Monetary Policy and the Economy

Quantity Theory of MoneyAggregate Demand ApproachMonetary Policy and the Long-RunThe Policy Debate

Question: How does changes in the nation’s money supply affect macroeconomic conditions (GDP, inflation, unemployment)?

Two approaches to thinking about this:

(i) Quantity theory of money(“Monetarism”)

(ii) Demand-Side(“Keynesian”)

Quantity Theory Approach

The equation of exchange is always true:

MV = PY

M = nominal money supply

P = price level

Y = real GDP

V = velocity of money

YPVM %%%%

The velocity of money is the average number of times a dollar is spent to buy goods and services:

M x V = $ value transactions

V = $ value transactions/M For the entire economy, $ value of transactions

can be approximated by nominal GDP = PY:

V = PY/M

The quantity theory of money says that if V is constant, then there is a direct relationship between nominal GDP and the nominal money supply:

Nominal GDP = M x (constant)

PY = M x (constant) If there is an M, then do we get

Case (1): Y?

Case (2): P?

Problems:

(1) How can we distinguish between effect of M on Y versus P?

(2) Historically V is not constant (for M1).

The Velocity of Circulation in the United States: 1930–1999

Aggregate Demand Approach

Question: How does monetary policy affect aggregate demand?

Answer: Interest rates (r):

MS r

opportunity cost of investment

ID

Y

Y = (spending multiplier)ID

An increase in MS shifts AD curve to the right. There will be a combination of Case (1) and (2):

MS Shifts AD right Y and P Monetary policy can be a powerful tool to fight

recessions:

- Recession is caused by lack of demand

- AD shifts left, Y and P.

- MS r and ID shifts AD back right

Question: If MS is so powerful, why doesn’t the Fed just keep MS growing and r at or very near 0%?

Answer: INFLATION

Monetary Policy in the Long-Run Recall the in LR, the adjustment of prices and

wages will cause the economy to gravitate back towards potential GDP (YP).

Monetary policy has no effect on YP (only labor productivity and labor force).

MS Y > YP

inflationary gap

W and P

Y returns to YP

How much does P? The quantity theory tells us the answer is Case (2):

MV = PY

%M%V = %P%Y

In the long-run, Y = YP and V is constant:

%M= %P

money supply growth = inflation rate In the long-run inflation is caused by growth in

the nation’s money supply

Money Growth andInflation in the United States

International evidence of hyperinflation: Post WWI Poland 522%

Russia 684%

Germany 3,800%

1980s Israel 370%

Argentina 1,110%

Bolivia 8000%

German Hyperinflation (1/22 – 12/23, 4000%)

Daily Newspaper Price

$0.30 (1/21)

$1,000,000 (10/23)

$7,000,000 (11/23) Why print so much money?

To finance government spending.

“Inflation is almost everywhere a monetary phenomena” – Milton Friedman (1976 Nobel Winner in Economics)

Demand-Supply Interpretation: Lack of scarcity lowers value.

Even if wages are keeping up with inflation there are still costs:(i) Shoe-leather(ii) Tax distortions(iii) Re-distribution of wealth

Classic Example – Wizard of Oz Post Civil War Era (1880-96) depression, bank

panics, deflation. Debtors hurt. Money tied to Gold Standard 1896 Presidential Election: William Jennings Bryant

versus William McKinnley Bryant – populist, bimetallic gold-silver standard

(“Cross of Gold Speech”) McKinnley – Preservation of gold standard.

Wizard of Oz (1900) – L. Frank Baum(MGM Movie – 1939)

Dorothy, Scarecrow, Tin Woodsman Cowardly Lion Yellow Brick Road leads to the Emerald City “OZ” – Ounce of Gold The Wizard – man behind the curtain. Powers of the Magical Silver Slippers Wicked Witch of the West Eventually gold discovered in Alaska and South

Africa provided relief.

“The Wizard of Oz: Parable on Populism,” by Henry Littlefield, American Quarterly 16, (Spring 1964)

“The Wizard of Oz as a Monetary Allegory,” Hugh Rockoff, Journal of Political Economy 98 (Aug 1990)

Fed needs to balance off the short-run gains of more GDP with long-run costs of more inflation:

(i) Disinflation policy of 1979-80

(ii) Loose Monetary Policy: 2001-2004

(iii) Recent Tightening: 2004-present

Monetary Policy: 2001-2005