Money, Financial System and Topic the Economy

7Topic Money, Financial System and

the Economy

Part II: Money and the Economy

Money and the Price Level

Classical economists believed that changes in the money supply affect the price level in the economy. Their position was based on the equation of exchange and on the simple quantity theory of money.

The Equation of Exchange

The equation of exchange is an identity stating that the money supply

(𝑀) multiplied by velocity (𝑉) must be equal to the price level (𝑃) times

Real GDP (𝑄).

𝑀𝑉 ≡ 𝑃𝑄

where ≡ means “must be equal to.” This is an identity, and an identity is

valid for all values of the variables.



As we learned in an earlier chapter, velocity is the average number

of times a dollar is spent to buy final goods and services in a year.

For example, assume an economy has only five $1 bills. Suppose

that over the course of the year, the first dollar bill changes hands 3

times; the second, 5 times; the third, 6 times; the fourth, 2 times; and

the fifth, 7 times.

Given this information, we can calculate the average number of

times a dollar changes hands in purchases. In this case, the number

is 4.6, which is velocity.



In reality, counting how many times each dollar changes hands

is impossible; so calculating velocity as we did in our example is

impossible. In reality, we use a different method.

We compute velocity using the equation of exchange:

𝑉 ≡𝑃𝑄

𝑀≡𝐺𝐷𝑃

𝑀



The equation of exchange can be interpreted in different ways:

1. The money supply multiplied by velocity must equal the price level

times Real GDP: 𝑀 × 𝑉 ≡ 𝑃 × 𝑄

2. The money supply multiplied by velocity must equal GDP: 𝑀 × 𝑉 ≡𝐺𝐷𝑃 (because 𝑃 × 𝑄 ≡ 𝐺𝐷𝑃).

3. Total spending or expenditures of buyers (measured by 𝑀𝑉) must

equal the total sales revenues of business firms (measured by 𝑃𝑄):

𝑀𝑉 ≡ 𝑃𝑄


From the Equation of Exchange to the Simple Quantity

Theory of Money

The equation of exchange is an identity, not an economic theory. To turn it

into a theory, we make some assumptions about the variables in the

equation. Many eighteenth-century classical economists, as well as

American economist Irving Fisher (1867–1947) and English economist

Alfred Marshall (1842–1924), made the following assumptions:

1. Changes in velocity are so small that for all practical purposes velocity

can be assumed to be constant (especially over short periods of time).

2. Real GDP, or 𝑄, is fixed in the short run.



Theory of Money

With these two assumptions, we have the simple

quantity theory of money: If 𝑉 and 𝑄 are constant, then

changes in 𝑀will bring about strictly proportional

changes in 𝑃.

In other words, the simple quantity theory of money

predicts that changes in the money supply will bring

about strictly proportional changes in the price level.


𝑀 𝑉 = 𝑃 𝑄

Taking ′ln′ on both sides

⇒ ln𝑀 + ln 𝑉 = ln𝑃 + ln 𝑄

differentiating both sides with respect to ′𝑡′

⇒1

𝑀

𝑑𝑀

𝑑𝑡+1

𝑉

𝑑 𝑉

𝑑𝑡=1

𝑃

𝑑𝑃

𝑑𝑡+1

𝑀

𝑑 𝑄

𝑑𝑡

⇒ 𝑀

𝑀=

𝑃

𝑃

⇒ 𝑔𝑀 = 𝑔𝑃

For any 𝑥, denote 𝑑𝑥

𝑑𝑡= 𝑥



Theory of Money

How well does the simple quantity theory of money predict?

The answer is that the strict proportionality between changes

in the money supply and changes in the price level does not

show up in the data (at least not very often).

Generally, though, the evidence supports the spirit (or

essence) of the simple quantity theory of money: the higher

the growth rate in the money supply, the greater the growth

rate in the price level.



Theory of Money

To illustrate, we would expect that a growth rate in the money

supply of, say, 40 percent would generate a greater increase

in the price level than, say, a growth rate in the money supply

of 4 percent.

Generally, this effect is what we see. For example, countries

with more rapid increases in their money supplies often

witness more rapid increases in their price levels than do

countries that witness less rapid increases in their money

supplies.


The Simple Quantity Theory of Money in an AD–AS

Framework

AD curve in the Simple Quantity Theory of Money

Recall that one way of interpreting the equation of exchange is that the

total expenditures of buyers (MV) must equal the total sales of sellers

(𝑃𝑄). So,

𝑀𝑉 = 𝐴𝑔𝑔𝑟𝑒𝑔𝑎𝑡𝑒 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒𝑠 (𝐴𝐸).

However,

𝐴𝐸 = 𝐶 + 𝐼 + 𝐺 + 𝑋 −𝑀

→ 𝑀𝑉 = 𝐶 + 𝐼 + 𝐺 + 𝑋 −𝑀



Framework

AD curve in the Simple Quantity Theory of Money

At a given price level, anything that changes 𝐶, 𝐼, 𝐺, 𝑋 or 𝑀changes

aggregate demand and thus shifts the aggregate demand (𝐴𝐷) curve. If

𝑀𝑉 equals 𝐶 + 𝐼 + 𝐺 + 𝑋 −𝑀, then a change in the money supply (𝑀)

or a change in velocity (𝑉) will change aggregate demand and therefore

lead to a shift in the 𝐴𝐷 curve.

In other words, aggregate demand depends on both the money supply

and velocity. But in the simple quantity theory of money, velocity is

assumed to be constant. Thus, only changes in the money supply can

shift the 𝐴𝐷 curve.



Framework

The AS curve in the simple quantity theory of money

In the simple quantity theory of money, the level of Real

GDP is assumed to be constant in the short run. The AS

curve is vertical at that constant level of Real GDP.



Framework

AD and AS in the simple quantity theory of money


Dropping the Assumptions that 𝑽 and 𝑸 Are Constant

If we drop the assumptions that velocity (𝑉) and Real GDP (𝑄) are

constant, we have a more general theory of the factors that cause

changes in the price level. In this theory, changes in the price level

depend on three variables:

1. Money supply

2. Velocity

3. Real GDP

Let’s again start with the equation of exchange: 𝑀 × 𝑉 ≡ 𝑃 × 𝑄

If the equation of exchange holds, then:

𝑃 ≡𝑀 × 𝑉

𝑄


Dropping the Assumptions that 𝑽 and 𝑸 Are Constant

This last equation shows that the price level depends on the money

supply, velocity, and Real GDP.

What kinds of changes in 𝑀, 𝑉, and 𝑄 will bring about inflation (an

increase in the price level), ceteris paribus?

Inflationary tendencies: 𝑀 ↑, 𝑉 ↑, 𝑄 ↓

What will bring about deflation (a decrease in the price level), ceteris

paribus?

Deflationary tendencies: 𝑀 ↓, 𝑉 ↓, 𝑄 ↑

Monetarism

Economists who call themselves monetarists have not been content to

rely on the simple quantity theory of money. They do not hold that

velocity is constant, nor do they hold that output is constant.

The Four Monetarist Positions

1. Velocity changes in a predictable way

2. Aggregate demand depends on the money supply and on velocity

3. The 𝑆𝑅𝐴𝑆 curve is upward sloping

4. The economy is self-regulating (prices and wages are flexible)

Monetarism


1. Velocity changes in a predictable way

Monetarists do not assume that velocity is constant, but rather that it

can and does change. However, they believe that velocity changes

in a predictable way, that is, not randomly, but in a way that can be

understood and predicted.

Monetarists hold that velocity is a function of certain variables—the

interest rate, the expected inflation rate, the frequency with which

employees receive paychecks, and more—and that changes in it

can be predicted.

Monetarism


2. Aggregate demand depends on the money supply and on velocity

Just like the Keynesians focus on components of 𝐴𝐸, the Monetarists

focus on the money supply (𝑀) and velocity (𝑉). For example,

Keynesians argue that changes in 𝐶, 𝐼, 𝐺, 𝑋, or 𝑀 (Import) can change

aggregate demand, whereas monetarists argue that 𝑀 and 𝑉 can change

aggregate demand.

3. The 𝑺𝑹𝑨𝑺curve is upward sloping

In the simple quantity theory of money, the level of Real GDP (𝑄) is

assumed to be constant in the short run. So the aggregate supply curve is

vertical. According to monetarists, Real GDP may change in the short run,

and therefore the 𝑆𝑅𝐴𝑆 curve is upward sloping.

Monetarism


4. The economy is self-regulating (prices and wages are

flexible)

Similar to Classical economists, Monetarists believe that prices and

wages are flexible. Monetarists therefore believe that the economy

is self-regulating; it can move itself out of a recessionary or

inflationary gap and into long-run equilibrium, producing Natural

Real GDP.

Monetarism

Monetarism and AD–AS

Monetarism

The Monetarist View of the Economy

According to the diagrams, the monetarists believe that:

The economy is self-regulating.

Changes in velocity and the money supply can change aggregate

demand.

Changes in velocity and the money supply will change the price

level and Real GDP in the short run but only the price level in the

long run.

Monetarism


We need to make one other important point with respect to

monetarists. Consider this question: Suppose velocity falls and

the money supply rises. Can a change in velocity offset a

change in the money supply?

Monetarists think that this condition—a change in velocity

completely offsetting a change in the money supply—does not

occur often. They believe (1) that velocity does not change very

much from one period to the next (i.e., it is relatively stable) and

(2) that changes in velocity are predictable.

Monetarism


So in the monetarist view of the economy, changes in velocity

are not likely to offset changes in the money supply.

Therefore, changes in the money supply will largely determine

changes in aggregate demand and thus changes in Real GDP

and the price level.

According to monetarists, for all practical purposes, an

increase in the money supply will raise aggregate demand,

increase both Real GDP and the price level in the short run,

and increase only the price level in the long run. A decrease in

the money supply will lower aggregate demand, decrease

both Real GDP and the price level in the short run, and

decrease only the price level in the long run.

Inflation

In everyday usage, the word inflation refers to any increase in the price

level. Economists, though, like to differentiate between two types of

increases in the price level: a one-shot increase and a continued

increase.

One-Shot Inflation

One-shot inflation can be thought of as a one-shot, or one-time,

increase in the price level. More precisely, if price level increases but

not on a continued basis, we call the price increase ‘one-shot inflation’.

Suppose the CPI for years 1 to 5 is as follows:

Inflation

One-shot inflation: demand-side induced

Price levels that go from 𝑃1 to 𝑃2 to 𝑃3 may seem like more than a one-

shot increase. But because the price level stabilizes (at 𝑃3), we cannot

characterize it as continually rising. So the change in the price level is

representative of one-shot inflation.

Inflation

One-shot inflation: supply-side induced

29

Inflation

Continued Inflation

Continued inflation can be demand-side induced (Demand-pull

inflation) or supply-side induced (Cost-push inflation)

Demand-pull inflation is an inflation that results from an initial

increase in aggregate demand.

Demand-pull inflation may begin with any factor that increases

aggregate demand, e.g., increases in the quantity of money,

increases in government purchases, or cuts in net taxes, an

increase in exports etc.

30

Inflation

Demand-pull inflation

This Figure illustrates

the start of a demand-

pull inflation.

Starting from full

employment, an

increase in aggregate

demand shifts the AD

curve rightward.

31

Inflation

Real GDP

increases, the

price level rises,

and an

inflationary gap

arises.

The rising

price level is

the first step

in the

demand-pull

inflation.


32

Inflation

Demand-pull

inflation

This Figure

illustrates the

money wage

response.

The higher level

of output means

that real GDP

exceeds potential

GDP—an

inflationary gap.

33

Inflation

Demand-pull

inflation

The money

wage rises and

the SRAS curve

shifts leftward.

Real GDP

decreases back

to potential

GDP but the

price level rises

further.

34

Inflation

Demand-pull

inflation

This Figure

illustrates a

demand-pull

inflation spiral.

Aggregate

demand keeps

increasing and the

process just

described repeats

indefinitely.

35

Inflation


Although any of several

factors can increase

aggregate demand to start a

demand-pull inflation, only

an ongoing increase in the

quantity of money can allow

it to continue.


occurred in the United States

during the late 1960s and

early 1970s.

36

Inflation

Cost-push inflation is an inflation that results from an

initial increase in costs.

There are two main sources of increased costs:

An increase in the money wage rate

An increase in the money price of raw materials, such as

oil.

37

Inflation

Cost-push inflation

This Figure

illustrates the start

of cost-push

inflation.

A rise in the price

of oil decreases

short-run

aggregate supply

and shifts the

SRAS curve

leftward.

38

Inflation

Cost-push

inflation

Real GDP

decreases and

the price level

rises—a

combination

called stagflation.

The rising price

level is the start

of the cost-push

inflation.

39

Inflation

Cost-push inflation

The initial increase in costs creates a one-shot rise in the

price level, not a continued inflation.

To create continued inflation, aggregate demand must

increase; which can happen because the Government or

the central bank may react to the rise in unemployment by

increasing aggregate demand.

40

Inflation

Cost-push

inflation

This Figure

illustrates an

aggregate demand

response to

stagflation, which

might arise because

the CB stimulates

demand to counter

the higher

unemployment rate

and lower level of

real GDP.

41

Inflation

Cost-push

inflation

The increase in

aggregate

demand shifts

the AD curve

rightward.

Real GDP

increases and

the price level

rises again.

42

Inflation

Cost-push

inflation

This Figure

illustrates a

cost-push

inflation spiral.

43

Inflation

If the oil producers raise the price of oil to try to keep its relative price higher, and the Govt. or the central bank responds with an increase in aggregate demand, a process of cost-push inflation continues.

Cost-push inflation

occurred in the United

States during 1974–

1978.

Cost-push

inflation

Inflation

Inflation is always and everywhere a monetary

phenomenon

The money supply is the only factor that can continually increase

without causing a reduction in one of the four components of total

expenditures (consumption, investment, government purchases, or

net exports).

This point is important because someone might ask, “Can’t

government purchases continually increase and so cause continued

inflation?” This is unlikely for two reasons.

Inflation


phenomenon

1. Government purchases cannot go beyond both real and political limits.

The real upper limit is 100 percent of GDP. No one knows what the

political upper limit is, but it is likely to be substantially less than 100

percent of GDP. In either case, once government purchases reach

their limit, they can no longer increase.

2. Some economists argue that government purchases that are not

financed with new money may crowd out one of the other expenditure

components. For example, for every additional dollar government

spends on public education, households may spend $1 less on private

education.

Inflation


phenomenon

The emphasis on the money supply as the only factor that can

continue to increase and thus cause continued inflation has led

most economists to agree with Nobel Laureate Milton Friedman

that “inflation is always and everywhere a monetary phenomenon.”

Inflation

Can You Get Rid of Inflation with Price Controls?

Say, in country A, the government uses price control to stem

inflation. Price ceilings (price control mechanism) are always set

below equilibrium price.

So, if the government has set up price ceiling say for good 𝑖 at $4

where the equilibrium price is $8 then there will be a shortage for

good 𝑖, and very likely, people will line up to buy it. Let’s say that, on

average, 25 people stand in line If the equilibrium price goes up to,

say, $12 (due to, say, increased demand) but the price ceiling for the

good remains set at $4, people will continue to line up to buy the

good, but now the lines will be longer. The average line may stretch

out to, say, 50 people.

So how is inflation felt in a country that imposes and maintains price

ceilings? The answer is in the length of the lines of people: the

longer the lines, the higher the inflation rate.

Money and Interest Rates

What Economic Variables Does a Change in the Money

Supply Affect?

Money supply can affect interest rates, but to understand how, we

need to review how the money supply affects different economic

variables.

Changes in the money supply (or changes in the rate of growth of

the money supply) can affect:

1. The supply of loans.

2. Real GDP.

3. The price level.

4. The expected inflation rate.



Supply Affect?

1. Money and the Supply of Loans

When the Central Bank (CB) undertakes an open market purchase

(buy government bonds from commercial banks), reserves in the

banking system increase. With greater reserves, banks can extend

more loans raising money supply. In other words, as a result of the

CB’s conducting an open market purchase, the supply of loans rises.

Similarly, when the Fed conducts an open market sale (sell government

bonds to commercial banks), the supply of loans decreases, i.e.,

money supply decreases. So, money supply and supply of loans go

hand in hand.



Supply Affect?

2. Money and Real GDP

In the short run, an increase in the money supply shifts the AD curve

rightward increasing real GDP. Similarly, in the short run, a decrease in

the money supply produces a lower level of Real GDP


What Economic Variables Does a Change in the Money Supply

Affect?

3. Money and the Price Level

An increase in the money supply shifts the 𝐴𝐷 curve rightward from 𝐴𝐷1 to 𝐴𝐷2.

In the short run, the price level in the economy moves from 𝑃1 to 𝑃2. In the long

run, the economy is at point 3, and the price level is 𝑃3. Panel (b) shows how a

decrease in the money supply affects the price level.



Supply Affect?

4. Money and the Expected Inflation Rate

Many economists say that because the money supply affects the price

level, it also affects the expected inflation rate, which is the inflation rate

that you expect. Changes in the money supply affect the expected

inflation rate, either directly or indirectly. The equation of exchange

indicates that the greater the increase in the money supply is, the

greater the rise in the price level will be. And we would expect that the

greater the rise in the price level is, the higher the expected inflation

rate will be, ceteris paribus. For example, we would predict that a

money supply growth rate of, say, 10 percent a year generates a

greater actual inflation rate and a larger expected inflation rate than a

money supply growth rate of 2 percent a year.


The Money Supply, the

Loanable Funds Market, and

Interest Rates

The demand for loanable funds (𝐷𝐿𝐹)

is downward sloping, indicating that

borrowers will borrow more funds as

the interest rate declines. The supply

of loanable funds (𝑆𝐿𝐹) is upward

sloping, indicating that lenders will

lend more funds as the interest rate

rises. The equilibrium interest rate (𝑖1)

is determined through the forces of

supply and demand. If there is a

surplus of loanable funds, the interest

rate falls; if there is a shortage of

loanable funds, the interest rate rises.


The Money Supply, the Loanable Funds Market,

and Interest Rates

Anything that affects either the supply of or the demand for

loanable funds will obviously affect the interest rate. All four

of the factors that are affected by changes in the money

supply—the supply of loans, Real GDP, the price level, and

the expected inflation rate—affect either the supply of or

demand for loanable funds.



Loanable Funds Market,

and Interest Rates

The Supply of Loans:

A CB open market purchase

increases reserves in the banking

system and therefore increases the

supply of loanable funds. As a

result, the interest rate declines.

This change in the interest rate due

to a change in the supply of

loanable funds is called the

liquidity effect.


The Money Supply, the Loanable Funds Market, and

Interest Rates

Real GDP:

A change in Real GDP affects both the supply of and the demand for

loanable funds. When Real GDP rises, people’s wealth is greater.

When people became wealthier, they often demand more bonds.

Demanding more bonds (buying more bonds), however, is nothing

more than lending more money to others. So, as Real GDP rises, the

supply of loanable funds increases.

When Real GDP rises, profitable business opportunities arise all

around, and businesses issue or supply more bonds to take

advantage of those opportunities. But supplying more bonds is nothing

more than demanding more loanable funds. So, when Real GDP

rises, corporations issue or supply more bonds, thereby demanding

more loanable funds.




and Interest Rates

Real GDP:

In summary, when Real GDP

increases, both the supply of and

the demand for loanable funds

increase. The overall effect on the

interest rate is that, usually, the

demand for loanable funds

increases by more than the supply

so that the interest rate rises. The

change in the interest rate due to a

change in Real GDP is called the

income effect.




and Interest Rates

The Price Level:

When the price level rises, the

purchasing power of money falls.

People may therefore increase their

demand for credit or loanable funds

to borrow the funds necessary to

buy a fixed bundle of goods. This

change in the interest rate due to a

change in the price level is called

the price-level effect.


The Money Supply, the Loanable Funds Market, and

Interest Rates

The Expected Inflation Rate:

Suppose the expected inflation rate is zero and that when the expected

inflation rate is zero, the equilibrium interest rate is 6%. Now suppose

the expected inflation rate rises from 0% to 4%. What will this rise in the

expected inflation rate do to the demand for and supply of loanable

funds?

As inflation is expected to rise in the future, households and firms will

want to buy more goods and services now, thus raising demand for

loanable funds → 𝐷𝐿𝐹 shifts to the right.

Lenders on the other hand will know that if they lend today and price

level increases tomorrow then the money they will get back tomorrow

will have less value than today. Therefore, they will be willing to lend

each dollar (or taka) at higher interest rate → 𝑆𝐿𝐹 shifts to the left.




and Interest Rates

The Expected Inflation Rate:

Thus an expected inflation rate of

4 percent increases the demand

for loanable funds and decreases

the supply of loanable funds. So

the interest rate is 4 percent higher

than it was when the expected

inflation rate was zero. A change in

the interest rate due to a change in

the expected inflation rate is

referred to as the expectations

effect or Fisher effect, after

economist Irving Fisher.


What Happens to the Interest Rate as the Money

Supply Changes?

Suppose:

Point 1 in Time: CB says it will increase the growth rate of the

money supply.

Point 2 in Time: If the expectations effect kicks in immediately,

then…

Point 3 in Time: Interest rates rise.

At point 3 in time, a natural conclusion is that an increase in the rate of

growth in the money supply raises the interest rate. The problem with

this conclusion, though, is that not all the effects (liquidity, income, etc.)

have occurred yet.


What Happens to the Interest Rate as the Money

Supply Changes?

In time, the liquidity effect puts downward pressure on the interest rate.

Suppose,

Point 4 in Time: Liquidity effect kicks in.

Point 5 in Time: As a result of what happened at point 4, the interest

rate drops. The interest rate is now lower than it was at point 3.

Then, someone at point 5 in time could say, “Obviously, an increase in

the rate of growth of the money supply lowers interest rates.”

The main idea is that a change in the money supply affects the

economy in many ways. The timing and magnitude of these effects

determine the changes in the interest rate.


The Nominal and Real Interest RatesNominal interest rate is the growth rate of your money whereas Realinterest rate is the growth rate of your purchasing power.

Fisher effect: Approximation

nominal interest rate = real interest rate + expected inflation rate

𝑖 = 𝑟 + 𝜋 or 𝑟 = 𝑖 − 𝜋

Example: 𝑖 = 9%,𝜋 = 6%

𝑟 = 𝑖 –𝜋 = 9%− 6% = 3%

In words, the real rate of interest is the nominal rate reduced by theloss of purchasing power resulting from inflation.


Fisher effect: Exact

Growth factor of your purchasing power, 1 + 𝑟, equals the growth factor of you money, 1 + 𝑖, divided by the new price level, that is, 1 + 𝜋 times its value in the previous period. Therefore, the exact relationship would be

1 + 𝑟 = (1 + 𝑖)/(1 + 𝜋)

𝑟 = (𝑖 − 𝜋) / (1 + 𝜋)

= (9% − 6%) / (1.06)

= 2.83%

Empirical Relationship

Inflation and nominal interest rates move closely together.

Money, Financial System and Topic the Economy

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