MONETARY POLICY

Can we maintain high-level employment and reasonably stable prices in a growing econ omy? The stakes are high, and the costs of failure are large.

To achieve these dual goals, aggregate demand must grow stably, just fast enough to take a growing high-employment output off the market at stable prices. Chapters 5—9 suggest that there is little reason to suppose the private economy on its own will generate just this amount of aggregate demand. Thus, we must turn to government for help in achieving the needed level of total spending.

Monetary policy (control over the money supply and interest rates) and fiscal policy (government spending and taxing) are the two main tools the government has to help keep aggregate demand growing stably. Monetary policy is the subject of this chapter, fiscal policy the subject of the next.

THE THEORY
OF MONETARY POLICY

Under the “gold standard” which prevailed in the western world during the century preceding ‘World W/ar II, the stock of money was largely controlled by an impersonal mechanism. The money supply increased and decreased when gold flowed in or out of a nation. But even in those days, many argued against leaving the supply of money solely to this mechanism. Instead, they argued, a “central bank” should be responsible for controlling the money stock in order to minimize inflations and depressions. The Bank of England is generally considered the forerunner of other central banks, and the “Old Lady of Threadnee.dIe Street” (as the Bank is often called) has played a significant part in influencing British monetary conditions for three centuries. The United States was one of the last major nations to establish a central bank. Our Federal Reserve was set up in 1914.1 But over the decades since, we have come to rely on Federal Reserve policy as one of our two big guns in the war against unemployment and inflation.

Monetary Policy, Interest Rates,
and the Money Stock

Chapters 5 to 9 provided the analytical foundation for monetary policy. If we want to increase or decrease aggregate demand, the central bank should increase or decrease M. Remember the main channels of effect.

The neo-Keynesian model suggests that more M may act only by increasing investment spending through reducing the rate of interest. Then the chain of effects runs like this:

+ M --> - r --> + I --> + G.N.P.

That is, an increase in M leads to a lower interest rate, which in turn leads to more investment, which in turn leads to a higher g.n.p. directly and through the multiplier. Or we could show the effects on a 45 degree diagram, like those in Chapter 6. Using Fig. 6-4 on page 67, the increased M and resulting lower interest rate would raise the level of investment, thus raising the C + I curve and increasing the equilibrium level of income.

Or more money may have a broader and more direct effect, as is argued by the portfoliobalancers. More M may lead not only to more investment through lower interest rates but also directly to more investment and consumption spending. This occurs because an increase in M will lower the marginal return on money relative to other assets, and will lead consumers and businesses to spend down their money balances, acquiring other assets (including both investment and consumer goods) instead.

What Is the Right Amount
of Money?

If total spending were a constant multiple of the stock of money (that is, if V were constant), then the task of monetary policy would be relatively simple. Determine the desired level of money g.n.p., and then move the stock of money up or down to obtain that desired level. But we know that the public’s demand for money balances varies, and that the V in MV = PT varies. Thus, to determine the right M to produce any desired level of aggregate money spending, we must take into account changes in the public’s demand for money balances. Figure 8-2 pictured the fluctuations in income velocity since 1900.

In a growing economy, the amount of money needed will gradually rise. Prima facie, we might expect the need for more money to grow apace with the growth in real output potential—say about 4 per cent a year. But just how fast M needs to grow in a growing economy will depend on how fast the public’s demand for money balances rises at full-employment levels.

The public’s demand for money balances depends on its level of income (or wealth) and on interest rates on money substitutes. The higher the income (or wealth) of the public, the larger, other things equal, will be the money balances it wishes to hold. The higher the interest rate on money substitutes, the lower will be the money balances it wishes to hold, because higher interest rates will lead people to shift their assets out of money (which yields no interest) into securities or other assets that do yield interest. Thus, for any level of aggregate demand we want to achieve, the right amount of M is that amount which the public desires to hold at that desired level of g.n.p. and at existing interest rates. More M than this amount will lead to higher spending than we want; less M will lead to lower spending.

The presumption that we need more M if we want a growing g.n.p. generally holds in the short run as well. The reasoning is familiar by now. But it may be useful to test it out by looking at an example which shows the interaction between M and government fiscal policy. Suppose that we want to raise aggregate demand to eliminate unemployment, and that to provide the stimulus we increase government spending without raising taxes. The rise in government spending will set off a multiplier effect on g.n.p., as desired. But the rising g.n.p. will also increase the public’s demand for money balances, and hence raise the interest rate unless M is increased so there will be more money to meet the growing demand. This higher interest rate will partially check the rising investment and g.n.p. Thus, if there is no increase in M, the expansionary fiscal policy will generate a higher interest rate which will partially offset, or limit, the expansionary multiplier effect of government spending on g.n.p.2 But if M is increased at the same time, this potential monetary drag can be avoided.

Summary: The right amount of money depends both on the desired level of aggregate demand (g.n.p.) and on the public’s demand to hold money balances at that level of g.n.p. and of interest rates. A rising g.n.p. without an increase in M will tend to raise interest rates and thus limit the growth in g.n.p. Thus, it is important that M grow gradually over the long pull and that monetary and fiscal policy be coordinated when we are trying to increase or decrease aggregate demand.