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1 The Equation of Exchange –The formula indicating that the number of monetary units times the number of times each unit is spent on final goods and services.

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Presentation on theme: "1 The Equation of Exchange –The formula indicating that the number of monetary units times the number of times each unit is spent on final goods and services."— Presentation transcript:

1 1 The Equation of Exchange –The formula indicating that the number of monetary units times the number of times each unit is spent on final goods and services is identical to the price level times output (or nominal national income) MV PY Monetary Policy and Inflation: Quantity Theory of Money

2 2 Money, Real GDP, and the Price Level The equation of exchange states that the quantity of money (M) multiplied by the velocity of circulation (V) equals GDP, or MV=PY

3 3 Money, Real GDP, and the Price Level GDP equals the price level (P) times real GDP (Y), or: GDP = PY

4 4 The equation of exchange and the quantity theory: MV = PY M = actual money balances held by non-banking public V = income velocity of money; the number of times, on average, cash monetary units are spent on final goods and services Monetary Policy and Inflation : Quantity Theory of Money

5 5 The equation of exchange and the quantity theory: MV = PY P = price level Y = real national output (real GDP) Monetary Policy and Inflation : Quantity Theory of Money

6 6 The equation of exchange as an identity MV PY PY = nominal national income MV = nominal national spending Monetary Policy and Inflation : Quantity Theory of Money

7 7 Money, Real GDP, and the Price Level We can convert the equation of exchange into the quantity theory of money by making two assumptions: 1)The velocity of circulation is not influenced by the quantity of money. 2)Potential income is not influenced by the quantity of money.

8 8 Money, Real GDP, and the Price Level The Quantity Theory of Money –The quantity theory of money is the proposition that in the long run, an increase in the quantity of money brings an equal percentage increase in the price level. –This theory is based upon the velocity of circulation and the equation of exchange.

9 9 Money, Real GDP, and the Price Level The Quantity Theory of Money The velocity of circulation is the average number of times a dollar of money is used annually to buy goods and services that make up GDP.

10 10 Money, Real GDP, and the Price Level Make the quantity of money M, and the velocity of circulation V is determined by: V = PY/M

11 11 The Velocity of Circulation in the United States: 1930–1999

12 12 Money, Real GDP, and the Price Level This can be shown by using the equation of exchange to solve for the price level. P = (V/Y)M

13 13 Money, Real GDP, and the Price Level In the long run, real GDP equals potential GDP, so the relationship between the change in the price level and the quantity of money is:

14 14 Money, Real GDP, and the Price Level Dividing this equation by an earlier one, P = (V/Y)M, gives us

15 15 Money, Real GDP, and the Price Level This equation shows that the proportionate change in the price level equals the proportionate change in the quantity of money. This gives us the quantity theory of money: In the long run, the percentage increase in the price level equals the percentage increase in the quantity of money.

16 16 The crude quantity theory of money and prices –Assume: V is constant Y is stable MV = PY Monetary Policy and Inflation : Quantity Theory of Money

17 17 The crude quantity theory of money and prices –Increases in M must be matched by equal increases in the price level Monetary Policy and Inflation : Quantity Theory of Money MV = PY

18 18 Figure 17-5

19 19 Money Growth and Inflation in the United States

20 20 Money Growth and Inflation in the United States

21 21 Money Growth and Inflation in the World Economy

22 22 Money Growth and Inflation in the World Economy

23 23 Money, Real GDP, and the Price Level Historical Evidence on the Quantity Theory of Money –The data are broadly consistent with the quantity theory of money, but the relationship is not precise. –The relationship is stronger in the long run than in the short run.

24 24 Money, Real GDP, and the Price Level Correlation, Causation, and Other Influences The evidence shows that money growth and inflation are correlated.

25 25 Money, Real GDP, and the Price Level Correlation, Causation, and Other Influences This does not represent causation. Does money growth cause inflation, or does inflation cause money growth? Does some other factor cause inflation (deficit spending)?

26 26 Money, Real GDP, and the Price Level The AS-AD model predicts the same outcome as the quantity theory of money. It also predicts a less precise relationship between the quantity of money and the price level in the short run than in the long run.

27 27 Monetary Policy The ultimate goal of all macro policy is to stabilize the economy at its full- employment capacity. A government has three basic tools of monetary policy: –Reserve requirements –Open-market operations –Discount rates

28 28 Changes in the reserve requirements –An increase in the required reserve ratio Makes it more expensive for banks to meet reserve requirements Reduces bank lending –A decrease in the required reserve ratio Makes it more expensive for banks to meet reserve requirements Increases bank lending The Tools of Monetary Policy

29 29 Reserve Requirements A lower reserve requirement increases the size of the money multiplier. –The money multiplier is the number of deposit (loan) dollars that the banking system can create from $1 of excess reserves.

30 30 A Decrease in Required Reserves A change in the reserve requirement causes: –A change in excess reserves. –A change in the money multiplier.

31 31 The Impact of Reduced Reserve Requirement

32 32 The Monetary Base The government can control the monetary base which equals –currency in public circulation plus bank reserves.

33 33 The Monetary Base However, HKMA cannot control the amount of the monetary base that flows outside the country.

34 34 Open market operations –The HKMA changes reserves by buying and selling bonds. The Tools of Monetary Policy

35 35 Open Market Activity The HKMA purchases and sells government bonds to alter bank reserves. –By buying bonds HKMA increases bank reserves. –By selling bonds HKMA reduces bank reserves.

36 36 Determining the Price of Bonds Quantity of Bonds per Unit Time Period Price of Bonds Contractionary Policy Fed sells bonds Supply of bonds increases Bond prices fall D S1S1 P1P1

37 37 Determining the Price of Bonds Quantity of Bonds per Unit Time Period Price of Bonds D Figure 17-2, Panel (a) Contractionary Policy Fed sells bonds Supply of bonds increases Bond prices fall S1S1 S1S1 P1P1 P2P2

38 38 Determining the Price of Bonds Quantity of Bonds per Unit Time Period Price of Bonds Expansionary Policy Fed buys bonds Supply of bonds falls Bond prices rise D S1S1 P1P1

39 39 Determining the Price of Bonds Quantity of Bonds per Unit Time Period Price of Bonds D Expansionary Policy Fed buys bonds Supply of bonds falls Bond prices rise Figure 17-2, Panel (b) S1S1 S3S3 P1P1 P3P3

40 40 Relationship between the price of existing bonds and the rate of interest –What happens to the interest on a bond when the price of a bond increases? The Tools of Monetary Policy

41 41 Example –You pay $1,000 for a bond that pays $50/year in interest The Tools of Monetary Policy Rate of interest = $50 $1000 = 5%

42 42 Example –Now suppose you pay $500 for the same bond The Tools of Monetary Policy Rate of interest = $50 $500 = 10%

43 43 The market price of existing bonds (and all fixed-income assets) is inversely related to the rate of interest prevailing in the economy. The Tools of Monetary Policy

44 44 The Tools of Monetary Policy Changes in the discount rate Increasing the discount rate increases the cost of borrowed funds for depository institutions that borrow reserves Decreasing the discount rate decreases the cost of borrowed funds for depository institutions that borrow reserves

45 45 When the money supply increases people have too much money –How can this be? –Have you ever had too much money? Effects of an Increase in the Money Supply

46 46 If you have a savings account the answer is yes. We must distinguish between income and money Effects of an Increase in the Money Supply

47 47 Expansionary monetary policy: effects on aggregate demand, the price level, and real GDP Monetary policy can be used to move the economy to its full- employment potential. Tools of Monetary Policy

48 48 Monetary policy can generate increases in the equilibrium level of real GDP. Monetary Policy During Periods of Underutilized Resources

49 49 Expansionary Policy The HKMA can increase AD/AE by increasing the money supply by: –Lowering reserve requirements. –Dropping the discount rate. –Buying more bonds: it increases bank lending capacity.

50 50 Real GDP per Year ($ trillions) Price Level 0 AD LRAS SRAS The contractionary gap is caused by insufficient AD To increase AD, use expansionary monetary policy AD increases and real GDP increases to full employment Expansionary Monetary Policy with Underutilized Resources E1E1 Recessionary gap

51 51 Real GDP per Year ($ trillions) Price Level 0 AD 1 SRAS E1E1 Recessionary gap Expansionary Monetary Policy with Underutilized Resources Figure LRAS AD E2E2 The contractionary gap is caused by insufficient AD To increase AD, use expansionary monetary policy AD increases and real GDP increases to full employment

52 52 Exhibit 4: Expansionary Monetary Policy to Correct a Contractionary Gap

53 53 The net export effect –Impact of expansionary monetary policy increase the money supply interest rates fall value of the local currency falls net exports increase the net export effect complements the effectiveness of monetary policy by making greater income growth Open Economy Transmission of Monetary Policy

54 54 The net export effect –Impact of expansionary fiscal policy revisited larger deficit higher interest rates attracts foreign capital value of the local currency appreciates net exports fall net export effect reduces the effectiveness of fiscal policy by making smaller income growth Open Economy Transmission of Monetary Policy

55 55 Adding Monetary Policy to the Keynesian Model Quantity of Money Interest Rate MdMd MSMS r1r1 MSMS

56 56 Adding Monetary Policy to the Keynesian Model Quantity of Money Interest Rate MdMd r2r2 MSMS At lower rates, a larger quantity of money will be demanded Interest rate falls Figure 17-7, Panel (a) MSMS r1r1

57 57 Adding Monetary Policy to the Keynesian Model Planned Investment Interest Rate I r1r1 I1I1

58 58 Adding Monetary Policy to the Keynesian Model Planned Investment Interest Rate I The decrease in interest stimulates investment Figure 17-7, Panel (b) r1r1 r2r2 I1I1 I2I2

59 59 Real GDP per Year ($ trillions) Price Level 0 AD 1 SRAS Adding Monetary Policy to the Keynesian Model 10.0 LRAS 7.0 E1E1

60 60 Real GDP per Year ($ trillions) Price Level 0 AD 1 SRAS 10.0 LRAS The increase in investment shifts the AD curve to the right Adding Monetary Policy to the Keynesian Model AD 2 Figure 17-7, Panel (c) E2E2 9.5 E1E1

61 61 Figure 17-4 Contractionary Monetary Policy via Open Market Operations

62 62 The monetarists views of money supply changes –They are those Macroeconomists who believe that inflation is always caused by excessive monetary growth and that changes in the money supply affect AD both directly and indirectly Monetary Policy in Action: The Transmission Mechanism

63 63 The monetarists views of money supply changes –Increase in the money supply increases aggregate demand directly –Based on the equation of exchange, prices always rise when the money supply is increased Monetary Policy in Action: The Transmission Mechanism

64 64 Monetarists criticism of monetary policy –Time lags are too long to use monetary policy effectively –Monetary policy is seen as a destabilizing force Monetary Policy in Action: The Transmission Mechanism

65 65 Monetary Rule –A monetary policy that incorporates a rule specifying the annual rate of growth of some monetary aggregate –Example Increase in the money supply smoothly at a rate consistent with the economys long-run average growth rate measured in terms of NI % change Monetary Policy in Action: The Transmission Mechanism

66 66 What do you think? –What would happen to the effectiveness of the monetary rule if V is not stable? Monetary Policy in Action: The Transmission Mechanism

67 67 Price vs. Output Effects The success of monetary policy depends on the conditions of aggregate demand and aggregate supply.

68 68 Aggregate Supply The shape of the AS curve determines the effectiveness of expansionary monetary policy in raising output.

69 69 Aggregate Supply Horizontal AS output increases without any inflation/price change. Vertical AS inflation occurs without changing output. Upward sloping AS both prices and output are affected by monetary policy.

70 70 Aggregate Supply With an upward-sloping AS curve, expansionary policy causes some inflation and restrictive policy causes some unemployment.

71 71 Q1Q1 QFQF P1P1 Aggregate supply AD 3 AD 2 AD 1 (a) The Keynesian view RATE OF OUTPUT (real GDP per time period) PRICE LEVEL (average price per unit of output) 0 P3P3 Contrasting Views of AS

72 72 RATE OF OUTPUT (real GDP per time period) QNQN PRICE LEVEL (average price per unit of output) (b) The Monetarist view 0 P4P4 Aggregate supply AD 5 AD 4 P5P5 Contrasting Views of AS

73 73 Figure Two Views on the Strength of Monetary Changes

74 74 RATE OF OUTPUT (real GDP per time period) Q6Q6 PRICE LEVEL (average price per unit of output) (c) A popular view 0 P6P6 P7P7 AD 7 AD 6 Aggregate supply Q7Q7 Contrasting Views of AS

75 75 Policy Perspectives The shape of the aggregate supply curve spotlights a central policy debate.

76 76 Fixed Rules or Discretion? Should the government try to fine-tune the economy with constant adjustments of the money supply?

77 77 Fixed Rules or Discretion? Or should the government instead simply keep the money supply growing at a steady pace?

78 78 Discretionary Policy The economy is constantly beset by expansionary and recessionary forces. There is a need for continual adjustments to money supply.

79 79 Fixed Rules Critics of discretionary monetary policy raise objections linked to the shape of the AS curve. AS curve could be vertical or at least upward sloping.

80 80 Fixed Rules With an upward-sloping AS curve, too much expansionary monetary policy leads to inflation.

81 81 Fixed Rules Fixed rules for money- supply management are less prone to error than discretionary policy.

82 82 Fixed Rules The money supply should increase by a constant (fixed) rate each year equal to that of potential Y growth.


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