Chapter 20 Money Growth_ Money Demand_ and Modern Monetary

Document Sample
Chapter 20 Money Growth_ Money Demand_ and Modern Monetary Powered By Docstoc
					   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.

				
DOCUMENT INFO
Shared By:
Categories:
Tags:
Stats:
views:3
posted:3/18/2012
language:English
pages:26