Ch. 14: Money and the Economy Del Mar College John Daly ©2003 South-Western Publishing, A Division of Thomson Learning

Money and the Price Level The Equation of Exchange is MV = PQ The money supply (M) multiplied by the Velocity (V) must be equal to the price level (P) times Real GDP (Q). Velocity is the average number of times a dollar is spent to buy final goods and services in a year.

The Equation of Exchange In a large economy such as ours, it is impossible to figure out how many times each dollar has changed hands. Velocity must be equal to GDP divided by the average money supply.

Interpreting the Equation of Exchange The money supply multiplied by velocity must equal the price level times Real GDP M x V  P x Q The money supply multiplied by velocity must equal GDP: M x V GDP Total spending or expenditures (measured by MV) must equal the total sales revenues of business firms (measured by PQ): MVPQ

From the Equation of Exchange to the Simple Quantity Theory of Money Fisher and Marshall assumed changes in velocity are so small that for all practical purposes velocity can be assumed to be constant. Fisher and Marshall assumed Real GDP is fixed in the short run. From these assumptions, we have the simple quantity theory of money: changes in M will bring about proportional changes in P.

The Simple Quantity Theory in an AD-AS Framework MV is equal to total expenditures. Total expenditures is equal to C+I+G+(EX-IM) Since MV=TE, MV=C+I+G+(EX-IM) A change in the money supply or a change in velocity will change aggregate demand and therefore lead to a shift in the AD curve. But, in the simple quantity theory of money, velocity is assumed to be constant.

The Simple Quantity Theory in an AD-AS Framework

Dropping the Assumptions that V and Q are Constant Remember: M x V  P x Q, then P = M x V Q Money supply, velocity, and Real GDP determine the Price Level. An increase in M or V or a decrease in Q will cause prices to rise. This is inflation. A decrease in M or V or an increase in Q will cause prices to fall. This is deflation.

Q & A If M times V increases, why does P times Q have to rise? What is the difference between the equation of exchange and the simple quantity theory of money? Predict what will happen to the AD curve as a result of each of the following: The money supply rises; Velocity falls; The money supply rises by a greater percentage than velocity falls; The money supply falls.

Monetarism: Key Views Velocity changes in a predictable way. Aggregate Demand depends on the money supply and on Velocity. The SRAS curve is upward sloping. The Economy is Self-Regulating (Prices and Wages are flexible)

Monetarism in an AD-AS Framework

The Monetarist View of the Economy The economy is self-regulating Changes in velocity and the money supply can change aggregate demand. Changes in velocity and the money supply will change the price level and Real GDP in the short run, but only the price level in the long run.

The Monetarist View of the Economy Changes in velocity are not likely to offset changes in the money supply. Changes in the money supply will largely determine changes in aggregate demand, and therefore changes in Real GDP and the price level. An increase in the money supply will raise aggregate demand and increase both Real GDP and the price level in the short run and increase the price level in the long run. A decrease in the money supply will lower aggregate demand and decrease both Real GDP and price level in the short run and decrease price level in the long run.

Q & A What do monetarists predict will happen in the short run and in the long run as a result of each of the following: Velocity rises; Velocity falls; The money supply rises; The money supply falls. Can a change in velocity offset a change in the money supply (on aggregate demand)? Explain your answer.

Inflation Inflation refers to any increase in the price level One shot inflation is a one time increase in price level. There are several theories on one-shot inflation:

One-Shot Inflation: Demand Side Induced

One-Shot Inflation: Supply-Side Induced

Continued Inflation From One-Shot Inflation Continued increases in aggregate demand cause continued increases in inflation, or continued inflation.

Changing One Shot Inflation Into Continued Inflation

What Causes Continued Increases In Aggregate Demand? The only factor that can change continually in such a way as to bring about continued increases in aggregate demand is the money supply. Money Supply is the only factor that can continually increase without causing a reduction in one of the four components of total expenditures: consumption, investment, government purchases, or net exports.

Q & A The prices of houses, cars, and television sets have increased. Has there been inflation? Is continued inflation likely to be supply-sided? Explain your answer. What type of inflation is Milton Friedman referring to when he says, “Inflation is always and everywhere a monetary phenomenon”?

Money and Interest Rates What economic variables are affected by a change in the money supply: Money & the supply of loans Money & the Real GDP Money & the Price Level They can also affect the expected inflation rate.

Money and Interest Rates Anything that affects either the supply of loanable funds or the demand for loanable funds will obviously affect the interest rate. A change in the interest rate due to a change in the supply of loanable funds is called the liquidity effect. When Real GDP increases, both the supply of and demand for loanable funds increase. The demand for loanable funds increases more than the supply of loanable funds, so that the interest rate rises. This change in interest rate is called the Income effect.

Money and Interest Rates, cont. When the price level rises, the purchasing power of money falls, and people may increase their demand for credit or loanable funds in order to borrow the funds necessary to buy a fixed bundle of goods. This change in the interest rate due to a change in the price level is called the price-level effect. An expected inflation rate increases the demand for loanable funds and decreases the supply of loanable funds, so that the interest rate is higher. This change in the interest rate is called the expectations effect.

The Interest Rate and the Loanable Funds Market

What Happens to the Interest Rate as the Money Supply Changes? A change in the money supply affects the economy in many ways: changing the supply of loanable funds directly, changing Real GDP and therefore changing the demand for and supply of loanable funds, changing the expected inflation rate, and so on.

The Nominal and Real Interest Rates Nominal interest rate is the interest rate that comes about through the interaction of the demand for and supply of loanable funds. The nominal interest rate may not be the true cost of borrowing because part of the nominal interest rate is a reflection of the expected inflation rate. The Real Interest Rate is equal to the Nominal Interest Rate minus the Expected Inflation Rate.

Q & A If the expected inflation rate is 4% and the nominal interest rate is 7%, what is the real interest rate? Is it possible for the nominal interest rate to immediately rise following and increase in the money supply? Explain your answer. “The Fed only affects the interest rate via the liquidity effect.” Do you agree or disagree? Explain your answer.

©2003 South-Western Publishing, A Division of Thomson Learning Ch. 15: Monetary Policy Del Mar College John Daly ©2003 South-Western Publishing, A Division of Thomson Learning

The Demand for Money The price of holding money balances is the interest rate. The interest rate is the opportunity cost of holding money. As the interest rate increases, the opportunity cost of holding money increases, and people choose to hold less money.

Supply and Demand for Money

Equilibrium in the Money Supply The money supply is not exclusively determined by the Fed because both the banks and the public are important players the money supply process. Equilibrium in the money market exists when the quantity demanded of money equals the quantity supplied.

Transmission Mechanisms The impact that changes in the money market have on the goods and services market and whether that impact is direct or indirect; and the routes and ripple effects created in the money market travel to affect the goods and services market are known as the transmission mechanism.

The Keynesian Transmission Mechanism The Money Market The Investment Goods Market The Goods and Services Market (AD-AS Framework) When the money supply increases, the Keynesian transmission mechanism works as follows: an increase in the money supply lowers the interest rate, which causes investment to rise and the AD curve to shift rightward. Real GDP increases and the unemployment rate drops.

The Keynesian Transmission Mechanism: Indirect

The Keynesian Mechanism May Get Blocked Some Keynesian economists believe that investment is not always responsive to interest rates. The Keynesian transmission mechanism would be short-circuited in the investment goods market, and the link between the money market and the goods and services market would be broken. Keynesians have sometimes argued that the demand curve for money could become horizontal at some low interest rate. This is called the Liquidity Trap.

Keynesian Transmission Mechanisms Because the Keynesian transmission mechanism is indirect, both interest insensitive investment demand and the liquidity trap may occur.

The Keynesian View of Monetary Policy

Bond Prices and Interest Rates As the price of a bond decreases, the actual interest rate return, or simply the interest rate, increases. The market interest rate is inversely related to the price of old or existing bonds. Consider the Liquidity Trap: the reason an increase in the money supply does not result in an excess supply of money at a low interest rate is that individuals believe bond prices are so high that an investment in bonds is likely to turn out to be a bad deal.

The Monetarist Transmission Mechanism: Direct In the Monetarist theory, there is a direct link between the money market and the goods and services market. An increase in the money supply means increased Aggregate Demand, Increased Real GDP, increased Prices and a decrease in unemployment. A decrease in the money supply means decreased Aggregate Demand, Decreased Real GDP, decreased Prices and an increase in unemployment.

The Monetarist Transmission Mechanism: Direct

Q & A Explain the inverse relationship between bond prices and interest rates. “According to the Keynesian transmission mechanism, as the money supply rises, there is a direct impact on the goods and services market.” Do you agree or disagree with this statement. Explain your answer. Explain how the monetarist transmission mechanism works when the money supply rises.

Monetary Policy and the Problem of Inflationary and Recessionary Gaps

Monetary Policy and an Inflationary Gap

Keynesians, Recession, and Inflation Most Keynesians believe that the natural forces of the market economy work much faster and more assuredly at eliminating an inflationary gap than a recessionary gap. Keynesians are more likely to advocate expansionary monetary policy to eliminate a stubborn recessionary gap than contractionary monetary policy to eliminate a not-so-stubborn inflationary gap. It has been argued that Keynesian monetary policy has an inflationary bias.

Monetary Policy and the Activist–Nonactivist Debate Activists argue that monetary and fiscal policies should be deliberately used to smooth out the business cycle. They are in favor of economic fine-tuning, which is the frequent use of monetary and fiscal policies to counteract even small undesirable movements in economic activity. Nonactivists argue against the use of deliberate fiscal and monetary policies. They believe the discretionary policies should be replaced by a stable and permanent monetary and fiscal framework and the rules should be established in place of activist policies.

The Case for Activist Monetary Policy The economy does not always equilibrate quickly enough at Natural Real GDP. Activist monetary policy works; it is effective at smoothing out the business cycle. Activist monetary policy is flexible; nonactivist monetary policy, which is based on rules, is not.

The Case for Nonactivist Monetary Policy In modern economies, wages and prices are sufficiently flexible to allow the economy to equilibrate at reasonable speed at Natural Real GDP. Activist monetary policies may not work. Activist monetary policies are likely to be destabilizing rather than stabilizing; they are likely to make matters worse rather than better.

Expansionary Monetary Policy and No Change in the Real GDP If expansionary monetary policy is anticipated, workers may bargain for and receive higher wage rates. It is possible that the SRAS curve will shift leftward to the degree that expansionary monetary policy shifts the AD curve rightward. Result: no change in Real GDP.

Monetary Policy May Destabilize the Economy In this scenario, the SRAS curve is shifting rightward, but Fed officials do not realize this is happening. They implement expansionary monetary policy, and the AD curve ends up intersecting SRAS2 at point 2 instead of SRAS1 at point 1’. Fed officials end up moving the economy into an inflationary gap and thus destabilizing the economy

Q & A Why are Keynesians more likely to advocate expansionary monetary policy to eliminate a recessionary gap than contractionary monetary policy to eliminate an inflationary gap? How might monetary policy destabilize the economy? If the economy is stuck in a recessionary gap, does this make the case for activist monetary policy stronger or weaker? Explain your answer.

Nonactivist Monetary Proposals A monetary rule describes monetary policy that is based on a predetermined steady growth rate in the money supply. Some economists would like the monetary rule to read as follows: The annual money supply growth rate will be constant at the average annual growth rate of the Real GDP. Others would like the monetary rule to read: The annual growth rate in the money supply will be equal to the average annual growth rate in Real GDP minus the growth rate in velocity. Some Monetary rule proponents claim that even if a monetary rule does not adjust for changes in velocity, there is little cause for concern.

A Gold Standard The money supply would be tied to the stock of gold. The government sets the price of gold at some dollar amount. The government promises to buy and sell gold at the official price. Critics charge that a gold standard is no guarantee against inflation. Critics also charge that a reduction in national output and an increase in unemployment will result if prices do not fall in the same proportion when the gold-backed money supply is reduced.

A Gold Standard

The Fed and The Taylor Rule There may be a middle ground between activist and nonactivist monetary policy. The Taylor Rule specifies how policy makers should set the target for the federal funds rate. Federal funds rate target = Inflation + Equilibrium real federal funds rate + ½ (Inflation Gap) + ½ (Output Gap)

Q & A Would a monetary rule produce price stability? Explain your answer. How would the gold standard (described in the text) work?