Chapter 20 Money Growth_ Money Demand_ and by hcj


									      Chapter 22

 Quantity Theory of Money,
Inflation and the Demand for
        Inflation and Money Growth

• How is inflation linked to money growth?

• The Quantity Theory of Money and the
  Velocity of Money
Inflation and Money Growth
        Inflation and Money Growth
• Previous slide shows can’t have high, sustained
  inflation without monetary accommodation

  • To avoid sustained high inflation, central bank must
    watch money growth

• Something beyond just differences in money
  growth accounts for the differences in inflation
  across countries. We need to study the velocity
  of money.
 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

                         MxV =P xY

Velocity of Money (V):

     These relationships are definitions
The Equation of Exchange – Dynamic Form

Money Growth + Velocity Growth = Inflation + Output Growth
From the Equation of Exchange to the
Quantity Theory of Money
The Quantity Theory of Money (Irving
• 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
 Quantity Theory of Money and Inflation

If V is constant, the rate of Inflation = the
rate of growth in the money supply minus
the rate of growth in aggregate output
          Average Inflation Rate Versus Average Rate of Money
          Growth for Selected Countries, 1997–2007

Source: International Financial Statistics.
M2 Money Growth and Inflation - US

• Hyperinflations are periods of extremely high
  inflation of more than 50% per month

•    Many economies—both poor and developed—have
    experienced hyperinflation over the last century,
    but the United States has been spared such turmoil

• One of the most extreme examples of hyperinflation
  throughout world history occurred recently in
  Zimbabwe in the 2000s
Examples of Hyperinflation:1980s and
Early 1990s
          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 (40 to 50 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.
Annual U.S. Inflation and Money Growth Rates,
       The Demand for Money
• Two motives:
• 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
Demand for Money


      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

• 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

Non-synchronization of income and
   The mismatch between the timing of
   money inflow to the household and the
   timing of money outflow for household
  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
Individual earns $1,200 per month. Paid on the 1st day of the month
and spends at a constant rate during the month.

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. Velocity of money is
$14,400/ $600 = 24.
    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 and the velocity of money = $14,000/ $300 = 48.
           Benefit and cost
•   Benefit - If the monthly interest rate is 1%, earn ½ X
    $600 x .01 = $3.00

•   Cost - transactions cost

•   For a given level of transactions cost, as i increases
    hold less money and more bonds.
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
Factors That Determine the Demand for
     Velocity is not constant!

• The procyclical movement of interest rates
  should induce procyclical movements in
• Velocity will change as expectations about
  future normal levels of interest rates change
• Interest rates ­ opportunity cost ­
   ÞDemand for money ¯ Þ velocity ­
          We will come back to this -
 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

  • 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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