Download Chapter 20 Money Growth, Money Demand, and Modern Monetary

Stephen G. CECCHETTI • Kermit L. SCHOENHOLTZ
Chapter Twenty
Money Growth, Money Demand, and
Modern Monetary Policy
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Introduction
• It would be easy to form a clear impression that
21st-century monetary policy has very little to
do with money, despite its focus on inflation.
• Everyone talks about interest rates and
exchange rates; no one talks about money.
• But you will find that central bankers and
monetary economists do care about money.
• We see concern for money, too, in statements
made by officials of the ECB.
20-2
Introduction
• The FOMC, in July 2000, decided to stop
publishing target ranges for the monetary
aggregates.
• They explained that “these ranges [no longer]
provide useful benchmarks for monetary policy.”
• The FOMC rarely makes any references to
money in public announcements of the federal
funds target rate.
20-3
Introduction
•
•
What accounts for the distinctly different
treatment of money growth in the two largest
central banks in the world?
The goal of this chapter is twofold:
1. To examine the link between money growth and
inflation in order to clarify the role of money in
monetary policy, and
2. To explain the logic underlying central bankers’
focus on interest rates.
20-4
Why We Care about Monetary
Aggregates
• The single most important fact in monetary
economics:
• The relationship between money growth and
inflation rates.
• Panel A of figure 20.1 shows the average
annual inflation and money growth in 150
countries over the 2 1/2 decades from 1981 to
2005.
20-5
Why We Care about Monetary
Aggregates
•
Two things are striking:
1. Some countries suffered inflation of more than
500 percent a year for two decades.
2. Every country with high inflation has high money
growth.
•
•
Panel B shows the large number of countries
with low inflation and low money growth.
To avoid sustained episodes of high inflation,
a central bank must be concerned with money
growth. Avoiding high inflation means
avoiding persistent rapid money growth.
20-6
Why We Care about Monetary
Aggregates
20-7
Why We Care about Monetary
Aggregates
• Figure 20.2 shows:
• Points lying about the 45-degree line represent
countries where average inflation exceeds average
money growth.
• Points lying below the 45-degree line represent
countries where money growth exceeds inflation.
• In general, countries with very high inflation
tend to lie above the line and countries with
moderate to low inflation tend to fall below it.
20-8
Why We Care about Monetary
Aggregates
20-9
Why We Care about Monetary
Aggregates
• When the currency that people are holding
loses value very rapidly, they will work to
spend what they have as quickly as possible.
• Spending money more quickly has the same effect
on inflation as an increase in money growth.
• By limiting the rate at which they purchase
securities, policymakers can control the rate at
which aggregates like M2 grow.
• It is impossible to have high, sustained
inflation without monetary accommodation.
20-10
Why We Care about Monetary
Aggregates
• This is why the ECB pays close attention to
growth in the money aggregates.
• But all money growth is not created equally.
• Something beyond just differences in money
growth accounts for the differences in inflation
across countries.
• Figure 20.1 suggests that money growth is a
useful guide to understanding long-term
movements in inflation.
• But what happens over shorter periods of a few
months or years?
20-11
• A number of countries that were created
following the collapse of the Soviet Union
experienced very high levels of inflation.
• Because they had command economies, the
state was involved in every aspect of economic
life.
• Government expenditures were financed by
printing money.
• To bring inflation under control, the authority
to print money was turned over to an
independent central bank.
20-12
• The CPI is the most commonly used and
closely watched measure of inflation in the
U.S.
• It tells us how much more it would cost today to
purchase the same basket of goods and services that
was bought on a fixed date in the past.
• However, the CPI systematically overstates
inflation:
• By about 1 percentage point a year.
• This is a lot at low levels of inflation.
20-13
• What are the biases in the CPI?
1. Consumers’ buying patterns change all the
time.
•
Consumers shift their purchases away from goods
that are relatively more expensive to those that are
relatively cheaper.
2. There is significant difficulty taking into
account improvements in the quality of goods
and services included in the CPI.
20-14
20-15
The Quantity Theory and the Velocity
of Money
• Thinking about the value or purchasing power
of money in terms of the goods needed to get
money makes the impact of inflation clear.
• We can think about how many dollars we need to
buy a cup of coffee or a sandwich.
• We can turn the question around an ask: how many
cups of coffee or sandwiches a person needs to buy
one dollar.
• A fall in the number of cups of coffee it takes
to buy one dollar represents a decline in the
price, or value, of money.
20-16
The Quantity Theory and the Velocity
of Money
• The price of money is determined by supply
and demand.
• Given steady demand, an increase in the supply
of money drives the price of money down.
• That’s inflation.
• If the central bank continuously floods the
economy with large amounts of money,
inflation will reach very high levels.
20-17
Velocity and the Equation of Exchange
• We need to focus on money as a means of
payment.
• Consider 4 college students:
• One has $100 in currency;
• One has two tickets to the weekend football game,
worth $50 each;
• One has $100 calculator; and
• One has a set of 25 high quality drawing pencils
that sell for $4 each.
20-18
Velocity and the Equation of Exchange
• The one with $100 buys the calculator.
• The person with the calculator now uses the
$100 to buy the football tickets.
• The person with the football tickets now uses
the $100 to buy the 25 pencils.
• The total value of the transactions is $300.
• In this 4-person economy, the $100 was used 3
times resulting in $300 worth of transactions.
20-19
Velocity and the Equation of Exchange
• We can say that:
• the number of dollars used is the quantity of money
in the economy;
• the number of times each dollar is used (per unit of
time) is called the velocity of money; and
• the first times the second is the dollar value of
transactions.
• The more frequently each dollar is used, the
higher the velocity of money.
20-20
Velocity and the Equation of Exchange
• We will focus on nominal gross domestic
product (GDP).
• Every one of the purchases counted in nominal
GDP requires the use of money.
Quantity of Money * Velocity of money   Nominal GDP

• M is the quantity of money, V is the velocity
and nominal GDP can be divided into two
parts:
• The price level, P and the quantity of real output, Y.
20-21
Velocity and the Equation of Exchange
• We can rewrite the previous equation as:
MV  PY
• This is called the equation of exchange, and
tells us that the quantity of money multiplied by
its velocity equals the level of nominal GDP.
•This provides the link between prices and
money that we are looking for.
• However, we care about inflation and money
growth.
20-22
Velocity and the Equation of Exchange
• We can rewrite the equation to allow for the
percentage change in each factor.
MV  PY
%M %V  %P %Y
• Money growth plus velocity growth equals
inflation plus real growth.

20-23
The Quantity Theory of Money
• Irving Fisher wrote the equation of exchange
and derived the implication above.
• He assumed that no important changes occur in
payment methods or the cost of holding money.
• If the interest rate is fixed and there is no financial
innovation, then velocity will be constant.
• He also assumed that real output is determined
solely by economic resources and production
technology, so it too is fixed in the short run.
20-24
The Quantity Theory of Money
• He concludes that money growth translates
directly into inflation, an assertion that is
termed the quantity theory of money.
• We can reinterpret the quantity theory of
money to describe the equilibrium between
money demand and money supply.
• Money demanded (Md) equals the total value of
transactions divided by the velocity of money (V).
20-25
The Quantity Theory of Money
• For the economy as a whole, the demand for
money equals nominal GDP divided by
1
velocity:
d
M 
V
PY
• The supply of money (MS)is determined by the
central bank and the behavior of the banking
system.

• Assuming velocity and real output are constant,
we can conclude that money growth equals
inflation.
20-26
The Quantity Theory of Money
•
The quantity theory of money accounts for
some important characteristics of the patterns
shown in Figure 20.1.
1. It tells us why high inflation and high money
growth go together.
2. It explains the tendency for moderate- and
low-inflation countries to fall below the 45degree line in Panel B of Figure 20.1.
20-27
The Quantity Theory of Money
• Money growth tends to be higher than inflation
in those countries because they are
experiencing real growth.
• If velocity is constant, then money growth
equals the sum of inflation and real growth.
• At a given level of money growth, the higher
the level of real growth, the lower the level of
inflation.
• In countries that are growing, inflation will be lower
than money growth, causing their economies to fall
below the 45-degree line.
20-28
The Facts about Velocity
• If the velocity of money is constant, it means the trend
in real growth is determined by the structure of the
economy and the rate of technological process.
• This means countries could control inflation directly by
limiting money growth.
• This logic led Milton Freidman to conclude that central
banks should simply set money growth at a constant
rate.
• M1 and M2 should grow at a rate equal to the rate of real
growth plus the desired level of inflation.
20-29
The Facts about Velocity
• To make the rule viable, he suggested changes
in regulations that would:
• Limit banks’ discretion in creating money, and
• Tighten the relationship between the monetary
aggregates and the monetary base, reducing
fluctuations in the money multiplier.
• For example, an increase in the reserve
requirement or restrictions on the number and
types of loans banks could make.
20-30
The Facts about Velocity
• But Friedman’s recommendation that the
central bank should keep money growth
constant would stabilize inflation only if
velocity were constant.
• In countries with high levels of inflation,
changes in velocity can probably be safely
ignored.
• But in countries where inflation rate is below
10% per year, changes in velocity could have a
significant impact on the relationship between
money growth and inflation.
20-31
The Facts about Velocity
• Panel A of Figure 20.4 shows the velocity of
M2 from 1959 to 2009.
• Over the long run, the velocity of M2 looks
stable, ending at 1.72 - precisely where it began
50 years earlier.
• This confirms Fisher’s conclusion: in the long
run, the velocity of money is stable, so that
controlling inflation means controlling the
growth of the money aggregates.
20-32
20-33
The Facts about Velocity
• But central bankers are concerned about
inflation over months and quarters, not years.
• The monetary aggregates, even broad ones, can
be useful guides to short-term policy only to
the extent that they signal changes in inflation
during the periods monetary policymakers care
about.
• We can look at the four-quarter (short-run)
percentage change in M2 velocity, shown in
Panel B of Figure 20.4.
20-34
The Facts about Velocity
• The shaded bars in the figure represent
recessions.
• In the short run, velocity fluctuates quite a bit.
• The scale of the figure runs from -12 to +8
percent.
20-35
20-36
The Facts about Velocity
• Notice the increase in velocity in the late 1970s
and early 1980s.
• This was a period of both high nominal interest
rates and significant financial innovations.
• This included the introduction of stock and bond
mutual funds that allow investors checking
privileges.
• Together these reduced the amount of money
individuals held for a given level of
transactions, raising the velocity of money.
20-37
The Facts about Velocity
• These data clearly suggest that fluctuations in
the velocity of money are tied to changes in
people’s desire to hold money.
• Policymakers must understand the demand for
money.
20-38
• When it was first started, the ECB looked at
money growth closely.
• Velocity appeared relatively stable.
• It created a reference value for money growth:
•
•
•
•
Inflation = 1 to 2%
Real Growth = 2 to 2½ %
Velocity Growth =  ½ to -1%
Money growth = 1½ % + 2¼ % - (-¾ %) = 4½ %.
• In 2003 the reference value was downgraded
and today it is a long-run guide.
20-39
The Transactions Demand for Money
• The quantity of money people hold for
transactions purposes depends on their
• Nominal income,
• The cost of holding money, and
• The availability of substitutes.
• The higher people’s nominal income, the more
they will spend, needing more money.
• The higher nominal income is, the higher
nominal money demand will be.
20-40
The Transactions Demand for Money
• Deciding how much money to hold depends on
the costs and benefits.
• Benefits: Holding money allows people to
make payments.
• The cost is based on opportunity cost.
• The interest that people lose in not buying an
interest-bearing bond is the opportunity cost of
holding money.
• The decision to hold money depends on how
high the bond yield is and how costly it is to
switch bank and forth.
20-41
The Transactions Demand for Money
• For a given cost of switching, as the nominal
interest rate rises, people reduce their checking
account balance, shifting funds into and out of
higher-yield investments.
• The higher the nominal interest rate, the higher
the opportunity cost of holding money, the less
money individuals will hold for a given level of
transactions, and the higher the velocity of
money.
20-42
The Transactions Demand for Money
• This relationship explains why inflation tends
to exceed money growth in the high-inflation
countries shows in Panel A of Figure 20.1.
• At high levels of inflation, money is losing
value very quickly.
• People respond to the high cost of holding
money by keeping as little of it as possible.
• They purchase durable goods that have zero real
return - better than negative return on currency.
20-43
The Transactions Demand for Money
• Their frantic spending drives up the velocity of
money.
• Because high inflation brings an increase in
velocity, inflation must be higher than money
growth in those countries.
• This places them above the 45-degree line in Panel
A of Figure 20.1.
20-44
The Transactions Demand for Money
• The transactions demand for money is affected
by technology.
• Financial innovation allows people to limit the
amount of money they hold.
• It reduces the cost of shifting funds from an
interest-bearing bond to a checking account.
• This lowers the money holdings at a given
level of income.
• This increases the velocity of your money.
20-45
The Transactions Demand for Money
• Finally, we all hold money to insure ourselves
against unexpected expenses.
• We call this the precautionary demand for
money, as part of transactions demand.
• This rises with risk.
• The higher the level of uncertainty about the
future, the higher the demand for money and
the lower the velocity of money will be.
20-46
• Bankers joke that “free checking” is really “fee
checking”.
• If you sign up for a bank account that is
supposed to be free, be sure you know when
you pay fees and when you don’t.
20-47
The Portfolio Demand for Money
• As a store of value, money provides
diversification when held along with a wide
variety of other assets.
• The demand for bonds depends on several
factors including:
•
•
•
•
•
Wealth,
The return relative to alternative investments,
Expected future interest rates on bonds,
Risk relative to alternative investments, and
Liquidity relative to alternative investments.
20-48
The Portfolio Demand for Money
• As wealth rises, the quantity of all these
investments, including money, rises with it.
• A decline in bond yields will increase the
portfolio demand for money.
• When interest rates rise, bond prices drop and
bondholders suffer a capital loss.
• If you think interest rates are likely to rise, bonds
will become less attractive than money to you.
• When interest rates are expected to rise, money
demand goes up.
20-49
The Portfolio Demand for Money
• If a sudden decrease in the liquidity of stocks,
bonds, or other assets occurred, we would
expect to see an increase in the demand for
money.
• Table 20.1 summarizes all of the factors that
increase the demand for money.
20-50
The Demand for Money
20-51
Targeting Money Growth in a
Low-Inflation Environment
• The only solution to high inflation is to reduce
money growth.
• In a low-inflation environment, controlling
inflation is not so simple.
• The quantity theory of money tells us that our
ability to use money growth as a policy guide
depends on the stability of the velocity of
money.
• Velocity is stable in the long-run but not in the
short-run.
20-52
Targeting Money Growth in a
Low-Inflation Environment
•
There are two criteria for the use of money
growth as a direct monetary policy target:
1. A stable link between the monetary base and the
quantity of money and
2. A predictable relationship between the quantity of
money and inflation.
•
The first of these allows policymakers to
predict the impact of change in the central
bank’s balance sheet on the quantity of
money.
20-53
Targeting Money Growth in a
Low-Inflation Environment
• The second allows them to translate changes in
money growth into changes in inflation.
• Central bankers need numerical estimates of
these relationships.
• The relationship between money demand and
its determinants listed in Table 20.1 must be
stable and predictable -- a problem for U.S.
policymakers.
20-54
The Instability of U.S. Money
Demand
• To study the demand for money quantitatively,
we will focus on the impact of the two factors
that affect the transactions demand for money:
• Nominal income, and
• Interest rates.
• Nominal income is roughly proportional to
money demand.
• Double nominal income means doubling the dollar
value of the transactions they engage in, so
doubling the original amount of money.
20-55
The Instability of U.S. Money
Demand
• Is there a stable relationship between the
velocity of money and the opportunity cost of
holding it?
• Figure 20.5 shows the velocity of M2 on the
vertical axis and the opportunity cost of
holding M2 on the horizontal axis.
• The opportunity cost of M2 is defined as the
yield on three-month U.S. Treasury bill minus
the return on holding M2.
20-56
The Instability of U.S. Money
Demand
•
•
The opportunity cost is a measure of the real
return that individuals give up when they
decide to hold M2 rather than a three-month
Treasury bill.
They fall into two distinct groups.
1. The first covers the decade of the 1980s.
2. The second covers the 1990s through 2009.
20-57
The Instability of U.S. Money
Demand
20-58
The Instability of U.S. Money
Demand
• There is a relationship between the velocity of
money and the opportunity cost of holding
money.
• But the relationship shifted quite a bit between the
two decades.
• Using the relationship from the 1980s as a
basis for policymaking in the1990s and
thereafter would not have produced the desired
result.
20-59
The Instability of U.S. Money
Demand
• What caused the instability of money demand
over these three decades?
• One reason has to do with the introduction of
financial instruments that paid higher returns
than money but could still be used as a means
of payment.
• While officials have tried to account for the
new instruments by changing the composition
of the monetary aggregates, money demand
continues to appear unstable.
20-60
• Making policy is about numbers.
• This means using statistical models.
• The problem is that when policymakers change
the way they make policy, everyone changes
the way they act: the Lucas critique.
• Following changes in policy regime, old
models may be a poor guide for future policy.
20-61
• Financial innovations influence the velocity of
money by changing the amount of money
people need to hold at a given level of income.
• This creates serious difficulties for statisticians
who are trying to construct useful definitions of
the monetary aggregates.
• The real difficulty is calculating the impact of
such changes as they are occurring so that the
information can be used for short-run
policymaking.
20-62
20-63
The Instability of U.S. Money
Demand
• A second explanation has to do with changes in
mortgage refinancing rates.
• As long-term interest rates fell throughout the
1900s, they spurred periods of intense activity
in the mortgage market.
• When mortgage interest rates fall dramatically,
large numbers of people pay off their old, highinterest rate mortgages and replace them with
new, low-interest mortgages.
20-64
The Instability of U.S. Money
Demand
• When a mortgage is refinanced, it created
demand for money in several ways.
• Some of their equity in the home is removed the
proceeds of which go into liquid deposit accounts.
• Funds for the new mortgage must be collected from
investors and transferred to holders of the old
mortgage.
• They flow through an account that is part of M2.
• Once interest rates stabilize, M2 settles down
but in the meantime velocity fluctuates.
20-65
Targeting Money Growth: The Fed
and the ECB
• Though today virtually no central bank targets
money growth, the practice was common in the
1970s.
• In the U.S., the Federal Reserve Board had to make
quarterly appearances to testify to the Fed’s money
growth targets for the coming year.
• But announcing an objective is one things;
achieving it is something else.
• The FOMC rarely hit its money growth targets.
20-66
Targeting Money Growth: The Fed
and the ECB
• Finally in July 2000, the committee stopped
publishing them.
• Policymakers could have hit their money
growth targets, but doing so would have meant
adjusting the federal funds rate target
frequently, and by large amounts.
• This is something policymakers are unwilling to do.
20-67
Targeting Money Growth: The Fed
and the ECB
• The ECB’s Governing Council periodically
announces a money growth rate that is intended
to serve as a long-run reference value.
• The difference of opinion between the Fed and
the ECB on this matter can be traced to their
divergent views on the stability of money
demand.
• Researchers who study the demand for money
in the euro-area have concluded that it is stable,
which implies that changes in velocity are
predictable.
20-68
Targeting Money Growth: The Fed
and the ECB
20-69
Targeting Money Growth: The Fed
and the ECB
• While short-run fluctuations in velocity were
significant, European policymakers point to the
tendency of velocity to return to its long-run
downward trend over periods of a few years.
• The ECB and the Fed have both chosen interest
rates as their operating target.
• Interest rates are the link between the financial
system and the real economy.
20-70
Targeting Money Growth: The Fed
and the ECB
• By keeping interest rates stable, policymakers
can insulate the real economy from
disturbances that arise in the financial system.
• 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.
20-71
Targeting Money Growth: The Fed
and the ECB
• Figure 20.8 shows a period of time when the
FOMC used reserves to target money growth,
allowing the federal funds rate to fluctuate.
• The shaded area represents the period when the
FOMC targeted the quantity of money.
• Notice how volatile the interest rate was during that
three-year period.
• Realizing this, policymakers have turned to the
only variable alternative - targeting and
smoothing fluctuations in interest rates.
20-72
Targeting Money Growth: The Fed
and the ECB
20-73
• Does money have a role in monetary policy?
• The Fed says no, while the ECB says yes.
• This article suggest that even in low-inflation
economies, money growth can provide
information about stress in the financial
system.
• This debate over the role of money in monetary
policy will likely continue for some time.
20-74
Stephen G. CECCHETTI • Kermit L. SCHOENHOLTZ
End of
Chapter Twenty
Money Growth, Money Demand, and
Modern Monetary Policy
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.