Tài chính doanh nghiệp - Chapter 5: Monetary theory and policy

Chapter 5Monetary Theory and PolicyFinancial Markets and Institutions, 7e, Jeff MaduraCopyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.1Chapter OutlineMonetary theoryTradeoff faced by the FedEconomic indicators monitored by the FedLags in monetary policyAssessing the impact of monetary policyIntegrating monetary and fiscal policiesGlobal effects of monetary policy2Monetary TheoryPure Keynesian TheoryOne of the most popular theories influencing the FedDeveloped by John Maynard KeynesSuggests how the Fed can affect the interaction between the demand for money and the supply of money to influence:Interest ratesThe aggregate level of spendingEconomic growth3Monetary Theory (cont’d)Pure Keynesian Theory (cont’d)Can be explained by using the loanable funds frameworkDemand for and supply of loanable funds determine the equilibrium interest rateThe business investment schedule illustrates the inverse relationship between interest rates on loanable funds and the level of business investment4Monetary Theory (cont’d)Pure Keynesian Theory (cont’d)Correcting a weak economyThe Fed would use open market operations to increase the money supply A higher level of the money supply would reduce interest ratesLower interest rates encourage more borrowing and spendingKeynesian philosophy advocates an active role for the government in correcting economic problems5Monetary Theory (cont’d)S2Correcting a Weak EconomyD1i2i1S1Demand and Supply of Loanable FundsBusiness Investment Schedulei1i2B1B26Monetary Theory (cont’d)Pure Keynesian Theory (cont’d)Correcting high inflationThe Fed would sell Treasury securities (decrease the money supply)A lower level of the money supply reduces the level of spendingLess spending slows economic growth and reduces inflationary pressure (demand-pull inflation)7Monetary Theory (cont’d)S1Correcting High InflationD1i1i2S2Demand and Supply of Loanable FundsBusiness Investment Schedulei2i1B2B18Monetary Theory (cont’d)Pure Keynesian Theory (cont’d)Effects of a credit crunch on a stimulative policyThe economic impact of monetary policy depends on the willingness of banks to lend fundsIf banks are unwilling to extend credit despite a stimulative policy, the result is a credit crunchA credit crunch can occur during a restrictive policy since some borrowers will not borrow because of the high interest rates9Monetary Theory (cont’d)Quantity Theory and the Monetarist approachThe quantity theory suggests a particular relationship between the money supply and the degree of economic activity in the equation of exchange:Velocity is the average number of times each dollar changes hands per yearThe right side of the equation is the total value of goods and services producedIf velocity is constant, a change in the money supply will produce a predictable change in the total value of goods and services10Monetary Theory (cont’d)Quantity Theory and the Monetarist approach (cont’d)An early form of the theory assumed a constant QAssumes a direct relationship between the money supply and pricesUnder the modern quantity theory of money, the constant quantity assumptions has been relaxedA direct relationship exists between the money supply and the value of goods and services11Monetary Theory (cont’d)Quantity Theory and the Monetarist approach (cont’d)Velocity represents the ratio of money stock to nominal outputVelocity is affected by any factor that influences this ratio:Income patternsFactors that change the ratio of households’ money holdings to incomeCredit cardsInflationary expectations12Monetary Theory (cont’d)Comparison of the Monetarist and Keynesian TheoriesThe Monetarist approach advocates stable, low growth in the money supplyAllows economic problems to resolve themselvesKeynesian approach would call for a loose monetary policy to cure a recession13Monetary Theory (cont’d)Comparison of the Monetarist and Keynesian Theories (cont’d)Monetarists are concerned about maintaining low inflation and are willing to tolerate a natural rate of unemploymentKeynesians focus on maintaining low unemployment and are willing to tolerate any inflation that results from stimulative monetary policies14Monetary Theory (cont’d)Theory of Rational ExpectationsHolds that the public accounts for all existing information when forming its expectationsSuggests that households and business will use historical effects of monetary policy to forecast the impact of an existing policy and act accordinglyHouseholds spend more with a loose monetary policy to avoid inflationBusinesses will increase their investment with a loose monetary policy to avoid higher costsLabor market participants will negotiate higher wages with a loose monetary policySupports the Monetarist view that changes in monetary policy do not have a sustained impact on the economy15Monetary Theory (cont’d)Which theory is correct?The FOMC recognizes the virtues and limitations of each theoryThe FOMC adjusts monetary growth targets to control economic growth, inflation, and unemploymentRecognizing the Monetarist view, the FOMC is concerned about the inflation resulting from a loose monetary policy16Tradeoff Faced by the FedIdeally, the Fed would like:Low inflationSteady GDP growthLow unemploymentThere is a negative relationship between unemployment and inflationPhillips curveA tight money policy can curb inflation but increase unemployment and vice versa17Tradeoff Faced by the Fed (cont’d)Impact of other forces on the tradeoffCost factors such as energy costs and insurance costs can influence the tradeoffWhen both inflation and unemployment are high, Fed members may disagree as to the type of monetary policy that should be implemented18Tradeoff Faced by the Fed (cont’d)Impact of other forces on the tradeoff (cont’d)How the Fed’s focus shifted during the Persian Gulf WarThere were numerous indications of a possible recession in the summer of 1990The abrupt increase in oil prices placed upward pressure on U.S. inflationHow the Fed’s emphasis shifted during 2001–2004The focus shifted from high inflation to the weak economy over timeFrom January to December 2001, the FOMC reduced the targeted federal funds rate ten timesIn 2002 and 2003, the Fed reduced the federal funds target rate twice19Economic Indicators Monitored by the FedIndicators of economic growthGross domestic product (GDP)Measures the total value of goods and services producedMeasured each monthThe most direct indicator of economic growthLevel of productionA high level indicates strong economic growth and can result in increased demand for labor20Economic Indicators Monitored by the Fed (cont’d)Indicators of economic growth (cont’d)National incomeThe total income earned by firms and individual employeesA strong demand for goods and services results in a large amount of incomeUnemployment rateDoes not necessarily indicate the degree of economic growthCan decrease in weak economic growth periods if new jobs are created21Economic Indicators Monitored by the Fed (cont’d)Indicators of economic growth (cont’d)Industrial production indexRetail sales indexHome sales indexComposite indexConsumer confidence surveys22Economic Indicators Monitored by the Fed (cont’d)Indicators of inflationProducer and consumer price indexesThe PPI measures prices at the wholesale levelThe CPI measures prices on the retail levelBoth indexes are used to forecast inflationAgricultural and housing price indexes also existOther indicatorsWages, oil prices, transportation costs, the price of gold, indicators of economic growth23Economic Indicators Monitored by the Fed (cont’d)How the Fed uses indicatorsThe Fed uses indicators to anticipate how economic conditions will change and then determines what monetary policy would be appropriateWeak economic conditions suggest an expansionary monetary policyHigh productivity and employment suggest a restrictive monetary policy24Economic Indicators Monitored by the Fed (cont’d)Index of Leading Economic IndicatorsThe Conference Board publishes indexes of leading, coincident, and lagging economic indicatorsLeading economic indicators are used to predict future economic activityThree consecutive monthly changes in the same direction suggest a turning point in the economyCoincident economic indicators reach their peaks and troughs at the same time as business cyclesLagging economic indicators tend to rise or fall a few months after business-cycle expansions and contractions25Lags in Monetary PolicyThe recognition lag is the lag between the time a problem arises and the time it is recognizedThe implementation lag is the lag between the time a serious problem is recognized and the time the Fed implements a policy to resolve itThe impact lag is the lag between the a policy is implemented and the time the policy has its full impact on the economy26Lags in Monetary Policy (cont’d)Lags hinder the Fed’s control of the economyBy the time a policy is implemented, economic conditions may have reversedWithout monetary policy lags, implemented policies would have a higher rate of success27Assessing the Impact of Monetary PolicyFinancial market participants will not all react to monetary policy in the same mannerDifferent securities are affected differentlyParticipants trading the same securities may still be affected differentlyExpectations about the policy’s impact on economic variables may differ28Assessing the Impact of Monetary Policy (cont’d)Forecasting money supply movementsPeriodicals sometimes specify the weekly ranges of M1 and M2 based on the Fed’s disclosure of target rangesWhen the actual money supply falls outside the target range, a change in the Fed’s range has not yet been publicly announcedImproved communication from the FedUncertainty about FOMC meeting results prior to 1999 caused volatile price movementsSince 1999, the Fed has been more willing to disclose its conclusions (federal funds rate target changes and possible future tightening or loosening of the money supply)29Assessing the Impact of Monetary Policy (cont’d)Forecasting the impact of monetary policyEven if market participants correctly anticipate changes in the money supply, they may not be able to predict future economic conditionsThe historic relationship between the money supply and economic variables has not been stableImpact of monetary policy across financial marketsMonetary policy affects the securities traded in all financial markets due to its effect on interest rates and economic growth30Integrating Monetary and Fiscal PoliciesThe Fed’s monetary policy is commonly influenced by the administration’s fiscal policiesThe Fed and the administration often use complementary policies to resolve economic problemsFiscal policy typically influences the demand for loanable funds, while monetary policy normally has a larger impact on the supply of loanable funds31Integrating Monetary and Fiscal Policies (cont’d)History Presidential administrations have been more concerned with maintaining strong economic growth and low unemploymentThe Fed shared the same concerns in the early 1970sBy 1980, there was high inflation and unemploymentThe administration cut taxes to stimulate the economyThe Fed used a tight monetary policy to reduce inflationThe Fed ultimately loosened the money supply in 198332Integrating Monetary and Fiscal Policies (cont’d)Monetizing the debtShould the Fed help finance the federal budget deficit that has been created from fiscal policy?Loosening the money supply in response to a higher budget deficit is called monetizing the debtIf the Fed does not monetize the debt, a weak economy may be more likelyIf the Fed monetizes the debt, higher money supply growth is required33Integrating Monetary and Fiscal Policies (cont’d)Market assessment of integrated policiesMarket participants must consider both fiscal and monetary policies when assessing future economic conditionsThe supply of loanable funds can be affected by the Fed’s adjustment of the money supply or changes in tax policiesThe demand for loanable funds is affected by changes in the money supply or government expenditures and possibly tax revisionsOnce the supply and demand for loanable funds has been forecasted, interest rate movements can be forecast34Global Effects of Monetary PolicyImpact of the dollarA weak dollar stimulates exports and discourages imports, which stimulates the economyThe Fed is less likely to use a stimulative monetary policy when the dollar is weakImpact of global economic conditionsWhen global economic conditions are strong, foreign countries purchase more U.S. products, which stimulates the U.S. economy35Global Effects of Monetary Policy (cont’d)Transmission of interest ratesUpward pressure on U.S. interest rates may be offset by foreign inflows of fundsA high U.S. budget deficit may lead to higher interest rates in other countriesGlobal crowding outFed policy during the Asian CrisisThe Fed may have lowered interest rates more than it would have without the crisisOffset the lower demand for U.S. exports and helped to sustain U.S. demand for foreign exports36