MONETARY POLICY

CHAPTER 38 - LIPSEY
 THE CONTEXT OF
MONETARY POLICY
• Monetary policy has to change to suit
the environment in which it is
operating.
• It operates differently under different
types of exchange rate regimes.
THE GOLD STANDARD REGIME
Under a gold standard regime, there is no
need for government involvement in monetary
policy.
The money supply is determined by the
interaction of international flows of gold and the
domestic banking system.
Interest rates are determined by market
forces in the international markets for loans and
deposits
 FIXED EXCHANGE RATES REGIME

Fixed exchange rate regimes involve the use of

government-owned foreign exchange reserves
to buy and sell foreign exchange for domestic
currency, in order to influence the exchange
rate.
FLOATING EXCHANGE RATES REGIME

Under floating exchange rates, monetary

policy is responsible for determining the value
of the of both domestic price level and the
external exchange value.
ALTERNATIVE MONEY DEFINITIONS
FOR THE USA: M1, M2, M3
TECHNIQUES OF MONETARY CONTROL
MONEY SUPPLY & THE MONEY MULTIPLIER
Money Multiplier

M = [(b+1)/(b+x)] * H

M:money stock, H:monetary base, b:cash to

deposit ratio, x:reserve ratio
TECHNIQUES OF MONETARY CONTROL

Monetary authorities could control money

supply by influencing the monetary base, H
(high powered money) . This is done through
open market operations.
Money supply can be altered by changing the
required reserve ratio (x) of banks.
 FIG.38.3 Use of interest rates to
control banks assets

By changing the
interest rates, the
central bank can
influence the
demand for loans
and therefore the
money supply
 Fig 38.4 THE INTEREST RATE & AD

A shift in AD can be
achieved by changing
MS and letting i adjust or
by changing i and letting
MS adjust
 MONETARY TARGETS

• For monetarists, the goals of controlling

inflation and of minimizing monetary shocks
to the economy are both achieved by setting
and sticking to a target rate of growth of the
money supply.
 INTEREST RATE & MONEY STOCK
CONTROL

• If money demand is unstable, fixing the

interest rate insulates the economy from the
effects of these disturbances, while fixing the
money stock does not.
• Fixing the money supply is preferable if
instability originates in real expenditures.
FIG 38.6 –
money sock
and interest
rates with
volatile
money
demand
If money demand is unstable
then pegging MS will to
volatile i and AD, while
pegging i will avoid this
instability
 FIG 38.7 – money stock vs interest
rate control with a volatile IS curve
If the IS curve
exhibits instability,
pegging the money
stock will lead to
smaller fluctuations
in AD than will
pegging the interest
rate
 The costs & benefits of a single
currency for the EU
• The EU single currency proposal is compatible
with the continuation of distinctive bank notes
in member states . What matters is that those
notes be convertible into each other at a
known price, at no cost to the public.
• The main benefit is the reduction in
transaction costs for intra-EU trade and travel
and the enhanced efficiency of the price
mechanism
• The main cost is the loss of the possibility for
an independent monetary policy.