Download Is this money?

Money, Output, and Prices
Classical vs. Keynesians
What is Money?
Is this money?
Is this money?
Is this money?
Is this money?
Is this money?
What is Money?
• We normally think of currency when we think of
money. However, more generally speaking,
money is any commodity which satisfies the
following:
– Unit of account
What is Money?
• We normally think of currency when we think of
money. However, more generally speaking,
money is any commodity which satisfies the
following:
– Unit of account
– Store of Value
What is Money?
• We normally think of currency when we think of
money. However, more generally speaking,
money is any commodity which satisfies the
following:
– Unit of account
– Store of Value
– Medium exchange
Commodity money vs. Fiat
Money
Commodity money vs. Fiat
Money
• In a commodity
money system, the
chosen “medium of
exchange” has real,
intrinsic value (gold,
silver, etc.)
Commodity money vs. Fiat
Money
• In a commodity
money system, the
chosen “medium of
exchange” has real,
intrinsic value (gold,
silver, etc.)
• With a fiat money
system , the chosen
medium of exchange
has no intrinsic value
(paper currency)
Commodity money vs. Fiat
Money
• In a commodity
money system, the
chosen “medium of
exchange” has real,
intrinsic value (gold,
silver, etc.)
• With a fiat money
system , the chosen
medium of exchange
has no intrinsic value
(paper currency)
• Fiat money is accepted
because of faith!
Standard Definitions of Money
Standard Definitions of Money
• Monetary Base (M0): Direct liabilities of the central bank
– Currency in circulation + Bank Reserves
Standard Definitions of Money
• Monetary Base (M0): Direct liabilities of the central bank
– Currency in circulation + Bank Reserves
• M1:
– Currency in circulation + Traveler's Checks + Checking accounts
Standard Definitions of Money
• Monetary Base (M0): Direct liabilities of the central bank
– Currency in circulation + Bank Reserves
• M1:
– Currency in circulation + Traveler's Checks + Checking accounts
• M2:
– M1 + Savings accounts + Money Market Accounts + Small Time
Deposits
Standard Definitions of Money
• Monetary Base (M0): Direct liabilities of the central bank
– Currency in circulation + Bank Reserves
• M1:
– Currency in circulation + Traveler's Checks + Checking accounts
• M2:
– M1 + Savings accounts + Money Market Accounts + Small Time
Deposits
• M3:
– M2 + Large Time Deposits + Eurodollars
Money Supply in the US
•
•
•
•
•
Currency in Circulation: $690B
Monetary Base: $732B
M1: $1.269T
M2: $6.015T
M3: $8.760T
0
1/1/1999
1/1/1997
1/1/1995
1/1/1993
1/1/1991
1/1/1989
1/1/1987
1/1/1985
1/1/1983
1/1/1981
1/1/1979
1/1/1977
1/1/1975
1/1/1973
1/1/1971
1/1/1969
1/1/1967
1/1/1965
1/1/1963
1/1/1961
1/1/1959
Money Supply in the US
14000
12000
10000
8000
6000
4000
M3
M2
M1
MB
2000
1/
1/
59
1/
1/
62
1/
1/
65
1/
1/
68
1/
1/
71
1/
1/
74
1/
1/
77
1/
1/
80
1/
1/
83
1/
1/
86
1/
1/
89
1/
1/
92
1/
1/
95
1/
1/
98
Money and Prices in the US
1400
1200
1000
800
600
400
200
0
200
180
160
140
120
100
80
60
40
20
0
M1
P
-2
-4
-6
-8
-10
1/1/00
1/1/98
1/1/96
1/1/94
1/1/92
1/1/90
1/1/88
1/1/86
1/1/84
1/1/82
Real Personal Income
8
6
4
2
0
Real Income
Real Personal Income &
Monetary Base
8
40
6
30
4
2
20
10
-2
0
1/
1/
19
82
1/
1/
19
84
1/
1/
19
86
1/
1/
19
88
1/
1/
19
90
1/
1/
19
92
1/
1/
19
94
1/
1/
19
96
1/
1/
19
98
1/
1/
20
00
0
-4
-10
-6
-8
-20
-10
-30
Real Income
MB/P
Real Personal Income & M1
8
25
6
20
15
4
2
0
10
5
-4
0
-5
-10
-6
-15
-8
-20
-25
1/
1/
19
82
1/
1/
19
84
1/
1/
19
86
1/
1/
19
88
1/
1/
19
90
1/
1/
19
92
1/
1/
19
94
1/
1/
19
96
1/
1/
19
98
1/
1/
20
00
-2
-10
Real Income
M1/P
1/
1/
19
82
1/
1/
19
84
1/
1/
19
86
1/
1/
19
88
1/
1/
19
90
1/
1/
19
92
1/
1/
19
94
1/
1/
19
96
1/
1/
19
98
1/
1/
20
00
Real Personal Income & M2
8
6
4
2
0
-2
-4
-6
-8
-10
15
10
5
0
-5
-10
-15
Real Income
M2/P
1/
1/
19
82
1/
1/
19
84
1/
1/
19
86
1/
1/
19
88
1/
1/
19
90
1/
1/
19
92
1/
1/
19
94
1/
1/
19
96
1/
1/
19
98
1/
1/
20
00
Real Personal Income & M3
8
6
4
2
0
-2
-4
-6
-8
-10
15
10
5
0
-5
-10
-15
Real Income
M3/P
Money and the Business Cycle
• Money is procyclical and leads the cycle
Money and the Business Cycle
• Money is procyclical and leads the cycle
• The money/income relationship is probably the most
widely debated issues in macroeconomics
Money and the Business Cycle
• Money is procyclical and leads the cycle
• The money/income relationship is probably the most
widely debated issues in macroeconomics
• Keynesian economists argue that money causes output (ie,
the Fed can stimulate the economy through monetary
policy)
Money and the Business Cycle
• Money is procyclical and leads the cycle
• The money/income relationship is probably the most
widely debated issues in macroeconomics
• Keynesian economists argue that money causes output (ie,
the Fed can stimulate the economy through monetary
policy)
• Classical economists (supply side) argue that output causes
money (i.e., the Fed responds to the economy rather than
the economy responding to the Fed)
Neoclassical Economics
• Classical economists assume that all prices are
free to adjust to any new information and markets
clear
Neoclassical Economics
• Classical economists assume that all prices are
free to adjust to any new information and markets
clear
• Therefore, output is completely determined by
conditions in labor/capital markets (a.k.a, the real
economy) – independent of money supply (i.e.,
“money is neutral” )
Neoclassical Economics
• Classical economists assume that all prices are
free to adjust to any new information and markets
clear
• Therefore, output is completely determined by
conditions in labor/capital markets (a.k.a, the real
economy) – independent of money supply (i.e.,
“money is neutral” )
• Given a fixed level of output, along with money
demand, the supply of money determines the price
level
Neoclassical Money Demand
• It is assumed that households choose to hold a fraction of
their nominal income in the form of cash (or a checking
account)
Neoclassical Money Demand
• It is assumed that households choose to hold a fraction of
their nominal income in the form of cash (or a checking
account)
Money Demand = k* PY
Neoclassical Money Demand
• It is assumed that households choose to hold a fraction of
their nominal income in the form of cash (or a checking
account)
Money Demand = k* PY
For example, suppose that National Income is $8T. If
the average household chooses to hold 10% of their
income in the form of cash, what is aggregate money
demand?
Neoclassical Money Demand
• It is assumed that households choose to hold a fraction of
their nominal income in the form of cash (or a checking
account)
Money Demand = k* PY
For example, suppose that National Income is $8T. If
the average household chooses to hold 10% of their
income in the form of cash, what is aggregate money
demand?
Money Demand = (.1)($8T) = $800B
Money Market Equilibrium
• The aggregate price level will adjust so that money supply
equal money demand
Money Market Equilibrium
• The aggregate price level will adjust so that money supply
equal money demand
M = Money Demand = k*PY
Money Market Equilibrium
• The aggregate price level will adjust so that money supply
equal money demand
M = Money Demand = k*PY
• Solving the above expression for price gives us
P = M/(kY)
What affects ‘k’?
• Interest rates: Cash is a non interest bearing
asset. As interest rates rise, households hold
less cash (k decreases)
What affects ‘k’?
• Interest rates: Cash is a non interest bearing
asset. As interest rates rise, households hold
less cash (k decreases)
• Transaction costs: As the cost of acquiring
cash rises, households hold more cash to
economize on transaction costs.
Money Demand and the Quantity
Theory of Money
• An alternative way of expressing the
previous expression is
MV = PY
Where ‘V’ is the velocity of money (V = 1/k)
• This is known as quantity theory of money
Velocity of M1: 1980 - 2003
Velocity of M2: 1980-2003
Velocity of M3: 1980-2003
What caused the change in
money velocity?
• Interest Rates
Fed Funds Rate: 1980-2003
What caused the change in
money velocity?
• Interest Rates:
– During the 80’s when interest rates were falling,
consumers switched into checkable deposits.
– During the 90’s as interest rates rose, consumers
switched into interest bearing accounts
What caused the change in
money velocity?
• Interest Rates:
– During the 80’s when interest rates were falling,
consumers switched into checkable deposits.
– During the 90’s as interest rates rose, consumers
switched into interest bearing accounts
• Financial innovation and deregulation significantly
lowered the cost of holding less liquid assets
Implications of the Quantity
Theory
Implications of the Quantity
Theory
• In the long run, velocity is relatively constant. Therefore, a
country’s inflation rate is equal to
Inflation = Money Growth – Output Growth
• In the short run, the price level is equal to
P = M/(kY)
Money and the Business Cycle
• Recall that money is procyclical (and leads the
cycle). How would neoclassical economics
explain this fact?
Money and the Business Cycle
• Recall that money is procyclical (and leads the
cycle). How would neoclassical economics
explain this fact?
• Given the formula P = M/(kY), if the money
supply stays constant, prices would fall during an
expansion.
Money and the Business Cycle
• Recall that money is procyclical (and leads the
cycle). How would neoclassical economics
explain this fact?
• Given the formula P = M/(kY), if the money
supply stays constant, prices would fall during an
expansion.
• Therefore, to maintain a constant price level, the
fed reacts to rising output by increasing the money
supply (hence, rising output causes an increase in
money!)
Keynesian Economics
• Keynesian economists begin with the same money demand
(MV = PY), but that money can influence real output in the
short run.
Keynesian Economics
• Keynesian economists begin with the same money demand
(MV = PY), but that money can influence real output in the
short run
• For example, suppose that the federal reserve increases the
money supply by 10%. (Assume that V is constant)
Keynesian Economics
• Keynesian economists begin with the same money demand
(MV = PY), but that money can influence real output in the
short run
• For example, suppose that the federal reserve increases the
money supply by 10%. (Assume that V is constant)
– Classical: Output remains constant, prices rise by 10%.
Keynesian Economics
• Keynesian economists begin with the same money demand
(MV = PY), but that money can influence real output in the
short run
• For example, suppose that the federal reserve increases the
money supply by 10%. (Assume that V is constant)
– Classical: Output remains constant, prices rise by 10%.
– Keynesian: Output rises , prices rise by less than 10%
in the short run.
Keynesian Economics
• Keynesian economists begin with the same money demand
(MV = PY), but that money can influence real output in the
short run
• For example, suppose that the federal reserve increases the
money supply by 10%. (Assume that V is constant)
– Classical: Output remains constant, prices rise by 10%.
– Keynesian: Output rises prices rise by less than 10% in
the short run
• The key to Keynesian economics is that some prices are
fixed in the short run. This allows the fed to affect relative
prices (in particular, the real wage)
“Sticky Wages”
• Suppose that nominal wages are fixed in the short run
“Sticky Wages”
• Suppose that nominal wages are fixed in the short run
• Most wage contracts are negotiated annually
• Minimum wage is adjusted infrequently
• Efficiency wages
“Sticky Wages”
• Suppose that nominal wages are fixed in the short run
• Most wage contracts are negotiated annually
• Minimum wage is adjusted infrequently
• Efficiency wages
• If the fed increases the money supply, prices rise, but the
nominal wage remains constant.
“Sticky Wages”
• Suppose that nominal wages are fixed in the short run
• Most wage contracts are negotiated annually
• Minimum wage is adjusted infrequently
• Efficiency wages
• If the fed increases the money supply, prices rise, but the
nominal wage remains constant.
• As the real wage (W/P) falls, labor becomes cheaper.
Firms hire more labor – this raises employment and output.
“Sticky Prices”
• The classical model assume that producers respond to
increases in money by instantly raising their prices.
Suppose that it is costly to raise prices (menu costs)
“Sticky Prices”
• The classical model assume that producers respond to
increases in money by instantly raising their prices.
Suppose that it is costly to raise prices (menu costs)
• Therefore, when the fed increases the money supply,
producers respond to this increase in demand by increasing
production rather than increasing prices. To hire more
labor, they must bid up the price (W increases).
“Sticky Prices”
• The classical model assume that producers respond to
increases in money by instantly raising their prices.
Suppose that it is costly to raise prices (menu costs)
• Therefore, when the fed increases the money supply,
producers respond to this increase in demand by increasing
production rather than increasing prices. To hire more
labor, they must bid up the price (W increases).
• As with the previous example, employment and output
rise. However, here the real wage (W/P) increases
Implications of Keynesian
Economics
• In the long run, prices are flexible and,
therefore, money is neutral.
• However, in the short run, some prices are
fixed. This allows the fed to affect real
output.
Implications of Keynesian
Economics
• In the long run, prices are flexible and, therefore,
money is neutral.
• However, in the short run, some prices are fixed.
This allows the fed to affect real output.
• Note that there is a natural tradeoff between
inflation and unemployment (the fed can lower
unemployment in the short run by increasing the
money supply, but ultimately, prices will rise).
This is known as the Phillips curve
The Phillips Curve
The Phillips Curve
Money and the Business Cycle
• Keynesian economics takes the exact opposite
stance on the money/output relationship. Increases
in output are caused by increases in the money
supply.
Money and the Business Cycle
• Keynesian economics takes the exact opposite
stance on the money/output relationship. Increases
in output are caused by increases in the money
supply.
• Which explanation is the correct one?
Money and the Business Cycle
• Keynesian economics takes the exact opposite
stance on the money/output relationship. Increases
in output are caused by increases in the money
supply.
• Which explanation is the correct one? Probably
both!
Money and the Business Cycle
• The sticky wage model has some real problems.
Money and the Business Cycle
• The sticky wage model has some real problems.
– Most labor contracts are indexed for inflation
– A very small fraction of the population is working for
minimum wage (3% of all workers work for minimum
wages)
– The sticky wage model implies a countercyclical real
wage which is counterfactual.
Money and the Business Cycle
• The sticky wage model has some real problems.
– Most labor contracts are indexed for inflation
– A very small fraction of the population is working for
minimum wage (3% of all workers are at or below
minimum wage)
– The sticky wage model implies a countercyclical real
wage which is counterfactual.
• The sticky price model is empirically valid (i.e., it predicts
a procyclical real wage). However, it relies on excess
capacity (i.e., when the fed increases the money supply
there needs to be jobs available)
Capacity Utilization
• Capacity utilization measures the
percentage of a country’s productive
capacity that is currently in use.
Capacity utilization in the US
Money and the Business cycle
• An economy with a very low rate of capacity
utilization would probably respond according to
the Keynesian version of the world. (increasing
the money supply increases employment)
• An economy with a very high rate of capacity
utilization will probably respond like the classical
version (increasing the money supply creates
inflation)
.