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Milton Friedman ( 1912 - 2006 ) The Revival of the Equation of Exchange and the Quantity Theory of Money. A Great Economist And a Product of his Times. Roger W. Garrison 2011. CPI CONSUMER PRICE INDEX (1982-1984 = 100). 220. 221. The dollar’s link to gold

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slide1

Milton Friedman (1912 - 2006)

The Revival of the Equation of Exchange

and the Quantity Theory of Money

A Great Economist

And a Product of his Times

Roger W. Garrison 2011

slide2

CPI

CONSUMER PRICE INDEX

(1982-1984 = 100)

220

221

The dollar’s link to gold

was severed on Aug. 15, 1971.

100

slide3

CPI

(1982-1984 = 100)

Last five years

221

220

211

slide4

Printing Money and Spending it.

CFO Chapter 18, pp. 341-343:

Monetarism

CFO Chapter 10:

The Money Supply

and the Federal Reserve System

The Equation of Exchange

and the Quantity Theory of Money

slide5

How much money is there, anyway?

But first….

What do we mean by “money”?

slide6

Tim Hudson earns a lot of money.

Bill Gates has a lot of money.

It’s better to buy a house when money is cheap.

I need to cash a check to get some money.

Money facilitates the exchange of goods and services.

slide7

Tim Hudson earns a lot of money.

Bill Gates has a lot of money.

It’s better to buy a house when money is cheap.

I need to cash a check to get some money.

Money facilitates the exchange of goods and services.

CURRENCY

CREDIT

MONEY

INCOME

WEALTH

slide8

How much money is there, anyway?

(Money is the medium of exchange.)

$ 1,861,000,000,000

slide9

M1 = $ 1,861 billion

Currency and coin: $ 920 billion

Checking deposits: $ 941 billion

C&C/M1 = 0.494, or about 49.4%

slide10

M1 = $ 1,861 billion

Currency and coin: $ 920 billion

US Population: 311,000,000

Per capita C&C: $ 2,958

Per family of four: $ 11,833

Just who’s holding all this C&C?

slide11

M is the money supply.

M1 = $ 1,861 billion

Inquiring minds want to know:

Has M1 always been $1,861 billion?

How does more MI get created?

Who makes the decisions?

Is more money always a good thing?

Are there some politics in play?

Did Keynes actually ignore M?

slide12

Monetarism

Friedman was a Marshallian,

but he was a macroeconomist.

He had his own research

Agenda: Money and Inflation.

And he was out to counter

Keynesian theory and policy.

MILTON FRIEDMAN

slide13

M stands for the Money supply.

M1 = $ 1,861 billion

GDP = Y = $ 14,870 billion

V = Y/M = 14,870 / 1,861 = 7.99

slide14

MV = Y

M

M1 = $ 1,861 billion

GDP = Y = $ 14,870 billion

V = Y/M = 14,870 / 1,861 = 7.99

slide15

MV = Y = E

M1 = $ 1,861 billion

--with “investment”

to incl. excess inventories

GDP = Y = $ 14,870 billion

V = Y/M = 14,870 / 1,861 = 7.99

slide16

MV = Y = E = PQ

M1 = $ 1,861 billion

--with “investment”

to incl. excess inventories

GDP = Y = $ 14,870 billion

V = Y/M = 14,870 / 1,861 = 7.99

slide17

MV = Y = E = PQ

2008: V = 10.18

2009: V = 9.09

2010: V = 8.22

2011: V = 7.99

--with “investment”

to incl. excess inventories

Dating from the beginning of the most recent contraction, the velocity of money has declined.

slide18

MV = Y = E = PQ

2008: V = 10.18

2009: V = 9.09

2010: V = 8.22

2011: V = 7.99

11.0

10.0

9.0

V E L O C I T Y

8.0

7.0

6.0

5.0

2008

2009

2010

2011

2012

Dating from the beginning of the most recent contraction, the velocity of money has declined.

slide19

MV = PQ

M is the money supply

(outside the banking system).

V is money’s velocity of circulation.

P is the price level.

Q is the economy’s output.

PQ is total expenditures (E).

MV is total income (Y)

slide20

A SAMPLE QUESTION

How much money is there, anyway?

A. M1 is a little under $1.861 billion.

B. M1 is a little under $6.168 billion.

C. M1 is a little under $1.861 trillion.

D. M1 is a little under $6.168 trillion.

Ask FRED. (FRED means Federal Reserve Economic Data.)

Click on Ben to go there.

slide21

MV = PQ

This is the “Equation of Exchange.”

No economist, dead or living, has ever denied that MV actually does equal PQ...

…because V is defined as PQ/M.

slide22

MV = PQ

In normal times:

V doesn’t change much.

Q changes in the low single digits.

slide23

Keynes believed that the velocity of money was subject to dramatic and unpredictable change.

He believed that people “hoard” money, more so some times than others. (increased hoarding means a decrease in velocity.)

In extreme episodes, people may be overcome by the “fetish of liquidity,” the fetish often accompanying the waning of animal spirits.

slide24

MV = PQ

So, what happens when M is doubled—say, from $ 1,861 billion to $ 3,722 billion?

P would also double.

But the doubling of P takes time.

slide25

MV = PQ

In the long run and with a constant V, the price level (P) moves in proportion to the money supply (M) in a no-growth (i.e., constant-Q) economy.

This is “The Quantity Theory of Money.”

A more descriptive name would be:

“The Quantity of Money Theory of the Price Level.”

slide26

MV = PQ

More generally,

In the long run, money-supply growth inexcess of real economic growth impinges wholly on the price level (P) and not at all on the level of real output.

Put bluntly: you can’t create real wealth by slapping green ink on paper.

slide27

Monetarism

MV = PQ

This is the unadorned tautology

that we call the Equation of Exchange

slide28

Monetarism

MV = PQ

18-30 months

This is the “Quantity Theory of Money.”

(The Quantity of Money Theory of the Price Level)

In the long run, increases in M affect nothing but P (and W).

slide29

Monetarism

Keynesianism is to Keynes as Monetarism is to

  • Ben Bernanke.
  • Tim Geithner.

C. Claude Monet.

D. Milton Friedman.

milton friedman 1912 2006
Milton Friedman (1912 - 2006)
  • MV = PQ
  • Inflation is always and everywhere a monetary phenomenon!!!
slide31

The equation of exchange is so near and dear to Milton Friedman’s heart that he

C. has written a parody to the popular Y.M.C.A to memorialize the equation in song.

B. has had it spelled out in pansies in the flower garden at Stanford’s Hoover Institution.

D. has adopted it as his vanity license plate number for his Cadillac Eldorado.

A. has made his wife Rose promise that it will make a tasteful appearance on his head stone.

slide32

The equation of exchange is so near and dear to Milton Friedman’s heart that he

  • tasteful appearance on his head stone.
  • B. spelled out in pansies in flower garden.
  • C. parody to the popular Y.M.C.A.
  • D. vanity license plate number.

Gribouillis économiques

slide33

GREG MANKIW’S BLOG

Random Observations for Students of Economics

September 16, 2006:

Curious question from Mankiw:

“How can you identify my car?”

Gregory Mankiw

Former Chairman

Council of Economic Advisors

George W. Bush Administration

slide34

mvpy writes:

    • You know, I hate to spoil things, but I must say, I think Milton Friedman has a better plate. This is from an article I came across:"Years ago, trying to find the Friedman’s apartment in San Francisco, I knew I was in the right location when I spotted a car with the number plate MV = PT."
  • A. Delaique writes:
    • Milton Friedman's license plate was MV = PQ, not MV = PT. Picture here : http://gribeco.free.fr/article.php3?id_article=12
  • Anonymous writes:
    • That's pretty ridiculous..
  • Canée writes:
    • I love economists.
slide36

Monetarist Policy

FOR A GROWING ECONOMY

MV = PQ

Normally, a healthy economy will experience real economic growth amounting to 2% or 3% per year.

Policy implication: Increase M at a slow, steady rate (2% or 3%) to match the long-run rate of growth.

slide37

Monetarist Policy

FOR A GROWING ECONOMY

MV = PQ

With this “Monetarist Rule” in effect, there will be no inflation and no deflation.

Price-level stability is the hallmark of macroeconomic stability.

slide38

Monetarism

Some diagnostics:

With the “Monetarist Rule” in effect (2 or 3%) and a constant V, the rate of inflation would be zero—or very close to zero.

Has the rate of inflation been zero?

slide39

Monetarism

Some diagnostics:

CPI for 1982-1984 = 100

CPI for January 2010 = 216

That is, prices on average are more than double now what they were in the early 1980s. (See FRED.)

slide40

CPI

CONSUMER PRICE INDEX

(1982-1984 = 100)

Last five years of the CPI

slide41

Monetarism

MV = PQ

Some diagnostics:

Has Q been falling for the past 25 years?

Has V been rising for the past 25 years?

Has M been rising for the past 25 years?

slide42

Monetarism

MV = PQ

Q rose by 88.5%, which is 2.80% per year.

V rose by 23.7%, which is 0.90% per year.

Suppose M had increased (in accordance with the monetary rule) at the rate of 2.5% per year.

slide43

Monetarism

2.80%

2.50%

0.90%

0.60%

MV = PQ

slide44

Monetarism

If M had risen at the rate of 2.5% over the period 1983—2008 and P had risen at the rate of 0.60%, the current CPI would be 115.0 instead of 216.

That is, prices in general would’ve been only 15% higher than they were in 1983.

slide45

5.0%

Monetarism

2.80%

3.1%

0.90%

MV = PQ

slide46

Monetarism

Q rose by 88.5%, which is 2.80% per year.

V rose by 23.7%, which is 0.90% per year.

M actually increased by 5.0% per year.

M, which rose from $450 billion to $1,383 billion (in 2008), more than tripled.

P more than doubles (from 100 to 216

slide47

10%

9%

8%

7%

6%

T H E N A T U R A L R A T E

O F U N E M P L O Y M E N T

5%

1992

2011

4%

slide48

10%

9%

8%

7%

SEPT 11 2001

6%

5%

4%

slide52

Sidewalk Survey on Dexter Avenue:

“What’s the cause of inflation?”

Greed.

Oil companies.

Medical industry.

Home-building industry.

Labor unions.

slide53

The Jane Fonda bull-by-the-horn approach to ending inflation.

Identify major groups of products whose prices have risen the most:

energy, medical, housing, food.

Enact pricing policies that hold the prices in these areas down and thereby counter the inflationary pressures.

slide54

What about the major groups of products whose prices have fallen the most:

computers, cameras, electronics.

Is the economic activity in these areas creating deflationary pressures?

slide55

MV = PQ

CPI = avg.(p1, p2, p3, p4, pgasoline, … pn)

The P in the equation of exchange is measured by the CPI (or the WPI or GPI), which is a price index. The index tracks the average of all prices.

slide56

?

CPI = avg.(p1, p2, p3, p4, pgasoline, … pn)

Good arithmetic; bad economics.

MV = PQ

slide57

CPI = avg.(p1, p2, p3, p4, pgasoline, … pn)

Many other prices go down.

--the price of complements (RV’s)

--the price of so-called “normal” goods generally (restaurant meals).

Some other prices go up, too.

--the price of substitutes (firewood).

--the price of goods and services for which oil in a substantial input (airfares).

slide58

Suppose that unrest in the Middle East causes a reduction in the supply of oil flowing to the U.S., which leads to a 20% increase in the price of oil. Economists who accept the quantity theory of money will claim that

A. prices in general will rise because everything depends upon (is related to) oil.

B. the Federal Reserve should increase the money supply so that people can pay the higher gas prices.

C. whatever the Federal Reserve does, there will be substantial inflation–although not a 20% inflation rate.

D. there will be no inflation in the U.S. so long as the Federal Reserve does not increase the money supply.

slide59

Bubbalonia

is experiencing inflation.

Prices in general are rising.

What are the logically possible causes,

as implied by the Equation of Exchange?

What is the actual (empirically demonstrated) cause according to the Quantity Theory?

INFLATION

IS ALWAYS AND EVERYWHERE

A MONETARY PHENOMENON.

--- Milton Friedman

MV = PQ

  • Increasing Q.
  • b. Decreasing Q
  • c. Increasing V.
  • d. Decreasing V.
  • e. Increasing M.
  • f. Decreasing M.

g. Increasing gas prices.

h. Credit-card mania.

i. Labor unions.

j. Greed.

slide60

Suppose that new taxes on tobacco products cause the tax-included price of cigarettes to double. Microeconomists would predict that the quantity of tobacco products bought will fall only slightly and that total spending on cigarettes will nearly double. Monetarists would claim that the tax will

A. result in a slightly higher rate of inflation.

B. cause the Federal Reserve to undertake compensatory policy actions.

C. have no effect on the general price level.

D. result in a slightly higher velocity of money.

slide61

Can you apply similar reasoning to show that none of the other oft-mentioned culprits are responsible for inflation?

Greed.

Oil companies.

Medical industry.

Home-building industry.

● Labor unions.

slide62

Do labor unions cause inflation?

Labor unions can call a strike—or just threaten to call a strike—in order to get higher wages.

And higher wages get translated into higher prices.

That’s inflation, isn’t it?

slide63

W

S

D

N

Union labor

slide64

W

S

D

N

Union labor

W

S

S’

D

N

Non-union labor

slide65

S’

W

P

S

S

D

D

N

Q

Union labor

Product market

W

S

S’

D

N

Non-union labor

slide66

S’

W

P

S

S

D

D

N

Q

Union labor

Product market

W

P

S

S

S’

S’

D

D

N

Q

Non-union labor

Product market

slide67

Do labor unions cause inflation?

No. But they can cause the prices of goods made by unionized labor to rise and the prices of goods made by non-unionized labor to fall.

However, if the central bank increases the money supply in an attempt to neutralize the effects of labor unions, the general price level will rise.

slide68

A Ceiling on Your Home (1945)

By the Office of Price Administration (OPA)

Synopsis: [This 12 minute film] shows the economic factors affecting postwar inflation and an appeal for public cooperation, an appeal to the public to assist in retail price control, and the difficulties veterans faced in locating jobs and housing.

CLICK ON POSTER GIRL TO SEE VIDEO

slide69

Reviewer: ERD -- March 7, 2006Subject: "Ceiling on Your Home" does a good jobThis 1945 film does a good job explaining about the purpose of rent control after World War II. Excellent narrative script and filming.

slide70

Reviewer: Christine Hennig -- December 9, 2003Subject: No Rentals Today, But Keep in Touch!This post-WWII film advocates rent control as a way to control inflation as a result of the post-war housing shortage. It portrays young couples struggling to find a decent place to live and start their families, and finding “NO RENTALS” signs everywhere. This is an interesting slice of life from the post-WWII era, before the problem would be eventually solved by huge housing developments in the suburbs.

slide71

Reviewer: Spuzz -- February 26, 2003Subject: Rent Rant.As the boys were coming home from war, much concern (I guess) was made about the lack of affordable housing for the soldiers and their new families. Luckily, the Office of Price Administration (whatever that is) was there to see that there was rent fixing, and that everyone would pay the same price. A persuasive film with plenty of great images.

slide72

Is it possible to increase the money supply without causing inflation?

Suppose that the velocity of money can (somehow) be made to fall as the money supply was being increased?

Couldn’t an increased M and a decreased V combine to allow for a constant price level?

slide74

The Anti-inflation campaign of the Ford Administration

People should wear their WIN buttons.

They should look for bargains…

…holding on to their money while they look.

Don’t spend it.

Just hold it.

MV=PQ

slide75

The Anti-inflation campaign of the Ford Administration

The Federal Reserve is increasing the money supply.

That means that prices will be rising.

It’s called inflation.

What can you do to keep inflation from occurring?

MV=PQ

slide76

The Anti-inflation campaign of the Ford Administration

You can earn money and then just hold on to it.

Holding on to money means a decrease in velocity.

The decreased V will offset our increasing M, keeping P from rising.

MV=PQ

In other words, the government can create money and spend it, and that won’t cause inflation if you are willing to earn money and not spend it.

slide77

The Anti-inflation campaign of the Ford Administration

MV=PQ: It’s always right, but there are no votes in it.

milton friedman 1912 200678
Milton Friedman (1912- 2006)
  • MV = PQ
  • Inflation is always and everywhere a monetary phenomenon!!!