Velocity of Money and the Equation of Exchange

Transcription

1 Velocity of Money and the Equation of Exchange

2 Velocity of Money the rate at which the dollar travels around the economy from consumer to consumer. measures the economic activity of a nation V = P x Y M V = velocity of money P x Y = nominal GDP (price level) x (output/real GDP) M = money supply An economy produces 100 pizzas, each pizza sells for $10 and the money supply is $50. What is the velocity of money? V = ($10 x 100)/ 50 V = 20 For $1,000 of spending to take place with a money supply of $50, each dollar must exchange hands 20 times.

3 The Velocity of Money Example with one good: pizza. Velocity formula: V = P x Y M In 2012, Y = real GDP = 3000 pizzas P = price level = price of pizza = $10 P x Y = nominal GDP = value of pizzas = $30,000 M = money supply = $10,000 V = velocity = $30,000/$10,000 = 3 The average dollar was used in 3 transactions.

4 A C T I V E L E A R N I N G 1 Exercise One good: corn. The economy has enough labor, capital, and land to produce Y = 800 bushels of corn. In 2008, MS = $2000, P = $5/bushel. Compute nominal GDP and velocity in 2008.

5 A C T I V E L E A R N I N G 1 Answers Given: Y = 800, MS = $2000, and P = $5 in Compute nominal GDP and velocity in Nominal GDP = P x Y = $5 x 800 = $4000 V = P x Y M = $4000 $2000 = 2

6 Velocity of Money What affects the velocity of money? Propensity to consume frequency of paychecks changes to incentives to save future expectations availability of credit rate of inflation changes in technology A high velocity of money results in high inflation.

7 Equation of Exchange states that the number of dollars multiplied by the number of times that they are used per year must equal the total number of dollar spent per year. MV = PY V = velocity of money M = money supply P x Y = nominal GDP Sometimes represented with Q or T (price level) x (output/real GDP) If the money supply is equal to $50 and the velocity of money is 5. What is the nominal GDP? $50 x 5 = $250 If one variable in the equation changes, another variable must change to maintain the balance. If M changes, but V is constnat, P or Q must also change. If money supply is increased to $60, the velocity of money remains constant, what is the nominal GDP? $60 x 5 = $300

8 Practice Suppose a simple economy produces only cruffins. That economy produces 50 cruffins and each cruffin sells for $4. The money supply is equal to $25. What is the velocity of money? $25(V) = 4 x 50 $25(V) = $200 V = 8 Suppose this year's money supply is $500, nominal GDP is $1000 and real GDP is $500. $500(V) = $1,000 What is the velocity of money? $500(V) = $1000 What is the price level? V = 2 PL = 2

9 Effectiveness of Monetary Policy According to Keynesian Economics, Classical Economics, Monetarism, and Rational Expectation Theory

10 MONEY SUPPLY AND THE PRICE LEVEL IN THE LONG RUN ACCORDING TO KEYNESIAN THEORY Recall. Keynes argued that investment demand depends more on expectations about the prosperity of the economy than on interest rates. Investment demand is relatively inelastic, making it largely unresponsive to change in the interest rate. Thus, asserts that change in the money supply have a relatively small effect on output.

11 MONEY SUPPLY AND THE PRICE LEVEL IN THE LONG RUN ACCORDING TO CLASSICAL THEORY Concludes that changes to the money supply have no effect on national output in the long-run, other than pushing up the price level. An increase in the money supply will increase AD but suppliers ultimately adjust to the change by raising prices not output (only an increase in resource availability or an advancement in technology will increase output).

12 MONEY SUPPLY AND THE PRICE LEVEL IN THE LONG RUN ACCORDING TO CLASSICAL THEORY claims that output (vertical aggregate supply curve) and velocity of money are stable, thus increases in M will have no effect other than to increase the price level. In the long run, prices will adjust proportionally to changes in the money supply. If M increases by 10%, so will PL. Equation of exchange Let assume the money supply is $500, the velocity of money is 2, the PL is 4 and real GDP is equal to $250. $500 x 2 = 4 x $250 If V and Q are stable and the Fed increases the money supply by 20%, nominal GDP will equal $1,200, Q will remain constant at $250 so PL is now 4.8 (1200/250). When the Fed increases the MS by 20%, it also increased the PL by 20%.

13 Quantity Theory of Money - a theory about the connection between money and prices that assumes that the velocity of money is constant. changes in prices correspond to changes in the money supply MONETARY NEUTRALITY/ NEUTRALITY OF MONEY Changes in the money supply only affect nominal variables (wages, interest rate) and not real variables (wages, interest rate). Nominal wages may double but they will still buy you the same quantity of goods/services (real wages). Most economists believe the neutrality of money describes the economy in the long run.

14 Interest rate in the Long Run In the long run, the level of the money supply does not influence the amount of real output nor the interest rate. If the MS increases by 5%, the PL will increase by 5%, thus money demand will increase by 5%. In the LR, the interest will increase at the same rate as the money supply.

15 MONEY SUPPLY AND THE PRICE LEVEL IN THE LONG RUN ACCORDING TO MONETARISM Milton Friedman and Ana Schwartz Grew out of classical economic theory In A Monetary History of the U.S. (1963), showed that business cycles have historically been associated with fluctuations in the money supply. Argues the Fed inadvertently contributes to economic instability on occasion by changing the interest rates. Argued that the money supply is the key determinant in national income and persuaded the use of monetary policy as a key role in economic management monetarism

16 Monetarist claim that the velocity is stable, so increases in the M must increase P and/or Y and thus increase nominal GDP (P x Y) MV = PY Let s assume $500 x 2 = 4 x $250 and V is stable. If the Fed increases the money supply to $600, then $600 x 2 = $1200 (nominal GDP) Asserts that in the short-run GDP will grow steadily if the money supply grows steadily. But in the long-run, monetary neutrality would hold true since in the LR, prices and wages would eventually adjust. To address LR inflation, asserts that the Fed should set constant rate of growth of the money supply, such as 3% per year and maintain that rate regardless of any fluctuations in the economy (monetary rule). Monetary policy would essentially be on autopilot. MONEY SUPPLY AND THE PRICE LEVEL IN THE LONG RUN ACCORDING TO MONETARISM

17 Regarding gov t intervention argues that without an increase in MS, fiscal policy will not be as effective. when AD shifts right, an increase in PL and Y will increase the money demand, this raising interest rates. So unless the central bank increases the money supply as the federal government uses expansionary fiscal policy, AD will not increase by much. MONEY SUPPLY AND THE PRICE LEVEL IN THE LONG RUN ACCORDING TO MONETARISM

18 Many economist believe this change in velocity was due to changes in banking rules (interest-bearing checking accounts) and new types of financial assets (mutual funds) MONEY SUPPLY AND THE PRICE LEVEL IN THE LONG RUN ACCORDING TO MONETARISM

19 Effectiveness of monetary policy according to

20 Rational Expectations Theory Outcome depends partly on what people expect to happen. If individuals believe the gov t and the central bank will pursue expansionary policies, they will expect inflation to occur. Accordingly, long-term wage contracts will be adjusted today to reflect future inflation. This reduction in supply nullifies the expansionary effect of the fiscal and monetary policies. Expansionary policies therefore will not lead to more output and less unemployment.