21
Chapter 20 Quantity Theory, Inflation and the Demand for Money (Lecture 2)
Chapter 20
Quantity Theory,
Inflation and the
Demand for
Money
(Lecture 2)
19-2
Recall from last time:
• Constant velocity according to equation of exchange
• Invalidated by data
• Keynesian money demand: Md/P=f(i,Y) Procyclical
velocity
19-3
Further Developments in the Keynesian
Approach
• Transaction Demand: Baumol and Tobin developed models illustrating that even transactions demand for money is sensitive to interest rates.
Q: Suppose an individual who receives $1000 as his salary at the beginning of each month. Instead of keeping all his salary as cash and spending over the month, this person can buy bonds with $500 for two weeks and then sell the bonds for the rest of the month. What is the consequence of this behavior?
Md=Ms (down)V (up)
Individual earns interest income
19-4
• There is an opportunity cost and benefit
to holding money
• The transaction component of the demand for
money is negatively related to the level of
interest rates
When market interest rates are high, opportunity
cost of holding money is high, it is worth the
individual to engage in transaction costs and keep
bonds: Md decreases
When market interest rates are low, opportunity
cost of holding M is low : Md increases
19-5
Precautionary Demand
• Similar to transactions demand
• As interest rates rise, the opportunity
cost of holding precautionary
balances rises
• The precautionary demand for money is
negatively related to interest rates
19-6
Friedman’s
Modern Quantity Theory of Money
• Friedman treated money as any other type of asset and analyzed its
demand accordingly:
( , , , )
=demand for real money balances
= meausre of wealth (permanent income)
= expected return on money
= expected return on bonds
= expected return on equity
= expected
de
p b m e m m
d
p
m
b
e
e
Mf Y r r r r r
P
M
P
Y
r
r
r
inflation rate
Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 19-7
Variables in
the Money Demand Function
• Permanent income (average long-run income)
Most important component of money demand according to Friedman (empirical findings)
It is much stable than annual income as it does not fluctuate much with business cycles or temporary changes in salary.
Friedman’s argument implies that individuals hold money based on expected income flow.
Ex: If you are a student today but expect a decent job on two years, you borrow against your future income and hold M accordingly
Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 19-8
Differences between Keynes’s and
Friedman’s Model (cont’d)
• There is a positive rate of return on money (rm)
due to services provided by banks and interest
paid on deposits
• BUT the rate spreads in the Md function are
constant
Md is mainly a function of income
Md /P ≈ f (Yp)
19-9
The demand for money is stable velocity is predictable
Money is the primary determinant of aggregate spending
• Pro-cyclical V is supported (similar to Keynes):
• Y (up), Yp (up)
• but and
• V=Y/ f(Yp ) (up)
PYVM ^
pYY
)(/
^
pYf
Y
PM
Y
M
PYV
)( pd
YfP
MY
Quantity Theory and Inflation
• Percentage Change in (x ✕ y) = (Percentage Change in x) + (Percentage change in y)
• Using this mathematical fact, we can rewrite the equation of exchange as follows:
• Subtracting from both sides of the preceding equation, and recognizing that the inflation rate, is the growth rate of the price level,
• So long as velocity is constant (or predictable) we can use quantity theory to link monetary policy to inflation and output growth
% % % %M V P Y
% % % %P M V Y
Figure 1 Relationship Between Inflation and
Money Growth
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. For panel (b), International Financial Statistics. International Monetary Fund,
www.imfstatistics.org/imf/.
Figure 2 Annual U.S. Inflation and Money
Growth Rates, 1965–2010
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.
19-13
Empirical Evidence (is it in favor of
Friedman or Keynes?)
• Stability of money demand Prior to 1970, evidence strongly supported stability of the money demand
function
Since 1973, instability of the money demand function has caused velocity to be harder to predict
• Implications for how monetary policy should be conducted
Shift away from monetary aggregates as the operating instrument (or nominal anchor)
19-14
End of Chapter Questions
Skip: 5,6,11,13,14,15,16,17
End of chapter question 18
• Why does the Keynesian view of the
demand for money suggest that velocity
is unpredictable?
19-15
End of chapter question 22
• Calculate what happens to nominal GDP
if velocity remains constant at 5 and the
money supply increases from $200
billion to $300 billion?
19-16
• MV=PY
%∆M+ %∆V= %∆(PY)
(300-200)/200+0= %∆(PY)
%∆(PY)=50%
Note (PY)1=M1V1=200.5=$1000 bn (or $1
trillion)
PY2=$1000+$1000.(0.5)=$1500 (or $1.5
trillion) 19-17
End of chapter question 24
• If velocity and aggregate output remain
constant at 5 and 1000, respectively,
what happens to the price level if the
money supply declines from $400 billion
to $300 billion?
19-18
• %∆M+ %∆V= %∆P+ %∆Y
%∆P= %∆M=(300-400)/400=-0.25%
P declines by 25 %
Note P1=M1V1/Y1=(400.5)/1000=2
P2=2-2.(1/4)=1.5
19-19
End of chapter question 25
• Suppose the liquidity preference function
is given by
• L(i,Y)=Y/8-1000i
Calculate velocity for each period using
the money demand equation, along with
the following table of values:
19-20
Period 1 Period 2
Y (in billions) 12,000 12,500
Interest Rate 0.05 0.07
• MV=PY
V=Y/(M/P)
Period 1: M/P=L(i,Y)=12000/8-1000(0.05)
=1500-50=1450
V=12000/1450=8.28
19-21
Period 1 Period 2
Y (in billions) 12,000 12,500
Interest Rate 0.05 0.07
