Monetary Policy and Inflation: Quantity Theory of Money

1

• The Equation of Exchange– The formula indicating that the number

of monetary units times the number of times each unit is spent on final goods and services is identical to the price level times output (or nominal national income)

MV PY

Monetary Policy and Inflation: Quantity Theory of Money

2

Money, Real GDP, andthe Price Level

The equation of exchange states that the quantity of money (M) multiplied by the velocity of circulation (V) equals GDP, or

MV=PY

3


GDP equals the price level (P) times real GDP (Y), or:

GDP = PY

4

• The equation of exchange and the quantity theory: MV = PYM = actual money balances held

by non-banking publicV = income velocity of money; the

number of times, on average, cash monetary units are spent on final goods and services

Monetary Policy and Inflation : Quantity Theory of Money

5

• The equation of exchange and the quantity theory: MV = PYP = price levelY = real national output (real

GDP)


6

• The equation of exchange as an identity

MV PYPY = nominal national income

MV = nominal national spending


7


We can convert the equation of exchange into the quantity theory of money by making two assumptions:

1) The velocity of circulation is not influenced by the quantity of money.

2) Potential income is not influenced by the quantity of money.

8


The Quantity Theory of Money– The quantity theory of money is the

proposition that in the long run, an increase in the quantity of money brings an equal percentage increase in the price level.

– This theory is based upon the velocity of circulation and the equation of exchange.

9


The Quantity Theory of Money The velocity of circulation is the average number of times a dollar of money is used annually to buy goods and services that make up GDP.

10


Make the quantity of money M, and the velocity of circulation V is determined by:

V = PY/M

11

The Velocity of Circulation in the United States: 1930–1999

12


This can be shown by using the equation of exchange to solve for the price level.

P = (V/Y)M

13


In the long run, real GDP equals potential GDP, so the relationship between the change in the price level and the quantity of money is:

MYVP )/(

14


Dividing this equation by an earlier one, P = (V/Y)M, gives us

MMPP //

15


This equation shows that the proportionate change in the price level equals the proportionate change in the quantity of money.

This gives us the quantity theory of money:In the long run, the percentage increase in the price level equals the percentage increase in the quantity of money.

16

• The crude quantity theory of money and prices–Assume: V is constant

Y is stable

MV = PY


17

• The crude quantity theory of money and prices–Increases in M must be

matched by equal increases in the price level


MV = PY

18Figure 17-5

19

Money Growth andInflation in the United States

20

Money Growth andInflation in the United States

21

Money Growth andInflation in the World Economy

22

Money Growth andInflation in the World Economy

23


Historical Evidence on the Quantity Theory of Money–The data are broadly consistent with

the quantity theory of money, but the relationship is not precise.

–The relationship is stronger in the long run than in the short run.

24


Correlation, Causation, and Other Influences The evidence shows that money growth and inflation are correlated.

25


Correlation, Causation, and Other InfluencesThis does not represent causation.

• Does money growth cause inflation, or does inflation cause money growth?

• Does some other factor cause inflation (deficit spending)?

27

Monetary Policy• The ultimate goal of all macro policy

is to stabilize the economy at its full-employment capacity.

• A government has three basic tools of monetary policy:

–Reserve requirements–Open-market operations–Discount rates

28

• Changes in the reserve requirements– An increase in the required reserve ratio

• Makes it more expensive for banks to meet reserve requirements

• Reduces bank lending

– A decrease in the required reserve ratio• Makes it more expensive for banks

to meet reserve requirements

• Increases bank lending

The Tools of Monetary Policy

29

Reserve Requirements

• A lower reserve requirement increases the size of the money multiplier.– The money multiplier is the number of

deposit (loan) dollars that the banking system can create from $1 of excess reserves.

30

A Decrease in Required Reserves

• A change in the reserve requirement causes:–A change in excess reserves.

–A change in the money multiplier.

31

Required Reserve Ratio 25 percent 20 percent

1. Total deposits $100 billion $100 billion 2. Total reserves 30 billion 30 billion 3. Required reserves 25 billion 20 billion 4. Excess reserves 5 billion 10 billion 5. Money multiplier 4 5 6. Unused lending capacity $20 billion $50 billion

The Impact of Reduced Reserve Requirement

32

The Monetary Base

• The government can control the monetary base which equals

–currency in public circulation plus bank reserves.

33

The Monetary Base

• However, HKMA cannot control the amount of the monetary base that flows outside the country.

34

• Open market operations

–The HKMA changes reserves by buying and selling bonds.


35

Open Market Activity• The HKMA purchases and sells

government bonds to alter bank reserves.–By buying bonds — HKMA

increases bank reserves.

–By selling bonds — HKMA reduces bank reserves.

36

Determining the Price of Bonds

Quantity of Bondsper Unit Time Period

Pric

e of

Bon

ds

Contractionary Policy• Fed sells bonds• Supply of bonds increases

• Bond prices fall

D

S1

P1

37



Pric

e of

Bon

ds

D

Figure 17-2, Panel (a)

Contractionary Policy• Fed sells bonds• Supply of bonds increases

• Bond prices fall

S1 S1

P1

P2

38



Pric

e of

Bon

ds

Expansionary Policy• Fed buys bonds• Supply of bonds falls• Bond prices rise

D

S1

P1

39



Pric

e of

Bon

ds

D

Expansionary Policy• Fed buys bonds• Supply of bonds falls

• Bond prices rise

Figure 17-2, Panel (b)

S1S3

P1

P3

40

• Relationship between the price of existing bonds and the rate of interest–What happens to the interest on a

bond when the price of a bond increases?


41

• Example– You pay $1,000 for a bond that pays

$50/year in interest


Rate of interest =$50

$1000= 5%

42

• Example– Now suppose you pay $500

for the same bond


Rate of interest =$50

$500= 10%

43

• The market price of existing bonds (and all fixed-income assets) is inversely related to the rate of interest prevailing in the economy.


44

The Tools of Monetary Policy• Changes in the discount rate

Increasing the discount rate increases the cost of borrowed funds for depository institutions that borrow reserves

Decreasing the discount rate decreases the cost of borrowed funds for depository institutions that borrow reserves

45

• When the money supply increases people have too much money–How can this be?

–Have you ever had too much money?

Effects of an Increasein the Money Supply

46

• If you have a savings account the answer is “yes.”

• We must distinguish between income and money

Effects of an Increasein the Money Supply

47

• Expansionary monetary policy: effects on aggregate demand, the price level, and real GDP

• Monetary policy can be used to move the economy to its full-employment potential.

Tools of Monetary Policy

48

• Monetary policy can generate increases in the equilibrium level of real GDP.

Monetary Policy DuringPeriods of Underutilized Resources

49

Expansionary Policy

• The HKMA can increase AD/AE by increasing the money supply by:–Lowering reserve requirements.–Dropping the discount rate.–Buying more bonds: it increases

bank lending capacity.

50Real GDP per Year($ trillions)

Pric

e Le

vel

0

AD1

10.0

LRAS

SRAS• The contractionary gap is caused by insufficient AD• To increase AD, use expansionary

monetary policy • AD increases and real GDP increases to full employment

Expansionary Monetary Policy with Underutilized Resources

9.5

120E1

Recessionary gap


Pric

e Le

vel

0

AD1

SRAS

9.5

120E1

Recessionary gap

Expansionary Monetary Policy with Underutilized Resources

Figure 17-3

10.0

LRAS

AD2

125 E2

• The contractionary gap is caused by insufficient AD• To increase AD, use expansionary

monetary policy • AD increases and real GDP increases to full employment

52

Exhibit 4: Expansionary Monetary Policy to Correct a Contractionary Gap

Exhibit 4: Expansionary Monetary Policy to Correct a Contractionary Gap

Price

leve

l

130

125

Potential output

0 7.8 8.0 Real GDP (trillions of dollars)

SRAS 130

AD

Contractionary gap

a

b

AD'

53

• The net export effect– Impact of expansionary monetary policy

• increase the money supply• interest rates fall• value of the local currency falls• net exports increase• the net export effect complements the

effectiveness of monetary policy by making greater income growth

Open Economy Transmission of Monetary Policy

54

• The net export effect– Impact of expansionary fiscal

policy revisited• larger deficit

• higher interest rates

• attracts foreign capital

• value of the local currency appreciates

• net exports fall

• net export effect reduces the effectiveness of fiscal policy by making smaller income growth

Open Economy Transmission of Monetary Policy

55

Adding Monetary Policy to the Keynesian Model

Quantity of Money

Inte

rest

Rat

e

Md

MS

r1

M’S

56


Quantity of Money

Inte

rest

Rat

e

Md

r2

M’S At lower rates, a larger

quantity of money will be

demanded

Interest rate falls

Figure 17-7, Panel (a)

MS

r1

57


Planned Investment

Inte

rest

Rat

e

I

r1

I1

58


Planned Investment

Inte

rest

Rat

e

I

The decrease in interest stimulates investment

Figure 17-7, Panel (b)

r1

r2

I1 I2


Pric

e Le

vel

0

AD1

SRAS


10.0

LRAS

7.0

E1


Pric

e Le

vel

0

AD1

SRAS

10.0

LRAS

The increase in investment shifts the

AD curve to the right


AD2

Figure 17-7, Panel (c)

E2

9.5

E1

61Figure 17-4

Contractionary Monetary Policyvia Open Market Operations

62

• The monetarist’s views of money supply changes– They are those Macroeconomists

who believe that inflation is always caused by excessive monetary growth and that changes in the money supply affect AD both directly and indirectly

Monetary Policy in Action:The Transmission Mechanism

63

• The monetarist’s views of money supply changes– Increase in the money supply

increases aggregate demand directly

– Based on the equation of exchange, prices always rise when the money supply is increased


64

• Monetarists’ criticism of monetary policy–Time lags are too long to use

monetary policy effectively

–Monetary policy is seen as a destabilizing force


65

• Monetary Rule– A monetary policy that incorporates a

rule specifying the annual rate of growth of some monetary aggregate

– Example• Increase in the money supply smoothly at a

rate consistent with the economy’s long-run average growth rate measured in terms of NI % change


66

• What do you think?–What would happen to the effectiveness of the monetary rule if V is not stable?


67

Price vs. Output Effects

• The success of monetary policy depends on the conditions of aggregate demand and aggregate supply.

68

Aggregate Supply

• The shape of the AS curve determines the effectiveness of expansionary monetary policy in raising output.

69

Aggregate Supply

• Horizontal AS — output increases without any inflation/price change.

• Vertical AS — inflation occurs without changing output.

• Upward sloping AS — both prices and output are affected by monetary policy.

70

Aggregate Supply

• With an upward-sloping AS curve, expansionary policy causes some inflation and restrictive policy causes some unemployment.

71

Q1 QF

P1

Aggregate supply

AD3

AD2

AD1

(a) The Keynesian view

RATE OF OUTPUT (real GDP per time period)

PR

ICE

LE

VE

L (a

vera

ge p

rice

per

unit

of o

utpu

t)

0

P3

Contrasting Views of AS

72


QN

PR

ICE

LE

VE

L (a

vera

ge p

rice

per

unit

of o

utpu

t)(b) The Monetarist view

0

P4

Aggregate supply

AD5

AD4

P5


73

Figure 28-10Two Views on the Strength of Monetary Changes

74


Q6

PR

ICE

LE

VE

L (a

vera

ge p

rice

per

unit

of o

utpu

t)

(c) A popular view

0

P6

P7

AD7

AD6

Aggregatesupply

Q7


75

Policy Perspectives

• The shape of the aggregate supply curve spotlights a central policy debate.

76

Fixed Rules or Discretion?

• Should the government try to fine-tune the economy with constant adjustments of the money supply?

77

Fixed Rules or Discretion?

• Or should the government instead simply keep the money supply growing at a steady pace?

78

Discretionary Policy

• The economy is constantly beset by expansionary and recessionary forces.

• There is a need for continual adjustments to money supply.

79

Fixed Rules

• Critics of discretionary monetary policy raise objections linked to the shape of the AS curve.

• AS curve could be vertical or at least upward sloping.

80

Fixed Rules

• With an upward-sloping AS curve, too much expansionary monetary policy leads to inflation.

81

Fixed Rules

•Fixed rules for money-supply management are less prone to error than discretionary policy.

82

Fixed Rules

• The money supply should increase by a constant (fixed) rate each year equal to that of potential Y growth.

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Monetary Policy and Inflation: Quantity Theory of Money

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