Thought experiment

1. Thought experiment • Imagine that money supply is doubled in the economy • It’s perfectly doubled in each place • Everybody knows this. • Information goes backwards. • Are there any real effects?

2. Quantity theory of money • Monetary effects, but no „real” effects • Changes in nominal magnitudes • Consumption and production should stay the same • Just as incomes of market participants • Interest rates should stay the same

3. Banking system vs. green fairy • New money is not ideally distributed • People have different knowledge • Money increases incomes at first in some places, and in others later on • Money goes into the economy through credit markets (lower interest rate)

4. Cantillon effects • Not all prices are effected to the same extent • Redistribution effects follow • The consumption/investment ratio is changed • The amount of capital has different value in the eyes of participants • Conclusion: money is not neutral

5. Equation of exchange (I. Fisher) • MV = PT • Money spent equals money received • Money supply multiplied by „velocity of circulation” • Average price and number of transactions

6. Actually the Germans were first again (Karl Heinrich Rau) • u is mittlere Umlaufszahl des Geldes (velocity) • g is Geldmenge (money supply) • p is Preisniveau (price level) • w is umgesetze Menge von Gütern und Leistungen (quantity of goods and services exchanged) • ug = wp

7. Monetarism and the business cycle • Cycles exists in the economy • Economy can fall below potential output • Economy can be stimulated into a boom (Phillips curve) • Solution: rules instead discretionary policies

8. Older monetarist program • Money supply should be constantly increased year by year • At the same pace as the economy grows • For example: 3-5% per year in order to achieve „price stability”

9. Assumptions of the monetarist model • Predictable policy is a good policy • Rules are better than discretion • Velocity is stable • Money supply can easily be measured • Can be controlled by the central bank • MOST IMPORTANT: Stable prices mean stability

10. Critique of the older monetarist program • Objective problems: velocity is not stable anymore • Money supply is not easily measured or controlled (financial innovation) • Stable prices might not mean stable economy (Japan 1980s, 1920s, 1990s USA) • In other words – CPI does not explain everything about economic activity

11. Quantity theory of money nowadays • The economic activity and prices are influenced by the money supply in the system • Hence monetary policy is the most important macroeconomic policy • Long run/Short run problem • Everybody and nobody is a monetarist

12. Fisher 1929 • Fisher in the end of 1920s believed that the economy had strong fundamentals • Prices were fine and were not overvalued • He used empirical analysis (past prices) • After the collapse he became a huge debtor until his death

13. Friedman in the 2004 • „At the moment, the fundamentals are rather well orientated. Inflation remains weak, and there is no sign of resumption in the increase of prices. Unemployment remains bearable. It went back up around 6 %, but it is a rate which, in the past, has been often observed, including in periods of prosperity. Quarter after quarter, productivity advances at a steady pace. There is no financial crisis. Banks are not in trouble. Our situation is rather good and the only thing which, in the course of the last few months, slowed down the situation is to be found - once again – in the uncertainties created by terrorist threat and the war in Iraq.” • CPI is not everything…