Connecting Money and Prices: Irving Fisher’s Quantity Equation

M × V = P × Y

The Quantity Theory of Money

V = Velocity of money The average number of times each dollar in the money supply is used to purchase goods and services included in GDP.

M

Y x PV

We can transform the quantity equation from Y x P V x M to:

Growth rate of the money supply + Growth rate of velocity

=

Growth rate of the price level (inflation rate) + Growth rate of real output

The growth rate of the price level is just the inflation rate•we can rewrite the quantity equation to help us understand the factors that determine inflation:

If velocity is constant,

Inflation rate = Growth rate of the money supply

+ Growth rate of velocity

− Growth rate of real output

The Quantity Theory of Money

Inflation rate = Growth rate of the money supply

− Growth rate of real output

• If money supply grows at a faster rate than real GDP inflation.• If money supply grows at a slower rate than real GDP, deflation.

Very high rates of inflation—in excess of hundreds or thousands of percentage points per year—are known as hyperinflation.

Economies suffering from high inflation usually also suffer from very slow growth, if not severe recession.

What Is Monetary Policy?

The Inflation Rate, 1952–2006

The Goals of Monetary Policy: Price Stability

High Employment

Other Goals of Monetary Policy

Economic Growth

•Policymakers aim to encourage stable economic growth

•Stable growth allows households and firms to plan accurately and encourages the long-run investment sustains growth.

Stability of Financial Markets and Institutions

•The Fed can’t control unemployment or inflation rates directly

•The Fed uses monetary policy targets, that it can control, that in turn, affect variables closely related to its policy goals—real GDP, employment, and the price level.

•These monetary policy targets include the growth rate of the money supply and, most importantly now, the federal funds interest rate

The Money Market and the Fed’s Choiceof Monetary Policy Targets

The Demand for Money

The Demand for Money

The Money Market and the Fed’s Choiceof Monetary Policy Targets

Shifts in the Money Demand Curve

Shifts in the Money Demand Curve

The Money Market and the Fed’s Choiceof Monetary Policy Targets

How the Fed Manages the Money Supply: A Quick Review

Equilibrium in the Money Market

The Impact on the Interest Rate When the Fed Increases the Money Supply

The Relationship between Treasury Bill Prices and Their Interest Rates

4 100 x 000,1$

P

P

What is the price of a Treasury bill that pays $1,000 in one year, if its interest rate is 4 percent?

When the price paid for a bond rises,

the interest rate earned on the bond falls

Monetary Policy and Economic Activity

• Consumption: lower rate save less, spend more

• Investment: lower rate finance more capital investment

• Net exports: lower rate $ depreciation NX increase

How Interest Rates Affect Aggregate Demand

Changes in interest rates will not affect government purchases, but they will affect the other three components of aggregate demand in the following ways:

The Importance of the Federal Funds Rate

Federal funds rate The interest rate banks charge each other for overnight loans.

Monetary Policy and Economic Activity

Expansionary monetary policy The Federal Reserve’s increasing the money supply and decreasing interest rates to increase real GDP.

The Effects of Monetary Policy on Real GDP and the Price Level: An Initial Look

Contractionary monetary policy The Federal Reserve’s adjusting the money supply to increase interest rates to reduce inflation.

Monetary Policy and Economic Activity

The Effects of Monetary Policy on Real GDP andthe Price Level: An Initial Look

Monetary Policy

Monetary Policy and Economic Activity

A Summary of How Monetary Policy Works

Expansionary and Contractionary Monetary Policies

The Fed Responds to the Terrorist Attacks of September 11, 2001

Makingthe

Connection

The day after the terrorist attacks of September 11, 2001, the Fed made massive discount loans to banks and succeeded in preventing a financial panic. Alan Greenspan, pictured here, was the chairman of the Fed at the time of the attacks.

Reserves Deposits that a bank keeps as cash in its vault or on deposit with the Federal Reserve.

Required reserves Reserves that a bank is legally required to hold, based on its checking account deposits.

Required reserve ratio The minimum fraction of deposits banks are required by law to keep as reserves.

Excess reserves Reserves that banks hold over and above the legal requirement.

The Inflation and Deflation of the Housing Market “Bubble”

Makingthe

Connection

Monetary Policy and Economic Activity

Can the Fed Get the Timing Right?

The Effect of a Poorly Timed Monetary Policy on the Economy

Don’t Let This Happen to YOU!Remember That with Monetary Policy, It’s the Interest Rates—Not the Money—That Counts

Why Doesn’t the Fed Target Both the Money Supply and the Interest Rate?

The Fed Can’t Target Both the Money Supply and the Interest RateSome economists have

argued that rather than use an interest rate as its monetary policy target, the Fed should use the money supply.

Milton Friedman and his monetarist followers favored replacing monetary policy with a monetary growth rule.

A Closer Look at the Fed’s Settingof Monetary Policy Targets

Taylor rule A rule developed by John Taylor that links the Fed’s target for the federal funds rate to economic variables.

The Taylor Rule

Federal funds target rate =

Current inflation rate

+ Real equilibrium federal funds rate

+ (1/2) x Inflation gap

+ (1/2) x Output gap

Should the Fed Target Inflation?

Makingthe

ConnectionHow Does the Fed Measure Inflation?

Is the Independence of theFederal Reserve a Good Idea?

The Case for Fed Independence

FIGURE 14.12

The More Independent the Central Bank, the Lower the Inflation Rate

Is the Independence of theFederal Reserve a Good Idea?

In democracies, elected representatives usually decide important policy matters. In the United States, however, monetary policy is not decided by elected officials. Instead, it is decided by the unelected FOMC.

Because those deciding monetary policy do not have to run for election, they are not accountable for their actions to the ultimate authorities in a democracy: the voters.

The Case against Fed Independence

Contractionary monetary policy

Expansionary monetary policy

Federal funds rate

Inflation targeting

Monetary policy

Taylor rule

K e y T e r m s