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Thus, some economists have suggested that the central bank should not just look at economic growth, inflation, and unemployment rates, but should also keep an eye on asset prices and leverage cycles. Such proposals are quite controversial. If a central bank had announced in 1997 that stock prices were rising “too fast” or in 2004 that housing prices were rising “too fast,” and then taken action to hold down price increases, many people and their elected political representatives would have been outraged. Neither the Federal Reserve nor any other central banks want to take the responsibility of deciding when stock prices and housing prices are too high, too low, or just right. As further research explores how asset price bubbles and leverage cycles can affect an economy, central banks may need to think about whether they should conduct monetary policy in a way that would seek to moderate these effects.

Let’s end this chapter with a Work it Out exercise in how the Fed—or any central bank—would stir up the economy by increasing the money supply.

Calculating the effects of monetary stimulus

Suppose that the central bank wants to stimulate the economy by increasing the money supply. The bankers estimate that the velocity of money is 3, and that the price level will increase from 100 to 110 due to the stimulus. Using the quantity equation of money, what will be the impact of an $800 billion dollar increase in the money supply on the quantity of goods and services in the economy given an initial money supply of $4 trillion?

Step 1. We begin by writing the quantity equation of money: MV = PQ. We know that initially V = 3, M = 4,000 (billion) and P = 100. Substituting these numbers in, we can solve for Q:

MV  =  PQ 4,000 × 3  =  100 × Q Q  =  120

Step 2. Now we want to find the effect of the addition $800 billion in the money supply, together with the increase in the price level. The new equation is:

MV  =  PQ 4,800 × 3  =  110 × Q Q  =  130.9

Step 3. If we take the difference between the two quantities, we find that the monetary stimulus increased the quantity of goods and services in the economy by 10.9 billion.

The discussion in this chapter has focused on domestic monetary policy; that is, the view of monetary policy within an economy. Exchange Rates and International Capital Flows explores the international dimension of monetary policy, and how monetary policy becomes involved with exchange rates and international flows of financial capital    .

The problem of the zero percent interest rate lower bound

In 2008, the U.S. Federal Reserve found itself in a difficult position. The federal funds rate was on its way to near zero, which meant that traditional open market operations, by which the Fed purchases U.S. Treasury Bills to lower short term interest rates, was no longer viable. This so called “zero bound problem,” prompted the Fed, under then Chair Ben Bernanke, to attempt some unconventional policies, collectively called quantitative easing. By early 2014, quantitative easing nearly quintupled the amount of bank reserves. This likely contributed to the U.S. economy’s recovery, but the impact was muted, probably due to some of the hurdles mentioned in the last section of this module. The unprecedented increase in bank reserves also led to fears of inflation. As of early 2015, however, there have been no serious signs of a boom, with core inflation around a stable 1.7%.

Key concepts and summary

Monetary policy is inevitably imprecise, for a number of reasons: (a) the effects occur only after long and variable lags; (b) if banks decide to hold excess reserves, monetary policy cannot force them to lend; and (c) velocity may shift in unpredictable ways. The basic quantity equation of money is MV = PQ, where M is the money supply, V is the velocity of money, P is the price level, and Q is the real output of the economy. Some central banks, like the European Central Bank, practice inflation targeting, which means that the only goal of the central bank is to keep inflation within a low target range. Other central banks, such as the U.S. Federal Reserve, are free to focus on either reducing inflation or stimulating an economy that is in recession, whichever goal seems most important at the time.


All other things being equal, by how much will nominal GDP expand if the central bank increases the money supply by $100 billion, and the velocity of money is 3? (Use this information as necessary to answer the following 4 questions.)

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Suppose now that economists expect the velocity of money to increase by 50% as a result of the monetary stimulus. What will be the total increase in nominal GDP?

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If GDP is 1,500 and the money supply is 400, what is velocity?

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If GDP now rises to 1,600, but the money supply does not change, how has velocity changed?

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If GDP now falls back to 1,500 and the money supply falls to 350, what is velocity?

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Tobin, James. “The Concise Encyclopedia of Economics: Monetary Policy.” Library of Economics and Liberty . Accessed November 2013. http://www.econlib.org/library/Enc/MonetaryPolicy.html.

Federal Reserve Bank of New York. “The Founding of the Fed.” Accessed November 2013. http://www.newyorkfed.org/aboutthefed/history_article.html.

Questions & Answers

Don't damend work in inflation
Mishael Reply
conceptand variable of macro economics
Bittu Reply
macro economics is the study of general factors in an economy.
what is fiscal policy?
fiscal policy refers to the use of government spending,taxation and borrowing to affect economic activity ,monetary policy on the other hand, entails the manipulation of interest rates.
A lots of thanks
you are welcome
Very informative talukder
yes Jafta
So scarcity will always be a problem, is something that can't be solved due to specialization of labor and choice?
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Kindly explain or give example of Voluntary unemployment.
when unemployment doesn't choose a accept job at wage of rate
Thanks Talukder
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I want someone to tell me everything about the inflation and and hyber inflation is plz
dot US Army higher South Korean citizen for the US base South Korea and pay them 50000 as a result
farzana Reply
What is production possibility frontier
adewale Reply
Production possibility frontier is a curve depicting all maximum output possibilities for two goods, given a set of inputs consisting of resources and other factors. The production possibility curve is frontir that all inputs are used efficiently.
what are some examples of a monetary policy?
Viccey Reply
expansionary policy contractionary policy
what is scarcity
van Reply
scarcity is like having so much of goods and services to access and you want them
how to calculate GDP
Gdp =c+I +nx +G
GDP=rent+interest+wages and salaries+profit
what are the assumptions of the marginal utility theory ?
GDPfc=GDI+stock dep-stock app+- residual errors
marginal cost and marginal benefits
Racheal Reply
what is unemployment
Nazer Reply
The total number of people in the labor force who are willing to work and actively looking for a job but cannot find one.
Heckchers Ohlin theory of International trade
Lal Reply
but if I may ask what brings this poverty in existence and how can such actions be deminish in our generation
Philemon Reply
Poverty comes from many factors, ranging from very low income for the households sector (purchasing power is low), basic needs such as safe drinking water, lack of sustainable development goals (roads, agriculture, technology, power, etc), business sector is poor, etc
Such action can be diminished by effectively and efficiently using the four (4) factors of production. Land, Labor , Capital and Technology.
Poverty - Increase in the cost of living without subsequent increase in the amount of minimum wage. Poverty can be reduced extremely if the minimum wage equals or equals more than the cost of living.
land labour capital and organisation factors of production
what are positive and normative statements
Alethia Reply
positive is realistic normative is imaginary
give basic idea about India's national income
Maloy Reply
what are the sources of recessions and booms
Zweli Reply
A few years ago, Ama paid $500 to put together a record collection. Today she sold her albums at a garage sale for $100. how does the same affect GDP?
teresa Reply
It saves time its creates more employment
Gold Reply
Scarcity means human wants exceeds the resources needed to satisfy them 1. Limited resources 2. Numerous human wants
Scarcity means shortage!!!
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What is mean by small open economy ?

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