The Economics of Money, Banking, and Financial Markets PDF

The Economics of Money, Banking, and Financial Markets Eighth Canadian Edition Chapter 20 Quantity Theory, Inflation, and the Demand for Money Copyright © 2023 Pe...

The Economics of Money, Banking, and Financial Markets Eighth Canadian Edition Chapter 20 Quantity Theory, Inflation, and the Demand for Money Copyright © 2023 Pearson Canada Inc. 20 - 1 Learning Objectives (1 of 2) 1. Assess the relationship between money growth and inflation in the short run and the long run, as implied by the quantity theory of money. 2. Identify the circumstances under which budget deficits can lead to inflationary monetary policy. 3. Summarize the three motives underlying the liquidity preference theory of money demand. Copyright © 2023 Pearson Canada Inc. 20 - 2 Learning Objectives (2 of 2) 4. Assess and interpret the empirical evidence on the validity of the liquidity preference and portfolio theories of money demand. Copyright © 2023 Pearson Canada Inc. 20 - 3 Velocity of Money and Equation of Exchange The equation of exchange: MV = PY M = the money supply P = price level Y= aggregate output (real GDP) PY = aggregate nominal income (nominal GDP) V = velocity of money (average number of times per year that a dollar is spent) Copyright © 2023 Pearson Canada Inc. 20 - 4 Determinants of Velocity Irving Fischer: velocity is determined by institutional and technological features of the economy – Charge accounts and credit cards for transactions – If people use credit cards more often, and consequently use money less often when making purchases, less money is required to conduct the transactions, and so velocity increases Velocity is normally reasonably constant in the short run Copyright © 2023 Pearson Canada Inc. 20 - 5 Demand for Money Fischer’s quantity theory can also be interpreted in terms of the demand for money (the quantity people want to hold) Take equation of exchange, divide by V: M = PY / V If money supply equals money demand, then M d = M If velocity of money is constant, then let k = 1/V Md = kPY Fisher’s theory suggests demand is purely a function of income PY; interest rates have no effect Copyright © 2023 Pearson Canada Inc. 20 - 6 From the Equation of Exchange to the Quantity Theory of Money From the equation of exchange to the quantity theory of money – Fisher’s view that velocity is fairly constant in the short run transforms the equation of exchange into the quantity theory of money, which states that nominal income (spending) is determined solely by movements in the quantity of money M P Y  M V Copyright © 2023 Pearson Canada Inc. 20 - 7 Quantity Theory and the Price Level Because the classical economists (including Fisher) thought that wages and prices were completely flexible, they believed that the level of aggregate output Y produced in the economy during normal times would remain at the full-employment level – dividing both sides by Ῡ, we can then write the price level as follows: M V P Y Copyright © 2023 Pearson Canada Inc. 20 - 8 Quantity Theory and Inflation The quantity theory of money can be transformed into a theory of inflation Price level is proportional to the money supply times the velocity of money divided by real GDP Since we assume velocity is constant,  %M  %Y The quantity theory of inflation indicates that the inflation rate equals the growth rate of the money supply minus the growth rate of aggregate output Copyright © 2023 Pearson Canada Inc. 20 - 9 Testing the Quantity Theory of Money The quantity theory of money is a good theory of inflation in the long run, but not in the short run The Long Run – Provides a long-run theory because it is based on the assumption that wages and prices are flexible – Empirically, the growth rate of aggregate output over 10-year periods does not vary very much – Good explanation for cross-country inflation differences The Short Run – Many years where money growth is high but inflation is low Copyright © 2023 Pearson Canada Inc. 20 - 10 Figure 20-1 Relationship Between Inflation and Money Growth (1 of 2) In panel (a), decades with higher money growth rates (the 1910s, the 1940s, and the 1970s) typically have a higher average inflation rate. Copyright © 2020 Pearson Canada Inc. 20 - 11 Figure 20-1 Relationship Between Inflation and Money Growth (2 of 2) This relationship also holds in panel (b), where we examine the 10-year inflation and money growth rates from 2009 to 2019 for various countries. Sources: Panel (a): Milton Friedman and Anna Schwartz, Monetary Trends in the United States and the United Kingdom: Their Relation to Income, Prices, and Interest Rates, 1867–1975; Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/. Panel (b) Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/. Copyright © 2020 Pearson Canada Inc. 20 - 12 Figure 20-2 Annual Canadian Inflation and Money Growth Rates, 1971–2020 Plots of the annual Canadian inflation rate against the annual money (M3) growth rate from two years earlier (to allow for lag effects from money growth to inflation) do not support a short-run link between inflation and money growth. There were many years in which money growth was high yet inflation was low. Source: Federal Reserve Bank of St. Louis, FRED (series CANGDPDEFQISMEI and MABMM301CAQ189S). Copyright © 2020 Pearson Canada Inc. 20 - 13 Budget Deficits and Inflation (1 of 2) Ways the government can pay for spending: – Raise revenue by levying taxes – Go into debt by issuing government bonds – Create money and use it to pay for goods and services The government budget constraint is Deficit = Spending − Taxes = Change in monetary base + change in government bonds Copyright © 2023 Pearson Canada Inc. 20 - 14 Budget Deficits and Inflation (2 of 2) The government budget constraint thus reveals two important facts: – If the government deficit is financed by an increase in bond holdings by the public, there is no effect on the monetary base and hence on the money supply – But, if the deficit is not financed by increased bond holdings by the public, the monetary base and the money supply increase If the central bank purchases the government bonds, this is called monetizing the debt or printing money Copyright © 2023 Pearson Canada Inc. 20 - 15 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 One of the most extreme examples of hyperinflation throughout world history occurred recently in Zimbabwe in the 2000s Copyright © 2023 Pearson Canada Inc. 20 - 16 Keynesian Theories of Money Demand Keynes’s Liquidity Preference Theory Why do individuals hold money? Three Motives – Transactions motive – Precautionary motive – Speculative motive Distinguishes between real and nominal quantities of money Copyright © 2023 Pearson Canada Inc. 20 - 17 Three Motives of Money Demand (1 of 2) Transactions Motive Keynes initially accepted the quantity theory view that the transactions component is proportional to income Later, he and other economists recognized that new methods for payment, referred to as payment technology, could also affect the demand for money Copyright © 2023 Pearson Canada Inc. 20 - 18 Three Motives of Money Demand (2 of 2) Precautionary Motive Keynes also recognized that people hold money as a cushion against unexpected wants Keynes argued that the precautionary money balances people want to hold would also be proportional to income Speculative Motive Hold money as a store of wealth Copyright © 2023 Pearson Canada Inc. 20 - 19 Putting the Three Motives Together (1 of 2) Be careful to distinguish between nominal quantities and real quantities Suppose people want to hold a certain amount of real money balances (Md / P) – Demand for real money balances falls with the interest rate and rises with real incomes In this case, velocity becomes V = PY/M = Y / L(i,Y) – The function L(i,Y) is the demand for real money – Velocity therefore rises with the interest rate Copyright © 2023 Pearson Canada Inc. 20 - 20 Putting the Three Motives Together (2 of 2) Velocity is not constant: – The demand for money is negatively related to interest rates; when i goes up, L(i, Y) declines, and therefore velocity rises. – Because interest rates undergo substantial fluctuations, Keynesian theories of the demand for money indicate that velocity undergoes substantial fluctuations as well. – Keynesian theories cast doubt on the classical quantity theory view that nominal income is determined primarily by movements in the quantity of money. Copyright © 2023 Pearson Canada Inc. 20 - 21 Portfolio Theories of Money Demand Theory of Portfolio Choice and Keynesian Liquidity Preference – The theory of portfolio choice can justify the conclusion from the Keynesian liquidity preference function that the demand for real money balances is positively related to income and negatively related to the nominal interest rate Other Factors that affect the Demand for Money: – Wealth – Risk – Liquidity of other assets Copyright © 2023 Pearson Canada Inc. 20 - 22 Factors That Determine the Demand for Money Summary Table 20-1 Factors That Determine the Demand for Money Change in Money Demand Variable Variable Response Reason Interest rates ↑ ↓ Opportunity cost of money rises Income ↑ ↑ Higher transactions Payment technology ↑ ↓ Less need for money in transactions Wealth ↑ ↑ More resources to put into money Risk of other assets ↑ ↑ Money relatively less risky and so more desirable Inflation risk ↑ ↓ Money relatively more risky and so less desirable Liquidity of other ↑ ↓ Money relatively less liquid and assets so less desirable Copyright © 2023 Pearson Canada Inc. 20 - 23 Evidence: Interest Rates and Money Demand If interest rates do not affect the demand for money: – Velocity is more likely to be constant (or at least predictable) – The quantity theory then is more likely to be true The more sensitive the demand for money is to interest rates: – The more unpredictable velocity will be – The less clear the link between the money supply and aggregate spending will be Evidence for the interest sensitivity of the demand for money is consistent Copyright © 2023 Pearson Canada Inc. 20 - 24 Evidence: Stability of Money Demand If the money demand function is unstable and undergoes substantial, unpredictable shifts then – Velocity is unpredictable – The quantity of money may not be tightly linked to aggregate spending, as it is in the quantity theory Post-1973, we find substantial instability – Led by rapid financial innovations – Calls into question whether theories are adequate – Important implications for conduct of money policy – Casts doubt on usefulness of money demand functions Copyright © 2023 Pearson Canada Inc. 20 - 25