Early Keynesian View
Increasing M lowers the interest rate
Stimulating investment
Therefore increasing GDP
Marginal efficiency of investment (MEI) declines as I increases
Effect works indirectly through the interest rate

Early Monetarist View
Monetary injection upsets agents’ portfolio equilibria
People reallocate wealth away from money, into other assets
Stocks, bonds, capital, houses, driving up their prices, increasing GDP
Direct rather than indirect effect
No change in interest rate necessary
 

Stock & Bond Prices
Present value
PV = ?Rj/(1+i)j for j = 1 to + infinity
PV is the stock (or bond) price
Changes whenever expected R (return or dividend) changes, or whenever i changes
Stock prices are more volatile

Monetary Transmission & GDP
M??i??durables??GDP?
M??Pstocks&bonds??Wealth? ?C??GDP?
M??Portfolio liquidity??Likelihood of financial distress??durables??GDP?
M??Portfolio liquidity??Likelihood of financial distress??housing??GDP
M??i??I??GDP?

Monetary Transmission
Through OMO
M??Fed securities portfolio??Bank reserves??Bank lending??I??GDP?
 

Monetary Transmission
James Tobin’s q
q = (Market value of firms)/(Replacement cost of capital)
M??PStocks??Tobin’s q??I??GDP?
 

Adverse Selection & Moral Hazard
Adverse selection – worst managed enterprizes are most badly in need of loans & most likely to borrow
Moral hazard – the lower a firm’s net worth, the more likely it is to engage in risky behavior
M?? PStocks??Net worth??Adverse selection & moral hazard problems??Bank loans??I??GDP?
 

Monetary Transmission & NX
M??i??[FCU/$] E rate? (Dollar depreciates)?(NX = X – M)??GDP?