Monetary Policy and Inflation: Quantity Theory of MoneyThe Equation of ExchangeThe formula indicating that the number of monetary units times the number of times each unit is spent on final goods and services is identical to the price level times output (or nominal national income)

Money, Real GDP, andthe Price Level The equation of exchange states that the quantity of money (M) multiplied by the velocity of circulation (V) equals GDP, orMV=PY

Money, Real GDP, andthe Price Level GDP equals the price level (P) times real GDP (Y), or:GDP = PY

Monetary Policy and Inflation : Quantity Theory of MoneyThe equation of exchange and the quantity theory: MV = PYM = actual money balances held by non-banking publicV = income velocity of money; the number of times, on average, cash monetary units are spent on final goods and services

Monetary Policy and Inflation : Quantity Theory of MoneyThe equation of exchange and the quantity theory: MV = PYP = price levelY = real national output (real GDP)

Monetary Policy and Inflation : Quantity Theory of MoneyThe equation of exchange as an identity

Money, Real GDP, andthe Price Level We can convert the equation of exchange into the quantity theory of money by making two assumptions:1)The velocity of circulation is not influenced by the quantity of money.2)Potential income is not influenced by the quantity of money.

Money, Real GDP, andthe Price LevelThe Quantity Theory of MoneyThe quantity theory of money is the proposition that in the long run, an increase in the quantity of money brings an equal percentage increase in the price level.This theory is based upon the velocity of circulation and the equation of exchange.

Money, Real GDP, andthe Price LevelThe Quantity Theory of Money The velocity of circulation is the average number of times a dollar of money is used annually to buy goods and services that make up GDP.

Money, Real GDP, andthe Price Level Make the quantity of money M, and the velocity of circulation V is determined by:V = PY/M

The Velocity of Circulation in the United States: 19301999

Money, Real GDP, andthe Price Level This can be shown by using the equation of exchange to solve for the price level.P = (V/Y)M

Money, Real GDP, andthe Price Level In the long run, real GDP equals potential GDP, so the relationship between the change in the price level and the quantity of money is:

Money, Real GDP, andthe Price Level Dividing this equation by an earlier one, P = (V/Y)M, gives us

Money, Real GDP, andthe Price Level This equation shows that the proportionate change in the price level equals the proportionate change in the quantity of money. This gives us the quantity theory of money:In the long run, the percentage increase in the price level equals the percentage increase in the quantity of money.

Monetary Policy and Inflation : Quantity Theory of MoneyThe crude quantity theory of money and pricesAssume: V is constantY is stable

Monetary Policy and Inflation : Quantity Theory of MoneyThe crude quantity theory of money and pricesIncreases in M must be matched by equal increases in the price level

Figure 17-5

Money Growth andInflation in the United States

Money Growth andInflation in the United States

Money Growth andInflation in the World Economy

Money Growth andInflation in the World Economy

Money, Real GDP, andthe Price Level Historical Evidence on the Quantity Theory of MoneyThe data are broadly consistent with the quantity theory of money, but the relationship is not precise.The relationship is stronger in the long run than in the short run.

Money, Real GDP, andthe Price LevelCorrelation, Causation, and Other Influences The evidence shows that money growth and inflation are correlated.

Money, Real GDP, andthe Price LevelCorrelation, Causation, and Other InfluencesThis does not represent causation.Does money growth cause inflation, or does inflation cause money growth?Does some other factor cause inflation (deficit spending)?

Money, Real GDP, andthe Price Level The AS-AD model predicts the same outcome as the quantity theory of money. It also predicts a less precise relationship between the quantity of money and the price level in the short run than in the long run.

Monetary PolicyThe ultimate goal of all macro policy is to stabilize the economy at its full-employment capacity.A government has three basic tools of monetary policy:Reserve requirementsOpen-market operationsDiscount rates

The Tools of Monetary PolicyChanges in the reserve requirementsAn increase in the required reserve ratioMakes it more expensive for banks to meet reserve requirementsReduces bank lendingA decrease in the required reserve ratioMakes it more expensive for banks to meet reserve requirementsIncreases bank lending

Reserve RequirementsA lower reserve requirement increases the size of the money multiplier.The money multiplier is the number of deposit (loan) dollars that the banking system can create from $1 of excess reserves.

A Decrease in Required ReservesA change in the reserve requirement causes:A change in excess reserves.A change in the money multiplier.

The Impact of Reduced Reserve Requirement

Required Reserve Ratio

25 percent

20 percent

1. Total deposits

$100 billion

$100 billion

2. Total reserves

30 billion

30 billion

3. Required reserves

25 billion

20 billion

4. Excess reserves

5 billion

10 billion

5. Money multiplier

4

5

6. Unused lending capacity

$20 billion

$50 billion

The Monetary BaseThe government can control the monetary base which equals currency in public circulation plus bank reserves.

The Monetary BaseHowever, HKMA cannot control the amount of the monetary base that flows outside the country.

The Tools of Monetary PolicyOpen market operationsThe HKMA changes reserves by buying and selling bonds.

Open Market ActivityThe HKMA purchases and sells government bonds to alter bank reserves.By buying bonds HKMA increases bank reserves.By selling bonds HKMA reduces bank reserves.

Determining the Price of BondsQuantity of Bonds per Unit Time PeriodPrice of BondsContractionary Policy Fed sells bonds Supply of bonds increases Bond prices fall

Determining the Price of BondsQuantity of Bonds per Unit Time PeriodPrice of BondsFigure 17-2, Panel (a)Contractionary Policy Fed sells bonds Supply of bonds increases Bond prices fall

Determining the Price of BondsQuantity of Bonds per Unit Time PeriodPrice of BondsExpansionary Policy Fed buys bonds Supply of bonds falls Bond prices rise

Determining the Price of BondsQuantity of Bonds per Unit Time PeriodPrice of BondsExpansionary Policy Fed buys bonds Supply of bonds falls Bond prices riseFigure 17-2, Panel (b)

The Tools of Monetary PolicyRelationship between the price of existing bonds and the rate of interestWhat happens to the interest on a bond when the price of a bond increases?

The Tools of Monetary PolicyExampleYou pay $1,000 for a bond that pays $50/year in interest

The Tools of Monetary PolicyExampleNow suppose you pay $500 for the same bond

The Tools of Monetary PolicyThe market price of existing bonds (and all fixed-income assets) is inversely related to the rate of interest prevailing in the economy.

The Tools of Monetary PolicyChanges in the discount rateIncreasing the discount rate increases the cost of borrowed funds for depository institutions that borrow reservesDecreasing the discount rate decreases the cost of borrowed funds for depository institutions that borrow reserves

Effects of an Increasein the Money SupplyWhen the money supply increases people have too much moneyHow can this be?Have you ever had too much money?

Effects of an Increasein the Money SupplyIf you have a savings account the answer is yes.We must distinguish between income and money

Tools of Monetary PolicyExpansionary monetary policy: effects on aggregate demand, the price level, and real GDPMonetary policy can be used to move the economy to its full-employment potential.

Monetary Policy DuringPeriods of Underutilized ResourcesMonetary policy can generate increases in the equilibrium level of real GDP.

Expansionary PolicyThe HKMA can increase AD/AE by increasing the money supply by:Lowering reserve requirements.Dropping the discount rate.Buying more bonds: it increases bank lending capacity.

Expansionary Monetary Policy with Underutilized ResourcesReal GDP per Year ($ trillions)Price Level0 The contractionary gap is caused by insufficient AD To increase AD, use expansionary monetary policy AD increases and real GDP increases to full employment

Expansionary Monetary Policy with Underutilized ResourcesReal GDP per Year ($ trillions)Price Level0Figure 17-3 The contractionary gap is caused by insufficient AD To increase AD, use expansionary monetary policy AD increases and real GDP increases to full employment

Exhibit 4: Expansionary Monetary Policy to Correct a Contractionary Gap

Open Economy Transmission of Monetary PolicyThe net export effectImpact of expansionary monetary policyincrease the money supplyinterest rates fallvalue of the local currency fallsnet exports increasethe net export effect complements the effectiveness of monetary policy by making greater income growth

Open Economy Transmission of Monetary PolicyThe net export effectImpact of expansionary fiscal policy revisitedlarger deficithigher interest ratesattracts foreign capitalvalue of the local currency appreciatesnet exports fallnet export effect reduces the effectiveness of fiscal policy by making smaller income growth

Adding Monetary Policy to the Keynesian ModelQuantity of MoneyInterest Rate

Adding Monetary Policy to the Keynesian ModelQuantity of MoneyInterest RateAt lower rates, a larger quantity of money will be demandedFigure 17-7, Panel (a)

Adding Monetary Policy to the Keynesian ModelPlanned InvestmentInterest Rate

Adding Monetary Policy to the Keynesian ModelPlanned InvestmentInterest RateThe decrease in interest stimulates investmentFigure 17-7, Panel (b)

Adding Monetary Policy to the Keynesian ModelReal GDP per Year ($ trillions)Price Level0

Adding Monetary Policy to the Keynesian ModelReal GDP per Year ($ trillions)Price Level0The increase in investment shifts the AD curve to the rightFigure 17-7, Panel (c)

Contractionary Monetary Policyvia Open Market OperationsFigure 17-4

Monetary Policy in Action:The Transmission MechanismThe monetarists views of money supply changesThey are those Macroeconomists who believe that inflation is always caused by excessive monetary growth and that changes in the money supply affect AD both directly and indirectly

Monetary Policy in Action:The Transmission MechanismThe monetarists views of money supply changesIncrease in the money supply increases aggregate demand directlyBased on the equation of exchange, prices always rise when the money supply is increased

Monetary Policy in Action:The Transmission MechanismMonetarists criticism of monetary policyTime lags are too long to use monetary policy effectivelyMonetary policy is seen as a destabilizing force

Monetary Policy in Action:The Transmission MechanismMonetary RuleA monetary policy that incorporates a rule specifying the annual rate of growth of some monetary aggregateExampleIncrease in the money supply smoothly at a rate consistent with the economys long-run average growth rate measured in terms of NI % change

Monetary Policy in Action:The Transmission MechanismWhat do you think?What would happen to the effectiveness of the monetary rule if V is not stable?

Price vs. Output EffectsThe success of monetary policy depends on the conditions of aggregate demand and aggregate supply.

Aggregate SupplyThe shape of the AS curve determines the effectiveness of expansionary monetary policy in raising output.

Aggregate SupplyHorizontal AS output increases without any inflation/price change.Vertical AS inflation occurs without changing output.Upward sloping AS both prices and output are affected by monetary policy.

Aggregate SupplyWith an upward-sloping AS curve, expansionary policy causes some inflation and restrictive policy causes some unemployment.

Contrasting Views of ASQ1QFP1Aggregate supplyAD3AD2AD1(a) The Keynesian viewP3

Contrasting Views of ASRATE OF OUTPUT (real GDP per time period) QNPRICE LEVEL (average price per unit of output)(b) The Monetarist view0Aggregate supplyAD5AD4

Figure 28-10Two Views on the Strength of Monetary Changes

Contrasting Views of ASRATE OF OUTPUT (real GDP per time period) Q6PRICE LEVEL (average price per unit of output)(c) A popular view0AD7AD6Q7

Policy PerspectivesThe shape of the aggregate supply curve spotlights a central policy debate.

Fixed Rules or Discretion? Should the government try to fine-tune the economy with constant adjustments of the money supply?

Fixed Rules or Discretion? Or should the government instead simply keep the money supply growing at a steady pace?

Discretionary PolicyThe economy is constantly beset by expansionary and recessionary forces.There is a need for continual adjustments to money supply.

Fixed RulesCritics of discretionary monetary policy raise objections linked to the shape of the AS curve.AS curve could be vertical or at least upward sloping.

Fixed RulesWith an upward-sloping AS curve, too much expansionary monetary policy leads to inflation.

Fixed RulesFixed rules for money-supply management are less prone to error than discretionary policy.

Fixed RulesThe money supply should increase by a constant (fixed) rate each year equal to that of potential Y growth.

87848882838586Instructor Notes:1) The velocity of circulation of M1 has increased over the years because financial innovation has developed M1 substitutes.2) The velocity of circulation of M2 has been relatively stable because the M1 substitutes that have resulted from financial innovation are new types of deposits that are part of M2.9091929396Instructor Notes:1) Year-to-year fluctuations in money growth and inflation are loosely correlated but decade average fluctuations in money growth and inflation are closely correlated.2) The burst of postwar inflation was caused by rapid money growth during World War II, and the rise in inflation during the 1970s was caused by more rapid money growth during the 1960s.97Instructor Notes:1) Year-to-year fluctuations in money growth and inflation are loosely correlated but decade average fluctuations in money growth and inflation are closely correlated.2) The burst of postwar inflation was caused by rapid money growth during World War II, and the rise in inflation during the 1970s was caused by more rapid money growth during the 1960s.

98Instructor Notes:Inflation and money growth in 60 countries and low-inflation countries show a clear positive relationship between money growth and inflation.999510010194