Chapter 22

Quantity Theory of Money, Inflation and the Demand for

Money

Inflation and Money Growth

• How is inflation linked to money growth?

• The Quantity Theory of Money and the Velocity of Money

Inflation and Money Growth

Inflation and Money Growth

• Previous slide shows can’t have high, sustained inflation without monetary accommodation

• To avoid sustained high inflation, central bank must watch money growth

• Something beyond just differences in money growth accounts for the differences in inflation across countries. We need to study the velocity of money.

The Equation of Exchange: M x V = P x Y

Nominal GDP = Price level (P) x Real Output (Y)

Quantity of Money (M) x Velocity (V) = Nominal GDP

M x V = P x Y

Velocity of Money (V):

M

PxY )Velocity(V

These relationships are definitions

http://research.stlouisfed.org/fred2/categories/24

Y

Y

P

P

V

V

M

M

or

Y% P% V% M%

derivecan we

Y x PV x M From

Money Growth + Velocity Growth = Inflation + Output Growth

The Equation of Exchange – Dynamic Form

The Quantity Theory of Money (Irving Fisher)

• assume velocity is constant => %ΔV = 0 • Or at least stable

• economy at full employment. • Strong condition %ΔY = 0.

• Double M => Double P• Inflation is a monetary phenomenon (Milton

Friedman).

From the Equation of Exchange to the Quantity Theory of Money

Y

Y

M

M

P

P

If V is constant, the rate of Inflation = the rate of growth in the money supply minus the rate of growth in aggregate output

Quantity Theory of Money and Inflation

Average Inflation Rate Versus Average Rate of Money Growth for Selected Countries, 1997–2007

Source: International Financial Statistics.

M2 Money Growth and Inflation - US

Hyperinflation

• Hyperinflations are periods of extremely high inflation of more than 50% per month

• Many economies—both poor and developed—have experienced hyperinflation over the last century, but the United States has been spared such turmoil

• One of the most extreme examples of hyperinflation throughout world history occurred recently in Zimbabwe in the 2000s

Examples of Hyperinflation:1980s and Early 1990s

Is Velocity Stable?

The Scale obscures the short-run movements in M2

Velocity of Money

Substantial short-run fluctuations in M2 velocity.

But the long-run trend is a modest increase from 1.72 to 1.82 over 45 years.

Velocity of Money

• The data tend to confirm Fisher’s conclusion that in the long run (40 to 50 years) the velocity of money (M2) is stable

• However, central banker’s are concerned with inflation over quarters and years.

• Velocity is volatile in the short-run, as shown on the previous chart and on the next chart.

Change in the Velocity of M1 and M2 from Year to Year, 1915–2008

To understand the velocity of money, must understand the demand for money.

Annual U.S. Inflation and Money Growth Rates, 1965–2010

The Demand for Money

• Two motives:

• Transactions demand

• Speculative or Portfolio demand

Transactions Demand for Money• The quantity of money the public holds for

transactions purposes depends

• on nominal income – P x Y• the cost of holding money• and the availability of substitutes

• As P and/or Y increase => money demand will increases

• As opportunity cost increases => money demand will decrease

Demand for Money

i

Md

Transactions Demand for Money • Higher nominal interest rate => higher

opportunity cost of holding money => the less money individuals and businesses will hold for a given level of transactions => higher velocity of money.

• In high inflation countries, the opportunity cost of holding money is high.

• M and V are increasing, so the increase in P is greater than the increase in M.

Further Developments in the Keynesian Approach

• Transactions demand• Baumol - Tobin model

• There is an opportunity cost and benefit to holding money

• The transaction component of the demand for money is negatively related to the level of interest rates

Cash Balances in the Baumol-Tobin Model

Non-synchronization of income and spending

The mismatch between the timing of money inflow to the household and the timing of money outflow for household expenses.

Income arrives only once a month, but spending takes place at a constant rate.

Cash Balances in the Baumol-Tobin Model

Could decide to deposit entire paycheck ($1,200) into checking account at the start of the month and run balance down to zero by the end of the month. In this case, average balance would be $600. Velocity of money is $14,400/ $600 = 24.

Cash Balances in the Baumol-Tobin ModelIndividual earns $1,200 per month. Paid on the 1st day of the month and spends at a constant rate during the month.

At midmonth, would sell the bond and deposit the $600 into checking account to pay the second half of the month’s bills. Following this strategy, average money holdings would be $300 and the velocity of money = $14,000/ $300 = 48.

Cash Balances in the Baumol-Tobin ModelAlternatively, could also choose to put half paycheck into checking account and buy a bond with the other half of income.

Benefit and cost

• Benefit - If the monthly interest rate is 1%, earn ½ X $600 x .01 = $3.00

• Cost - transactions cost

• For a given level of transactions cost, as i increases hold less money and more bonds.

Portfolio or Speculative Demand for Money

• As a store of value, money provides diversification when held with a wide variety of other assets, including stocks and bonds

• Portfolio demand depends on• Wealth• the expected return relative to the alternatives • expectations that interest rates will change in the future • Risk• Liquidity

Factors That Determine the Demand for Money

Velocity is not constant!

• The procyclical movement of interest rates should induce procyclical movements in velocity.

• Velocity will change as expectations about future normal levels of interest rates change

• Interest rates opportunity cost Demand for money velocity

Two criteria for the use of money growth as a direct monetary policy target:

• A stable link between the monetary base and the quantity of money: MB x m = M

• A predictable relationship between the quantity of money and inflation: M x V = P x Y

We will come back to this -

Targeting Money Growth

(MB x m) x V =P x Y

• Possible explanation for the instability of U.S. money demand over the last quarter of the 20th century.

• Primary - The introduction of financial instruments that paid higher returns than money.

• Most Central Banks use interest rates as their operating instrument

• Interest rates are the link between the financial system and the real economy

• While inflation is tied to money growth in the long run, interest rates are the tool policymakers use to stabilize inflation in the short run.