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Chapter 22

Chapter 22. Quantity Theory, 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. Inflation and Money Growth.

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Chapter 22

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  1. Chapter 22 Quantity Theory, Inflation, and the Demand for Money

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

  3. Inflation and Money Growth

  4. Inflation and Money Growth • Previous slide shows cannot have high, sustained inflation without monetary accommodation • 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.

  5. The Equation of Exchange: M x V = P x Y Nominal GDP = Price level(P) x Real Output(Y) Quantity of Money(M) x Velocity(V) = Nominal GDP M x V = P x Y Velocity of Money (V): These relationships are definitions http://research.stlouisfed.org/fred2/categories/24

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

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

  8. Budget Deficits and Inflation • There are two ways the government can pay for spending: raise revenue or borrow -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

  9. Budget Deficits and Inflation • The government budget constraint: Def = 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)

  10. 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

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

  12. 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.

  13. 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.

  14. 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.

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

  16. 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

  17. 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.

  18. Inflation and Money Growth

  19. 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

  20. 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.

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

  22. 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.

  23. 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.

  24. 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

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

  26. Targeting Money Growth 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 (MB x m) x V =P x Y

  27. 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.

  28. 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.

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