1 Monetary Theory and Policy CHAPTER 30 © 2003 South-Western/Thomson Learning

2 Demand for Money The demand for money refers to the relationship between how much money people want to hold and the interest rate Distinction between income and money Money is a stock and people express their demand for money by holding some of their wealth as money Income is a flow and people express their demand for income by selling their labor and other resources

3 Demand for Money The most obvious reason why people demand money is to carry out transactions The greater the value of transactions to be financed in a given period, the greater the demand for money  the greater the volume of exchange of goods and services as reflected by the level of real output, the greater the demand for money The demand for money also supports expenditures people expect to make in the course of normal economic affairs plus various unexpected expenditures Focus here is on money as a medium of exchange

4 Demand for Money Additionally, money serves as a store of value  people can store their purchasing power as money or in the form of other financial assets – stocks, bonds, etc When people purchase bonds and other financial assets, they are lending their money and are paid interest for doing so or are paid dividends or expect stock prices to yield gains

5 Demand for Money The demand for any asset is based on the flow of services it provides The big advantage of money is its liquidity  it can be immediately exchanged for whatever needs to be purchased By way of contrast, other financial assets must first be liquidated, or exchanged for money

6 Demand for Money Money, however, has one major disadvantage when compared to other financial assets Money held as currency or as travelers checks earns no interest and checkable deposits earn interest that is typically below that which could be earned on other financial assets  the interest forgone is the opportunity cost of holding money

7 Money Demand and Interest Rates When the market rate of interest is low, other things constant, the cost of holding money (liquidity) is low  people hold a larger fraction of their wealth in the form of money Conversely, when the market rate of interest is high, the cost of holding money is high  people hold less of their wealth in money and more in other financial assets Thus, other things constant, the quantity of money demanded varies inversely with the market interest rate

8 Supply of Money and Interest Rate The supply of money – the stock of money available in the economy at a particular time – is determined primarily by the Fed through its control over currency and over excess reserves The supply of money is shown in Exhibit 2 as a vertical line  the quantity of money supplied is independent of the interest rate

9 Interest Rates and Planned Investment Money affects the economy through changes in the interest rate Suppose the Fed believes the economy is operating below its potential output and decides to increase the money supply in order to stimulate output and employment by either Purchasing U.S. government securities Lowering the discount rate Lowering the reserve requirement

10 Summary The sequence of events in Exhibit 3 can be summarized as follows M   i   I   AD   Y  An increase in the money supply, M, reduces the interest rate, i. The lower interest rate stimulates investment spending, I, which leads to an increase in aggregate demand from AD to AD'. At a given price level, real GDP demanded increases. The entire sequence is traced out in Exhibit 3 by the movement from point a to b

11 Decrease in the Interest Rate Consider the effect of a Fed- orchestrated increase in interest rates This would be illustrated graphically by a movement from point b to point a in each of the panels in Exhibit 3 A decrease in the money supply would create an excess demand for money at the initial interest rate,  people will attempt to exchange other financial assets for money

12 Decrease in the Interest Rate These efforts to get more money result in an increase in the market interest rate which will increase until the quantity of money demanded declines just enough to equal the now-lower quantity of money supplied At the higher interest rate, businesses find it more costly to finance investment plans and households find it more costly to finance new homes

13 Decrease in the Interest Rate The resulting decline in investment leads to a magnified decrease in aggregate expenditures which in turn leads to a decline in aggregate demand As long as the interest rate is sensitive to changes in the money supply and as long as investment is sensitive to changes in the interest rate, changes in the supply of money affect planned investment

14 Adding Short-Run Aggregate Supply To determine the complete effects of monetary policy on the equilibrium level of real GDP we need the supply side An aggregate supply curve can help show how a given shift in the aggregate demand curve affects real GDP and the price level In the short run, the aggregate supply curve slopes upward  the quantity supplied will expand only if the price level increases

15 Adding Short-Run Aggregate Supply For a given shift of the aggregate demand curve, the steeper the short-run aggregate supply curve, the smaller the increase in real GDP and the larger the increase in the price level

16 Fiscal Policy with Money Previously we found that an increase in government purchases increases aggregate demand, leading in the short run to both a greater output and a higher price level However, once money enters the picture, we must recognize that an increase in either real output or the price level increases the demand for money since more money is needed for the additional spending

17 Fiscal Policy with Money For a given supply of money, an increase in the demand for money leads to a higher interest rate  reduces investment spending  that the fiscal stimulus of government purchases crowds out some investment This reduction in investment dampens the expansionary effects of fiscal policy  the simple spending multiplier overstates the impact arising from any given fiscal stimulus

18 Fiscal Policy with Money Likewise, monetary effects will temper any fiscal policy designed to reduce aggregate demand Suppose in an attempt to cool inflation, income taxes are increases, which reduces consumption  reduces aggregate expenditures and aggregate demand  equilibrium output and the price level fall in the short run  less money is needed to carry out transactions  demand for money declines

19 Fiscal Policy with Money So long as the supply of money remains unchanged, a decline in the demand for money leads to a lower interest rate which stimulates investment spending, to some extent offsetting the effects of higher taxes Thus, given the supply of money, the impact of changes in the demand for money on interest rates reduces the effectiveness of fiscal policy

20 Money in the Long Run The long-run view of money is more direct in that if the central bank supplies more money to the economy, people eventually spend more However, since long-run aggregate supply is fixed at the economy’s potential output, this greater spending simply increases the price level It is to this explanation that we now turn

21 Equation of Exchange Recall that one of the implications of the circular flow is that every transaction in the economy involves a two-way swap The seller surrenders for money, and the buyer surrenders money for goods One way of expressing this relationship among key variables in the economy is the equation of exchange

22 Equation of Exchange The basic version of the equation of exchange M x V = P x Y M is the quantity of money in the economy V is the velocity of money, or the average number of times per year each dollar is used to purchase final goods and services P is the price level Y is real national output, or real GDP Thus, the quantity of money in circulation multiplied by the number of times that money turns over equals the average price times real output  P times Y equals nominal GDP

23 Equation of Exchange By rearranging the equation of exchange, we would find that velocity equals nominal GDP divided by the money stock V = (P x Y) / M The velocity of money indicates how often each dollar is used on average to pay for final goods and services during the year

24 Equation of Exchange Given the value of total output and the money supply in 2001, each dollar was spent approximately 9 times on average to pay for final goods and services Classical economists developed the equation of exchange as a way of explaining the economy’s price level The equation of exchange is simply an identity  a relationship in such a way that it is true by definition

25 Quantity Theory of Money If velocity is relatively stable over time, or at least predictable, the equation of exchange turns from an identity into a theory – the quantity theory of money – which can be used to predict the effects of changes in the money supply on nominal GDP, P x Y For example, if M is increased by 5% and if V remains constant, then P x Y must also increase by 5%

26 Quantity Theory of Money How this increase in P x Y is divided between changes in the price level and changes in real GDP is not answered by the quantity theory of money The answer lies in the shape of the aggregate supply curve Recall that the long-run aggregate supply curve is vertical at the economy’s potential level of output

27 Quantity Theory of Money Thus, with output, Y, fixed, and the velocity of money, V, relatively stable or at least predictable, then an increase in the stock / supply of money translates directly into a higher price level

28 Velocity of Money Velocity depends on the customs and conventions of commerce The electronic transmission of funds takes only seconds  the same stock of money can move around much more quickly to finance many more transactions The velocity of money has also been increased by a variety of commercial innovations – wider range of charge accounts and credit cards – that have facilitated exchange

29 Velocity of Money Another institutional factor influencing velocity is the frequency with which workers get paid, e.g., the more often workers get paid, other things constant, the lower their average money balance so the more active the money supply  the greater the velocity The better money serves as a store of value, the more of it people want to hold so the lower its velocity –For example, during a period of inflation, money turns out to be a poor store of value  velocity increases with a rise in the inflation rate, other things constant

30 How Stable is Velocity? Between 1960 and 1980 M1 velocity increased steadily but in a rather predictable fashion However, during the 1980s, it bounced around in a rather unpredictable fashion During the last decade, more and more banks began offering money market funds that included check writing privileges and people began using their ATM or debit cards

31 How Stable is Velocity? Thus, M2 might provide a better perspective on the velocity of money The velocity of M2 has been much more stable However, even the M2 velocity became more volatile in the early 1990s Since 1993, the equation of exchange has been considered more of a rough guide linking changes in the money supply to inflation in the long run

32 Targets for Monetary Policy The principal implication of the preceding discussions is that monetary policy affects the economy largely by influencing the interest rate However, in the long run, changes in the money supply affect the price level, though with an uncertain lag Should monetary authorities focus on interest rates in the short run or the supply of money in the long run?

33 Contrasting Policies A growing economy needs a growing money supply to pay for the increase in aggregate output If monetary authorities maintain a constant growth in the money supply, and if velocity remains stable, the interest rate will fluctuate unless the growth in the supply of money each period just happens to match the growth in the demand for money

34 Contrasting Policies Alternatively, monetary authorities could try to adjust the money supply each period by the amount needed to keep the interest rate stable  changes in the money supply each period would have to offset any changes in the demand for money This is essentially what the Fed does when it holds the federal funds target constant

35 Contrasting Policies Interest rate fluctuations could be harmful if they created undesirable fluctuations in investment For interest rates to remain stable during economic expansions, the money supply would have to grow at the same rate as the demand for money Likewise, for interest rates to remain stable during contractions, the money supply would have to shrink at the same rate as the demand for money

36 Contrasting Policies That is, for monetary authorities to maintain the interest rate at some specified level, the money supply must increase during economic expansions and decrease during contractions However, an increase in the money supply during an expansion would increase aggregate demand even more, and a decrease in the money supply during a contraction would reduce aggregate demand even more  Fed adding more instability to the economy

37 Targets Between World War II and October 1979, the Fed attempted to stabilize interest rates During this period, Milton Friedman argued that this exclusive attention to interest rates made monetary policy a source of instability in the economy because changes in the money supply reinforced fluctuations in the economy  Fed should focus more on a steady and predictable growth in the money supply

38 Targets In October 1979, the Fed announced that it would de-emphasize interest rates and would instead target the growth in specific money aggregates with the result that the interest rate became more volatile In October 1982, the Fed announced in would again pay more attention to interest rates

39 Targets The rapid pace of financial innovations and deregulation during the 1980s made the definition and measurement of the money supply more difficult In 1987, the Fed announced it would no longer target M1 growth and switched to a M2 However, by the early 1990s, the link between M2 and nominal GDP had also deteriorated

40 Targets In recent years, under Alan Greenspan, the Fed has targeted the federal funds rate No central bank in a major economy now makes significant use of money aggregates to guide policy in the short run The Fed has less control over long-term interest rates