Question

How effective is monetary policy? Answer this question from the perspective of (a) keynes, (b) the classical economists, (c) the monetarists and (d) modern money theory . How would you judge “ effectiveness”?

Answer 1

(A)

According to the Keynesian model,

• contractionary monetary policy is more likely to be effective than expansionary monetary policy because banks have no choice but to reduce loans when reserves fall, but they can maintain positive excess reserves; If the Fed acts to reduce bank reserves, banks may borrow reserves from the Fed on a temporary basis, but will have to contract their loan portfolios to avoid negative excess reserves.
• In the Keynesian model, monetary policy may be ineffective if interest rates do not fall or if investment spending does not increase.
• In the Keynesian model, monetary policy is effective when banks lower interest rates and increase lending.

Problems in Implementing Monetary Policy.

• Like fiscal policy, monetary policy is subject to lags.

• Monetary policy impacts a few sectors of the economy more heavily, rather than being spread evenly throughout the economy

Effective monetary policy increases bank reserves, which results inmore lending and more investment spending; If banks are willing to lend and businesses are willing to borrow, monetary policy has a significant impact on aggregate demand.

(B)

Classical Economists focus on Long-Run Adjustments in economic activity

• They assume that wages, prices, and interest rates are flexible
• As a result, labor, product, and capital markets are expected to adjust to keep the economy at full employment.

The Effect of Monetary Policy

• Classical economists believe that expansionary monetary policy only creates inflation
• Velocity is assumed to be fixed
• Output - is fixed at full employment
• As a result, any change in money supply will translate directly to a change in price

(C)

The Monetarists believe

• an increase in money supply will increase spending in the short run but leads only to inflation in the long run.

Associated with the work of Milton Friedman:

• -Consumption depends on income and wealth: permanent income hypothesis
• Monetarists believe that the crowding out effect makes fiscal policy ineffective

Monetarists MODEL

• An increase in money supply = higher output in the short run

(D)

Modern money theory

• our individual experience concerning our household budgets has no application to the government budget. We use the currency the government issues. Our individual experience about our own budgetsdoes not generate knowledge about the government budget yet, on a daily basis, we act as if it does.
• A household always has to consider its financial means. Common sense tells us that if we have "too much debt" then we can save and reduce that debt. But, whether public debt is problematic aside, if the government tries to "save" (another inapplicable conceptual transfer from the individual level) then public debt will probably rise.

Monetary Policy Summary: in the long run

• increases in money supply = inflation
• -Classical Economists believe this happens immediately, so monetary and fiscal policies are ineffective

• - Keynesians believe that in the short run, fiscal policy is effective

• - Monetarists believe that in the short run, monetary policy is effective.