FIN 30220: Macroeconomic Analysis

Money, Output, and Prices

FIN 30220: Macroeconomic Analysis

Why does this piece of paper (cloth, actually)have value?

In the early 1920’s, Germany experienced a period where the monthly inflation rate was 29,500% per month! Prices doubled roughly every four days!!!

Using money to stoke a furnace!Money was more valuable as the paper it was printed on!

Yugoslavia (1994)• 313,000,000 %/mo.• Prices double every 34

hours

Zimbabwe (2008)• 79,000,000,000 %/mo.• Prices double every 24.7

hours

Hungary (1946)• 13,600,000,000,000,000 %/mo.• Prices double every 15 hours

All time top inflation rates

What is Money?

“I can’t define it, but I know it when I see it!”

ANY commodity that satisfies three basic properties can be called money

Unit of Account

Store of Value

Medium of exchange

Throughout history, many different commodities have been used as money

The earliest money was commodity money whose value comes from the commodity itself

Tobacco Leaves

Cocoa Beans

Cowrie Shells

Animal Skins

Salt

Precious Metals

Coinage began with King Sadyattes of Lydia, most commonly dated to 630-620 BC.

While remaining a topic of debate by some, this type is now commonly considered to be the first official coin, meeting all of the requirements laid out in the dictionary definition: it is the first coin to have certified markings which signify a specific exchange value and be issued by a governmental authority for use as money.

The Chinese were also developing metal coins around 600BC

Leonidas ISparta

C. 480BC

Alexander the GreatC. 330BC

Julius CaesarRomansC. 120AD

Constantine IByzantine Empire

C. 330AD

CharlemagneFranks

C. 800AD Henry VIIIEngland

C. 1520AD

…and time marches on….

Egypt. 80-77BC

Can you guess who these people are?

Cleopatra and Mark Antony

Elizabeth Taylor and Richard Burton from the 1963 film “Cleopatra”

The English Penny was introduced around 785AD by King Offa of Mercer. Originally, it was a coin of 1.3 - 1.5 grams of pure silver

From the time of King Offa, the penny was the only denomination of coin minted in England for 500 years, until the gold coinage issue of King Henry III around 1257 AD.

The penny was eventually standardized to 1/240 of a Tower pound (350g) of 92.5% silver (sterling silver)…this was later switched to 1/240 of a Troy pound (373g)

Note: Avoirdupois LB = 453G

Early on, the colonies (being British colonies) used British money

Shilling (12 pence)

Pence (Penny)

Pound (20 shillings)Guineas or Sovereigns were gold coins with a value of one pound sterling

All these coins are during the reign of Charles I (1625 – 1649). Inadequate supply of British money put commerce in jeopardy in the colonies.

Taking matters into their own hand, Boston authorities allowed John Hull and Robert Sanderson to set up a mint in 1652. “Pine Tree” shillings were minted until 1674 when the mint was shut down

All the coins bear the date 1652. Why? Coinage was the sole prerogative of the king, but in 1652 there was no king (King Charles I had been beheaded three years earlier). They kept the date so they could deny any illegality if and when a monarchy was once again reestablished which it was in 1660.

Spanish coins remained legal tender until the coinage act of 1857!

Spain established a mint in what is now Mexico City in 1535. Spanish ships returning to Europe would stop off in the colonies to buy supplies. This made Spanish money widely available in the colonies.

Doubloon = 4 dollars (1/5 oz. of gold)Spanish dollar = 8 Reals (.88 ounces of silver)

2 Bits is still considered slang for a quarter!

On April 2, 1792 Congress passed the coinage act which created the mint.

US coins made in 1792 were not minted for circulation and are EXTEMELY valuable. This 1792 penny sold for $603,750!

The Constitution (1787) gives the congress the right to “To coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights and Measures” (Section 8, Clause 5)

The Coinage Act of 1792 defined a US Dollar as .0538 ounces of pure gold or .86 ounces of pure silver (15:1 ratio) – same (almost) as the Spanish dollar

The US mint began production in 1793

Where does the dollar sign come from?

SUP

The back of a Spanish peseta had two columns (the pillars of Hercules) wrapped with a scroll that reads “plus ultra”- beyond the pillars, there are other lands. Could this be the origin of the dollar sign?

Imagine a U and an S (for United States overlapping)

The dollar was fashioned after the Spanish peseta - the P stands for Peseta, the “s” makes it plural (what if the P and S overlap), the line indicates an abbreviation

SP8

Note that from 1793 to 1857, the cent was larger than a modern quarter

The “Chain link penny” caused a lot of controversy..many believed that the chains represented slavery!

The chain was immediately replaced with a victory wreath.

The first circulated penny was released in 1793

Half penny 1793

All American coins must have “an impression emblematic of liberty and the word liberty as well as the year. On the reverse of copper coins was required the denomination.

Half dime introduced in 1794 The dime was first issued in 1796

Quarter: 1796

1794: US Half dollar

1794: US dollar (A gold dollar was released in 1849)

On the reverse of gold and silver coins will be an eagle and “United states of America” . Denominations didn’t begin showing up on silver coins until 1804

Production of silver coins ceased in 1964

1796: Quarter Eagle ($2.50)

US Half eagle ($5) - 1796

US eagle ($10) - 1795

On the reverse of gold and silver coins will be an eagle an “United states of America” . Denominations didn’t begin showing up on gold coins until 1807

Production of gold coins ceased in 1934

US double eagle ($20) - 1849

1964: JFK appears on the half dollar

1909: Lincoln appeared on the cent to commemorate the 100 anniversary of his birth

1932, George Washington appears on the quarter

1938: Jefferson appears on the nickel

1946: FDR appears on the dime due to his big support for the march of dimes

Currently, the US mint produces between 4B and 10B coins annually. As a self funded agency, the mint generated 3.89B dollars of revenues in 2010.

The US mint has facilities in Washington DC, Philadelphia, West Point, Denver , San Francisco, and the bullion depository at Fort Knox.

Women finally made it onto US coins!

Susan B. Anthony was the first non-mythical woman to appear on a US coin in 1978

Sacagawea followed in Susan’s footsteps in 2000

None of our coins has any precious metal content

99% Zinc, 1%Copper

Annual Production: 6.8M

75% Copper, 25% Nickel

Annual Production: 1.4B







88% Copper, 6% Zinc, 3% Magnesium, 3% Nickel


Paper money first makes an appearance in China around 900AD

Due to a severe copper shortage, the Chinese begin issuing paper currency. Frequent reissues fuel inflation

Each of the colonies issued currency. Most of these were “bills of credit”

Beginning in 1775, the Continental congress issued currency to finance the revolutionary war. Continentals were bills of credit – not backed by gold or silver. Easily counterfeited, the notes quickly devalued, giving rise to the phrase “not worth a continental!”

A private business chartered by the confederation congress. Was the first IPO in the United States and the first Private Commercial bank. Later re-chartered as the Bank of Pennsylvania. Eventually acquired by Wells Fargo

The founding fathers feared fiat money (for good reason with the failure of the continental). In fact, the constitution forbids states from issuing paper fiat money.

Bank of North America (1782 – 1786)

The First bank of the US was chartered in 1791. While officially a private bank, the US government controlled 25%. The charter was not renewed in 1811.

The Second Bank of the US was chartered in 1816. Its charter renewal was vetoed by Andrew Jackson in 1836

The second bank of the US existed for five more years until going bankrupt in 1841

The founding fathers feared fiat money (for good reason with the failure of the continental). In fact, the constitution forbids states from issuing paper fiat money.

Prior to 1838, a bank charter could be obtained only by a specific legislative act. However laws passes by various states after 1838 allowed the automatic chartering of banks by the states without any special legislative consent.

From 1840 – 1863 all banking business was done by state banks

1837 – 1863 over 8,000 “brands of currency issued by banks, state governments, private individuals, and private companies

Anyone who satisfied the chartering requirements could become a bank and issue currency!

US notes were last placed into circulation in 1971

The US began issuing United States Notes in 1862 after passing the legal tender act. US Notes were not backed by gold, but were “legal tender for all debts public and private”

US Notes were nicknamed “greenbacks”

The National Banking Act of 1863 allowed Nationally chartered banks to distribute bank notes (deemed legal tender) backed by US Treasuries.

State bank notes were subject to very high taxes and soon disappeared

National banknotes were printed by the US Treasury

The Federal Reserve was created in 1913 to as a solution to bank panics (particularly, the banking panic of 1907)

Denominations of $500, $1,000, $5,000, and $10,000 were no longer printed after 1946 for fear of German counterfeiting!!

William McKinley - $500 Grover Cleveland- $1,000

James Madison- $5,000 Salmon P. Chase - $10,000 (Treasury Secretary under Lincoln)

The largest denomination ever printed was a $100,000 gold certificate. It was never circulated, but was used for inter-bank transfers

The beginning of the end: 1934

During the great depression, US citizens were converting paper currency into gold in large quantities. The government didn’t have enough gold to back up the currency, so FDR passed an executive order that made it illegal for US citizens to hold gold.

Only foreign central banks could convert paper dollars into gold

This coin sold at auction in 1996 for $7.5M!!

Old Version (prior to 1935)

Secretary of Agriculture (and later, vice president) Henry Wallace saw the Latin phrase “Novus Ordo Seclorum” which means a new order of the ages and thought it meant “The new deal of the ages” both were freemasons and saw the symbol above the pyramid as the “all seeing eye” – the Masonic symbol for the great architect of the universe.

New version (began in 1935)

FDR put the Great Seal on US Currency in 1935

In God We Trust was adopted officially as the motto of the United States in 1956 as an alternative or replacement to E Pluribus Unum.

In God we trust has appeared on currency since 1957

In god we trust has appeared sporadically on coins since 1864

Some atheists have been known to mark out the motto with a custom made stamp

On August 15, 1971, Nixon closes the gold window and the US dollar ceases to be convertible into gold by anyone. This marks the beginning of a truly anchorless system

The U.S. Department of the Treasury first issued paper currency of the United States in 1862 as a result of a shortage of coins and the need to finance the Civil War.

Today, the BEP has facilities in Washington DC and Fort Worth Texas

•Currently, the BEP produces around 38 million notes per day with a face value of approximately $500M (mostly to replace worn out currency)•Average Lifetime

• $ 1 ...............18 months• $ 5 ................ 2 Years• $ 10................ 3 Years• $ 20 .............. 4 Years• $ 50 ............... 9 Years• $100 ...............9 Years

•The average cost of a note is 9.1 cents

The BEP has had a contract with the Crane paper company to supply the paper for our currency since 1879.

•The “paper” is 75% cotton and 25% linen with blue and red silk threads running through it• Have you ever wondered how many times you could fold a piece of currency before it would tear? About 4,000 double folds (first forward and then backwards) are required before a note will tear.

All bills, regardless of denomination, utilize green on the backs. Faces use black ink, color shifting ink, and metallic ink. Inks are formulated and blended by the BEP

US currency utilizes a combination of offset and Intaglio printing. In Intaglio printing, images are engraved on plates. Ink is applied to the plate and then pressed into the paper under great pressure.

Signature of the Treasurer of the US (Note: Every Treasurer of the US has been a woman since 1949 under Truman)

Signature of the Secretary of the Treasury

Series Date

Seal of the US Treasury

Federal Reserve District Seal:

A (1) = Boston, B (2) = New York, C (3) = Philadelphia, D (4) = Cleveland, E (5) = Richmond, F (6) = Atlanta, G (7) = Chicago, H (8) = St. Louis, I (9) = Minneapolis, J (10) = Kansas City, K (11) = Dallas, L (12) = San Francisco

Federal Reserve District Number

Each printing plate has 32 objects. The plate, therefore, is divided into 32 locations…

A100000001

E100800001

A303200001

E304000001

B100200001

F101000001

B303400001

F304200001

C100400001

G101200001

C303600001

G304400001

D100600001

H101400001

C303800001

H304600001

A201600001

E202400001

A404800001

E405600001

B201800001

F202600001

B405000001

F405800001

C202000001

G202800001

C405200001

G406000001

D202200001

H203000001

D405400001

H406200001

One press run will be 200,000 sheets. The serial numbers are applied use skip numbering. The numbers are placed so that when the sheets are stacked and cut, the stacks of bills will be sequential.

This would be the serial number locations for the first page of the first run of 200,000 sheets.

A106400001

E107200001

B106600001

F107400001

C106800001

G107600001

D107000001

H107800001

After the first run of 200,000, the process is repeated starting with 06400001

After 15 runs of 200,000 (1 cycle) we are at serial number 96000000. At this point, we go back to 00000001

Given the numbering system, each serial number is guaranteed to come from one particular plate location. This gives currency an anti counterfeiting device…

Serial number

Federal Reserve District

This letter identifies the number of “cycles”: Y = 25

Plate position

Plate serial number

Can you find the owl on the $1 Bill?

Did you know that the owl is a Masonic symbol of wisdom?

See it now?

Some argue that when looked at even closer, it’s a spider, not an owl.

Assets Liabilities

$11,036 (Gold) $793,705 (Currency in Circulation)

Federal Reserve System (2006)

$792,581 (US Bonds)

The narrowest definition of money would be the Monetary Base (also called M0, Inside Money, or High Power Money). The monetary base is a direct liability of the Federal Reserve – that is, cash!

In Millions

$64 (Loans)

Total: $882,649

$78,968 (Other)

$12,346 (Reserve Deposits)

$61,323 (Other)

Total: $882,649

Monetary Base = Cash in Circulation + Vault Cash + Reserve Deposits

$15,275 (US Treasury Deposits)

Reserves

Needless to say, we are living in interesting times. This can be seen in the Fed’s balance sheets

Assets Liabilities

$11,036 (Gold) $793,705 (Currency in Circulation)


$792,581 (US Bonds)

In Millions

$64 (Loans)

Total: $882,649

$78,968 (Other)

$12,346 (Reserve Deposits)

$61,323 (Other)

Total: $882,649

$15,275 (US Treasury Deposits)

Assets Liabilities

$11,041 (Gold) $1,392,478 (Currency in Circ.)


$2,461,813 (US Bonds)

In Millions

$179 (Loans)

Total: $4,541,691

$2,068,658 (Other)

$2,657,762 (Reserve Deposits)

Total: $4,541,691

$226 (US Treasury Deposits)

$491,225 (Other)

Quantitative easing program

QE1 (Nov. 2008): $2.1T in Bank Debt, Mortgage Backed Securities and TreasuriesQE2 (Nov. 2010): $600B in Treasury SecuritiesQE3 (Sept. 2012): $40B per month (increased to $85B/mo. In Dec. 2012)

QE1 QE2 QE3

$1.7T

$4T

$2.7T

Quantitative easingB

illi

on

s o

f d

oll

ars

QE1 QE2 QE3

$1.3T

$4T

$2.3T

Bil

lio

ns

of

do

llar

sQuantitative easing

Monetary Base•Normal Annual Growth: 7% per year•2006 – 2015 Growth: 21% per year

Currency in Circulation•Normal Annual Growth: 7% per year•2006 – 2015 Growth: 6% per year

The lack of inflation from QE is largely because the cash injected isn’t circulating!

$3T

$1.7T

$1.3T

M1 = Currency in Circulation + Checkable DepositsB

illi

on

s o

f D

oll

ars

(Note: Bank Reserves ARE NOT included in M1)

M2 = M1 + Savings Deposits + MMM Funds + Small Time Deposits

$11.8T

$3T

$7.7T

$600B$500B

Bil

lio

ns

of

Do

llar

s

M2 ($11.8T)

M1 ($2.9T)

M0 ($4T)

“Quantitative Easing”

Money in the United States

By purchasing and/or selling securities, the Fed can directly control the quantity of M0. Suppose that the Federal Reserve wants to increase the Monetary Base.

Bond DealerFederal Reserve

Dealers Sell bonds to the Fed

The Fed credits the reserve account of the dealer’s bank

This is called an open market purchase

Assets Liabilities

Suppose that the Federal Reserve purchases a $10,000 Treasury. It pays for it by crediting the bond dealer’s bank account at Citibank.

+ $10,000 (Reserve Deposits)

Assets Liabilities

+ $10,000 (Treasuries)

Citigroup’s balance sheet is affected as follow:

+ $10,000 (Deposits)+ $10,000 (Reserves Deposits)

Citigroup’s reserve account

Bond dealer’s checking account

Assets Liabilities

The federal reserve requires that 5% of transaction deposits must be kept on reserve with the federal reserve. The remainder, the bank is free to lend out.

+ $10,000 (Deposits)

Assets Liabilities

+ $500 (Required Reserves)

Suppose that Citibank makes a $9,500 car loan

+ $9,500 (Excess Reserves)

+ $10,000 (Deposits)+ $500 (Required Reserves)+ $9,500 (Excess Reserves)+ $9,500 (Car Loan)

+ $9,500 (Line of Credit)

Assets Liabilities

Eventually, the $9,500 will end up in the bank account of the car dealership. At that point, Citibank covers the credit line by a transfers a $9,500 credit into Bank of America’s account

+ $10,000 (Deposits)

Assets Liabilities

+ $500 (Required Reserves)

Now, Bank of America has $9,500 in new reserves, 5% must be kept at the Fed, the rest can be lent out.

+ $9,500 (Deposits)+ $9,025 (Excess Reserves)

+ $9,500 (Car Loan)

+ $475 ( Required Reserves)

Car dealer’s checking account

Assets Liabilities

+ $10,000 (Reserve Deposits)+ $10,000 (Treasuries)

Assets Liabilities

+ $10,000 (Deposits)+ $500 (Required Reserves)

+ $9,500 (Car Loan)

Assets Liabilities

+ $9,500 (Deposits)+ $9,025 (Excess Reserves)+ $475 ( Required Reserves)

Change in MB = $10,000

Change in M1=$19,500

The initial bond purchase creates a “ripple effect” through the banking system

This process will continue as payments get passed from bank to bank.

$ Change in M1 = (mm)$ Change in MB

mm = 1 +

Cash Deposits

Cash Deposits

Reserves Deposits

+

In our example, Reserves

Deposits= 5%

Cash

Deposits= 0%

$ Change in M1 = $10,000 = $200,0001

.05

Currently in the US….• Currency in Circulation = $1.3T• Reserves = $2.3T• Checkable Deposits = $1.7T

1.311

1.7 .831.3 2.31.7 1.7

CDmm

C RD D

Think of money demand as a portfolio allocation problem. You have a fixed amount of income and you are allocating it over several assets.

Less Liquid Higher Return

More Liquid Lower Return

$5,000/month

Cash $400

Checking Account$2,000

Savings Account$600

Stock/Bonds $2,000

M1

M2

Income

Money DemandSuppose that you are planning on spending $120 over the coming month. You currently have all your money in a savings account earning interest. To buy things you will need cash.

As long as your money is in a savings account it is counted as M2, but not M1

The cash you withdraw is included in M1

ATM Withdrawals

Cash Balance Hits Zero

Suppose you go to the bank three times per month (every 10 days). You withdraw $40 each time. More generally, if you make plan on Spending PY dollars per month. If you make N trips to the ATM

N

PY

Average Cash Balances (Money Demand)

Real Money Demand

2

0,, N

PY

NYPM d

N

Y

P

NYM d

2

,

What determines N?

Interest Cost 2

Yi

N tN Cost n Transactio

If you make very few trips to the bank (N is small), you will need to withdraw more cash – having more cash entails more lost interest

If you make a lot of trips to the bank, you will withdraw less each time (less interest cost), but you will pay more in transaction costs

The objective here is to choose the number of times you go to the bank to get money

There are two costs associated with money:

tNN

YiMinimize

N 2

02 2

tN

YiTake the derivative with respect to ‘N’

t

YiN

2 Solve for N

Money Demand

t

YiN

2

As the interest rate goes up, you hold less cash. Therefore, you make more trips to the bank

As ATM fees rise, you make less trips to the bank, but withdraw more each time

This is the optimal behavior (i.e. trips to the ATM per month)

Money Demand

i

Yt

N

Y

P

M d

22

Real Money Demand

Real Income

Nominal Interest Rate

Transaction Costs

Generally Speaking….

tiYMP

M d

,,

Real Money Demand

Real Income (+)

Nominal Interest Rate (-)

Transactions Costs (Cost of obtaining money) (+)

“is a function of…”

Remember, eri

A common form of money demand can be written as follows:

YtikP

M d

),(

Real money demand is equal to a fraction (k is between zero and one) of real income. That fraction depends on interest rates (-) and transaction costs (+)

Constant between 0 and 1

The Quantity Theory of Money

Nominal Income

Velocity – Measures the number of times a dollar changes hands

Money Supply

PYMV

Note: We could rewrite this as percentage changes…

YPVM %%%%

The Quantity Theory of Money and Money Demand

When money demand drops– velocity increases.

( , )SMk i t Y

P

PYMV

1V

k

Money Demand

1SM PYk

Equilibrium condition in the money market

Trend

M1 Demand Rises from 1980 - 1993

M1 Money Demand falls dramatically starting in 1995

In 1995, we saw a dramatic change in household portfolio decisions…why?

As interest rates rose, households switched out of checking accounts and into savings accounts….technology (online banking, ATMs, etc. made this transition easier)

Rising Demand for M2

Falling demand for M2

P

M

ed tYM ,,

P

M s

r

When the money market is in equilibrium, real money supplied equals real money demanded.

*r

real interest rate

real money

Nominal Money Supply(determined by the Fed)

real output (determined in the labor market)

Transactions costs

Expected inflation

Price Level

r

I

S

I

Determined in capital markets

Y C I G

S I

P

M

ed tYM ,,

P

M s

r

Suppose that the Fed increases the money supply by 10% (assume inflation expectations are zero)

*r

At the existing interest rate, there is excess supply of money. Now what?

r

I

S

I


Y C I G

S I

Nothing in the real economy has changed

P

M

ed tyM ,,

P

M s

r

The price level increases by an equal 10%. The price increase returns real money to its original level (Money is neutral)

*r

r

I

S

I


Y C I G

S I

This one time increase in the money supply creates no inflation…just a one time adjustment in prices

Time

M

10%

Time

P

10%

Again, the real economy is unaffected and “money is neutral”

0% Growth 0% Growth

0% Growth 0% Growth

Suppose that prior to the 10% increase in the money supply, there was $100M in circulation. Further, assume that there is only one good in the economy – beer – six packs of beer initially cost $10.

Prior to the increase in money supply: MM

P

M10

10$

100$

six packs of beer

After the increase in money supply: MM

P

M10

11$

110$

six packs of beer

10%% MP

No net gain/loss, right? However, there is something going on here!

Remember, the government must use the newly printed currency to buy something in order to send it into circulation. In this example, the only thing available to buy is beer (Party at Janet’s house!!!).

10$

10$100$110$

P

MMMM Janet uses the $10M in newly created money to buy 1M beers!

If there is zero net gain, or loss, then this 1M gain in beers by the government must be offset somewhere!

MMM

P

M

P

M1

11$

110$

10$

110$'

''

Once prices rise, anyone holding money sees a drop in their purchasing power!!!

Really, we can think of an increase in the money supply as an invisible tax – the inflation tax!

5%

Now, lets repeat the example, but now assume that the money supply increase alters households expectations. Suppose households believe that the fed will increase the money supply by 10% every year

10%

P

M s

r

0,, ed tYM

10,, ed tYM

Now, prices increase by more than 10%

r

I

S

I


Y C I G

S I

The rise in inflation expectations creates an “overreaction” in prices due to the drop in money demand

Time

M

0% Growth

Time

P

20%

10% Growth

0% Growth 10% Growth

Lets make this example a little more specific. Suppose that prior to the 10% increase in the money supply, there was $100M in circulation. Further, assume that there is only one good in the economy – beer – six packs of beer initially cost $10.

Prior to the increase in money supply: MM

P

M10

10$

100$

six packs of beer

After the increase in money supply: $110

9.1$12

M MM

P

six packs of beer

% % 20P M

Now we have a very real loss…who pays here? Surely not the government!

Remember, the government must use the newly printed currency to buy something in order to send it into circulation. In this example, the only thing available to buy is beer (Party at Janet’s house!!!).

10$

10$100$110$

P

MMMM Janet uses the $10M in newly created money to buy 1M beers!

If there is zero net gain, or loss, then this 1M gain in beers by the government must be offset somewhere!

' '

'

$110 $1101.9

$10 $12

M M M MM

P P

Now, the households loss is bigger than the governments gain!

Essentially, the loss is coming from the fact that people are spending too much time trying to avoid holding money and too little time making beer!!

Where do hyperinflations come from?

Yugoslavia (1994)• 313,000,000 %/mo.• Prices double every 34

hours

Zimbabwe (2008)• 79,000,000,000 %/mo.• Prices double every 24.7

hours

Hungary (1946)• 13,600,000,000,000,000 %/mo.• Prices double every 15 hours

PYMV Recall the quantity theory

YPVM %%%%

Or, in percentages

Inflation

% % % %P M V Y

% % % %P M V Y

For relative low rates of money growth, money demand is relatively constant (change in velocity is close to zero)

% % %P M Y

For high rates of money growth, money demand falls(change in velocity is close to positive)

% % % %P M V Y

Rising velocity creates more inflation

Rising inflation creates more velocity

P

M

ed tyM ,,

P

M sr

Money, Prices, and the Business Cycle….

*rThe increase in real output should increase money demand

r

I

S

I

Investment demand rises during expansions due to the rise in productivity. Anticipating the rise in income to be temporary, savings rises

The Real interest rate falls.

At the new equilibrium real interest rate, we have excess demand for real money

Prices need to fall to increase the real value of money circulating

Just the facts ma’am.

Money, Prices and the business cycle

Given the mechanics of the money market, what relationships would we expect to see between money supply, prices and output?

Output

Money (Money is a policy variable) 0

Prices -

Correlation = -.21

The Price level vs. GDP

% D

evia

tion

fro

m T

rend

Correlation = -.02

M1 Money Supply vs. GDP

% D

evia

tion

fro

m T

rend

Correlation = .25

M2 Money Supply vs. GDP

% D

evia

tion

fro

m T

rend

This is a problem

Our model would also predict a zero correlation between the money supply and the real interest rate

Correlation = -.09

% D

evia

tion

fro

m T

rend

Real Interest Rate vs. M1

% D

evia

tion

fro

m T

rend

Correlation = -.20

Real Interest Rate vs. M2

This is a problem

Example: Oil Price Shocks in the 1970’s

Do

llar

s p

er B

arre

l

1973 Arab Oil Embargo(Permanent Shock)

1979 Iranian Revolution(Temporary Shock)

r WYS ,

*r

** IS

LAI ,IS ,

P

M

ed tyM ,,

P

M sr

*rThe decrease in real output should lower money demand

New equilibrium interest rate

Price needs to increase so that the real supply of money equals the new demand at the new interest rate

In prior analyses, we already determined that both events looked like declines in productivity …

The resulting decline in investment lowers the real interest rate

1973 Arab Oil Embargo

1979 Iranian Revolution

r

M

P

sM

P

DM

rsM

P

DM

Pric

e Le

vel (

% D

ev.

Fro

m t

rend

)CPI (1972 – 1982)

M

P

Documents

FIN 30220: Macroeconomic Analysis