lecture two(1) (2).pptx

8/18/2019 Lecture Two(1) (2).pptx

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Monetary Theory andPolicy

Unit 02: Money andInfation

Dr. Kwame P Osei-Assiey


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!ontents o" this #ect$re

• %$ic& re'iew o" asic conce(ts o" money

• %$antity theory o" money demand

• #i)$idity (re"erence theory o" money demand

•

Interest rates and money demand• Port"olio theory o" money demand


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#ect$re O*ecti'es

• At the end o" this lect$re :

• +e wo$ld $nderstand the meanin, o" mon

• +e sho$ld e ale to e(lain the moti'atio

"or (eo(le to hold money.• +e wo$ld $nderstand the lin& etween mo

infation and the interest rate


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+hat is Money

• To the lay(erson or e'eryday street lan,$a,e the term is $s$ally associated with c$rrency wealth and income

• /$t money is not the same as-

• +ealth: the total collection o" (ro(erty that ser'es as a store o

• Income: a fow o" earnin,s (er $nit o" time money is a stoc&1

• To the economist: Money is dened as an asset that is,enerally acce(ted in (ayment "or ,oods and ser'ices othe re(ayment o" dets.


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3$nctions o" Money

• Three main "$nctions-

• Medi$m o" echan,e

• Unit o" acco$nt

• 4tore o" 5al$e


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3$nctions o" Money: As a Medi$m

6chan,e• Meas$re the 'al$e o" other ,oods and

ser'ices in term o" money

• a'in, a $nit o" acco$nt red$ces the

n$mer o" relati'e (rices in the econom


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Money Demand 3$nction: The %$antity TheoryMoney

• The )$antity theory o" money is the (rod$ct o" theclassical economists: Ir'in, 3isher ,a'e an e(licite(osition o" this theory in


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Money Demand 3$nction: %$antity Theo" Money > 6)$ation o" 6chan,e

• Amo$nt o" money in an economy and the total s(endin, on ,oods and sedescried y the relationshi(-

•


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Money Demand 3$nction: %$antity Theory Money and Demand "or Money

• +e can also e(lain )$antity theory $sin, the demand "or

• The demand "or money 1 is the )$antity o" money that (ewant to hold

• In 6)$iliri$m the demand "or is e)$al to the s$((ly o" mo

th$s-• $t "rom


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Money Demand 3$nction: %$antitTheory o" Money and Demand "or Mo

• 4ince 'elocity is ass$med to e constant ased on the )$antity theory-wewith a constant &

• Th$s "rom e)$ation B

• C1

• Im(lyin, that-

• #e'el o" transactions y a ed le'el o" nominal income determines themoney (eo(le wants to hold 1

• 3isher theory mainly s$,,ests

• Demand "or money is inde(endent o" interest rates

• /$t-($rely a "$nction o" income

•


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Money : %$antity Theory o" Money and Price

• /$t7the classical economists also elie'ed that in the short-r$n

• +a,es and (rices were com(letely feile

• Also elie'ed that in normal times le'el o" a,,re,ate o$t($t wremain at "$ll em(loyment le'el

• Th$s ; in (re'io$s e)$ation can ar,$aly also e treated as const

• Th$s E1 "ollows direce)$ation

• Th$s chan,es in P can only e descried y chan,es in M as 5 anconstants

• Th$s the 'iew y classical economists $sin, the quantity theory to e(lain mo'ements in (rice le'el-Changes in the quantity of lead to proportional changes in price level

•


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Money : %$antity Theory o" Mon

and Price #e'el• Im(lications "rom slides


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Money 4$((ly: Another !lassic

Dichotomy• 3rom 3isher e9ect we &now that

• =1

• +here i re(resents nominal interest rate r is real interest rates and e(ected

• The 3isher e9ect is a res$lt o" the 3isher e)$ation and the classicaldichotomy: +hen infation is e(ected to rise nominal interest rates

rise (ro(ortionallyand there is no e9ect on real interest rates1• Im(lications o" the 3isher e9ect: Increasin, money s$((lytoday1 w

(eo(le to e(ect an increase in infation in the lon,-r$n. This will onto an increase in nominal interest rates witho$t a9ectin, real rates real 'ariales li&e cons$m(tion in'estment1

•


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Testin, the 3isher 69ect•

The ,conrms3isher e9

• !eteris (ari

infation m$s&e(t low iwant to elower inte

r


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Money : Trans"ormin, the %$antiTheory o" Money to Theory o" Infa

• 3rom the mathematical identity on the relationshi( etween (erchan,e o" (rod$cts o" 2 'ariales and the s$m o" (ercenta,e chathis 'ariale

• i.e. Percenta,e !han,e in a (rod$ct o" 2 'ariales F and ; FPercenta,e !han,e in F1 H Percenta,e chan,e in ; 1

• Or

• A((lyin, this identity on o$r e)$ation o" echan,e

• T can e re(resented as-

• 1

•


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Money : Trans"ormin, the %$antiTheory o" Money to Theory o" Infa

• I" we ma&e JP the s$*ect o" the e)$ation and ass$mconstant-

• Then JP ?JM- J; . Lote that 5 is eliminated sincchan,es in a constant e)$als 0

• Low we &now that (ercenta,e chan,e in (rice le'els irate or JP ?

• Th$s ?JM- J;

• Th$s the quantity theory of ination indicates that infation rate e)$als the ,rowth rate o" the money s$((

the ,rowth rate o" a,,re,ate o$t($t


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%$antity Theory o" Money: 6m(ir Assessment #on,-r$n1

• Plot o" ten-year a'era,es o" U4 infation r,row

• 8ecall e)$ation N relationshi( etween mone

• Dia,ram shows decades o" hi,her money ,rowt

• Th$s "or lon,-r$n analysis the )$antity ththeory o" infation )$iet well as (rice


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%$antity Theory o" Money :6m(irical Assessment #on,-r$

• +hat ao$t co$ntries with hi,

• The dia,ram also s$,,est that co$ntries wirates e(erien

• 4ee T$r&


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%$antity Theory o" Money :6m(irical Assessment 4hort-r$

• Plot o" ann$al U4rate a,ainst 2

ann$al M

• Lo short r$n rel

• In "act some200B-2001 show

,rowth $t low


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%$antity Theory o" Money: In4$mmary

• The )$antity theory o" money (ro'ides a lon,theory o" infation it e(lains di9erin, lon,-rinfation rates across co$ntries.

• owe'er in the short-r$n the relationshi( isalmost non-eistent

• In the short-r$n (rices and wa,es are stic&yKeynesian 5s Monetarist economists attles


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/$d,et Decits as a 4o$rce

Infation• ow can $d,et decit e a so$rce o" infation

• 3irst letQs disc$ss the many ways the ,o'ernmenance its s(endin,-

• 8aisin, re'en$e y le'yin, taes

• /orrowin, money y iss$in, onds

• Print money directly to s(end on the ,oods ser'ices.


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/$d,et Decits as a 4o$rce

Infation• Ro'ernments $d,et constraint

• ? H D63 re(resents decit R is ,o'ern=− ∆ ∆s(endin, T is ta re'en$e M/ is the monetary ase / oheld y ($lic.

• The ,o'ernment $d,et constraint th$s re'eals twoim(ortant "acts:

• I" the ,o'ernment decit is nanced y an increase in ondholdin,s y the ($lic there is no e9ect on the monetary hence on the money s$((ly

• /$t i" the decit is not nanced y increased ond holdin,the ($lic the monetary ase and the money s$((ly increa

conse)$ently raisin, infation


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/$d,et Decits as a 4o$rce o" Infation: Timawean y(erinfation 6(erienc

• 6arly 2000s imawe e(erienced h$,e decits d$e to ins$9icient tare'en$e "rom redistri$ted "arms.

• The ,o'ernment was also not s$ccess"$l with orrowin, "rom the ($licwas le"t with no o(tion than to (rint money increase M/1.

• the increase in the money s$((ly led to imawe e(eriencin, hyperias infation rate reached o'er


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Keynesian Theory o" Demand "Money: Transaction Moti'e

• Day-to-day transactions is the main reason (eo(le hold money al

• The le'el o" transaction and hence demand "or money1 has a si,ni(ro(ortional relationshi( with income

• This s$,,ests Keynes initial acce(tance o" the )$antity theory 'iewtransactions com(onent is (ro(ortional to income

• /$t in addition he and other economists later reco,niVed that nmethods "or (ayment re"erred to as (ayment technolo,y co$ldthe demand "or money

• As technolo,y im(ro'es and transactions increase demand "or money wo$ld li&ely decline relati'e to income


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Keynesian Theory o" Demand "Money: Preca$tionary Moti'e

• Uncertainties are realities o" li"e

• Keynes also reco,niVed that (eo(le hold money as a c$shion a,ain$ne(ected wants e.,. accidents illnesses etc.

• Keynes ar,$ed that the (reca$tionary money alances (eo(le wanhold wo$ld also e (ro(ortional to income

• 4imilar to the transaction moti'e (reca$tionary demand helasticities relati'e to interest rate $nless rates are really

• Th$s ,enerally (reca$tionary demand "or money is ne,atrelated to interest rates


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Keynesian Theory o" Demand "Money: 4(ec$lati'e Moti'e

• Keynes also elie'ed (eo(le choose to hold money astore o" wealth which he called the s(ec$lati'e mot

• Money c$rrency1 earn no interest e'en chec&in, acde(osits earns 'ery little interest.

• ence o((ort$nity cost o" holdin, money is the ret$nancial asset "or,one

• As i W o((ort$nity cost o" money W (eo(le hold les(reca$tionary alances1 and X

•


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P$ttin, the Three Moti'es

To,ether• The total demand "or real money alances is-

• (ositi'ely related to the real income ; and ne,ati'elrelated to the nominal interest rate i

• i.e. ? =1 rewritin, and ecl$

the si,na,e "or sim(licity we ha'e• ?


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Keynesian 5s !lassical Monetar 5iew ao$t /eha'io$r o" 5eloci

• 3rom the li)$idity (re"erence relationshi(s- we &now that real money ane,ati'ely related to interest rates

• which means that i" i increases decreases and 5 increases since is a in e)$ation


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Keynesian 5s !lassical Monetar 5iew ao$t /eha'io$r o" 5eloci

• The more sensiti'e the demand "or money "$nction is to irates the more $n(redictale will e the 'elocity and theclear will e the relation etween money s$((ly M1 anda,,re,ate s(endin, P; 1. The )$antity theory is less li&ee tr$e.

• The (rocyclical mo'ement o" interest rates sho$ld ind$ce(rocyclical mo'ements in 'elocity

• 5elocity will chan,e as e(ectations ao$t "$t$re normal o" interest rates chan,e


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Port"olio Theories o" MoneyDemand

• /eyond nominal interest rates and income are there o"actors that a9ect o$r demand "or money

• +e t$rn to theory o" (ort"olio choice "or some more an

• +hat ma&es $( a (ort"olio o" wealth: e.,. money intere

earin, onds shares (hysical assets• Port"olio theory: Addresses the (rolem o" how est in

can o(timiVe their ret$rns in the allocation o" reso$rcedi9erent assets ha'in, di9erent ris&s.


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Theory o" Port"olio !hoice andKeynesian #i)$idity Pre"erenc

• All thin,s ein, e)$al wealth and income tend to mo'e to

• i,her income Yhi,her wealth so what does this mean "or demanmoney alance as an asset

• +hen interest rate rises-

• +hat ha((ens to money as an asset

• +hat ha((ens to interest earin, assets

• Th$s "rom (ort"olio theory hi,her interest rate ma&es thedemand "or money to "all th$s *$sti"yin, the Keynesian #iPre"erence


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3riedman Model o" Port"olio Theo" Demand "or Money

• Milton 3riedmanQs denedreal money demand as a"$nction o" wealth andrelati'e ret$rns o" otherassets

• 3riedmanQs etension o"Keynesian theory iss$mmariVed y the modelelow-

• 8eal mon

• +ealth or Permanent inco

e(ected a'era,e income co$rse o" oneQs li"e. H1

• The ecess ret$rn on ond-1

• The ecess ret$rn on e)$imoney -1

• The rate at which money l($rchasin, (ower. !an alo" as the ecess ret$rn on money. -1

−−−=−−−+ )()()()(

,,, me

memb P

d

r r r r r Y f P

M π


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Di9erences /etween 3riedmanQs anKeynesian Theories and their Im(licat


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Di9erences /etween 3riedmanQs anKeynesian Theories and their Im(licat

B. e(ected ret$rns on money not constant $t ecessret$rns on onds is ass$med to e constant eca$seret$rns on assets increase y same (ro(ortion. Lote thdi9erence etween asset held as c$rrency does not eainterest1 $t sa'in,s de(osits and ed de(osits which

re(resented as 1 earn interests• 3rom (oint B interest rate does not a9ect money demand t

stale "$nction

•


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3riedman Model o" Port"olio Theo" Demand "or Money

•


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4$mmary o" 3actors that Determthe Demand "or Money

• Usin, the Keynesian and Port"olio theory we can ded$ce "actors


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4$mmary o" 3actors that Determthe Demand "or Money


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6m(irical 6'idence "or the Demand "or MoInterest 8ate and Demand "or Money

• Keynes: Money demand sensiti'e to interest rates hasem(irical s$((ort

• The more sensiti'e or $ltra sensiti'e this relationshi( is th$n(redictale ! will e.

• #i)$idity or illi)$idity1 tra( is an etreme case o" $ltra-s

• Lo em(irical s$((ort e'en at lower rates ece(t when rat,one to Vero e.,. Sa(an1. In the "ace o" s$ch e(erience can&s resort to noncon'entional monetary (olicy li&e )$aeasin,.


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6m(irical 6'idence "or the Demand "or MoInterest 8ate and Demand "or Money

• Lote that there is em(irical s$((ort "or Keynes $does not in'alidate 3riedmanQs theory on relationsetween demand "or money and interest rates.

• +hat i" interest rate does not si,nicantly a9ect monedemand

• +hat wo$ld e the ass$med eha'io$r o" 5

• +hat wo$ld e the e9ect o" money s$((ly on a,,re,ates(endin,


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!onse)$ences o" Post


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!onse)$ences o" Post


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8e'iew %$estions

lecture two(1) (2).pptx

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