x = %ΔX = rate of change of spending m = %ΔM = rate of change of the money supply v = %ΔV = rate of change of the velocity of money

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1 THE CREDIT MARKET EQUATION: is: x = m + v addresses the question: o What are the causes of changes of spending? o How is it possible for spending to change? o What must happen in order for spending to change? says: In order for spending to rise we must have (a) more money and/or (b) the money we have must -- o be spent faster o change hands faster o be held on to less can be used to describe how monetarists and Keynesians differ in their views on monetary and fiscal policies. Notation X = Spending = Nominal GDP M = the Money Supply V = the Velocity of Money x = %ΔX = rate of change of spending m = %ΔM = rate of change of the money supply v = %ΔV = rate of change of the velocity of money The Velocity of Money In 1990, the US money supply (measured by M2) was about $5 trillion. GDP was about $10 trillion. You can look at that as saying that each dollar of M2 was spent twice in the course of that year. Five trillion dollars were used to buy ten trillion dollars worth of GDP. The ratio of GDP to the money supply is known as the velocity of money defined as V = GDP/M. In 1990, this number was about 2 = $10 trillion/$5 trillion. You might think of this as a measure of how fast money is moving. Using X to stand for GDP we can say: V = X/M or X = MV. That is, spending in a year (X) must equal the number of dollars in the economy (M) multiplied by the number of times each dollar is used to buy GDP in a year (V). Converting this into rate-of-change vocabulary produces The Credit Market Equation: x = m + v. For spending to increase by 10% this year, there must be some combination of more money (m) and using money faster (v) that adds up to 10%. 1. Where does the more money come from? the ability of banks to create money when they make loans the ability of the central bank (the eral Reserve in the US) to print money money inflows from out of the country 2. How can money speed up? Velocity changes are less well understood than money supply changes, but this much seems to be true. Making money move faster often requires higher interest rates. Interest is the payment to money: Money will run faster if it is paid better.

2 Money moves faster if people hold less of it. The more liquid the public wants to be -- the more people try to hold on to money -- the slower money moves. An increase in the velocity of money can be pictured as people holding money for shorter periods of time. Velocity and the ox The box is a fictional place added to the circular flow diagram to try to picture the velocity of money. If people want to hold more money we would show that as an increase in money demand, with money flowing into the ox. (See diagram). We would associate this with money being slowed down -- with a decrease of the velocity of money, and a decrease of spending. THE CLASSICAL/MONETARIST-KEYNESIAN DEATE The CMT assumption is v = 0. 1 Classical/monetarist theory assumes that the velocity of money is a constant: That it cannot change significantly. Since the ox is used to show velocity changing, the CMT model is drawn without a ox. The KT assumption is v 0. Keynesian theory assumes that the velocity of money can change significantly as people change their demand for liquidity. KT model is drawn with the ox. The Four Questions. We can now approach four questions: We will ask each of the two theories -- CMT and KT -- what they think about each of the governments two policies -- monetary and fiscal policies. MODEL/THEORY 1. CMT v = 0. No box 2. KT v 0 box a. Monetary 1a 2a b. Fiscal 1b 2b 1. Classical/monetarist theory. With v = 0, the credit market equation becomes x = m. This means that spending will change by the same percent that the money supply changes. a. Monetary policy. In terms of changing the economy, for better or for worse, the is considered extraordinarily important. It is the money supply that causes spending to change and it is the that controls the money supply. x m v b. Fiscal policy. Assuming constant velocity also says that, in classical theory, only the money supply can cause total spending to change: If the money supply doesn t change, then spending cannot change. In particular this means that fiscal policy -- changes of 1 It is one of the improvements of monetarism over classical theory to drop the assumption that velocity cannot change at all, and to replace it with more sophisticated attempts to

3 government spending for example -- can have no effect on total spending. Here s why. If there s only so much money around and if it can only go so fast, then only so much spending can occur. If someone -- the government, for example -- starts to spend more, they must be taking money away from someone else whose spending must therefore fall. So, when someone s spending rises, someone else s spending falls by an equal amount. Total spending does not change, only the type of spending. The term crowding out is used to describe this. It is usually applied specifically to the government crowding out private investment. 2. Keynesian theory. Changes of the velocity of money open up two possibilities. a. Monetary policy. Increasing the money supply might not x m v stimulate the economy, if it is accompanied by a decrease of 0 5 the velocity of money. This would happen if the printed money but no one wanted to borrow and spend it. The new money would wind up sitting around as excess reserves, slowing down the velocity of money. The reverse could happen if the reduces the money supply and people continue spending by raising the velocity of money. b. Fiscal policy. It might be possible to raise spending, and x m v stimulate the economy, without printing money. Specifically, increased government spending might be able to raise overall spending by increasing the velocity of money; by using more quickly the money that was previously turning over slowly. The reverse case means that a drop in government spending reduces velocity and reduces overall spending. IN SUMMARY a. Monetary b. Fiscal 1. CMT v = 0. No ox changes of the money supply will affect total spending and cause inflation m x p changes of the deficit will not affect total spending due to crowding out of Investment G I x=0 MODEL/THEORY 2. KT v can change. ox changes of the money supply might not affect total spending. m v x=0 changes of the deficit might affect total spending. G v x q Summary The Credit Market Equation stated that spending (x) can only rise if: there is more money (m) and/or money is used faster (v) This was used to compare Keynesian and classical/monetarist theories according to their differing views of: whether velocity can change or not, and as a consequence, the likely effects of monetary and fiscal policies.

4 THE EQUATION OF EXCHANGE Combining the Product Market and Credit Market Equations 1. The Quantity Theory of Money is one of the oldest bits of economic wisdom. The essential observation is that increases of the money supply cause inflation, not real growth. That is, you can t make a country richer merely by increasing the money supply. That will just create inflation. Milton Friedman (a monetarist) summarized the quantity theory in a famous quote, Inflation is everywhere and always a monetary phenomenon. That is, if you observe inflation, it necessarily means that there is too much money around. It our case, it probably means that the is doing its job badly. 2. A Money Growth Rule. Friedman proposed a monetary growth rule to tell the how to behave. The rule states that the should always increase the money supply at the long run rate of growth of real GDP. He felt that this would create more stability for the economy than having the constantly trying to figure out the correct growth rate based on the immediate condition of the economy. Derivations. We will derive these results by using the equation of exchange. If we combine the credit market equation (x = m + v) and the product market equation (x = p + q) we get the equation of exchange: m + v = p + q The quantity theory of money. Printing money causes inflation. We will make two assumptions that reflect the classical view of the economy. a. The velocity of money is constant. (v = 0). b. Increased spending does not cause growth (q = 0) That means that the equation of exchange reduces to: m = p This says the rate of inflation will equal the rate of growth of the money supply. Inflation results from printing too much money. Problem: Suppose we want no inflation. According to the quantity theory, we should not change the money supply at all. That is, p = 0 requires m = 0. Most economists think the money supply should grow as the economy grows. 2. Friedman s Money Growth Rule. Make money growth equal the long run growth rate of real GDP. This time let s assume: a. v = 0. Using the same logic as did the quantity theory. b. q = q*. There is long run output growth (q*) due mostly to technological change. The equation of exchange now looks like: m = p + q* In order to get no inflation (p = 0) we should follow Friedman s rule: m = q*. Money should be printed at the long run growth rate of real GDP. Over the past decades this number (q*) would be about 3.5%. In addition to eliminating inflation, the purpose of this 2 This is the rate of change version. The equation of exchange is usually stated in the form M V = P Q.

5 rule is to reduce the power of the by forcing it to follow a rule rather than exercise its own judgment. It is felt that this might add some stability to the economy by being something people could count on. MONETARIST No box = Constant velocity Long run, Low unemployment THEORY KEYNESIAN box = Variable velocity Short run, high unemployment MONETARY eral Reserve oard OMO s eral Funds Target Discount Rate Req. Res. Rat. Money Supply interest rates Dangerous, since any money printed will be spent at the constant rate and likely cause inflation Ineffective if changes of the money supply are off-set by changes of money demand/velocity. +0 FISCAL Congress President Treasury Gov t Purchases Taxes the Deficit Dangerous, since increased government borrowing diverts funds that would otherwise have been used for private sector investment. Crowding out occurs.. +0 Trsy Effective if the increased government spending can increase the velocity of money (decrease ) by spending money that otherwise would not have been spent. Trsy Monetary and Fiscal Policy together: Printing money to finance the deficit makes it appear as if fiscal policy is effective. Trsy P O L I C Y MP FP CMT THEORY Effective (often for the worse by causing inflation) because money is spent at a constant velocity not held. Ineffective because the government merely replaces -- does not add to -- private sector spending. KT Ineffective if money supply changes are off-set by changes of the velocity of money (shown by changes of ). Effective because it uses resources including money -- that are otherwise unemployed.