Money, Output, and Prices

1. Money, Output, and Prices Classical vs. Keynesians

2. What is Money?

3. Is this money?

4. Is this money?

5. Is this money?

6. Is this money?

7. Is this money?

8. What is Money? • We normally think of currency when we think of money. However, more generally speaking, money is any commodity which satisfies the following: • Unit of account

9. What is Money? • We normally think of currency when we think of money. However, more generally speaking, money is any commodity which satisfies the following: • Unit of account • Store of Value

10. What is Money? • We normally think of currency when we think of money. However, more generally speaking, money is any commodity which satisfies the following: • Unit of account • Store of Value • Medium exchange

11. Commodity money vs. Fiat Money

12. In a commodity money system, the chosen “medium of exchange” has real, intrinsic value (gold, silver, etc.) Commodity money vs. Fiat Money

13. In a commodity money system, the chosen “medium of exchange” has real, intrinsic value (gold, silver, etc.) With a fiat money system , the chosen medium of exchange has no intrinsic value (paper currency) Commodity money vs. Fiat Money

14. In a commodity money system, the chosen “medium of exchange” has real, intrinsic value (gold, silver, etc.) With a fiat money system , the chosen medium of exchange has no intrinsic value (paper currency) Fiat money is accepted because of faith! Commodity money vs. Fiat Money

15. Standard Definitions of Money

16. Standard Definitions of Money • Monetary Base (M0): Direct liabilities of the central bank • Currency in circulation + Bank Reserves

17. Standard Definitions of Money • Monetary Base (M0): Direct liabilities of the central bank • Currency in circulation + Bank Reserves • M1: • Currency in circulation + Traveler's Checks + Checking accounts

18. Standard Definitions of Money • Monetary Base (M0): Direct liabilities of the central bank • Currency in circulation + Bank Reserves • M1: • Currency in circulation + Traveler's Checks + Checking accounts • M2: • M1 + Savings accounts + Money Market Accounts + Small Time Deposits

19. Standard Definitions of Money • Monetary Base (M0): Direct liabilities of the central bank • Currency in circulation + Bank Reserves • M1: • Currency in circulation + Traveler's Checks + Checking accounts • M2: • M1 + Savings accounts + Money Market Accounts + Small Time Deposits • M3: • M2 + Large Time Deposits + Eurodollars

20. Money Supply in the US • Currency in Circulation: $690B • Monetary Base: $732B • M1: $1.269T • M2: $6.015T • M3: $8.760T

21. Money Supply in the US

22. Money and Prices in the US

23. Real Personal Income

24. Real Personal Income & Monetary Base

25. Real Personal Income & M1

26. Real Personal Income & M2

27. Real Personal Income & M3

28. Money and the Business Cycle • Money is procyclical and leads the cycle

29. Money and the Business Cycle • Money is procyclical and leads the cycle • The money/income relationship is probably the most widely debated issues in macroeconomics

30. Money and the Business Cycle • Money is procyclical and leads the cycle • The money/income relationship is probably the most widely debated issues in macroeconomics • Keynesian economists argue that money causes output (ie, the Fed can stimulate the economy through monetary policy)

31. Money and the Business Cycle • Money is procyclical and leads the cycle • The money/income relationship is probably the most widely debated issues in macroeconomics • Keynesian economists argue that money causes output (ie, the Fed can stimulate the economy through monetary policy) • Classical economists (supply side) argue that output causes money (i.e., the Fed responds to the economy rather than the economy responding to the Fed)

32. Neoclassical Economics • Classical economists assume that all prices are free to adjust to any new information and markets clear

33. Neoclassical Economics • Classical economists assume that all prices are free to adjust to any new information and markets clear • Therefore, output is completely determined by conditions in labor/capital markets (a.k.a, the real economy) – independent of money supply (i.e., “money is neutral” )

34. Neoclassical Economics • Classical economists assume that all prices are free to adjust to any new information and markets clear • Therefore, output is completely determined by conditions in labor/capital markets (a.k.a, the real economy) – independent of money supply (i.e., “money is neutral” ) • Given a fixed level of output, along with money demand, the supply of money determines the price level

35. Neoclassical Money Demand • It is assumed that households choose to hold a fraction of their nominal income in the form of cash (or a checking account)

36. Neoclassical Money Demand • It is assumed that households choose to hold a fraction of their nominal income in the form of cash (or a checking account) Money Demand = k* PY

37. Neoclassical Money Demand • It is assumed that households choose to hold a fraction of their nominal income in the form of cash (or a checking account) Money Demand = k* PY For example, suppose that National Income is $8T. If the average household chooses to hold 10% of their income in the form of cash, what is aggregate money demand?

38. Neoclassical Money Demand • It is assumed that households choose to hold a fraction of their nominal income in the form of cash (or a checking account) Money Demand = k* PY For example, suppose that National Income is $8T. If the average household chooses to hold 10% of their income in the form of cash, what is aggregate money demand? Money Demand = (.1)($8T) = $800B

39. Money Market Equilibrium • The aggregate price level will adjust so that money supply equal money demand

40. Money Market Equilibrium • The aggregate price level will adjust so that money supply equal money demand M = Money Demand = k*PY

41. Money Market Equilibrium • The aggregate price level will adjust so that money supply equal money demand M = Money Demand = k*PY • Solving the above expression for price gives us P = M/(kY)

42. What affects ‘k’? • Interest rates: Cash is a non interest bearing asset. As interest rates rise, households hold less cash (k decreases)

43. What affects ‘k’? • Interest rates: Cash is a non interest bearing asset. As interest rates rise, households hold less cash (k decreases) • Transaction costs: As the cost of acquiring cash rises, households hold more cash to economize on transaction costs.

44. Money Demand and the Quantity Theory of Money • An alternative way of expressing the previous expression is MV = PY Where ‘V’ is the velocity of money (V = 1/k) • This is known as quantity theory of money

45. Velocity of M1: 1980 - 2003

46. Velocity of M2: 1980-2003

47. Velocity of M3: 1980-2003

48. What caused the change in money velocity? • Interest Rates

49. Fed Funds Rate: 1980-2003

50. What caused the change in money velocity? • Interest Rates: • During the 80’s when interest rates were falling, consumers switched into checkable deposits. • During the 90’s as interest rates rose, consumers switched into interest bearing accounts