5.9 financial markets and central bank online test
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L11ECON3507-21.pptxMoney Growth, Money Demand, and Modern Monetary Policy
Chapter 20
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Learning Objectives
Discuss the role of monetary aggregates.
Define the velocity of money and its role in the quantity theory of money.
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20-2
Why We Care about Monetary Aggregates
The single most important fact in monetary economics: the relationship between money growth and inflation rates.
“Inflation is always and everywhere a monetary phenomenon.” ----- Milton Friedman
Panel A of Figure 20.1 shows the average annual inflation and money growth in 160 countries over the 3 decades, from 1980 to 2009.
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Why We Care about Monetary Aggregates
Two things are striking:
Some countries suffered inflation that averaged more than 200% a year for over three decades.
Every country with high inflation has high money growth.
To avoid sustained episodes of high inflation, a central bank must be concerned with money growth. Avoiding high inflation means avoiding persistent rapid money growth.
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Why We Care about Monetary Aggregates
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Why We Care about Monetary Aggregates
Figure 20.2 shows:
Points lying about the 45-degree line represent countries where average inflation exceeds average money growth.
Points lying below the 45-degree line represent countries where money growth exceeds inflation.
In general, countries with very high inflation tend to lie above the line and countries with moderate to low inflation tend to fall below it.
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Why We Care about Monetary Aggregates
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Why We Care about Monetary Aggregates
When the currency that people are holding loses value very rapidly, they will work to spend what they have as quickly as possible.
Spending money more quickly has the same effect on inflation as an increase in money growth.
By limiting the rate at which they purchase securities, policymakers can control the rate at which aggregates like M2 grow.
It is impossible to have high, sustained inflation without monetary accommodation.
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Normally the central bank provides reserves to the banking system, and banks respond by increasing loans, which expand deposits in the banking system, raising the broad monetary aggregates
Higher growth of broad money over time will lead to higher inflation
In recent years, banks have not been lending much, but there has not been a sizable impact on broad money and inflation has remained low
Credit and broader economic expansions picked up first in the U.S., inflation picked up a little, and the Federal Reserve was the fist central bank to begin raising interest rates.
20-9
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The Quantity Theory and the Velocity of Money
Thinking about the value or purchasing power of money in terms of the goods needed to get money makes the impact of inflation clear.
We can think about how many dollars we need to buy a cup of coffee or a sandwich.
We can turn the question around an ask: how many cups of coffee or sandwiches a person needs to buy one dollar.
A fall in the number of cups of coffee it takes to buy one dollar represents a decline in the price, or value, of money.
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The Quantity Theory and the Velocity of Money
The price of money is determined by supply and demand.
Given steady demand, an increase in the supply of money drives the price of money down.
That’s inflation.
If the central bank continuously floods the economy with large amounts of money, inflation will reach very high levels.
20-11
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Velocity and the Equation of Exchange
We need to focus on money as a means of payment.
Consider 4 college students:
One has $100 in currency;
One has two tickets to the weekend football game, worth $50 each;
One has $100 calculator; and
One has a set of 25 high quality drawing pencils that sell for $4 each.
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Velocity and the Equation of Exchange
The one with $100 buys the calculator.
The person with the calculator now uses the $100 to buy the football tickets.
The person with the football tickets now uses the $100 to buy the 25 pencils.
The total value of the transactions is $300.
In this 4-person economy, the $100 was used 3 times resulting in $300 worth of transactions.
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Velocity and the Equation of Exchange
We can say that:
the number of dollars used is the quantity of money in the economy;
the number of times each dollar is used (per unit of time) is called the velocity of money; and
the first multiplied the second is the dollar value of transactions.
The more frequently each dollar is used, the higher the velocity of money.
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Velocity and the Equation of Exchange
Every one of the purchases counted in nominal GDP requires the use of money.
M is the quantity of money, V is the velocity and nominal GDP can be divided into two parts:
The price level, P and the quantity of real output, Y.
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Velocity and the Equation of Exchange
We can rewrite the previous equation as:
This is called the equation of exchange, and tells us that the quantity of money multiplied by its velocity equals the level of nominal GDP.
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Velocity and the Equation of Exchange
We can rewrite the equation to allow for the percentage change in each factor.
Money growth plus velocity growth equals inflation plus real growth.
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The Quantity Theory of Money
Irving Fisher wrote the equation of exchange and derived the implication above.
He assumed that no important changes occur in payment methods or the cost of holding money.
If the interest rate is fixed and there is no financial innovation, then velocity will be constant.
He also assumed that real output is determined solely by economic resources and production technology, so it too is fixed in the short run.
20-18
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The Quantity Theory of Money
He concludes that money growth translates directly into inflation, an assertion that is termed the quantity theory of money.
We can reinterpret the quantity theory of money to describe the equilibrium between money demand and money supply.
Money demanded (Md) equals the total value of transactions divided by the velocity of money (V).
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The Quantity Theory of Money
For the economy as a whole, the demand for money equals nominal GDP divided by velocity:
The supply of money (MS)is determined by the central bank and the behavior of the banking system.
Assuming velocity and real output are constant, we can conclude that money growth equals inflation.
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The Quantity Theory of Money
The quantity theory of money accounts for some important characteristics:
It tells us why high inflation and high money growth go together.
It explains the tendency for moderate- and low-inflation countries to fall below the 45-degree line.
20-21
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The Quantity Theory of Money
Money growth tends to be higher than inflation in those countries because they are experiencing real growth.
If velocity is constant, then money growth equals the sum of inflation and real growth.
At a given level of money growth, the higher the level of real growth, the lower the level of inflation.
In countries that are growing, inflation will be lower than money growth, causing their economies to fall below the 45-degree line.
20-22
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The Facts about Velocity
If the velocity of money is constant, it means the trend in real growth is determined by the structure of the economy and the rate of technological process.
This means countries could control inflation directly by limiting money growth.
This logic led Milton Freidman to conclude that central banks should simply set money growth at a constant rate.
M1 and M2 should grow at a rate equal to the rate of real growth plus the desired level of inflation.
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The Facts about Velocity
To make the rule viable, he suggested changes in regulations that would:
Limit banks’ discretion in creating money, and
Tighten the relationship between the monetary aggregates and the monetary base, reducing fluctuations in the money multiplier.
For example, an increase in the reserve requirement or restrictions on the number and types of loans banks could make.
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The Facts about Velocity
But Friedman’s recommendation that the central bank should keep money growth constant would stabilize inflation only if velocity were constant.
In countries with high levels of inflation, changes in velocity can probably be safely ignored.
But in countries where inflation rate is below 10% per year, changes in velocity could have a significant impact on the relationship between money growth and inflation.
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The Facts about Velocity
Historical data seem consistent with Fisher’s conclusion: in the long run, the velocity of money is stable, so that controlling inflation means controlling the growth of the money aggregates.
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The Velocity of M2, 1959-2019
The Facts about Velocity
Central bankers are concerned about inflation over months and quarters, not years.
The monetary aggregates, even broad ones, can be useful guides to short-term policy only to the extent that they signal changes in inflation during the periods monetary policymakers care about.
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The Velocity of M2, 1959-2019
The Facts about Velocity
Notice the increase in velocity in the late 1970s and early 1980s.
This was a period of both high nominal interest rates and significant financial innovations.
This included the introduction of stock and bond mutual funds that allow investors checking privileges.
Together these reduced the amount of money individuals held for a given level of transactions, raising the velocity of money.
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The Facts about Velocity
These data clearly suggest that fluctuations in the velocity of money are tied to changes in people’s desire to hold money.
Policymakers must understand the demand for money.
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When it was first started, the ECB looked at money growth closely.
Velocity appeared relatively stable.
It created a reference value for money growth:
Inflation = 1 to 2%
Real Growth = 2 to 2½ %
Velocity Growth = ½ to -1%
Money growth = 1½ % + 2¼ % - (-¾ %) = 4½ %.
In 2003 the reference value was downgraded and today it is a long-run benchmark.
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