Key Concepts and Summary

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.

Glossary

basic quantity equation of money

money supply × velocity = nominal GDP

excess reserves

reserves banks hold that exceed the legally mandated limit

inflation targeting

a rule that the central bank is required to focus only on keeping inflation low

velocity

the speed with which money circulates through the economy; calculated as the nominal GDP divided by the money supply