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Monetary Theory and Policy

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© 2003 South-Western/Thomson Learning

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Demand for Money

The demand for money refers to the relationship between how much money people want to hold and the interest rate

Distinction between income and money

Money is a stock and people express their demand for money by holding some of their wealth as moneyIncome is a flow and people express their demand for income by selling their labor and other resources

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Demand for MoneyThe most obvious reason why people demand money is to carry out transactions

The greater the value of transactions to be financed in a given period, the greater the demand for money the greater the volume of exchange of goods and services as reflected by the level of real output, the greater the demand for moneyThe demand for money also supports expenditures people expect to make in the course of normal economic affairs plus various unexpected expendituresFocus here is on money as a medium of exchange

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Demand for MoneyAdditionally, money serves as a store of value people can store their purchasing power as money or in the form of other financial assets – stocks, bonds, etc

When people purchase bonds and other financial assets, they are lending their money and are paid interest for doing so or are paid dividends or expect stock prices to yield gains

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Demand for MoneyThe demand for any asset is based on the flow of services it provides

The big advantage of money is its liquidity it can be immediately exchanged for whatever needs to be purchased

By way of contrast, other financial assets must first be liquidated, or exchanged for money

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Demand for MoneyMoney, however, has one major disadvantage when compared to other financial assets

Money held as currency or as travelers checks earns no interest and checkable deposits earn interest that is typically below that which could be earned on other financial assets the interest forgone is the opportunity cost of holding money

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Money Demand and Interest Rates

When the market rate of interest is low, other things constant, the cost of holding money (liquidity) is low people hold a larger fraction of their wealth in the form of moneyConversely, when the market rate of interest is high, the cost of holding money is high people hold less of their wealth in money and more in other financial assets Thus, other things constant, the quantity of money demanded varies inversely with the market interest rate

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Supply of Money and Interest Rate

The supply of money – the stock of money available in the economy at a particular time – is determined primarily by the Fed through its control over currency and over excess reserves

The supply of money is shown in Exhibit 2 as a vertical line the quantity of money supplied is independent of the interest rate

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Interest Rates and Planned Investment

Money affects the economy through changes in the interest rateSuppose the Fed believes the economy is operating below its potential output and decides to increase the money supply in order to stimulate output and employment by either

Purchasing U.S. government securitiesLowering the discount rateLowering the reserve requirement

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SummaryThe sequence of events in Exhibit 3 can be summarized as follows

M i I AD Y

An increase in the money supply, M, reduces the interest rate, i. The lower interest rate stimulates investment spending, I, which leads to an increase in aggregate demand from AD to AD'. At a given price level, real GDP demanded increases. The entire sequence is traced out in Exhibit 3 by the movement from point a to b

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Decrease in the Interest RateConsider the effect of a Fed- orchestrated increase in interest rates

This would be illustrated graphically by a movement from point b to point a in each of the panels in Exhibit 3

A decrease in the money supply would create an excess demand for money at the initial interest rate, people will attempt to exchange other financial assets for money

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Decrease in the Interest RateThese efforts to get more money result in an increase in the market interest rate which will increase until the quantity of money demanded declines just enough to equal the now-lower quantity of money supplied

At the higher interest rate, businesses find it more costly to finance investment plans and households find it more costly to finance new homes

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Decrease in the Interest Rate

The resulting decline in investment leads to a magnified decrease in aggregate expenditures which in turn leads to a decline in aggregate demand

As long as the interest rate is sensitive to changes in the money supply and as long as investment is sensitive to changes in the interest rate, changes in the supply of money affect planned investment

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Adding Short-Run Aggregate Supply

To determine the complete effects of monetary policy on the equilibrium level of real GDP we need the supply side

An aggregate supply curve can help show how a given shift in the aggregate demand curve affects real GDP and the price level

In the short run, the aggregate supply curve slopes upward the quantity supplied will expand only if the price level increases

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Adding Short-Run Aggregate Supply

For a given shift of the aggregate demand curve, the steeper the short-run aggregate supply curve, the smaller the increase in real GDP and the larger the increase in the price level

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Fiscal Policy with Money

Previously we found that an increase in government purchases increases aggregate demand, leading in the short run to both a greater output and a higher price level

However, once money enters the picture, we must recognize that an increase in either real output or the price level increases the demand for money since more money is needed for the additional spending

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Fiscal Policy with MoneyFor a given supply of money, an increase in the demand for money leads to a higher interest rate reduces investment spending that the fiscal stimulus of government purchases crowds out some investment

This reduction in investment dampens the expansionary effects of fiscal policy the simple spending multiplier overstates the impact arising from any given fiscal stimulus

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Fiscal Policy with MoneyLikewise, monetary effects will temper any fiscal policy designed to reduce aggregate demand

Suppose in an attempt to cool inflation, income taxes are increases, which reduces consumption reduces aggregate expenditures and aggregate demand equilibrium output and the price level fall in the short run less money is needed to carry out transactions demand for money declines

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Fiscal Policy with Money

So long as the supply of money remains unchanged, a decline in the demand for money leads to a lower interest rate which stimulates investment spending, to some extent offsetting the effects of higher taxes

Thus, given the supply of money, the impact of changes in the demand for money on interest rates reduces the effectiveness of fiscal policy

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Money in the Long RunThe long-run view of money is more direct in that if the central bank supplies more money to the economy, people eventually spend more

However, since long-run aggregate supply is fixed at the economy’s potential output, this greater spending simply increases the price level

It is to this explanation that we now turn

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Equation of ExchangeRecall that one of the implications of the circular flow is that every transaction in the economy involves a two-way swap

The seller surrenders for money, and the buyer surrenders money for goods

One way of expressing this relationship among key variables in the economy is the equation of exchange

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Equation of ExchangeThe basic version of the equation of exchangeM x V = P x Y

M is the quantity of money in the economyV is the velocity of money, or the average number of times per year each dollar is used to purchase final goods and servicesP is the price levelY is real national output, or real GDPThus, the quantity of money in circulation multiplied by the number of times that money turns over equals the average price times real output P times Y equals nominal GDP

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Equation of ExchangeBy rearranging the equation of exchange, we would find that velocity equals nominal GDP divided by the money stock

V = (P x Y) / M

The velocity of money indicates how often each dollar is used on average to pay for final goods and services during the year

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Equation of Exchange

Given the value of total output and the money supply in 2001, each dollar was spent approximately 9 times on average to pay for final goods and services

Classical economists developed the equation of exchange as a way of explaining the economy’s price level

The equation of exchange is simply an identity a relationship in such a way that it is true by definition

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Quantity Theory of Money

If velocity is relatively stable over time, or at least predictable, the equation of exchange turns from an identity into a theory – the quantity theory of money – which can be used to predict the effects of changes in the money supply on nominal GDP, P x Y

For example, if M is increased by 5% and if V remains constant, then P x Y must also increase by 5%

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Quantity Theory of MoneyHow this increase in P x Y is divided between changes in the price level and changes in real GDP is not answered by the quantity theory of money

The answer lies in the shape of the aggregate supply curve

Recall that the long-run aggregate supply curve is vertical at the economy’s potential level of output

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Quantity Theory of MoneyThus, with output, Y, fixed, and the velocity of money, V, relatively stable or at least predictable, then an increase in the stock / supply of money translates directly into a higher price level

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Velocity of Money

Velocity depends on the customs and conventions of commerce

The electronic transmission of funds takes only seconds the same stock of money can move around much more quickly to finance many more transactionsThe velocity of money has also been increased by a variety of commercial innovations – wider range of charge accounts and credit cards – that have facilitated exchange

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Velocity of Money

Another institutional factor influencing velocity is the frequency with which workers get paid, • e.g., the more often workers get paid, other

things constant, the lower their average money balance

• so the more active the money supply the greater the velocity

The better money serves as a store of value, the more of it people want to hold• so the lower its velocity

– For example, during a period of inflation, money turns out to be a poor store of value velocity increases with a rise in the inflation rate, other things constant

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How Stable is Velocity?Between 1960 and 1980 M1 velocity increased steadily but in a rather predictable fashion

However, during the 1980s, it bounced around in a rather unpredictable fashion

During the last decade, more and more banks began offering money market funds that included check writing privileges and people began using their ATM or debit cards

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How Stable is Velocity?Thus, M2 might provide a better perspective on the velocity of moneyThe velocity of M2 has been much more stable

However, even the M2 velocity became more volatile in the early 1990s

Since 1993, the equation of exchange has been considered more of a rough guide linking changes in the money supply to inflation in the long run

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Targets for Monetary PolicyThe principal implication of the preceding discussions is that monetary policy affects the economy largely by influencing the interest rate

However, in the long run, changes in the money supply affect the price level, though with an uncertain lag

Should monetary authorities focus on interest rates in the short run or the supply of money in the long run?

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Contrasting PoliciesA growing economy needs a growing money supply to pay for the increase in aggregate output

If monetary authorities maintain a constant growth in the money supply, and if velocity remains stable, the interest rate will fluctuate unless the growth in the supply of money each period just happens to match the growth in the demand for money

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Contrasting Policies

Alternatively, monetary authorities could try to adjust the money supply each period by the amount needed to keep the interest rate stable changes in the money supply each period would have to offset any changes in the demand for money

This is essentially what the Fed does when it holds the federal funds target constant

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Contrasting PoliciesInterest rate fluctuations could be harmful if they created undesirable fluctuations in investment

For interest rates to remain stable during economic expansions, the money supply would have to grow at the same rate as the demand for money

Likewise, for interest rates to remain stable during contractions, the money supply would have to shrink at the same rate as the demand for money

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Contrasting PoliciesThat is, for monetary authorities to maintain the interest rate at some specified level, the money supply must increase during economic expansions and decrease during contractions

However, an increase in the money supply during an expansion would increase aggregate demand even more, and a decrease in the money supply during a contraction would reduce aggregate demand even more Fed adding more instability to the economy

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Targets

Between World War II and October 1979, the Fed attempted to stabilize interest rates

During this period, Milton Friedman argued that this exclusive attention to interest rates made monetary policy a source of instability in the economy because changes in the money supply reinforced fluctuations in the economy Fed should focus more on a steady and predictable growth in the money supply

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TargetsIn October 1979, the Fed announced that it would de-emphasize interest rates and would instead target the growth in specific money aggregates with the result that the interest rate became more volatile

In October 1982, the Fed announced in would again pay more attention to interest rates

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TargetsThe rapid pace of financial innovations and deregulation during the 1980s made the definition and measurement of the money supply more difficult

In 1987, the Fed announced it would no longer target M1 growth and switched to a M2

However, by the early 1990s, the link between M2 and nominal GDP had also deteriorated

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Targets

In recent years, under Alan Greenspan, the Fed has targeted the federal funds rate

No central bank in a major economy now makes significant use of money aggregates to guide policy in the short run

The Fed has less control over long-term interest rates