Money & Banking Video 02--Money Demand What is Money? ( Chapter 3) Quantity Theory of Money...

Money & Banking

Video 02--Money Demand

What is Money? (Chapter 3)Quantity Theory of Money (Chapter 20)

Hal W. Snarr8/20/2015

Chapter 3

What is money?

In the absence of money, goods and services are exchanged in a barter system where individuals directly exchange the surplus from the fruits of their labor.

– The following gives the number of barter prices there would be in an economy with N goods, with x = 2 because exchanges are done in pairs:

– Among competing forms of money, the least marketable tend

to be one by one rejected until at last only a single commodity remained, which was universally employed as a medium of exchange – Mises, 1953, pp. 32-33

– The winner of this contest is durable, divisible, transportable, and difficult to counterfeit.

!!( )!

Nx

NCx N x

2!

2!( 2)!N NC

N

2( 1)( 2)!N N N NC 2!( 2)!N 2

( 1)2

N N NC

Money

Commodity Money:

Gold coins in 1776-Colonial America

“Tiger Tongue” from Siam, Bronze Coin

Stone Money, Island of Yap

Money

Paper Money is backed by something like Gold

Money

Paper Money is backed by something like Gold

Money

Fiat Money: gov’t decreed money backed by Gold

Money

Checks: Electronic Payment E-Money (electronic money):

Debit card Stored-value card (smart card) E-cash

Are We Headed for a Cashless Society?

Louisiana House Bill 195 bans cash on all second-hand transactions, which passed near unanimously with one nay vote in the senate. (www.forbes.com)

http://www.youtube.com/watch?v=7ujgi4rXsiQ www.youtube.com/watch?v=yrGMgsJQGUE

Money

Table 1

Money

www.federalreserve.gov/releases/h6/Current

Figure 1 Growth Rates of M1 & M2

Money

http://research.stlouisfed.org/fred2/graph/?id=BOGMBASE#

M1, M2 and the Monetary Base

Money

Chapter 20

Quantity Theory of Money?

Fisher’s Equation of Exchange

M V P Y

Irving Fisher’s equation of exchange

Mainstream economics defines inflation as a general increase in the prices of products

p = Pis/Pwas – 1 > 0

• Demand-pull inflation

• Cost-push inflation

• Excessive growth in the quantity of money

> 0

Demand-pull inflation

ADSRAS

15

LRAS

16

15.5

14.5p = 6.9% = 15.5/14.5 – 1

Fisher’s Equation of Exchange

ADSRAS

15

LRAS

16.5

16

15.5

14.5p = 16.5/14.5 – 1

Demand-pull inflation

M V P Y

= 14.8%

Fisher’s Equation of Exchange

ADSRAS

15

LRAS

16

15.5

14.5p = 0% = 14.5/14.5 – 1

Demand-pull inflation?

17

Fisher’s Equation of Exchange

Cost-push inflation

ADSRAS

15

LRAS

14

15.5

14.5p = 6.9% = 15.5/14.5 – 1

M V P Y

Fisher’s Equation of Exchange

ADSRAS

15

LRAS

15.5

14.5p = 0% = 14.5/14.5 – 1

Cost-push inflation?

14

M V P Y

Fisher’s Equation of Exchange

If Velocity of money is fairly constant in short run and u = un,• an increase in the quantity of Money• the Price level increases

M V P Y

16.5

A

15.5

SRAS AD

LRAS

14.5

15 16

Fisher’s Equation of Exchange

Excessive growth in the quantity of money• causes inflation

• Who agrees?

• Milton Friedman (The Counter-Revolution in Monetary Theory):

Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the

quantity of money than in output.

Fisher’s Equation of Exchange

Assuming V is constant in the short run gives the quantity theory of money (QTM)

Nominal income is determined by changes in the quantity of money

The above can be written as follows

Quantity Theory of Money

P MY V

% % % % VMP Y

+ ≈ +

Assuming V is constant in the short run gives the quantity theory of money (QTM)

Nominal income is determined by changes in the quantity of money

The above can be written as follows

P MY V

% % % % VMP Y

% %M Y

The quantity theory of money is also a theory of inflation

p

Mg g

Quantity Theory of Money

Figure 1

Sources: For panel (a), Milton Friedman and Anna Schwartz, Monetary trends in the United States and the United Kingdom: Their Relation to Income, Prices, and Interest Rates, 1867–1975, Federal Reserve Economic Database (FRED), Federal Reserve Bank of St. Louis, http://research.stlouisfed.org/fred2/categories/25 and Bureau of Labor Statistics at http://data.bls.gov/cgi-bin/surveymost?cu.

Source: IFS data for 120 countries, averaged over years 1996-2004

Quantity Theory of Money

Figure 2

Sources: FRED, Federal Reserve Economic Data, Federal Reserve Bank of St. Louis; Bureau of Labor Statistics, http://research.stlouisfed.org/fred2/categories/25; accessed September 30, 2010.

High Money Growth & low inflation

Quantity Theory of Money

… but high money growth is followed by accelerating inflation

Sources: FRED, Federal Reserve Economic Data, Federal Reserve Bank of St. Louis; Bureau of Labor Statistics, http://research.stlouisfed.org/fred2/categories/25; accessed September 30, 2010.

Quantity Theory of MoneyFigure 2

Government expenditures is paid for by

• Raising tax revenue

• Treasuries can print money

‒ In the U.S., the Fed buys bonds directly from Treasury

• Treasuries can sell more bonds

‒ If the deficit is financed by selling bonds to the public, there is no effect on the MB = R + C, and on the MS

‒ If the deficit is financed by the Fed buying bonds from banks, the MB and MS increase

o $1 could buy 11% more goods in 1912 than in 1776

o $1 could buy 95% fewer goods in 2008 than in 1913

$1m held from 1913 to 2008 is worth $50kwww.lewrockwell.com/2009/07/erik-voorhees/the-record-of-the-federal-reserve/

Quantity Theory of Money

Example – CPI data from the FRED

Quantity Theory of Money

Hyperinflation is a period of high inflation (> 50% per month)

Larry Allen’s The Encyclopedia of Money:• Bolshevik Revolution• Prior to 1917, prices rose 2 to 3 times faster than wages. • After 1917, prices rose by

92,300% from 1913 to 1919 64,823,000,000% from 1913 to 1923

• Post WWI Germany• In 1914, there were 6,323 million marks in circulation• By 1923 there were 17,393,000 million. • A newspaper costing one mark in May 1922 cost 1,000 marks 16 months later,

and 70 million marks a year and a half later. • At its worst,

Customers rolled wheelbarrows full of money to the grocery store Customers and restaurants negotiated the cost of meals in advance Printed money was bailed like hay to heat one’s home. It took about 4 days for prices to double

Quantity Theory of Money

Hyperinflation is a period of high inflation (> 50% per month)

• Erich Maria Remarque’s The Black Obelisk:

Workmen are given their pay twice a day now--in the morning and in the afternoon, with a recess of a half-hour each time so that they can rush

out and buy things--for if they waited a fewhours the value of their money would drop

• Steve Hanke’s R.I.P. Zimbabwe Dollar:• The time it took for prices to double ino 1994 Yugoslavia, 33.6 hourso 2008 Zimbabwe, 24.7 hours o 1946 Hungary, 15.6 hours

Quantity Theory of Money

The Fisher Effect: Rising inflation (caused by excessive money growth) raises the nominal rate of interest (i)

Source: IFS data for 120 countries, averaged over years 1996-2004Source: Federal Reserve Economic Data (FRED)

i = r + p

Quantity Theory of Money

• Using current inflation assumes inflation does not change.

• Future r will be different from what it was expected to be when loans were signed.

• Borrowers do better and lenders do worse when loans are repaid with devalued money.

• In an uncertain world, the Fisher Effect must account for uncertainty

• pe is commonly estimated using ‒ the difference between the yields on TIPS and Treasuries (TIPS spread)

i = r + pe

The Fisher Effect: Rising inflation (caused by excessive money growth) raises the nominal rate of interest (i)

Quantity Theory of Money

M

Money DemandFisher

i

billions $

Y

V

dM

P

Y

V

Money Demand

billions $

M

i

Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3dM

P

Fisher

Money Demand

15000

1.5

M

i

billions $

dM

P

Fisher

Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3

dM

P

Money Demand

10,000

M

MDFisher

10000

i

billions $

Fisher

Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3

MDFisher

2.5

Money Demand

M

15

i

10000 billions $

dM

P10,000

Fisher

Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3

i

Money Demand

MDFisher

2.5

M

( , )L Y i

10000 billions $

dM

P

Keynes

Money Demand

MDFisher

2.5

M

i

10000 billions $

0.7 200Y i dM

P

Keynes

Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3

Money Demand

dM

P

MDFisher

2.5

M

i

10000 billions $

15,0000.7 200 i

Keynes

Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3

Money Demand

MDFisher

2.5

M

i

10000 billions $

10500 200 i dM

P

Keynes

Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3

Money Demand

MDFisher

2.5

M

i

10000 billions $

10500 2 .00 2 5 dM

P

Keynes

Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3

Money Demand

MDFisher

2.5

M

i

10000 billions $

10500 500dM

P

Keynes

Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3

Money Demand

MDFisher

2.5

M

i

10000 billions $

10000dM

P

Keynes

Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3

Money Demand

MDFisher

2.5

M

i

10000 billions $

0.7 200Y i

MDKeynes

dM

P

Keynes

MDKeynes

Money Demand

( , , , ) b e ep r r r r rYf

MDFisher

M

2.5

i

10000 billions $

dM

P

Friedman

Money Demand

dM

P

MDKeynes

MDFisher

M

2.5

i

10000 billions $

10 ( 2336.25 ) 7770.833 ( ) 7770.833 ( ) 7770.831500 2 (0 4 33 )r r ri

Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3

Friedman

Money Demand

dM

P

MDKeynes

MDFisher

M

2.5

i

10000 billions $

23362.5 7770.833 21500 ( )00 4 3i r r r

Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3

Friedman

Money Demand

dM

P

MDKeynes

MDFisher

M

2.5

i

10000 billions $

23362.5 7770.833 (9 )15 30000 i r

Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3

Friedman

Money Demand

dM

P

MDKeynes

MDFisher

M

2.5

i

10000 billions $

23362.5 7770.833 39 7770.833150000 ri

Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3

Friedman

MDKeynes

Money Demand

MDFisher

M

2.5

i

10000 billions $

dM

P80062.5 23362.5 7770.83 3( )3 eii

Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3

Friedman

MDKeynes

Money Demand

MDFisher

M

2.5

i

10000 billions $

dM

P80062.5 23362.5 7770 3( 3).833i i

Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3

Friedman

MDKeynes

Money Demand

MDFisher

M

2.5

i

10000 billions $

dM

P80062.5 23362.5 7770.833 7770.83 3 93ii

Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3

Friedman

MDKeynes

Money Demand

MDFisher

M

2.5

i

10000 billions $

dM

P10125 50 i

Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3

Friedman

MDKeynes

Money Demand

MDFisher

M

2.5

i

10000 billions $

dM

P10125 50 i

Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3

Friedman

MDKeynes

Money Demand

MDFisher

M

2.5

i

10000 billions $

dM

P10125 5 .0 2 5

Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3

Friedman

MDKeynes

Money Demand

MDFisher

M

i

10000 billions $

dM

P10000

2.5

Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3

Friedman

MDKeynes

Money Demand

MDFisher

M

2.5

i

10000 billions $

dM

P10125 50 i

Friedman

MDFriedman

People and firms demand money because there are benefits to doing so because doing so makes it easier to pay for things.

The marginal benefit of holding an additional dollar diminishes as the amount held increases. • E.g., the benefit of holding $2 rather than $1 is greater than holding an

additional dollar when one has $1000.

Holding the additional dollar is also costly • interest is forgone• inflation reduces its buying power. • i = r + pe is the price of holding money; as it rises, Md falls.

Money Demand

i MD

Empirical evidence:

• The quantity of money demanded increases as i falls.

M

Money Demand

i MD

Empirical evidence:

• The quantity of money demanded increases as i falls.

• Money demand increases in• income• Wealth• Risk of other assets

M

Money Demand

i

M

MD

Empirical evidence (Table 1):

• The quantity of money demanded increases as i falls.

• Money demand increases in• income• Wealth• Risk of other assets

• Money demand decreases in • Payment technology• Inflation risk• Liquidity of other assets

Money Demand

If Keynes is correct• money demand fluctuates with i• velocity oscillates and is unpredictable• the link between M and aggregate spending is weak • The Fed should target interest rates

If Friedman is correct• Money demand is relatively insensitive to changes i• velocity is stable and predictable• QTM’s view of aggregate spending being determined by M is more likely

to be true • The Fed should target MS

Money Demand