Money

A.9a) Keynesian monetary policy can stimulate the economy. This happens in a sequence of events. This will be elucidated in the following lines:
The Federal Reserve controls monetary policy. It can boost the economy through expansionary monetary policy. It can embark on a policy of open market purchases at a given price level. This will increase the nominal quantity of non-borrowed reserves in the banking system from NBR1 to NBR2. We know that the demand for total depository institution reserves depends negatively on the federal funds rate. The supply of total depository institution reserves is perfectly federal funds rate inelastic and is determined solely by the Federal Reserve. The rise or increase in nonborrowed reserves shifts the supply of total depository institution reserves to the right while the demand for total depository institution reserves remains the same. This induces a decline in the Federal Reserve funds rate.
Financial market traders will interpret the Federal Reserve’s policy actions as one that is intended to bring about a long-lasting reduction in the equilibrium federal funds rate, then the expectations theory of the term structure of interest rates indicates that the federal funds yield curve must shift downward as the expected federal funds rate for future days and weeks decrease. As long as the risk structure of interest rates remains unchanged, this also induces a downward shift in the treasury securities yield curve. Thus, the longer term interest rates relevant to business investment decisions decreases to r2.
The decline in longer-term interest rates has a huge impact. Desired investment spending is very sensitive and very elastic to interest rates. Thus, a drop in interest rates will lead to more demand for loans by businesses to invest in producer and consumer goods and will provide an incentive to individuals to consume more and save less and will fuel an increase in both transactions and speculative demand and also expansion of credit as more and more people will want to take loans to buy houses, cars or for getting education.
The increase in investment spending as well as consumption will lead to an increase in aggregate demand and a consequent increase in equilibrium real national output and national income. Exports will also be boosted by a fall in interest rates as goods can be exported cheaper. Thus, we will see a virtuous cycle in which the economy will be booming.
The classical economists and their modern incarnates who advocate the theory of rational expectations dispute the Keynesian monetary policy prescription. The rational expectations school believes that people (workers, consumers) are essentially rational and cannot be fooled. They believe that people generally do not experience money illusion.
However, there can be rare exceptions. They believe that in most circumstances people can anticipate the effects of monetary policy correctly. It is only in rare cases that they do not anticipate the effects of monetary policy. Keynesian monetary mechanism revives the economy only when people cannot anticipate the effects of monetary policy and experience money illusion and are fooled into thinking that their real wage has risen whereas their nominal wage has risen due to an increase in the price level while their real wage remains unchanged. All this is due to an increase in real non-borrowed reserves as the Federal Reserve embarks on open-market purchases bringing about decreases in federal funds rate, which later translates into a decrease in interest rates boosting investment, consumption and exports. All this increases aggregate demand and leads to an increase in the price level, which leads to an increase in the demand for labor and a nominal wage increase.
Workers get fooled into believing that their real wage has risen and therefore increase their supply of labor, thus increasing the supply of output. Thus, the economy is propelled forward when workers cannot anticipate the effects of monetary policy.
b) However, the new classical economists argue that in most cases Keynesian monetary policy will fail to revive the economy. They assert that people will not have money illusion and will correctly anticipate the effects of monetary policy. They are convinced that the only thing expansionary monetary policy by the Federal Reserve will do is that it will lead to inflation with no change in output and no change in employment. Thus, even the unemployment rate will be unaffected. The mechanism explained in the following lines will explain how Keynesian monetary policy will fail.
When the Federal Reserve engages in expansionary market operations then there is an increase in the supply of non-borrowed reserves to NBR2 that leads to a fall in the federal funds rate and later manifests itself as a drop in interest rates. The drop in interest rates boosts investment, consumption and exports thereby increasing aggregate demand leading to an increase in the price level as the classical economists believe that prices are always flexible and adjust quickly to market forces. Workers correctly predict the increase in price level. People therefore anticipate that their real wage will fall. Workers therefore cut back on the supply of labor to firms and thus output supply curve to firms decreases and shifts to the left and firms produce less output at the new price level P2 than what should have been produced. The output produced is the same as that in the previous lower price level. Thus, output does not change. There is only inflation. Thus, Keynesian monetary policy fails to revive the economy in this situation.

A.7 The development of an innovation like digital cash will affect the process of determining the quantity of money in circulation namely money supply. It will become imperative to redefine monetary aggregates. Digital cash will function as a medium of exchange and will thus be included in M1. M2 and M3 include M1 and thus will also incorporate digital cash.
Digital cash can be denoted as DC. M1 will now be expressed as a sum of currency (C), transactions deposits (D) and digital cash (DC). The public’s desired holdings of digital cash relative to transactions deposits can be denoted as dc, so DC = dc * D. Again C = c * D, where c is the holding of currency relative to transactions deposits. Thus, M1 can be written as:
M1 = C + D + DC
M1 = c * D + D + dc * D
M1 = D (c + 1 + dc)
M1 money multiplier = M1 / MB
= D (c +1 + dc) / (RR + ER + C)
= D (c + 1 + dc) / D (rrd + e + c)
= (c + dc + 1) / (rrd + e + c)
This expression indicates that other things being equal, the widespread use of digital cash – the addition of the factor dc and an increase in its value as more and more people adopt digital cash – increases the money supply M1 and the money multiplier M1 / MB. The inclusion of dc in the money multiplier raises the value of the numerator, thereby pushing up the value of the multiplier. This happens because if people hold digital cash on smart cards, personal computers or other devices, then an increase in reserves in the banking system induces an expansion effect on the volume of transactions deposits and consequently on transactions deposits.