Ec 123 Section 11 THIS SECTION –The Quantity Equation of Money –Case: The U.S. Financial Crisis of 1931 NEXT –National Income Accounting

Ec 123 Section 12 The Quantity Theory of Money The quantity equation of money relates the money in circulation (M) to the price level (P) and annual output (Q). MV  PQ V is known as the velocity of money. It is equal to the average number of times a dollar is used during the year. The quantity equation is an accounting identity (true by definition) but what you use for M (M1 or M2) can affect V number.

Ec 123 Section 13 Monetarism Monetarist's view of money's impact on economy can be represented in the quantity equation framework MV = PQ, Increases in V imply individuals and firms are less willing to hold cash. Opposite for decrease in V. Monetarists claim that, under normal circumstances, V is stable (or grows at predictable rate). Changes in V can be attributed to –financial innovation –change in interest rates

Ec 123 Section 14 Monetarism Big policy implication: If V is stable, then the only way to change nominal GDP (=PQ) is through changes in the money supply. In the long run, changes in M effect only the price level, P. BUT in the short run changes can effect both P and real income, Q, because it takes people time to adjust their decisions to changes in the money supply.

Ec 123 Section 15 The Fed: Institutional overview Federal Reserve System created in Decentralized power structure –12 Districts –New York has dominant position on FOMC Major responsibilities “…to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.” - Federal Reserve Act, 1913

Ec 123 Section 16 The Fed: Monetary Policy (Pre 1933) Real Bills Doctrine –40% of assets must be GOLD –Other assets must be “productive credit” Discount Window Borrowing –At the discretion of the regional Fed –Primary monetary policy tool What is the motivation for these policies? What is the cost of these policies?

The Fed’s Balance Sheet and the Real Bills Doctrine Ec 123 Section 17 GOLD Productive Loans Assets 40% Required Free Gold Currency in Circulation Liabilities Currency in Circulation Demand Deposits M1 Determined by multiplier Govt. Sec. GOLD Productive Loans Assets Govt. Sec. 40% Required Currency in Circulation Liabilities Currency in Circulation Demand Deposits M1 Determined by multiplier Currency in Circulation Demand Deposits M1 Determined by multiplier External GOLD drain Drop in M1 due to external drain Drop in M1 due to internal drain Internal drain due to increased leakages lowering the multiplier

Monetary policy tools available to the Fed (Pre 2008) Change reserve requirement ratio (hardly ever used) Change discount rate (sometimes) –Short term, secured loans to banks (1 day but now can be 30 days) –At a higher interest rate than the Fed Funds rate (lowered difference) –Negative Stigma associated with bank usage Open market operations (most commonly used today) 8Ec 123 Section 1

9 Open Market Operations

Ec 123 Section 110 The Fed’s experience during the 1920’s In response to a severe 1920 recession the Fed raised the discount rate to stem the loss of “free gold.” In the Fed’s view –the recession was caused by international forces beyond Fed control –recession “cleansed” the economy for vigorous expansion. In 1927, the Fed helped the U.K. back to a gold standard –used open market operations to expand the money supply –lead to higher inflation and lower interest rates –sterling pound appreciated relative to the dollar

Ec 123 Section 111 Changes in the money supply

Ec 123 Section 112 The role of money in causing the Great Depression

Ec 123 Section 113

Ec 123 Section 114

Ec 123 Section 115

Monetary policy tools available to the Fed (TODAY) Change reserve requirement ratio (hardly ever used) Change discount rate (sometimes) Open market operations (most commonly used today) Term Auction Facility –Auction for short term (30 day) secured loans to banks –Bidding starts at the Fed Funds interest rate. –First auction was December The kitchen sink…. 16Ec 123 Section 1

17 U.S. Financial Crisis of 1931: Summary The quantity equation of money is an accounting identity linking money to the larger economy. Monetarism implies that careful control of the money supply is sufficient to stabilize the economy (PQ). Money multiplier story. Fed doesn't set the money supply, but does have a heavy influence. The goals and organization of the Fed are critical to the conduct of monetary policy. One’s understanding of how the money supply influences the economy is crucial to the evaluation of monetary policy.