhile suppose that the Fed was holding down its federal funds rate target. What would probably be happening to M2 velocity? Explain your answer.
Explanation / Answer
1.
Monetarist believe that money plays a huge role in the economic unlike the classical theory where money plays no role in the economy because it assumes Velocity and Quantity is fixed.
There are two monetary policies Fixed Rules and Discretionary monetary policy (monetarist view)
- Fixed rules
keep growth of money at constant level
feds only change monetary policy when it is needed.
- discretionary monetary policy
Feds act at what is coming up therefore adjusts Money supply by increasing or decreasing.
removes instability of pro cyclical or anti cyclical events
fixed rules doesn't adjust for velocity which is highly volatile.
3.
periods of high interest rates means the fed is executing the Contractionary Policy-- meaning they are trying to control inflation by pulling dollars out of circulation. They also sell US treasury bonds and receive the payment in cash-- so, by removing dollars out of circulation, the "change of hands" (aka the velocity of money) for cash is decreased, so it slows down the velocity of money.
The very opposite occurs when the fed wants to encourage economic activity--called the Expansionary Policy-- when things are down, they lower the short term interest rate to encourage people and businesses to borrow. This means more cash is being spent by business and consumers, so money changes hands more quickly. Also, instead of selling US Treasury bonds, they BUY bonds and pay with cash--therefore, more money is put into circulation, and the velocity (or "change of hands" of money) of cash increases....this encourages economic growth.
With economic growth comes inflation, and then the fed once again decides whether to increase or decrease the interest rate. They are constantly doing this, because of the trade-off between ecnomic growth vs. controlling inflation in order to maintain a stable economy.
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