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## Chapter 22

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**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**• 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): These relationships are definitions http://research.stlouisfed.org/fred2/categories/24**The Equation of Exchange – Dynamic Form**Money Growth + Velocity Growth = Inflation + Output Growth**From the Equation of Exchange to the Quantity Theory of**Money 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).**Quantity Theory of Money and Inflation**If V is constant, the rate of Inflation = the rate of growth in the money supply minus the rate of growth in aggregate output**Average Inflation Rate Versus Average Rate of Money Growth**for Selected Countries, 1997–2007 Source: International Financial Statistics.**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**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.**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.**Cash Balances in the Baumol-Tobin Model**Income arrives only once a month, but spending takes place at a constant rate.**Cash Balances in the Baumol-Tobin Model**Individual earns $1,200 per month. Paid on the 1st day of the month and spends at a constant rate during the month. 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 Model**Alternatively, could also choose to put half paycheck into checking account and buy a bond with the other half of income. 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.**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**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 **We will come back to this -Targeting Money**Growth 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 (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.