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Monetary Policy and Inflation: Quantity Theory of Money

MV º PY. Monetary Policy and Inflation: Quantity Theory of Money. The Equation of Exchange

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Monetary Policy and Inflation: Quantity Theory of Money

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  1. MV º PY Monetary Policy and Inflation: Quantity Theory of Money • The Equation of Exchange • The formula indicating that the number of monetary units times the number of times each unit is spent on final goods and services is identical to the price level times output (or nominal national income)

  2. Money, Real GDP, andthe Price Level The equation of exchange states that the quantity of money (M) multiplied by the velocity of circulation (V) equals GDP, or MV=PY

  3. Money, Real GDP, andthe Price Level GDP equals the price level (P) times real GDP (Y), or: GDP = PY

  4. Monetary Policy and Inflation : Quantity Theory of Money • The equation of exchange and the quantity theory: MV = PY • M = actual money balances held by non-banking public • V = income velocity of money; the number of times, on average, cash monetary units are spent on final goods and services

  5. Monetary Policy and Inflation : Quantity Theory of Money • The equation of exchange and the quantity theory: MV = PY • P = price level • Y = real national output (real GDP)

  6. MV º PY PY = nominal national income MV = nominal national spending Monetary Policy and Inflation : Quantity Theory of Money • The equation of exchange as an identity

  7. Money, Real GDP, andthe Price Level We can convert the equation of exchange into the quantity theory of money by making two assumptions: 1) The velocity of circulation is not influenced by the quantity of money. 2) Potential income is not influenced by the quantity of money.

  8. Money, Real GDP, andthe Price Level The Quantity Theory of Money • The quantity theory of money is the proposition that in the long run, an increase in the quantity of money brings an equal percentage increase in the price level. • This theory is based upon the velocity of circulation and the equation of exchange.

  9. Money, Real GDP, andthe Price Level The Quantity Theory of Money The velocity of circulation is the average number of times a dollar of money is used annually to buy goods and services that make up GDP.

  10. Money, Real GDP, andthe Price Level Make the quantity of money M, and the velocity of circulation V is determined by: V = PY/M

  11. The Velocity of Circulation in the United States: 1930–1999

  12. Money, Real GDP, andthe Price Level This can be shown by using the equation of exchange to solve for the price level. P = (V/Y)M

  13. Money, Real GDP, andthe Price Level In the long run, real GDP equals potential GDP, so the relationship between the change in the price level and the quantity of money is:

  14. Money, Real GDP, andthe Price Level Dividing this equation by an earlier one, P = (V/Y)M, gives us

  15. Money, Real GDP, andthe Price Level This equation shows that the proportionate change in the price level equals the proportionate change in the quantity of money. This gives us the quantity theory of money: In the long run, the percentage increase in the price level equals the percentage increase in the quantity of money.

  16. MV = PY Monetary Policy and Inflation : Quantity Theory of Money • The crude quantity theory of money and prices • Assume: Vis constant Y is stable

  17. ­MV = ­PY Monetary Policy and Inflation : Quantity Theory of Money • The crude quantity theory of money and prices • Increases in M must be matched by equal increases in the price level

  18. Figure 17-5

  19. Money Growth andInflation in the United States

  20. Money Growth andInflation in the United States

  21. Money Growth andInflation in the World Economy

  22. Money Growth andInflation in the World Economy

  23. Money, Real GDP, andthe Price Level Historical Evidence on the Quantity Theory of Money • The data are broadly consistent with the quantity theory of money, but the relationship is not precise. • The relationship is stronger in the long run than in the short run.

  24. Money, Real GDP, andthe Price Level Correlation, Causation, and Other Influences The evidence shows that money growth and inflation are correlated.

  25. Money, Real GDP, andthe Price Level Correlation, Causation, and Other Influences This does not represent causation. • Does money growth cause inflation, or does inflation cause money growth? • Does some other factor cause inflation (deficit spending)?

  26. Monetary Policy • The ultimate goal of all macro policy is to stabilize the economy at its full-employment capacity. • A government has three basic tools of monetary policy: • Reserve requirements • Open-market operations • Discount rates

  27. The Tools of Monetary Policy • Changes in the reserve requirements • An increase in the required reserve ratio • Makes it more expensive for banks to meet reserve requirements • Reduces bank lending • A decrease in the required reserve ratio • Makes it more expensive for banks to meet reserve requirements • Increases bank lending

  28. Reserve Requirements • A lower reserve requirement increases the size of the money multiplier. • The money multiplier is the number of deposit (loan) dollars that the banking system can create from $1 of excess reserves.

  29. A Decrease in Required Reserves • A change in the reserve requirement causes: • A change in excess reserves. • A change in the money multiplier.

  30. The Impact of Reduced Reserve Requirement

  31. The Monetary Base • The government can control the monetary base which equals • currency in public circulation plus bank reserves.

  32. The Monetary Base • However, HKMA cannot control the amount of the monetary base that flows outside the country.

  33. The Tools of Monetary Policy • Open market operations • The HKMA changes reserves by buying and selling bonds.

  34. Open Market Activity • The HKMA purchases and sells government bonds to alter bank reserves. • By buying bonds— HKMA increases bank reserves. • By selling bonds— HKMA reduces bank reserves.

  35. S1 P1 D Determining the Price of Bonds Contractionary Policy • Fed sells bonds • Supply of bonds increases • Bond prices fall Price of Bonds Quantity of Bondsper Unit Time Period

  36. S1 S1 P1 P2 D Determining the Price of Bonds Contractionary Policy • Fed sells bonds • Supply of bonds increases • Bond prices fall Price of Bonds Quantity of Bondsper Unit Time Period Figure 17-2, Panel (a)

  37. S1 P1 D Determining the Price of Bonds Expansionary Policy • Fed buys bonds • Supply of bonds falls • Bond prices rise Price of Bonds Quantity of Bondsper Unit Time Period

  38. S3 S1 P3 P1 D Determining the Price of Bonds Expansionary Policy • Fed buys bonds • Supply of bonds falls • Bond prices rise Price of Bonds Quantity of Bondsper Unit Time Period Figure 17-2, Panel (b)

  39. The Tools of Monetary Policy • Relationship between the price of existing bonds and the rate of interest • What happens to the interest on a bond when the price of a bond increases?

  40. $50 Rate of interest = = 5% $1000 The Tools of Monetary Policy • Example • You pay $1,000 for a bond that pays $50/year in interest

  41. $50 Rate of interest = = 10% $500 The Tools of Monetary Policy • Example • Now suppose you pay $500 for the same bond

  42. The Tools of Monetary Policy • The market price of existing bonds (and all fixed-income assets) is inversely related to the rate of interest prevailing in the economy.

  43. The Tools of Monetary Policy • Changes in the discount rate • Increasing the discount rate increases the cost of borrowed funds for depository institutions that borrow reserves • Decreasing the discount rate decreases the cost of borrowed funds for depository institutions that borrow reserves

  44. Effects of an Increasein the Money Supply • When the money supply increases people have too much money • How can this be? • Have you ever had too much money?

  45. Effects of an Increasein the Money Supply • If you have a savings account the answer is “yes.” • We must distinguish between income and money

  46. Tools of Monetary Policy • Expansionary monetary policy: effects on aggregate demand, the price level, and real GDP • Monetary policy can be used to move the economy to its full-employment potential.

  47. Monetary Policy DuringPeriods of Underutilized Resources • Monetary policy can generate increases in the equilibrium level of real GDP.

  48. Expansionary Policy • The HKMA can increase AD/AE by increasing the money supply by: • Lowering reserve requirements. • Dropping the discount rate. • Buying more bonds: it increases bank lending capacity.

  49. LRAS SRAS E1 120 Recessionary gap AD1 9.5 10.0 Expansionary Monetary Policy with Underutilized Resources • The contractionary gap is caused by insufficient AD • To increase AD, use expansionary monetary policy • AD increases and real GDP increases to full employment Price Level 0 Real GDP per Year($ trillions)

  50. LRAS SRAS 125 E2 E1 120 AD2 Recessionary gap AD1 9.5 10.0 Expansionary Monetary Policy with Underutilized Resources • The contractionary gap is caused by insufficient AD • To increase AD, use expansionary monetary policy • AD increases and real GDP increases to full employment Price Level 0 Real GDP per Year($ trillions) Figure 17-3

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