Ryan Smith Professor Schmidt

November 5, 2003 Wed Page Assignment

Introduction:

My topic focuses on the impact of monetary policy on our economy. We all know that our government controls the money supply and adjusts it according to the status of our economy, which can be measured in multiple ways. The measurement that my paper concerns is that of consumption. If consumption is high, then our economy is good. As a result, how effective are money supply adjustments in influencing our consumption?

Obviously, consumption is somewhat dependent on the money supply based on macroeconomics. I chose this topic to attempt to find a more precise answer to the question of how effective monetary policy is in stimulating consumption, instead of seeing the typical shift in the graphs with no monetary values attached. Therefore, consumption is my dependent variable and money supply is my primary independent variable. My hypothesis only assumes the impact of monetary policy to be greater than zero, although I am looking for a more precise numerical value. The value I found will be explained in the results.

Model:

The model that is of most relevance to this relationship between consumption and money supply is the aggregate supply and demand model, accompanied by the IS-LM model, which were the centers of macroeconomics. These models illustrate that an increase in the supply of money will increase demand, hence increasing consumption. These models also bring into play other independent variables such as interest rates, of which I included the prime rate and the federal funds rate, disposable income, GDP and inflation (inflation shows up as “realx” in my regressions where x depends on the variable that has been adjusted).

Data:

My regression included the following independent variables, in addition to money supply and the dependent variable consumption that I have already explained. Interest rates were necessary because the consumption theory states that whatever disposable income a person possesses, that money is either spent or saved. The percentage that goes towards savings depends on the amount of interest it will earn, therefore the interest rate can sway a consumer to save instead of spend or visa versa. Interest rates are displayed in percentages. Disposable income is mentioned above and is necessary in order to consume or save any amount of money, so this was also included as an independent variable. Both disposable income and consumption are represented in their actual monetary values in relation to the average income earned. GDP is another measurement of our economy’s status that I did not believe would harm my results; it is measured in billions of dollars as is money supply also. Lastly, inflation had to be accounted for because it could easily misconstrue the results of any macroeconomic tests over periods of time. All of these variables were found under the DRI database and imported through eviews.

Results:

Below is my final regression minus the explanation of how I arrived at it.

Dependent Variable: PERCENTC
Method: Least Squares
Date: 10/30/03 Time: 18:24
Sample(adjusted): 1960:2 2002:2
Included observations: 85 after adjusting endpoints
Variable	Coefficient	Std. Error	t-Statistic	Prob.
PERCENT$SUPPLY	0.134917	0.038019	3.548721	0.0007
PERCENTDISPINC	0.184961	0.065909	2.806304	0.0063
PERCENTGDP	0.499752	0.059603	8.384661	0.0000
FYPR	0.040834	0.018658	2.188575	0.0315
C	0.433742	0.210491	2.060621	0.0426
R-squared	0.833188	Mean dependent var		3.730312
Adjusted R-squared	0.824847	S.D. dependent var		1.208889
S.E. of regression	0.505935	Akaike info criterion		1.532207
Sum squared resid	20.47765	Schwarz criterion		1.675892
Log likelihood	-60.11880	F-statistic		99.89531
Durbin-Watson stat	1.478694	Prob(F-statistic)		0.000000

As you can see in the t-Statistics, the remaining independent variables have significance towards consumption. Only one variable was dropped, which was the federal funds rate, because of its insignificance in earlier regressions and because of the reality that the prime interest rate affects consumers more than the federal funds rate. Another note of importance is that money supply, disposable income and GDP were all adjusted for inflation, hence changed to real values, and then changed into the percent growths that you see in this regression. This was done to avoid the inherent problems of macroeconomic statistics because they grow over time. As a result, this final regression was most accurate.

Conclusions:

My hypothesis has been proven correct, which I had assumed in the beginning, that a change in money supply does increase consumption. How effective increasing the money supply is on stimulating consumption can be represented by the PERCENT$SUPPLY’s b₁ value that equals .134917. Thus, theoretically, a $1 increase in money supply will increase consumption by about $.13. The b₁ value that PERCENTDISPINC (disposable income) has is about .05 greater than the money supply. This makes sense because consumption is more easily stimulated when that money is actually in the hands of consumers in the form of disposable income. Simply increasing the money supply does increase consumption, but not as effectively because that money does not come in the same readily-able-to-spend form as disposable income.

One last test I would like to make would be to estimate the extreme of increasing the money supply. In other words, our government cannot continue to increase the money supply to stimulate consumption with no regard for inflation. So, where is that point where inflation ruins the attempt to stimulate consumption? This test should provide my project with a better perspective on the difficulties of monetary policy if there are evident dangers in expanding the economy too much.