QUANTITY THEORY OF MONEY �& MONETARISM

Readings: QE and the long-run.

MONEY NEUTRALITY

• In the long run, changes in the money supply affect the aggregate price level but not real GDP or the real interest rate.
• There is monetary neutrality: changes in the money supply have no real effect on the economy.

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• So monetary policy is ineffectual in the long run.

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• Monetary Policy is a short run tool!

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• NEXT: OMO & Monetary Policy Review

DRAW:SETTING THE FEDERAL FUNDS RATE (EXPANSIONARY)�- PUSHING THE INTEREST RATE DOWN TO THE TARGET RATE

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The target federal funds rate is the Federal Reserve’s desired federal funds rate.

DRAW: SETTING THE FEDERAL FUNDS RATE (CONTRACTIONARY)�- PUSHING THE INTEREST RATE UP TO THE TARGET RATE

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TO WHAT EXTENT SHOULD MONETARY POLICY BE USED?

• Useful all the time, even alone (skip the fiscal policy)?
• Useful tool when used with appropriate fiscal policy?
• Useful when attempting to slow an economy, but useless when attempting to grow an economy (“pushing on a string;” much easier to pull)?
• Not useful; a nuisance; let the markets work after setting a rigid, automatic policy rule?
• Disastrous and will lead to inflation; get rid of the entire Fed System and back to gold?

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MONETARY POLICY TOOLS

• Main: Open Market Operations (Buy & Sell bonds (or securities, or treasuries).
• 1) Federal Funds Interest Rate (short run)
• 2) Discount Interest Rate (1% above Fed. Funds)
• 3) Required Reserves Ratio (Large banks 10%; smaller 3%)
• 4) Term Auction Facility (for short run loans from the Fed (without the stigma of sending out the SOS distress call)).

FEDERAL FUNDS RATE

DISCOUNT RATE REPLACED WITH PRIMARY CREDIT RATE

• Reserve Banks will extend primary credit at a rate above the federal funds rate, which should eliminate the incentive for institutions to borrow for the purpose of exploiting the positive spread of money market rates over the discount rate.
• The Board anticipates that the primary credit rate will be set initially at 100 basis points (1%) above the FOMC's Target Federal Funds Rate.

DISCOUNT RATE (ABOUT 1% ABOVE FED FUNDS RATE)

REPLACED “OLD” DISCOUNT RATE�PRIMARY (DISCOUNT) CREDIT RATE (.75)

REQUIRED RESERVES AS SET BY THE FED:

• Transaction Accounts RR Date
• $0 to $11.5 million: 0% (12-29-11)     

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• More than $11.5 million to $71.0 million: 3% (12-29-11)   

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• More than $71.0 million: 10% (12-29-11)

HAPPY BIRTHDAY, KEN HOFFMAN!� NICE HEELS!

THE QUANTITY THEORY OF MONEY

The Equation of Exchange: M*V=P*Q

RELATING MONEY TO GDP

• Irving Fisher was a contemporary of Keynes.
• Yale economist, Irving Fisher postulated that:

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• Nominal GDP = The Money Supply * Money’s Velocity

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(COPY) THE MONETARY EQUATION OF EXCHANGE OR THE QUANTITY THEORY OF MONEY:

MV = PQ

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• M = money supply (M1 or M2)
• V = money’s velocity (M1 or M2)
• P = price level (PL on the AS/AD diagram)
• Q = real GDP (sometimes labeled Y on the AS/AD diagram)
• P_*Q or PQ = Nominal GDP

THE MONETARY EQUATION OF EXCHANGE

• MV=PQ
• M1=$2 trillion
• V of M1 = 7
• PQ = $14 trillion

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GDP_R

PL

AD

SRAS

LRAS

Q_F

P

WHAT HAPPENS WHEN MORE MONEY IS ADDED TO THE FORMULA? NOMINAL GDP INCREASES, BUT DOES IT LEAD TO ANY REAL GROWTH?

• MV = PQ

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• M = money supply (M1 or M2)
• V = money’s velocity (M1 or M2)
• P = price level (PL on the AS/AD diagram)
• Q = real GDP (sometimes labeled Y on the AS/AD diagram)

MONETARISM

Critics of active monetary policy

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MONETARIST VIEW OF MONETARY POLICY

• Monetarist View: This label is applied to a modern form of classical economics (in opposition to Keynesianism).
• Money supply is the focus of monetarist theory.
• Monetarism argues that the price and wage flexibility provided by competitive markets cause fluctuations in product and resource prices, rather than output and employment.
• Therefore, a competitive market system would provide substantial macroeconomic stability if there were no government interference in the economy.
• It is government that has caused downward inflexibility through the minimum wage law, pro‑union legislation, and guaranteed prices for some products as in agriculture.
• Monetarists say that government also contributes to the economy’s business cycles through clumsy, mistaken, monetary policies.

MONETARISM

• When the central bank changes interest rates or the money supply based on its assessment of the state of the economy, it is engaged in active monetary policy.
• Monetarists will argue that a monetary policy rule, a formula that determines the central bank’s actions, is needed.
• Recalling the velocity equation: M × V = P × Y:
• Monetarists believed that V was stable, so they believed that if the Federal Reserve kept M on a steady growth path, nominal GDP would also grow steadily without inflation.

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FRIEDMAN, MONETARISM & CHICAGO SCHOOL

• A hands-off approach to monetary policy.
• Monetary policy, via a rule, should be automatic and not be toyed with by the FED.
• From 1960 to 1980, the velocity of money followed a smooth trend, leading monetarists to believe that steady growth in the money supply would lead to a stable economy.
• After 1980, however, velocity began moving erratically, undermining the case for strict monetarism.

THE VELOCITY OF MONEY

• Possible reasons for the change? Income fluctuations, cyclical considerations, computers, & financial innovations like credit cards & interest bearing demand-accounts.

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1970S RESPONSE TO STAGFLATION: MONETARIST SCHOOL

• Monetarists believe that changes in the money supply are both a necessary and sufficient condition to cause inflation.
• Slow, steady, unflinching, and predictable growth of the money supply is what Monetarists prescribe. Think of a robotic Fed, no humans to screw it up.
• If AD was low, increasing the money supply would only increase short-run economic activity. �           A. Eventually short-term expansion stops and increasing the money supply only adds to inflation in the long run. �          �           B. Monetarists believe that government involvement in the economy, especially monetary intervention, increases the swings of the business cycle.
• To some degree monetarism is an extension of classical economics. Its advocates believe that a competitive market, free from government interference, results in economic stability and a reasonable growth rate.
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MONETARISM TODAY

• Father of Monetarism: Milton Friedman, University of Chicago, softened his view on the usefulness of monetary policy and the idea of a strict and rigid rule system to govern the supply of money via the Fed.
• Mainstream economists view instability of investment as the main cause of the economy’s instability.
• Mainstream economists see monetary policy as a stabilizing factor since it can adjust interest rates to keep investment and aggregate demand stable.

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KEN (THE ONE IN THE RED SHIRT)

MONETARY POLICY:�INFLATION & THE LONG RUN

Strengths & Weaknesses

Examples: Brazil & Japan

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MONEY AND THE PRICE LEVEL

• Classical macroeconomics asserted that monetary policy affected only the aggregate price level, not aggregate output, and that the short run was unimportant.
• According to the classical model, prices are flexible, making the aggregate supply curve vertical even in the short run. As a result, an increase in the money supply leads, other things equal, to an equal proportional rise in the aggregate price level, with no effect on aggregate output.
• As a result, increases in the money supply lead to inflation, and that’s all.

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POLICY TO FIGHT RECESSIONS

• The main practical consequence of Keynes’s work was that it legitimized macroeconomic policy activism—the use of monetary and fiscal policy to smooth out the business cycle.

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• Keynes will focus on the short-run.

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CLASSICAL VERSUS KEYNESIAN MACROECONOMICS

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STRENGTHS OF MONETARY POLICY:�

• It is speedier and more flexible than fiscal policy since the Fed can buy and sell securities daily.
• It is (supposed to be) less political. Fed Board members are isolated from political pressure, since they serve 14‑year terms, and policy changes are more subtle and not noticed as much as fiscal policy changes.
• It is easier to make good, but unpopular decisions. Imagine the political fight over QE in Washington if a publicized vote were needed.

PROBLEMS AND COMPLICATIONS OF MONETARY POLICY�

• Recognition and operational lags impair the Fed’s ability to quickly recognize the need for policy change and to affect that change in a timely fashion.
• Although policy changes can be implemented rapidly, there is a lag of at least 3 to 6 months before the changes will have their full impact.
• Cyclical asymmetry may exist: a restrictive monetary policy works effectively to brake inflation, but an expansionary monetary policy is not always as effective in stimulating the economy from recession. “You can lead a horse to water, but you can’t make it drink” (or pushing on a string).

THE LONG-RUN RELATIONSHIP BETWEEN MONEY AND INFLATION�(INCREASE THE MONEY SUPPLY = INCREASE IN THE PRICE LEVEL)

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MONEY AND PRICES (DRAW)

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According to the classical model of the price level, the real quantity of money is always at its long-run equilibrium level. (Skip the SR E2; Money supply increase leads to inflation from E1 to E3).

MONEY SUPPLY GROWTH AND INFLATION �IN BRAZIL (NOTE: THERE IS NO OBVIOUS LAG)

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MONEY AND PRICES IN BRAZIL, 1985-1995 �OVER THE 10-YEAR PERIOD, THE MONEY SUPPLY AND THE AGGREGATE PRICE LEVEL BOTH ROSE BY 100 BILLION PERCENT.

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LIMITATIONS OF MONETARY POLICY:

• There is a zero bound on the nominal interest rate: it cannot go below zero.
• A situation in which monetary policy can’t be used because nominal interest rates cannot fall below the zero bound is known as a liquidity trap.
• A liquidity trap can occur whenever there is a sharp reduction in demand for loanable funds.

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JAPAN’S TRAP & DEFLATION

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THE FEDS RESPONSE TO THE 2001 RECESSION

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CONCLUSION

• There are continuing debates about the appropriate role of monetary policy.
• Some economists advocate explicit inflation targets, but others oppose them (current implicit: 2%).
• Inflation targeting requires that the central bank try to keep the inflation rate near a predetermined target rate.
• There’s also a debate about whether monetary policy should take asset prices into account.
• Quantitative Easing (see readings).

FISCAL POLICY WITH A FIXED MONEY SUPPLY�FISCAL AND MONETARY POLICY WORKING TOGETHER TO PREVENT CROWDING OUT.

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THE MODERN CONSENSUS

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Five Key Questions About Macroeconomic Policy:

MODERN/MAINSTREAM CONSENSUS

EXTRA: FISHER EFFECT

FISHER EFFECT

• Expected inflation and interest rates:
• According to the Fisher effect, expected inflation raises the nominal interest rate one-for-one so that the real interest rate remains unchanged.

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THE FISHER EFFECT

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FORMULAS TO KNOW:

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• Money Multiplier = 1/Required Reserve Ratio
• (or, m=1/R)
• Max. Money Creation = excess reserves x money multiplier
• (or, E * m)
• MV=PQ
• M = money supply
• V = money’s velocity
• P = price level
• Q = real GDP
• P_*Q or PQ = Nominal GDP