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Ec 123 Section 1

Ec 123 Section 1. THIS SECTION The Quantity Equation of Money Case: The U.S. Financial Crisis of 1931 NEXT National Income Accounting. The Quantity Theory of Money. The quantity equation of money relates the money in circulation (M) to the price level (P) and annual output (Q).

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Ec 123 Section 1

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  1. Ec 123 Section 1 • THIS SECTION • The Quantity Equation of Money • Case: The U.S. Financial Crisis of 1931 • NEXT • National Income Accounting Ec 123 Section 1

  2. The Quantity Theory of Money The quantity equation of money relates the money in circulation (M) to the price level (P) and annual output (Q). MV = PQ V is known as the velocity of money. It is equal to the average number of times a dollar is used during the year. The quantity equation is an accounting identity (true by definition) but what you use for M (M1 or M2) can affect V number. Ec 123 Section 1

  3. Monetarism • Monetarist's view of money's impact on economy can be represented in the quantity equation framework MV = PQ, • Increases in V imply individuals and firms are less willing to hold cash. Opposite for decrease in V. • Monetarists claim that, under normal circumstances, V is stable (or grows at predictable rate). • Changes in V can be attributed to • financial innovation • change in interest rates Ec 123 Section 1

  4. Monetarism Big policy implication: If V is stable, then the only way to change nominal GDP (=PQ) is through changes in the money supply. • In the long run, changes in M effect only the pricelevel, P. • BUT in the short run changes can effect both P and real income, Q, because it takes people time to adjust their decisions to changes in the money supply. Ec 123 Section 1

  5. The Fed: Institutional overview • Federal Reserve System created in 1913. • Decentralized power structure • 12 Districts • New York has dominant position on FOMC • Major responsibilities “…to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.” - Federal Reserve Act, 1913 Ec 123 Section 1

  6. The Fed: Monetary Policy (Pre 1933) • Real Bills Doctrine • 40% of assets must be GOLD • Other assets must be “productive credit” • Discount Window Borrowing • At the discretion of the regional Fed • Primary monetary policy tool What is the motivation for these policies? What is the cost of these policies? Ec 123 Section 1

  7. The Fed’s Balance Sheet and the Real Bills Doctrine Internal drain due to increased leakages lowering the multiplier Drop in M1 due to external drain Drop in M1 due to internal drain Currency in Circulation Demand Deposits Assets Assets Liabilities Liabilities Currency in Circulation External GOLD drain Currency in Circulation Demand Deposits Demand Deposits Govt. Sec. Productive Loans Currency in Circulation Govt. Sec. M1 Determined by multiplier M1 Determined by multiplier M1 Determined by multiplier Productive Loans Free Gold Currency in Circulation GOLD GOLD 40% Required 40% Required Ec 123 Section 1

  8. Monetary policy tools available to the Fed(Pre 2008) • Change reserve requirement ratio (hardly ever used) • Change discount rate (sometimes) • Short term, secured loans to banks (1 day but now can be 30 days) • At a higher interest rate than the Fed Funds rate (lowered difference) • Negative Stigma associated with bank usage • Open market operations (most commonly used today) Ec 123 Section 1

  9. Open Market Operations Ec 123 Section 1

  10. The Fed’s experience during the 1920’s • In response to a severe 1920 recession the Fed raised the discount rate to stem the loss of “free gold.” In the Fed’s view • the recession was caused by international forces beyond Fed control • recession “cleansed” the economy for vigorous expansion. • In 1927, the Fed helped the U.K. back to a gold standard • used open market operations to expand the money supply • lead to higher inflation and lower interest rates • sterling pound appreciated relative to the dollar Ec 123 Section 1

  11. Changes in the money supply 1928-33 Ec 123 Section 1

  12. The role of money in causing the Great Depression Ec 123 Section 1

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  16. Monetary policy tools available to the Fed(TODAY) • Change reserve requirement ratio (hardly ever used) • Change discount rate (sometimes) • Open market operations (most commonly used today) • Term Auction Facility • Auction for short term (30 day) secured loans to banks • Bidding starts at the Fed Funds interest rate. • First auction was December 2008. • The kitchen sink…. Ec 123 Section 1

  17. U.S. Financial Crisis of 1931: Summary • The quantity equation of money is an accounting identity linking money to the larger economy. • Monetarism implies that careful control of the money supply is sufficient to stabilize the economy (PQ). • Money multiplier story. Fed doesn't set the money supply, but does have a heavy influence. • The goals and organization of the Fed are critical to the conduct of monetary policy. • One’s understanding of how the money supply influences the economy is crucial to the evaluation of monetary policy. Ec 123 Section 1

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