Question

According to Friedman Milton on his essay "The Role of Monetary Policy"

1. What is monetary policy?

2. Why can't monetary policy peg interest rates and the rate of unemployment for more than very limited time periods (long run)

3. What can the monetary policy do?

4. Explain the effects of rising income (liquidity preference schedule, demand for loans, prices)

5. What is the relationship between interest rates and the quantity of money

6. What is the similarity between Wicksell's statement and the Philips curve?

7. how should the monetary policy be conducted?

Please answer what you can in a detailed manner!

Answer 1

Q.1. Economy constantly undergoes a cyclical change. From Boom to recessions cycles go. To handle and correct output gaps in an economy. Government and central bank has two policies which are called fiscal and monetary policies respectively.

Recession is when real GDP growth is negative for six months. To avoid recession there should be enough aggregate demand in an economy. Aggregate demand should keep shifting right and it should be complemented by shift in aggregate supply as well so that economy potential goes up without inflationary impact on an economy.

This will be helped by both demand and supply side policies.

Demand side policies:

Fiscal policy is a policy controlled by the government and it has two tools: taxes and govt. spending. During recessions govt. decreases taxes and increases govt. spending which is called expansionary fiscal policy. During inflation govt. increases taxes and decreases govt. spending which is called contractionary fiscal policy.

Monetary policy is a policy determined by central bank and has two tools; interest rates and money supply. When there is inflation and central bank wants to reduce over consumption in an economy then it increases interest rates and decreases money supply. This is called as contractionary monetary policy. When there is recession and central bank wants to boost economic activity then it decreases interest rates and increases money supply. This is called as expansionary monetary policy.

Expansionary policies create more aggregate demand, decrease unemployment. It can be inflationary if all resources are fully used and there is no spare capacity.