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Money & Banking
Video 02--Money Demand
What is Money? (Chapter 3)Quantity Theory of Money (Chapter 20)
Hal W. Snarr8/20/2015
Chapter 3
What is money?
In the absence of money, goods and services are exchanged in a barter system where individuals directly exchange the surplus from the fruits of their labor.
– The following gives the number of barter prices there would be in an economy with N goods, with x = 2 because exchanges are done in pairs:
– Among competing forms of money, the least marketable tend
to be one by one rejected until at last only a single commodity remained, which was universally employed as a medium of exchange – Mises, 1953, pp. 32-33
– The winner of this contest is durable, divisible, transportable, and difficult to counterfeit.
!!( )!
Nx
NCx N x
2!
2!( 2)!N NC
N
2( 1)( 2)!N N N NC 2!( 2)!N 2
( 1)2
N N NC
Money
Commodity Money:
Gold coins in 1776-Colonial America
“Tiger Tongue” from Siam, Bronze Coin
Stone Money, Island of Yap
Money
Paper Money is backed by something like Gold
Money
Paper Money is backed by something like Gold
Money
Fiat Money: gov’t decreed money backed by Gold
Money
Checks: Electronic Payment E-Money (electronic money):
Debit card Stored-value card (smart card) E-cash
Are We Headed for a Cashless Society?
Louisiana House Bill 195 bans cash on all second-hand transactions, which passed near unanimously with one nay vote in the senate. (www.forbes.com)
http://www.youtube.com/watch?v=7ujgi4rXsiQ www.youtube.com/watch?v=yrGMgsJQGUE
Money
Table 1
Money
www.federalreserve.gov/releases/h6/Current
Figure 1 Growth Rates of M1 & M2
Money
http://research.stlouisfed.org/fred2/graph/?id=BOGMBASE#
M1, M2 and the Monetary Base
Money
Chapter 20
Quantity Theory of Money?
Fisher’s Equation of Exchange
M V P Y
Irving Fisher’s equation of exchange
Mainstream economics defines inflation as a general increase in the prices of products
p = Pis/Pwas – 1 > 0
• Demand-pull inflation
• Cost-push inflation
• Excessive growth in the quantity of money
> 0
Demand-pull inflation
ADSRAS
15
LRAS
16
15.5
14.5p = 6.9% = 15.5/14.5 – 1
Fisher’s Equation of Exchange
ADSRAS
15
LRAS
16.5
16
15.5
14.5p = 16.5/14.5 – 1
Demand-pull inflation
M V P Y
= 14.8%
Fisher’s Equation of Exchange
ADSRAS
15
LRAS
16
15.5
14.5p = 0% = 14.5/14.5 – 1
Demand-pull inflation?
17
Fisher’s Equation of Exchange
Cost-push inflation
ADSRAS
15
LRAS
14
15.5
14.5p = 6.9% = 15.5/14.5 – 1
M V P Y
Fisher’s Equation of Exchange
ADSRAS
15
LRAS
15.5
14.5p = 0% = 14.5/14.5 – 1
Cost-push inflation?
14
M V P Y
Fisher’s Equation of Exchange
If Velocity of money is fairly constant in short run and u = un,• an increase in the quantity of Money• the Price level increases
M V P Y
16.5
A
15.5
SRAS AD
LRAS
14.5
15 16
Fisher’s Equation of Exchange
Excessive growth in the quantity of money• causes inflation
• Who agrees?
• Milton Friedman (The Counter-Revolution in Monetary Theory):
Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the
quantity of money than in output.
Fisher’s Equation of Exchange
Assuming V is constant in the short run gives the quantity theory of money (QTM)
Nominal income is determined by changes in the quantity of money
The above can be written as follows
Quantity Theory of Money
P MY V
% % % % VMP Y
+ ≈ +
Assuming V is constant in the short run gives the quantity theory of money (QTM)
Nominal income is determined by changes in the quantity of money
The above can be written as follows
P MY V
% % % % VMP Y
% %M Y
The quantity theory of money is also a theory of inflation
p
Mg g
Quantity Theory of Money
Figure 1
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.
Source: IFS data for 120 countries, averaged over years 1996-2004
Quantity Theory of Money
Figure 2
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.
High Money Growth & low inflation
Quantity Theory of Money
… but high money growth is followed by accelerating inflation
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.
Quantity Theory of MoneyFigure 2
Government expenditures is paid for by
• Raising tax revenue
• Treasuries can print money
‒ In the U.S., the Fed buys bonds directly from Treasury
• Treasuries can sell more bonds
‒ If the deficit is financed by selling bonds to the public, there is no effect on the MB = R + C, and on the MS
‒ If the deficit is financed by the Fed buying bonds from banks, the MB and MS increase
o $1 could buy 11% more goods in 1912 than in 1776
o $1 could buy 95% fewer goods in 2008 than in 1913
$1m held from 1913 to 2008 is worth $50kwww.lewrockwell.com/2009/07/erik-voorhees/the-record-of-the-federal-reserve/
Quantity Theory of Money
Hyperinflation is a period of high inflation (> 50% per month)
Larry Allen’s The Encyclopedia of Money:• Bolshevik Revolution• Prior to 1917, prices rose 2 to 3 times faster than wages. • After 1917, prices rose by
92,300% from 1913 to 1919 64,823,000,000% from 1913 to 1923
• Post WWI Germany• In 1914, there were 6,323 million marks in circulation• By 1923 there were 17,393,000 million. • A newspaper costing one mark in May 1922 cost 1,000 marks 16 months later,
and 70 million marks a year and a half later. • At its worst,
Customers rolled wheelbarrows full of money to the grocery store Customers and restaurants negotiated the cost of meals in advance Printed money was bailed like hay to heat one’s home. It took about 4 days for prices to double
Quantity Theory of Money
Hyperinflation is a period of high inflation (> 50% per month)
• Erich Maria Remarque’s The Black Obelisk:
Workmen are given their pay twice a day now--in the morning and in the afternoon, with a recess of a half-hour each time so that they can rush
out and buy things--for if they waited a fewhours the value of their money would drop
• Steve Hanke’s R.I.P. Zimbabwe Dollar:• The time it took for prices to double ino 1994 Yugoslavia, 33.6 hourso 2008 Zimbabwe, 24.7 hours o 1946 Hungary, 15.6 hours
Quantity Theory of Money
The Fisher Effect: Rising inflation (caused by excessive money growth) raises the nominal rate of interest (i)
Source: IFS data for 120 countries, averaged over years 1996-2004Source: Federal Reserve Economic Data (FRED)
i = r + p
Quantity Theory of Money
• Using current inflation assumes inflation does not change.
• Future r will be different from what it was expected to be when loans were signed.
• Borrowers do better and lenders do worse when loans are repaid with devalued money.
• In an uncertain world, the Fisher Effect must account for uncertainty
• pe is commonly estimated using ‒ the difference between the yields on TIPS and Treasuries (TIPS spread)
i = r + pe
The Fisher Effect: Rising inflation (caused by excessive money growth) raises the nominal rate of interest (i)
Quantity Theory of Money
M
Money DemandFisher
i
billions $
Y
V
dM
P
Y
V
Money Demand
billions $
M
i
Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3dM
P
Fisher
Money Demand
15000
1.5
M
i
billions $
dM
P
Fisher
Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3
dM
P
Money Demand
10,000
M
MDFisher
10000
i
billions $
Fisher
Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3
MDFisher
2.5
Money Demand
M
15
i
10000 billions $
dM
P10,000
Fisher
Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3
i
Money Demand
MDFisher
2.5
M
( , )L Y i
10000 billions $
dM
P
Keynes
Money Demand
MDFisher
2.5
M
i
10000 billions $
0.7 200Y i dM
P
Keynes
Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3
Money Demand
dM
P
MDFisher
2.5
M
i
10000 billions $
15,0000.7 200 i
Keynes
Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3
Money Demand
MDFisher
2.5
M
i
10000 billions $
10500 200 i dM
P
Keynes
Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3
Money Demand
MDFisher
2.5
M
i
10000 billions $
10500 2 .00 2 5 dM
P
Keynes
Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3
Money Demand
MDFisher
2.5
M
i
10000 billions $
10500 500dM
P
Keynes
Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3
Money Demand
MDFisher
2.5
M
i
10000 billions $
10000dM
P
Keynes
Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3
Money Demand
MDFisher
2.5
M
i
10000 billions $
0.7 200Y i
MDKeynes
dM
P
Keynes
MDKeynes
Money Demand
( , , , ) b e ep r r r r rYf
MDFisher
M
2.5
i
10000 billions $
dM
P
Friedman
Money Demand
dM
P
MDKeynes
MDFisher
M
2.5
i
10000 billions $
10 ( 2336.25 ) 7770.833 ( ) 7770.833 ( ) 7770.831500 2 (0 4 33 )r r ri
Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3
Friedman
Money Demand
dM
P
MDKeynes
MDFisher
M
2.5
i
10000 billions $
23362.5 7770.833 21500 ( )00 4 3i r r r
Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3
Friedman
Money Demand
dM
P
MDKeynes
MDFisher
M
2.5
i
10000 billions $
23362.5 7770.833 (9 )15 30000 i r
Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3
Friedman
Money Demand
dM
P
MDKeynes
MDFisher
M
2.5
i
10000 billions $
23362.5 7770.833 39 7770.833150000 ri
Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3
Friedman
MDKeynes
Money Demand
MDFisher
M
2.5
i
10000 billions $
dM
P80062.5 23362.5 7770.83 3( )3 eii
Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3
Friedman
MDKeynes
Money Demand
MDFisher
M
2.5
i
10000 billions $
dM
P80062.5 23362.5 7770 3( 3).833i i
Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3
Friedman
MDKeynes
Money Demand
MDFisher
M
2.5
i
10000 billions $
dM
P80062.5 23362.5 7770.833 7770.83 3 93ii
Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3
Friedman
MDKeynes
Money Demand
MDFisher
M
2.5
i
10000 billions $
dM
P10125 50 i
Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3
Friedman
MDKeynes
Money Demand
MDFisher
M
2.5
i
10000 billions $
dM
P10125 50 i
Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3
Friedman
MDKeynes
Money Demand
MDFisher
M
2.5
i
10000 billions $
dM
P10125 5 .0 2 5
Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3
Friedman
MDKeynes
Money Demand
MDFisher
M
i
10000 billions $
dM
P10000
2.5
Example: P = 1, V = 1.5, Y = 15,000, rb = 2, re = 4, pe = 3
Friedman
MDKeynes
Money Demand
MDFisher
M
2.5
i
10000 billions $
dM
P10125 50 i
Friedman
MDFriedman
People and firms demand money because there are benefits to doing so because doing so makes it easier to pay for things.
The marginal benefit of holding an additional dollar diminishes as the amount held increases. • E.g., the benefit of holding $2 rather than $1 is greater than holding an
additional dollar when one has $1000.
Holding the additional dollar is also costly • interest is forgone• inflation reduces its buying power. • i = r + pe is the price of holding money; as it rises, Md falls.
Money Demand
i MD
Empirical evidence:
• The quantity of money demanded increases as i falls.
M
Money Demand
i MD
Empirical evidence:
• The quantity of money demanded increases as i falls.
• Money demand increases in• income• Wealth• Risk of other assets
M
Money Demand
i
M
MD
Empirical evidence (Table 1):
• The quantity of money demanded increases as i falls.
• Money demand increases in• income• Wealth• Risk of other assets
• Money demand decreases in • Payment technology• Inflation risk• Liquidity of other assets
Money Demand
If Keynes is correct• money demand fluctuates with i• velocity oscillates and is unpredictable• the link between M and aggregate spending is weak • The Fed should target interest rates
If Friedman is correct• Money demand is relatively insensitive to changes i• velocity is stable and predictable• QTM’s view of aggregate spending being determined by M is more likely
to be true • The Fed should target MS
Money Demand