Chapter Twenty. In This Chapter 4/29/2018. Chapter 22 Quantity Theory, Inflation and the Demand for Money

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1 Chapter Twenty Chapter 22 Quantity Theory, Inflation and the Demand for Money In This Chapter 1. The quantity theory of money. 2. The velocity of, and demand for, money. 3. Money targeting. Money Growth and Inflation Probably the single most important fact in monetary economics: The relationship between money growth and inflation rates. Compare Panels A and B of next figure the average annual inflation and money growth in 160 countries over the 3 decades, from 1980 to

2 Figure 1- Inflation and money Growth Money Growth and Inflation Countries with very high inflation tend to lie above the line Countries with moderate to low inflation tend to fall below it. When the currency that people hold loses value very rapidly, they spend what they have quickly. Spending money more quickly has the same effect on inflation as an increase in money growth. The rate at which money is spent is the velocity of money Velocity of Money and the Equation of Exchange Nominal gross domestic product NGDP = P x Y where, Y = RGDP and P is the price level. Every purchase counted in nominal GDP requires the use of money - Quantity of Money * Velocity of money Nominal GDP M is the quantity of money, V is the velocity and nominal GDP can be divided into two parts: M x V = P x Y 2

3 Velocity of Money and the Equation of Exchange M x V = P x Y, is called the equation of exchange, and tells us that the quantity of money multiplied by its velocity equals the level of nominal GDP. Velocity - PY V M Velocity of Money and the Equation of Exchange Velocity fairly constant in short run We can derive a formula for a demand for money M d = 1 V (PY) = k(py), where k= 1 V If velocity is constant, the demand for money is proportional to the level of economic activity. The demand for money is not affected by interest rates. Velocity and the Equation of Exchange We care about inflation and money growth. We can rewrite the equation of exchange to allow for the percentage change in each factor. MV PY % M % V % P % Y Money growth plus velocity growth equals inflation plus real growth. 3

4 The Quantity Theory of Money Irving Fisher He assumed that no important changes occur in payment methods or the cost of holding money. If the interest rate is fixed and there is no financial innovation, then velocity will be constant. He also assumed that real output is determined solely by economic resources and production technology, so it too is considered to be fixed in the short run. The Quantity Theory of Money Assuming V and Y are relatively constant, money growth translates directly into inflation, an assertion that is termed the quantity theory of money. MV PY % M % V % P % Y % P % M % V % Y % P % M The Quantity Theory of Money The quantity theory of money equation explains the patterns shown in Figure 1. Velocity and real GDP growth are not constant over long periods of time. 1. High inflation, changing velocity and high money growth go together Panel A. 2. Moderate and low inflation countries fall below the 45-degree line - Panel B. % P % M % V % Y 4

5 The Facts about Velocity If the velocity of money is constant, and the trend in real growth is determined by the structure of the economy and the rate of technological process. countries could control inflation directly by limiting money growth. % P % M % Y This logic led Milton Freidman to conclude that central banks should simply set money growth at a constant rate. M1 and M2 should grow at a rate equal to the rate of real growth plus the desired level of inflation. The Facts about Velocity To make the rule viable, Friedman suggested changes in regulations that would: Limit banks discretion in creating money, and Tighten the relationship between the monetary aggregates and the monetary base, reducing fluctuations in the money multiplier. For example, an increase in the reserve requirement or restrictions on the number and types of loans banks could make. The Facts about Velocity But Friedman s recommendation to keep money growth constant to stabilize inflation works only if velocity is constant. Is the Velocity of Money constant? 5

6 Over the long run ( ), velocity of M2 looks stable; net effect about a 0.2% decline in velocity. Seems to confirm Fisher s conclusion that in the long run, the velocity of money is stable, so that controlling inflation means controlling the growth of the money aggregates. The Facts about Velocity But central bankers are concerned about inflation over months and quarters, not just years. The chart shows the short-run percentage change in M2 velocity not constant. The Facts about Velocity Notice the increase in velocity in the late 1970s and early 1980s. This was a period of both high nominal interest rates and significant financial innovations. introduction of stock and bond mutual funds that allow investors checking privileges. Together, these reduced the amount of money individuals held (money demand) for a given level of transactions, raising the velocity of money. 6

7 The Facts about Velocity The data clearly suggest that fluctuation in the velocity of money is tied to changes in people s desire to hold money. Policymakers must understand the demand for money. The Demand for Money: Transactions Demand And Portfolio Demand Transactions Demand The quantity of money people and firms hold for transactions purposes depends on Nominal income (remember that s PxY) The opportunity cost of holding money, and The availability of substitutes. Higher nominal income, higher spending The higher nominal income is, the higher nominal money demand (M d ) will be. The Transactions Demand for Money But, there is a cost to holding money. The cost is based on opportunity cost. The interest that people lose in not buying an interest-bearing bond is the opportunity cost of holding money. The decision to hold money depends on how high the bond yield is and how costly it is to switch bank and forth. 7

8 The Transactions Demand for Money For a given cost of switching, as the nominal interest rate rises, people reduce their checking account balance, shifting funds into and out of higher-yield investments. 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, and the higher the velocity of money. Money demand and velocity move in opposite directions. Money demand i interest rate Money Demand The Transactions Demand for Money This relationship explains why inflation tends to exceed money growth in the high-inflation countries. (look back at Figure 1) At high levels of inflation, money is losing value very quickly. People respond to the high cost of holding money by keeping as little of it as possible. They purchase durable goods that have zero real return - better than negative return on currency. 8

9 The Transactions Demand for Money Frantic spending drives up the velocity of money. Because high inflation brings an increase in velocity, inflation must be higher than money growth in those countries. This places countries above the 45-degree line in Panel A of Figure 1. The Transactions Demand for Money The transactions demand for money is affected financial Innovation It reduces the cost of shifting funds from an interest-bearing bond to a checking account. This lowers the money holdings at a given level of income. This increases the velocity of your money. The Precautionary Demand for Money There is also a precautionary demand for money included as part of transactions demand. individuals and business firms hold money to insure against unexpected expenses. The precautionary demand rises with risk and the desire for liquidity. The higher the level of uncertainty about the future, the higher the demand for money and the lower the velocity of money will be. 9

10 The Portfolio Demand for Money As a store of value, money provides diversification when held along with a wide variety of other assets. Keynes called this the speculative demand for money. Recall, the demand assets depends on: Wealth, The return relative to alternative investments, Expected future interest rates, Risk relative to alternative investments, and Liquidity relative to alternative investments. The Portfolio Demand for Money As wealth rises, asset demand, including money, rises. A decline in interest rates will increase the portfolio demand for money. Opportunity cost is lower, and If interest rates are low and you think interest rates are likely to rise, bonds are less attractive (capital loss) and money more attractive. When interest rates are expected to rise, money demand goes up. The Portfolio Demand for Money Finally, if a sudden decrease in liquidity of stocks, bonds, or other assets occurs, there will be an increase in the demand for money. 10

11 Summary Table 1 Factors That Determine the Demand for Money Targeting Money Growth as a Policy Instrument The quantity theory of money tells us that our ability to use money growth as a policy instrument depends on the stability of the velocity of money. Velocity is stable in the long-run but not in the short-run. Targeting Money Growth as a Policy Instrument There are two criteria for the use of money growth as a direct monetary policy instrument: 1. A stable link between the monetary base and the quantity of money - MB x m = M 2. A predictable relationship between the quantity of money and inflation - M x V = P x Y (MB x m) x V = P x Y Not stable 11

12 The Instability of Money Demand and Velocity What caused the instability of money demand over these three decades? One reason is the introduction of new financial instruments that paid higher returns than money, but could still be used as a means of payment (money substitutes) Officials have tried to account for the new financial instruments by changing the composition of the monetary aggregates consensus is money demand continues to be unstable. Targeting Money Growth: The Fed and the ECB Though today virtually no central bank targets money growth, the practice was common in the 1970s. In the U.S., the Federal Reserve Board had to make quarterly appearances to testify to the Fed s money growth targets for the coming year. The FOMC rarely hit its money growth targets. Targeting Money Growth: The Fed and the ECB The ECB s Governing Council periodically announces a money growth rate that is intended to serve as a long-run reference value. The difference of opinion between the Fed and the ECB on this matter can be traced to their divergent views on the stability of money demand. Researchers who study the demand for money in the euro-area have concluded that it is stable, which implies that changes in velocity are predictable. 12

13 Targeting Money Growth: The Fed and the ECB Targeting Money Growth: The Fed and the ECB While short-run fluctuations in velocity were significant, European policymakers point to the tendency of velocity to return to its long-run downward trend over periods of a few years. Targeting Money Growth: The Fed and the ECB The ECB and the Fed have both chosen interest rates as their conventional operating target. Interest rates are the link between the financial system and the real economy. Bottom Line: 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. 13