Download Monetary Policy and the Econnomy

Monetary Policy and the
Economy
Quantity Theory of Money
Aggregate Demand Approach
Monetary Policy and the Long-Run
The Policy Debate
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Question: How does changes in the nation’s
money supply affect macroeconomic
conditions (GDP, inflation, unemployment)?
Two approaches to thinking about this:
(i) Quantity theory of money (“Monetarism”)
(ii) Demand-Side
(“Keynesian”)
Quantity Theory Approach
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The equation of exchange is always true:
MV = PY
M = nominal money supply
P = price level
Y = real GDP
V = velocity of money

%M  %V  %P  %Y
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The velocity of money is the average number of
times a dollar is spent to buy goods and
services:
M x V = $ value transactions

V = $ value transactions/M
For the entire economy, $ value of transactions
can be approximated by nominal GDP = PY:
V = PY/M
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The quantity theory of money says that if V is
constant, then there is a direct relationship
between nominal GDP and the nominal money
supply:
Nominal GDP
=
M x (constant)
PY
=
M x (constant)
If there is an  M, then do we get
Case (1):  Y?
Case (2):  P?
 Problems:
(1) How can we distinguish between effect of M
on Y versus P?
(2) Historically V is not constant (for M1).
The Velocity of Circulation in the
United States: 1930–1999
Aggregate Demand Approach
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Question: How does monetary policy affect
aggregate demand?
Answer: Interest rates (r):
 MS   r
  opportunity cost of investment
  ID
 Y
Y =
(spending multiplier)ID
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
An increase in MS shifts AD curve to the right.
There will be a combination of Case (1) and (2):
Shifts AD right   Y and  P
 MS 
Monetary policy can be a powerful tool to fight
recessions:
- Recession is caused by lack of demand
- AD shifts left,  Y and  P.
-  MS   r and  ID  shifts AD back right
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Question: If MS is so powerful, why doesn’t
the Fed just keep MS growing and r at or very
near 0%?
Answer: INFLATION
Monetary Policy in the Long-Run
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Recall the in LR, the adjustment of prices and
wages will cause the economy to gravitate back
towards potential GDP (YP).
Monetary policy has no effect on YP (only labor
productivity and labor force).
 MS  Y > YP
 inflationary gap
  W and P
 Y returns to YP


How much does P? The quantity theory tells us
the answer is Case (2):
MV = PY

%M  %V
=
%P  %Y
In the long-run, Y = YP and V is constant:

%M
=
%P
money supply growth = inflation rate
In the long-run inflation is caused by growth in
the nation’s money supply
Money Growth and
Inflation in the United States
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
International evidence of hyperinflation:
Post WWI
Poland
522%
Russia
684%
Germany 3,800%
1980s
Israel
370%
Argentina 1,110%
Bolivia
8000%
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
German Hyperinflation (1/22 – 12/23, 4000%)
Daily Newspaper Price
$0.30
(1/21)
$1,000,000
(10/23)
$7,000,000
(11/23)
Why print so much money?
To finance government spending.
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“Inflation is almost everywhere a monetary
phenomena” – Milton Friedman (1976 Nobel
Winner in Economics)
Demand-Supply Interpretation: Lack of scarcity
lowers value.
Even if wages are keeping up with inflation there
are still costs:
(i) Shoe-leather
(ii) Tax distortions
(iii) Re-distribution of wealth
Classic Example – Wizard of Oz
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Post Civil War Era (1880-96) depression, bank
panics, deflation. Debtors hurt.
Money tied to Gold Standard
1896 Presidential Election: William Jennings Bryant
versus William McKinnley
Bryant – populist, bimetallic gold-silver standard
(“Cross of Gold Speech”)
McKinnley – Preservation of gold standard.
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Wizard of Oz (1900) – L. Frank Baum
(MGM Movie – 1939)
Dorothy, Scarecrow, Tin Woodsman
Cowardly Lion
Yellow Brick Road leads to the Emerald City
“OZ” – Ounce of Gold
The Wizard – man behind the curtain.
Powers of the Magical Silver Slippers
Wicked Witch of the West
Eventually gold discovered in Alaska and South
Africa provided relief.
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“The Wizard of Oz: Parable on Populism,” by
Henry Littlefield, American Quarterly 16, (Spring
1964)
“The Wizard of Oz as a Monetary Allegory,”
Hugh Rockoff, Journal of Political Economy 98
(Aug 1990)

Fed needs to balance off the short-run gains
of more GDP with long-run costs of more
inflation:
(i) Disinflation policy of 1979-80
(ii) Loose Monetary Policy: 2001-2004
(iii) Recent Tightening: 2004-present
Monetary Policy: 2001-2005