Money and Economy

1. Money and Economy Thus far… • Evolution of money and banks • Workings of commodity money • Determinants of the quantity of fiat money • Implementation of monetary policy Now… How do changes in the quantity of money affect ‘the economy?’

2. Money and the Economy Long-run: price level is ‘flexible’ → quantity of money affects prices, and does not affect output (this was the approach we used for the gold standard model). Short-run: price level is ‘fixed’ → quantity of money affects interest rates and output. And the transition: prices adjust gradually so the effect of money on output declines over time.

3. Long run: The Quantity Theory of Money M = nominal stock of money (say M2) P = aggregate price level (say CPI) Y = (flow) production of goods/output (say real GDP) V = velocity of money (average ‘turnover’ of dollars spent on GDP) =P·Y/M Equation of exchange (Irving Fisher): M·V = P·Y (= nominal GDP) Example: M = $10, P·Y=$25 → V = 2.5 US (M2) velocity fluctuates around 2: http://research.stlouisfed.org/publications/mt/page12.pdf

4. Long run: The Quantity Theory of Money Equation of exchange as a theory of the aggregate demand for money: Md = (1/V)·P·Y = k·P·Y Md/P = k·Y k = proportion of real income held as real money balances. If V = 2.5, k = 0.40 → 40% of real income held on average in real money balances

5. Long run: The Quantity Theory of Money Fundamental (theoretical) assumptions of the quantity theory of money. In the long-run: • k is independent of money supply (k). Depends on characteristics of payments system (e.g. are there ATMs?) • Y is independent of money supply, equal to its potential, or full-employment, level, Yf. Standard macro theory implies that output deviates from its potential only in short-run, when market prices are ‘rigid.’

6. Long run: The Quantity Theory of Money Ms = supply of money (determined by Fed, banks, non-bank public). Md = (nominal) demand for money (public) Ms = Md = M (equilibrium) M = k·P·Yf → P = M/(k·Yf) Implications: • P changes proportionately with changes in M (%∆M = %∆P); real money won’t change when Ms changes. • Changes in M are ‘neutral’: only nominal prices are affected, not real production. This proposition is accepted as a stylized fact; it has been understood at least since Hume in 1752.

10. Long run: The Quantity Theory of Money Why? Suppose M supply rises (e.g. Fed increases base). At the initial price level, people have ‘too much’ money because their demand has not changed. They dispose of excess real money by spending. In the long-run, such spending cannot affect output, so prices in all markets will be driven up.

11. Long run: The Quantity Theory of Money 1/P 1/P0 1/P1 Md = (P)kYf M M0 M1

12. Long run: The Quantity Theory of Money QT of M does not imply that only M causes changes in the price level. Assuming M is fixed: Yf↑→P↓: more output increases demand for money; if M constant, this comes about by a decrease in P as supply in markets exceeds demand. k↑→P↓: increase in real money demand can only come about by reduction in P. However, these changes in P are NOT inflation; they are changes in RELATIVE prices, or more precisely, they reflect change in real money balances.

13. Long run: The Quantity Theory of Money In general, %∆P = %∆M + (% ∆V − %∆y) Jan. 1959 to Apr. 2008 (annual growth rates): %∆P = 4.00% %∆M2 = 6.75% → Growth rate of real GDP (net of M2 velocity growth) has been 2.75%.

14. Long run: The Quantity Theory of Money Hyperinflation: %∆P ↑ = %∆M↑ + (% ∆V↑ − %∆Y) When money growth is very large and anticipated, velocity increases (demand for money falls), which exacerbates inflation.

15. Short-run: Money, interest rates, and output P is relatively fixed in the short-run: firms tend to accommodate demand rather than adjust prices. P = P. In this case, quantity theory does not hold: M = kPY; either (or both) k and Y must change in the face of changes in M. If the latter, the quantity of money is no longer neutral.

16. A model of money, interest rates and output in the short-run The model comprises: • Portfolio balance – output/income and interest rates must balance households’ demand to hold money and bonds with supply of money and bonds, at any point in time. Changes in the supply of money affect portfolio balance. • Loanable funds (discussed earlier) – output/income and interest rates must balance supply of and demand for credit, as flows over time. Relates interest rates to the overall demand for spending.

17. Portfolio Balance We saw earlier that the ‘equation of exchange’ can be interpreted as demand for real money, where we assumed k is constant: Md/P = k·Y However, a better assumption accounts for bonds as an alternative to holding money; the interest rate is the opportunity cost of holding wealth as money (instead of bonds): Md/P = k(R)·Y where k(R) is inversely related to R. Thus, the demand for real money rises with income and falls with interest rates. In equilibrium, Ms = Md = M. Thus, M/P = k(R)·Y For a given supply of money (M) and price level (P), R and Y must adjust to ensure this relationship.

18. Portfolio balance LM curve Portfolio Balance LM R0 R1 k(R)Y0 k(R)Y1 M/P Y1 Y0

19. Changes in M (and P) … shift the LM curve. Portfolio Balance LM(M0) LM(M1) R0 R1 k(R)Y0 M0/P M1/P Y0

20. Loanable funds Real aggregate spending Loanable funds and spending S(Y0) R R S(Y1) R0 R1 IS D LF Y = spending Y0 Y1

21. Shifts in S and D (other than change in R or Y)… shift the IS curve Loanable funds and spending S(Y0) R R R0 R1 IS0 D IS1 D1 LF Y = spending Y0

22. In the short-run, interest rates and output adjust until there is portfolio balance and the loanable funds market is in equilibrium. Macroeconomic equilibrium in the short-run R LM IS Y

23. At point A, R is “too low” given Y0→ excess demand for credit; excess demand for money → interest rates will rise. At point B, Y is “too high” given R0 → excess supply of credit; excess demand for money → spending will fall. Macroeconomic equilibrium in the short-run R LM B R0 A IS Y0 Y

24. An increase in M shifts the LM curve to the right. The increase in real money drives interest rate down, which induces additional spending through the loanable funds market. Because P is fixed, firms accommodate the increase in demand by producing more stuff: real GDP rises. Effects of money R LM IS Y

25. Financial market uncertainty disrupts credit markets, shifting IS curve to the left (red), reducing output below full employment. Stabilization policy R LM Rtarget 0 IS Yf Y

26. Financial market uncertainty disrupts credit markets, shifting IS curve to the left (red), reducing output below full employment. Fed responds by lowering interest rate target by increasing the money supply (blue), bringing output back to full employment. Stabilization policy R LM Rtarget 0 Rtarget 1 IS Yf Y

27. When output exceeds its full employment level (expansion), prices will gradually rise, eliminating the expansion. When output falls below full employment (recession), prices will gradually rise, eliminating the recession. Output will naturally return to full employment, even without stabilization policy. Transition to full-employment in the long-run LM(M0/P0)=LM(M1/P1) LM(M1/P0) IS Y1 Yf

28. Transition to long-run full employment (and monetary neutrality) Increase in money stock (from M0 to M1) increases output as before, in this case above full-employment (an economic expansion). Because demand and output is high, firms eventually run into constraints, and gradually start to raise prices. Real money gradually falls, interest rates gradually rise, demand and output return to full employment levels.

29. Transition to long-run full employment (and monetary neutrality) When actual output exceeds full employment output (an economic expansion), the price level tends to rise, lowering demand until full employment is reached. When actual output falls below full employment output (an economic recession), the price level tends to fall, raising demand until full employment is reached.