Chapter 22 Quantity Theory of Money, Inflation, and the Demand for Money

Money Growth, Money Demand, and Monetary Policy How is inflation linked to money growth? The Quantity Theory of Money and the Velocity of Money

Inflation and Money Growth

Previous slide shows high rates of growth in money supply creates high inflation. To avoid sustained high inflation, central bank must watch money growth Something beyond just differences in money growth accounts for the differences in inflation across countries.

The Equation of Exchange: M x V = P x Y Nominal GDP = P x Y =Price level x Real Output Quantity of Money(M) x Velocity(V) = Nominal GDP M x V = P x Y These relationships are definitions

Money Growth + Velocity Growth = Inflation + Output Growth The Equation of Exchange – Dynamic Form

The Quantity Theory of Money (Irving Fisher) assume velocity is constant => %ΔV = 0 or at least stable Assume economy at full employment. Strong condition %ΔY = 0. Double M => Double P Inflation is a purely a monetary phenomenon (Milton Friedman). From the Equation of Exchange to the Quantity Theory of Money

Budget Deficits and Inflation Raise revenue by levying taxes or go into debt by issuing government bonds The government can also create money and use it to pay for the goods and services it buys

Budget Deficits and Inflation The government budget constraint: G = T + ∆B + ∆MB Deficit = G – T = ∆B + ∆MB reveals two important facts: –If the government deficit is financed by an increase in bond holdings by the public (∆B), there is no effect on the monetary base and hence on the money supply –But, if the deficit is not financed by increased bond holdings by the public, the monetary base and the money supply increase (∆MB)

Budget Deficits and Inflation the monetary base and the money supply increase (∆MB) Two cases – -The Treasury issues currency -Not allowed in US and many countries -Central bank OMO -Monetizing the debt Financing a persistent deficit by money creation will lead to sustained inflation

Is Velocity Stable? The Scale obscures the short-run movements in M2

Velocity of Money Substantial short-run fluctuations in M2 velocity. But the long-run trend is a modest increase from 1.72 to 1.82 over 45 years. Seems to have fallen apart.

Velocity of Money The data tend to confirm Fisher’s conclusion that in the long run (40 to 50 years) the velocity of money (M2) is stable However, central banker’s are concerned with inflation over quarters and the next few years. Velocity is volatile in the short-run as shown on the next chart.

Change in the Velocity of M1 and M2 from Year to Year, 1915–2008 To understand the velocity of money, must understand the demand for money.

Keynesian Demand for Money Two motives for holding money: Transactions demand Speculative or Portfolio demand

Transactions Demand for Money The quantity of money the public holds for transactions purposes depends on nominal income – P x Y the cost of holding money and the availability of substitutes As P and/or Y increase => money demand will increases As opportunity cost increases ( i ) => money demand will decrease

Transactions Demand for Money Higher i => higher opportunity cost of holding money => the less money individuals and businesses will hold for a given level of transactions => higher velocity of money. High inflation countries, the opportunity cost of holding money is high. M and V are increasing, so the increase in P is greater than the increase in M.

Inflation and Money Growth

Further Developments in the Keynesian Approach Baumol - Tobin model of Transactions demand The transaction component of the demand for money is negatively related to the level of interest rates – opportunity cost and availability of alternatives

Demand for Cash Balances in the Baumol- Tobin Model Income and spending are not synchronized Mismatch between the timing of money inflow to a household and the timing of money outflow for household expenses.

Income arrives only once a month, but spending takes place at a constant rate. Cash Balances in the Baumol-Tobin Model

Could decide to deposit entire paycheck ($1,200) into checking account at the start of the month and run balance down to zero by the end of the month. In this case, average balance would be $600. Cash Balances in the Baumol-Tobin Model

Alternatively, could also choose to put half paycheck into checking account and buy a bond with the other half of income. At midmonth, would sell the bond and deposit the $600 into checking account to pay the second half of the month’s bills. Following this strategy, average money holdings would be $300. Cash Balances in the Baumol-Tobin Model

Keynesian Portfolio or Speculative Demand for Money As a store of value, money provides diversification when held with a wide variety of other assets, including stocks and bonds Portfolio demand depends on Wealth the expected return relative to the alternatives expectations that interest rates will change in the future Risk Liquidity

Velocity is not constant! The procyclical movement of interest rates should induce procyclical movements in velocity. Interest rates   opportunity cost   Demand for money   velocity 

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Two criteria for the use of money growth as a monetary policy target: A stable link between the monetary base and the quantity of money: MB x m = M A predictable relationship between the quantity of money and inflation: M x V = P x Y Targeting Money Growth (MB x m) x V =P x Y

Possible explanation for the instability of U.S. money demand over the last quarter of the 20th century. Primary - The introduction of financial instruments that paid higher returns than money.

Most Central Banks use interest rates as their operating instrument Interest rates are the link between the financial system and the real economy While inflation is tied to money growth in the long run, interest rates are the tool policymakers use to stabilize inflation in the short run.