differences

5:"6 trillion. The velocitY :.: money indicates how ::::en each dollar is used ;3 average to PaY for final .;ods and services during --:e year. So in zoo8, veloc- -:.; was $r+.3 trillion divided :.; Sr.6 trillion, or 8.9. Given -fP and the moneY suP- :...', each dollar in circula- ::--n must have been spent 3 ; times on average to PaY ::: final goods and services.

, =;ues of the other variables' -::::dentally, velocitY mea- : tr:es spending oniY on final

":cds and services-not on intermediate products,

:,=::ndhand goods, or financial assets, even though .-:r spending also occurs. So velocity underesti- :-raies how hard the money supply works during the

"-a:.

The equation of exchange saYS '::: iota] spending (M x V) is alwaYs

::--.iai to total receipts (P x Y), as was ::-n .ase in our circuiar-flow analY- ::-:. rs described so far, however, the

=-,;aiion of exchange is simPlY an ;:r.:ry-a relationship exPressed :. s;ch a way that it is true bY :=::::ition. Another examPle of an

-:=i::ity wouid be a relationshiP .: -aiing miles per gallon to the :-i:rnce driven divided bY the :.-:line required.

?he Suarnt$ty Th*orgr of Mc>meY

the economy's potential level of output' With reai output, Y fixed and the velocity of money, V, rela- tively stable, a change in the stock of money trans- lates directly into a change in the price level' Exhibit

5 on the next page shows the effect of an increase

in the money supply in the long run. An increase in

the money iupply causes a rightward shift of the aggregate demand curve, which increases the price

level but leaves output unchanged

So an i.ncrease in the money supPlY results in more spending in the long rLin, meaning a higher nominal GDP. How is this increaseinPxYdivided between changes in the price level and changes in real GDP? The answer does not lie in the quan- tity theory for that theory is stated onlY in terms of nominai GDP. The answer lies in the shaPe of the aggregate suPPiY curve.

The long-run aggregate supply curve is vertical at

at potential GDP. So the economY's potential output level is not affected by changes in the money suPPlY' In the long run, increases in the moneY supply, with velocittl stable or at least not decreqsing, result only in higher prices. For example, an examination of 73 inflation periods across major economies since r96o concludes that important triggers to inflation were expansionary monetary Policies-

To review: If velocity is stable, or at least predictable, the quantity theory of money says that changes in the money sup-

quantity theorY of money if the vei*eitY o{ nrtl*eY is st;tble, 0r at least !:l'*dictahle, ehang*s in ih€ m*lreY suPPll have prad;ctaili€ *f{ects on nami*al GBP

rri3€== a

liXV:pXy

7:PxvF

.: 'i:iccity is reiatively stable over time, or at least ::=;:ctable, the equation ofexchange turns from an -:=::iqy into a theory-the quantity theory of money. l::: :,rar:ti{r t}:*ory af mo*ey states that if the veloc- .:,- ;: :noney is stable, or at least predictable, then ::.= :quation of exchange can be used to predict the ::::;:s of changes in the money supply on nominal ,ll. ? x Y For example, if M increases by 5 percent ::-i -ut remains constant, then P x Y or nominal GDP, :-- -:r: also increase by 5 percent. For a while, some :-::::mists believed they could use the equation of =:,:iange to predict nominal output in the short run. :;:;' ii's used primarily as a guide in the iong run.

ply r.r.rill, in the long run, result in predictable effects on the

economy's price leve| Velocity's stability and predict- ability are key to the quantity theory of money'

What Betermimes the \fele>c$tY of Money? Velocity depends on the customs and conventions of commerce. In colonial times, money might be tied up in transit for daYs as a courier on horseback carried a payment from a merchant

H;.'::

CHAPTER I6 l\4cneiary 'i"hurrry ;ind l'ciiry 233

Lxirii:it 3 ln the Long Run, an lncrease in the Money Supply

Besults in a Higher Price Level, or lnflation

in Boston to one in Baltimore. Today, the electronic transmission of funds occurs in an instant, so the same stock of money can move around much more quickly to finance many more transactions' The uelociry of money has also increased because of a vari'

ety of commercial innovations that facilitate exchange' for exampie, a wider use of charge accounts and credit cards has reduced the need for shoppers to carry cash. Likewise, automatic teiler machines have

made cash more accessible at more times and in more places. What's more, debit cards are used at a growing number of retail outiets, such as grocery

stores and drug stores, so people *eed less "walking

130

around" money. Another institutional

factor that determines velocity is the frequencY with which workers get paid. Suppose a worker who earns $5z,ooo Per year gets paid $z,ooo every two weeks. Earnings are spent evenlY during the two-week period and are

other things constant. Money becomes a hc: potato-nobody wants to hold it for long'

Again, the usefulness of the quantity theory i: predicting changes in the price level in the long rul hittg"s on how stable and predictable the velociry c: money is over time.

ffisqru 5t*b3e Es Xfe$ssitY? Exhibit 6 graphs velocity since r96o, measured bof- as nominal GDP divided by Mr in panel (a) and a: nominal GDP divided by Mz in panel (b)' Betwee:: r95o and r98o, Mr velocity increased steadily and ir-

that sense could be considered at least predictabi'. Mr velocitybounced around duringthe r98os' Buti;:

tices change slowly over time, and the effects

of these changes on velocity are predictable' Another factor affecting veiocity depends

on how stable money is as a store of value. Th;

better money serues as a store of value, the morz

money people hold, so the Tower its uelociry. For

example, the introduction of interest-bearinE checking accounts made money a better store

of value, so people were more wiiling to holc money in checking accounts and this finar:- cial innovation reduced velocity' On the other hand, when inflation increases unexpectedlt-" money turns out to be a poorer store of value

People become reluctant to hold money an: try to exchange it for some asset that retains its value better. This reduction in people': willingness to hoid money during periods cf high inflation increases the velocity of mone'; During hyperinflations, workers usualiy ge: paid daily, boosting velocity even more. Thus. velacity increases with a rise in the inJlation rar'i

the early r99os, more ar.: more banks began offe:- ing money market func= that inciuded limite: check-writing privilege: or what is considere : Mz. Deposits shiftel from Mr to M2, whi:- increased the velocitY :; Mr. Also in recent Years more peopie began usir-*

Potential outPut LRAS

0)

0) 140

'. o_

't4.0 Real GDP (triltions of dollars)

,

gone by the end of the period. In that case, a work-

"r', uu"t"gu money balance during the pay period is

$r,ooo. If a worker earns the same $5z,ooo per year but, instead, gets paid $r,ooo weekly, the average money balance during the week falls to $5oo' Thus, the more often workers get paid,other things constant, the

lower their qverqge money balances, so the more active the

money supply and the greater its uelocity. Payment prac-

their ATM and debit cards to pay directiy at grc- cery stores, drugstores, and a growing number c: outlets, and this too increased the velocity of l{: because peopie had less need for walking-arou:-: money. Mr velocity increased from about 6'o i:' r993 to over 8,o more recently. Mz veiocity appea:-! more stable, as you can see by comparing the tru: paneis in Exhibit 6.

234 PAR'T' 3 Fiscal and tulonetary Poltcv

i:r a few years, the Fed focused on changes in soney supply as a target for monetary pollcy

:le short run. Because Mr velocily became so ,,t'31e during the r98os, the Fed in 1987 switched :- iargeting Mr to targeting Mz. But when Mz :::ry became volatile in the early r99os, the Fed '.:,:nced that money aggregates, including Mz' *-e no longer be considered reliable guides for :-.iary policy in the short run. Since 1993, the .:jon of exchange has been considered more of a

';.1' {:

'*ri{city of Money

rough guide linking changes in the money supply to

inflation in the long run. What is the long-run relationship between

increases in the money supply and inflation? Since the Federal Reserve System was established in r9r3, the United States has suffered three episodes of high inflation, and each was preceded and accompa-

nlea Uy sharp increases in the money suppiy' These occurred from r9r3 to t9zo, 1939 to t948, and ry67 to r98o.

11ll

(a) Velocity of M1

:960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2008

(b) Velocity of M2

1360 1965 1970 1975 1980 1985 1990 1995 2000 2005 2008 WE 3:::cnic Repoft of the President, January 2009. To compute the latest velocity, go to htto:// r-:!:=;,::ss.sq!&o!l1 find the statistical tables in the appendix then divide nominal GDP by Ml and by M2

LO4 Targets for Monetary PolicY In the short run, monetary Pol- icy affects the economY iargelY by influencing the interest rate. In the long run, changes in the money suPPiY affect the Price level, though with an uncertain lag. Should monetary authorities focus on the interest rates in the short run or the suPPlY of moneY in the long run? As we will see, the Fed lacks the tools to focus on both at the same time.

eontrasting Polieies To demonstrate the effects of dif- ferent policies, we begin with the money market in equilibrium at point e in Exhibit 7. The interest rate is i and the money stock is M, values the monetary authodties find appropriate. SuPPose there is an increase in the demand for money in the economy, PerhaPs because of an increase in nominal GDP. The money demand curve shifts to the right, from D* to D'*'

When confronted with an increase in the demand for mone):' monetary authorities can choose to do nothing, therebY ailowing the interest rate to rise, or they can increase the moneY suPPlY enough to hold the interest rate constant' If monetary authorities do nothing, the quantitY of moneY in the econ- omy remains at M, but the inter- est rate rises because the greater demand for moneY increases the

CHAPTER r6 Monetary iheory and Policy 235