# Chapter 20 Money Growth_ Money Demand_ and Modern Monetary

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```					   Chapter 22

Money Growth,
Money Demand, and
Monetary Policy
Money Growth, Money Demand, and Monetary
Policy

• How is inflation linked to money growth?

• The Quantity Theory of Money and
Velocity
Inflation and Money Growth
Inflation and Money Growth
• To avoid sustained high inflation, central bank
must watch money growth

• Can’t have high, sustained inflation without
monetary accommodation

• Something beyond just differences in money
growth accounts for the differences in inflation
across countries.
The Equation of Exchange: M x V = P x Y

Nominal GDP = Price level (P) x Real Output (Y)

Quantity of Money (M) x Velocity (V) = Nominal GDP

PxY
Velocity of Money (V):    Velocity(V) 
M

These relationships are definitions
The Equation of Exchange – Dynamic Form

From M x V  P x Y
we can derive
% M  % V  %  P  %  Y

Money Growth + Velocity Growth = Inflation + Output Growth
The Quantity Theory of Money
and the Velocity of Money
The Quantity Theory of Money (Irving Fisher)
• assume velocity is constant => %ΔV = 0
• Or at least stable
• economy at full employment.
• Strong condition %ΔY = 0.
• Double M => Double P

• Inflation is a monetary phenomenon (Milton
Friedman).
Is Velocity Stable?

The Scale obscures the short-run movements in M2
Velocity of Money

Substantial short-run fluctuations in M2 velocity.
But the long-run trend is a modest increase from 1.72 to 1.82
over 45 years.
Velocity of Money
• The data tend to confirm Fisher’s
conclusion that in the long run (45 years)
the velocity of money (M2) is stable

• However, central banker’s are concerned
with inflation over quarters and years.

• Velocity is volatile in the short-run, as
shown on the previous chart and on the
next chart.
Change in the Velocity of M1 and M2
from Year to Year, 1915–2008

To understand the velocity of money, must understand the
demand for money.
The Demand for Money

• Transactions demand

• Speculative or Portfolio demand
Transactions Demand for Money
• The quantity of money the public holds for
transactions purposes depends

• on nominal income – P x Y
• the cost of holding money
• and the availability of substitutes

• As P and/or Y increase => money demand
will increases
• As opportunity cost increases => money
demand will decrease
Transactions Demand for Money
• Higher nominal interest rate => higher
opportunity cost of holding money => the less
money individuals and businesses will hold for a
given level of transactions => higher velocity of
money.

• In high inflation countries, the opportunity cost of
holding money is high.

• M and V are increasing, so the increase in P is
greater than the increase in M.
Further Developments in the Keynesian Approach
• Transactions demand
• Baumol - Tobin model
• There is an opportunity cost and benefit
to holding money
• The transaction component of the
demand for money is negatively related
to the level of interest rates
Cash Balances in the Baumol-Tobin Model

Income arrives only once a month, but spending takes place
at a constant rate.
Cash Balances in the Baumol-Tobin Model

Non-synchronization of income and
spending
The mismatch between the timing of
money inflow to the household and the
timing of money outflow for household
expenses.
Cash Balances in the Baumol-Tobin Model

Could decide to deposit entire paycheck (\$1,200) into checking account
at the start of the month and run balance down to zero by the end of the
month. In this case, average balance would be \$600.
Cash Balances in the Baumol-Tobin Model

Alternatively, could also choose to put half paycheck into checking account and buy a
bond with the other half of income. At midmonth, would sell the bond and deposit the
\$600 into checking account to pay the second half of the month’s bills. Following this
strategy, average money holdings would be \$300.
Portfolio or Speculative Demand for Money

• As a store of value, money provides diversification when
held with a wide variety of other assets, including stocks
and bonds

• Portfolio demand depends on
•   Wealth
•   the expected return relative to the alternatives
•   expectations that interest rates will change in the future
•   Risk
•   Liquidity
Velocity is not constant!

• The procyclical movement of interest rates
should induce procyclical movements in
velocity.
• Velocity will change as expectations about
future normal levels of interest rates change
Another Look at Policy Instruments:
Targeting Money Growth

• Interest rates   opportunity cost 
Demand for money   velocity 

• Creates upward sloping relationship between
interest rates and velocity

• To use monetary aggregates policymakers need
to find a relationship with a predictable slope
Targeting Money Growth

Two criteria for the use of money growth as a
direct monetary policy target:

• A stable link between the monetary base and the
quantity of money: MB x m = M

• A predictable relationship between the quantity of
money and inflation: M x V = P x Y

(MB x m) x V =P x Y
• Possible explanation for the instability of U.S.
money demand over the last quarter of the 20th
century.

• Primary - The introduction of financial instruments
that paid higher returns than money.
• Most Central Banks use interest rates as
their operating instrument

• Interest rates are the link between the
financial system and the real economy

• 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.

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 views: 3 posted: 3/18/2012 language: English pages: 26