Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Chapter 20

Money Growth, Money Demand, and

Monetary Policy

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Money Growth, Money Demand, and Monetary Policy: The Big Questions

• How is inflation linked to money growth?

• Why do the Fed and the ECB treat money growth differently?

20-3

Money Growth, Money Demand, and Monetary Policy: Roadmap

• Why we care about monetary aggregates

• The quantity theory and velocity

• Money growth in a low-inflation environment

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Inflation and Money Growth

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Inflation and Money Growth

• Avoid sustained high inflation:Central bank must watch money growth

• Can’t have high, sustained inflation without monetary accommodation

• Something beyond just differences in money growth accounts for the differences in inflation across countries.

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Inflation and Money Growth

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• A number of countries created following the collapse of the Soviet Union experienced very high levels of inflation

• Because they had command economies, the state was involved in every aspect of economic life

• Government expenditures were financed by printing money

• To bring inflation under control, the authority to print money was turned over to an independent central bank

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• CPI: How much would it cost to purchase today the basket of goods people bought on a fixed date in the past?

• Fixed expenditure weights

CPI is known to overstate inflation:•Doesn’t adjust for changes in buying patterns•Difficulty in adjusting for quality•Hard to introduce new goods

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Velocity of money (V)

• The number of times each dollar is used (per unit of time).

The Quantity Theory and the Velocity of Money

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The Quantity Theory and the Velocity of Money

Quantity of Money (M) x Velocity (V)

= Nominal GDP

Nominal GDP

= Price level (P) x Real Output (Y)

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The Quantity Theory and the Velocity of Money

MV = PY

implies

%M + %V = %P + %Y

Money Growth + Velocity Growth

= Inflation + Real Growth

20-12

Irving Fisher’s Quantity Theory of Money:

• assume that %ΔV = 0 and %ΔY = 0.

• Double M double P

• Inflation is a monetary phenomenon (Milton Friedman)

The Quantity Theory and the Velocity of Money

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Velocity of M2

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Velocity of Money

• Historical data confirm Fisher’s conclusion that in the long run, the velocity of money is stable.

• Controlling inflation means controlling the growth of the monetary aggregates.

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• When it was first started, the ECB looked at money growth closely

• Velocity appeared relatively stable• Created a reference value

– Inflation = 1½%– Real Growth = 2¼%– Velocity Growth = ¾%Reference value for money growth= 1½%+ 2¼%+¾% = 4½%

• In 2003 the reference value was downgraded and today it is a long-run guide

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The Demand for Money:Transactions Demand

• The quantity of money people hold for transactions purposes depends– on their nominal income– the cost of holding money– and the availability of substitutes

• As the nominal interest rate rises– people reduce their checking account balances– shift funds into and out of higher-yield

investments more frequently

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The Demand for Money:Transactions Demand

The higher the nominal interest rate,the higher the opportunity cost of holding money,the less money individuals will hold for a given level of transactions.

20-18

The Demand for Money:Portfolio Demand

• As a store of value, money provides diversification when held with a wide variety of other assets, including stocks and bonds

• Portfolio demand depends on– Wealth– the expected return relative to the alternatives – expectations that interest rates will change in the future – Risk– Liquidity

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20-20

• Bankers joke that “free checking” is really “fee checking”

• If you sign up for a bank account that is supposed to be free be sure you know when you pay fees and when you don’t

20-21

Targeting Money Growth in a Low-Inflation Environment

• In the long run: inflation is tied to money growth.

• High-inflation environment:– moderate variations in the growth of

velocity are an annoyance– the only way to reduce high inflation is to

reduce money growth.

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Low-inflation environment: Policymakers can use money growth as a policy guide if velocity stable

Targeting Money Growth in a Low-Inflation Environment

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Two criteria for the use of money growth as a direct monetary policy target:

– A stable link between the monetary base and the quantity of money

– A predictable relationship between the quantity of money and inflation

Targeting Money Growth in a Low-Inflation Environment

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Targeting Money Growth in a Low-Inflation Environment

When criteria are met, policymakers can– predict the impact of changes in the

central bank’s balance sheet on the quantity of money

– translate changes in money growth into changes in inflation.

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Targeting Money Growth in a Low-Inflation Environment

• Interest rates opportunity cost Demand for money velocity

• Creates upward sloping relationship between interest rates and velocity

• To use monetary aggregates policymakers need to find a relationship with a predictable slope

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M2 Velocity and the Opportunity Cost of M2

Problem:

Relationship shifted in early 1990s.

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• Making policy is about numbers• This means using statistical models• The problem is that when policymakers

change the way they make policy, everyone changes the way they act

• Following changes in policy regime, old models may be a poor guide for future policy

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Targeting Money Growth in a Low-Inflation Environment

• Possible explanations for the instability of U.S. money demand over the last quarter of the 20th century.– the introduction of financial instruments

that paid higher returns than money.– changes in mortgage refinancing rates.

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Targeting Money Growth in a Low-Inflation Environment

• The ECB and the Fed have both chosen interest rates as their operating instrument

• Interest rates are the link between the financial system and the real economy

• By keeping interest rates stable, policymakers can insulate the real economy from disturbances that arise in the financial system

• While inflation is tied to money growth in the long run, interest rates are the tool policymakers use to stabilize inflation in the short run.

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