Thought experiment

Imagine that money supply is doubled in the economy

It’s perfectly doubled in each place Everybody knows this. Information goes backwards. Are there any real effects?

Quantity theory of money

Monetary effects, but no „real” effects Changes in nominal magnitudes Consumption and production should stay the

same Just as incomes of market participants Interest rates should stay the same

Banking system vs. green fairy

New money is not ideally distributed People have different knowledge Money increases incomes at first in some

places, and in others later on Money goes into the economy through credit

markets (lower interest rate)

Cantillon effects

Not all prices are effected to the same extent Redistribution effects follow The consumption/investment ratio is changed The amount of capital has different value in

the eyes of participants Conclusion: money is not neutral

Equation of exchange (I. Fisher)

MV = PT Money spent equals money received Money supply multiplied by „velocity of

circulation” Average price and number of transactions

Actually the Germans were first again (Karl Heinrich Rau)

u is mittlere Umlaufszahl des Geldes (velocity)

g is Geldmenge (money supply) p is Preisniveau (price level) w is umgesetze Menge von Gütern und

Leistungen (quantity of goods and services exchanged)

ug = wp

Monetarism and the business cycle

Cycles exists in the economy Economy can fall below potential output Economy can be stimulated into a boom

(Phillips curve) Solution: rules instead discretionary policies

Older monetarist program

Money supply should be constantly increased year by year

At the same pace as the economy grows For example: 3-5% per year in order to

achieve „price stability”

Assumptions of the monetarist model

Predictable policy is a good policy Rules are better than discretion Velocity is stable Money supply can easily be measured Can be controlled by the central bank MOST IMPORTANT: Stable prices mean

stability

Critique of the older monetarist program

Objective problems: velocity is not stable anymore

Money supply is not easily measured or controlled (financial innovation)

Stable prices might not mean stable economy (Japan 1980s, 1920s, 1990s USA)

In other words – CPI does not explain everything about economic activity

Quantity theory of money nowadays

The economic activity and prices are influenced by the money supply in the system

Hence monetary policy is the most important macroeconomic policy

Long run/Short run problem Everybody and nobody is a monetarist

Fisher 1929

Fisher in the end of 1920s believed that the economy had strong fundamentals

Prices were fine and were not overvalued He used empirical analysis (past prices) After the collapse he became a huge debtor

until his death

Friedman in the 2004

„At the moment, the fundamentals are rather well orientated. Inflation remains weak, and there is no sign of resumption in the increase of prices. Unemployment remains bearable. It went back up around 6 %, but it is a rate which, in the past, has been often observed, including in periods of prosperity. Quarter after quarter, productivity advances at a steady pace. There is no financial crisis. Banks are not in trouble. Our situation is rather good and the only thing which, in the course of the last few months, slowed down the situation is to be found - once again – in the uncertainties created by terrorist threat and the war in Iraq.”

CPI is not everything…