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Chapter 20 Money Growth, Money Demand, and Monetary Policy McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Money Growth, Money Demand, and Monetary Policy: The Big Questions • How is inflation linked to money growth? • Why do the Fed and the ECB treat money growth differently? 20-2 Money Growth, Money Demand, and Monetary Policy: Roadmap • Why we care about monetary aggregates • The quantity theory and velocity • Money growth in a low-inflation environment 20-3 Inflation and Money Growth 20-4 Inflation and Money Growth • Avoid sustained high inflation: Central bank must watch money growth • Can’t have high, sustained inflation without monetary accommodation • Something beyond just differences in money growth accounts for the differences in inflation across countries. 20-5 Inflation and Money Growth 20-6 • A number of countries 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 20-7 • CPI: How much would it cost to purchase today the basket of goods people bought on a fixed date in the past? • Fixed expenditure weights CPI is known to overstate inflation: •Doesn’t adjust for changes in buying patterns •Difficulty in adjusting for quality •Hard to introduce new goods 20-8 The Quantity Theory and the Velocity of Money Velocity of money (V) • The number of times each dollar is used (per unit of time). 20-9 The Quantity Theory and the Velocity of Money Quantity of Money (M) x Velocity (V) = Nominal GDP Nominal GDP = Price level (P) x Real Output (Y) 20-10 The Quantity Theory and the Velocity of Money MV = PY implies %M + %V = %P + %Y Money Growth + Velocity Growth = Inflation + Real Growth 20-11 The Quantity Theory and the Velocity of Money Irving Fisher’s Quantity Theory of Money: • assume that %ΔV = 0 and %ΔY = 0. • Double M double P • Inflation is a monetary phenomenon (Milton Friedman) 20-12 Velocity of M2 20-13 Velocity of Money • Historical data confirm Fisher’s conclusion that in the long run, the velocity of money is stable. • Controlling inflation means controlling the growth of the monetary aggregates. 20-14 • When it was first started, the ECB looked at money growth closely • Velocity appeared relatively stable • Created a reference value – Inflation = 1½% – Real Growth = 2¼% – Velocity Growth = ¾% Reference value for money growth= 1½%+ 2¼%+¾% = 4½% • In 2003 the reference value was downgraded and today it is a long-run guide 20-15 The Demand for Money: Transactions Demand • The quantity of money people hold for transactions purposes depends – on their nominal income – the cost of holding money – and the availability of substitutes • As the nominal interest rate rises – people reduce their checking account balances – shift funds into and out of higher-yield investments more frequently 20-16 The Demand for Money: Transactions Demand 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. 20-17 The Demand for Money: Portfolio Demand • 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 20-18 20-19 • 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 20-20 Targeting Money Growth in a Low-Inflation Environment • In the long run: inflation is tied to money growth. • High-inflation environment: – moderate variations in the growth of velocity are an annoyance – the only way to reduce high inflation is to reduce money growth. 20-21 Targeting Money Growth in a Low-Inflation Environment Low-inflation environment: Policymakers can use money growth as a policy guide if velocity stable 20-22 Targeting Money Growth in a Low-Inflation Environment 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 – A predictable relationship between the quantity of money and inflation 20-23 Targeting Money Growth in a Low-Inflation Environment When criteria are met, policymakers can – predict the impact of changes in the central bank’s balance sheet on the quantity of money – translate changes in money growth into changes in inflation. 20-24 Targeting Money Growth in a Low-Inflation Environment • Interest rates opportunity cost Demand for money velocity • Creates upward sloping relationship between interest rates and velocity • To use monetary aggregates policymakers need to find a relationship with a predictable slope 20-25 M2 Velocity and the Opportunity Cost of M2 Problem: Relationship shifted in early 1990s. 20-26 • 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 • Following changes in policy regime, old models may be a poor guide for future policy 20-27 Targeting Money Growth in a Low-Inflation Environment • Possible explanations for the instability of U.S. money demand over the last quarter of the 20th century. – the introduction of financial instruments that paid higher returns than money. – changes in mortgage refinancing rates. 20-28 20-29 Targeting Money Growth in a Low-Inflation Environment • The ECB and the Fed have both chosen interest rates as their operating instrument • Interest rates are the link between the financial system and the real economy • 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. 20-30 20-31