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Chapter 14
Money and the Economy 14 CHAPTER Money and the Price Level Classical economists believed that changes in the money supply affect the price level in the economy. Their position was based on the equation of exchange and on the simple quantity theory of money. The Equation of Exchange The equation of exchange is an identity stating that the money supply (π) multiplied by velocity (π) must be equal to the price level (π) times Real GDP (π). ππ β‘ ππ where β‘ means βmust be equal to.β This is an identity, and an identity is valid for all values of the variables. Money and the Price Level The Equation of Exchange ο§ As we learned in an earlier chapter, velocity is the average number of times a dollar is spent to buy final goods and services in a year. ο§ For example, assume an economy has only five $1 bills. Suppose that over the course of the year, the first dollar bill changes hands 3 times; the second, 5 times; the third, 6 times; the fourth, 2 times; and the fifth, 7 times. ο§ Given this information, we can calculate the average number of times a dollar changes hands in purchases. In this case, the number is 4.6, which is velocity. Money and the Price Level The Equation of Exchange In reality, counting how many times each dollar changes hands is impossible; so calculating velocity as we did in our example is impossible. In reality, we use a different method. We compute velocity using the equation of exchange: ππ πΊπ·π πβ‘ β‘ π π Money and the Price Level The Equation of Exchange The equation of exchange can be interpreted in different ways: 1. The money supply multiplied by velocity must equal the price level times Real GDP: π × π β‘ π × π 2. The money supply multiplied by velocity must equal GDP: π × π β‘ πΊπ·π (because π × π β‘ πΊπ·π). 3. Total spending or expenditures of buyers (measured by ππ) must equal the total sales revenues of business firms (measured by ππ): ππ β‘ ππ Money and the Price Level From the Equation of Exchange to the Simple Quantity Theory of Money The equation of exchange is an identity, not an economic theory. To turn it into a theory, we make some assumptions about the variables in the equation. Many eighteenth-century classical economists, as well as American economist Irving Fisher (1867β1947) and English economist Alfred Marshall (1842β1924), made the following assumptions: 1. Changes in velocity are so small that for all practical purposes velocity can be assumed to be constant (especially over short periods of time). 2. Real GDP, or π, is fixed in the short run. Money and the Price Level From the Equation of Exchange to the Simple Quantity Theory of Money ο§ With these two assumptions, we have the simple quantity theory of money: If π and π are constant, then changes in π will bring about strictly proportional changes in π. ο§ In other words, the simple quantity theory of money predicts that changes in the money supply will bring about strictly proportional changes in the price level. Money and the Price Level Money and the Price Level From the Equation of Exchange to the Simple Quantity Theory of Money ο§ How well does the simple quantity theory of money predict? The answer is that the strict proportionality between changes in the money supply and changes in the price level does not show up in the data (at least not very often). ο§ Generally, though, the evidence supports the spirit (or essence) of the simple quantity theory of money: the higher the growth rate in the money supply, the greater the growth rate in the price level. Money and the Price Level From the Equation of Exchange to the Simple Quantity Theory of Money ο§ To illustrate, we would expect that a growth rate in the money supply of, say, 40 percent would generate a greater increase in the price level than, say, a growth rate in the money supply of 4 percent. ο§ Generally, this effect is what we see. For example, countries with more rapid increases in their money supplies often witness more rapid increases in their price levels than do countries that witness less rapid increases in their money supplies. Money and the Price Level The Simple Quantity Theory of Money in an ADβAS Framework AD curve in the Simple Quantity Theory of Money Recall that one way of interpreting the equation of exchange is that the total expenditures of buyers (MV) must equal the total sales of sellers (ππ). So, ππ = π΄πππππππ‘π πΈπ₯ππππππ‘π’πππ (π΄πΈ). However, π΄πΈ = πΆ + πΌ + πΊ + π β π β ππ = πΆ + πΌ + πΊ + π β π Money and the Price Level The Simple Quantity Theory of Money in an ADβAS Framework AD curve in the Simple Quantity Theory of Money At a given price level, anything that changes πΆ, πΌ, πΊ, π or π changes aggregate demand and thus shifts the aggregate demand (π΄π·) curve. If ππ equals πΆ + πΌ + πΊ + π β π, then a change in the money supply (π) or a change in velocity (π) will change aggregate demand and therefore lead to a shift in the π΄π· curve. In other words, aggregate demand depends on both the money supply and velocity. But in the simple quantity theory of money, velocity is assumed to be constant. Thus, only changes in the money supply can shift the π΄π· curve. Money and the Price Level The Simple Quantity Theory of Money in an ADβAS Framework The AS curve in the simple quantity theory of money In the simple quantity theory of money, the level of Real GDP is assumed to be constant in the short run. The AS curve is vertical at that constant level of Real GDP. Money and the Price Level The Simple Quantity Theory of Money in an ADβAS Framework AD and AS in the simple quantity theory of money Money and the Price Level Dropping the Assumptions that π½ and πΈ Are Constant If we drop the assumptions that velocity (π) and Real GDP (π) are constant, we have a more general theory of the factors that cause changes in the price level. In this theory, changes in the price level depend on three variables: 1. Money supply 2. Velocity 3. Real GDP Letβs again start with the equation of exchange: π × π β‘ π × π If the equation of exchange holds, then: πβ‘ π×π π Money and the Price Level Dropping the Assumptions that π½ and πΈ Are Constant ο§ This last equation shows that the price level depends on the money supply, velocity, and Real GDP. ο§ What kinds of changes in π, π, and π will bring about inflation (an increase in the price level), ceteris paribus? Inflationary tendencies: π β, π β, π β ο§ What will bring about deflation (a decrease in the price level), ceteris paribus? Deflationary tendencies: π β, π β, π β Monetarism Economists who call themselves monetarists have not been content to rely on the simple quantity theory of money. They do not hold that velocity is constant, nor do they hold that output is constant. The Four Monetarist Positions 1. 2. 3. 4. Velocity changes in a predictable way Aggregate demand depends on the money supply and on velocity The ππ π΄π curve is upward sloping The economy is self-regulating (prices and wages are flexible) Monetarism The Four Monetarist Positions 1. Velocity changes in a predictable way ο§ Monetarists do not assume that velocity is constant, but rather that it can and does change. However, they believe that velocity changes in a predictable way, that is, not randomly, but in a way that can be understood and predicted. ο§ Monetarists hold that velocity is a function of certain variablesβthe interest rate, the expected inflation rate, the frequency with which employees receive paychecks, and moreβand that changes in it can be predicted. Monetarism The Four Monetarist Positions 2. Aggregate demand depends on the money supply and on velocity Just like the Keynesians focus on components of π΄πΈ, the Monetarists focus on the money supply (π) and velocity (π). For example, Keynesians argue that changes in πΆ, πΌ, πΊ, π, or π can change aggregate demand, whereas monetarists argue that π and π can change aggregate demand. 3. The πΊπΉπ¨πΊ curve is upward sloping In the simple quantity theory of money, the level of Real GDP (π) is assumed to be constant in the short run. So the aggregate supply curve is vertical. According to monetarists, Real GDP may change in the short run, and therefore the ππ π΄π curve is upward sloping. Monetarism The Four Monetarist Positions 4. The economy is self-regulating (prices and wages are flexible) Similar to Classical economists, Monetarists believe that prices and wages are flexible. Monetarists therefore believe that the economy is self-regulating; it can move itself out of a recessionary or inflationary gap and into long-run equilibrium, producing Natural Real GDP. Monetarism Monetarism and ADβAS Monetarism Monetarism and ADβAS Monetarism The Monetarist View of the Economy According to the diagrams, the monetarists believe that: ο§ The economy is self-regulating. ο§ Changes in velocity and the money supply can change aggregate demand. ο§ Changes in velocity and the money supply will change the price level and Real GDP in the short run but only the price level in the long run. Monetarism The Monetarist View of the Economy ο§ We need to make one other important point with respect to monetarists. Consider this question: Suppose velocity falls and the money supply rises. Can a change in velocity offset a change in the money supply? ο§ Monetarists think that this conditionβa change in velocity completely offsetting a change in the money supplyβdoes not occur often. They believe (1) that velocity does not change very much from one period to the next (i.e., it is relatively stable) and (2) that changes in velocity are predictable. Monetarism The Monetarist View of the Economy ο§ So in the monetarist view of the economy, changes in velocity are not likely to offset changes in the money supply. Therefore, changes in the money supply will largely determine changes in aggregate demand and thus changes in Real GDP and the price level. ο§ According to monetarists, for all practical purposes, an increase in the money supply will raise aggregate demand, increase both Real GDP and the price level in the short run, and increase only the price level in the long run. A decrease in the money supply will lower aggregate demand, decrease both Real GDP and the price level in the short run, and decrease only the price level in the long run. Inflation In everyday usage, the word inflation refers to any increase in the price level. Economists, though, like to differentiate between two types of increases in the price level: a one-shot increase and a continued increase. One-Shot Inflation One-shot inflation can be thought of as a one-shot, or one-time, increase in the price level. More precisely, if price level increases but not on a continued basis, we call the price increase βone-shot inflationβ. Suppose the CPI for years 1 to 5 is as follows: Inflation One-shot inflation: demand-side induced Price levels that go from π1 to π2 to π3 may seem like more than a oneshot increase. But because the price level stabilizes (at π3 ), we cannot characterize it as continually rising. So the change in the price level is representative of one-shot inflation. Inflation One-shot inflation: supply-side induced Inflation Continued Inflation Continued inflation can be demand-side induced (Demand-pull inflation) or supply-side induced (Cost-push inflation) Demand-pull inflation is an inflation that results from an initial increase in aggregate demand. Demand-pull inflation may begin with any factor that increases aggregate demand, e.g., increases in the quantity of money, increases in government purchases, or cuts in net taxes, an increase in exports etc. 29 Inflation Demand-pull inflation This Figure illustrates the start of a demandpull inflation. Starting from full employment, an increase in aggregate demand shifts the AD curve rightward. 30 Inflation Demand-pull inflation Real GDP increases, the price level rises, and an inflationary gap arises. The rising price level is the first step in the demand-pull inflation. 31 Inflation Demand-pull inflation This Figure illustrates the money wage response. The higher level of output means that real GDP exceeds potential GDPβan inflationary gap. 32 Inflation Demand-pull inflation The money wage rises and the SRAS curve shifts leftward. Real GDP decreases back to potential GDP but the price level rises further. 33 Inflation Demand-pull inflation This Figure illustrates a demand-pull inflation spiral. Aggregate demand keeps increasing and the process just described repeats indefinitely. 34 Inflation Demand-pull inflation Although any of several factors can increase aggregate demand to start a demand-pull inflation, only an ongoing increase in the quantity of money can allow it to continue. Demand-pull inflation occurred in the United States during the late 1960s and early 1970s. 35 Inflation Cost-push inflation is an inflation that results from an initial increase in costs. There are two main sources of increased costs: ο§ An increase in the money wage rate ο§ An increase in the money price of raw materials, such as oil. 36 Inflation Cost-push inflation This Figure illustrates the start of cost-push inflation. A rise in the price of oil decreases short-run aggregate supply and shifts the SRAS curve leftward. 37 Inflation Cost-push inflation Real GDP decreases and the price level risesβa combination called stagflation. The rising price level is the start of the cost-push inflation. 38 Inflation Cost-push inflation The initial increase in costs creates a one-shot rise in the price level, not a continued inflation. To create continued inflation, aggregate demand must increase; which can happen because the Government or the central bank may react to the rise in unemployment by increasing aggregate demand. 39 Inflation Cost-push inflation This Figure illustrates an aggregate demand response to stagflation, which might arise because the CB stimulates demand to counter the higher unemployment rate and lower level of real GDP. 40 Inflation Cost-push inflation The increase in aggregate demand shifts the AD curve rightward. Real GDP increases and the price level rises again. 41 Inflation Cost-push inflation This Figure illustrates a cost-push inflation spiral. 42 Inflation Cost-push inflation If the oil producers raise the price of oil to try to keep its relative price higher, and the Govt. or the central bank responds with an increase in aggregate demand, a process of cost-push inflation continues. Cost-push inflation occurred in the United States during 1974β 1978. 43 Inflation Inflation is always and everywhere a monetary phenomenon ο§ The money supply is the only factor that can continually increase without causing a reduction in one of the four components of total expenditures (consumption, investment, government purchases, or net exports). ο§ This point is important because someone might ask, βCanβt government purchases continually increase and so cause continued inflation?β This is unlikely for two reasons. Inflation Inflation is always and everywhere a monetary phenomenon 1. Government purchases cannot go beyond both real and political limits. The real upper limit is 100 percent of GDP. No one knows what the political upper limit is, but it is likely to be substantially less than 100 percent of GDP. In either case, once government purchases reach their limit, they can no longer increase. 2. Some economists argue that government purchases that are not financed with new money may crowd out one of the other expenditure components. For example, for every additional dollar government spends on public education, households may spend $1 less on private education. Inflation Inflation is always and everywhere a monetary phenomenon The emphasis on the money supply as the only factor that can continue to increase and thus cause continued inflation has led most economists to agree with Nobel Laureate Milton Friedman that βinflation is always and everywhere a monetary phenomenon.β Inflation Can You Get Rid of Inflation with Price Controls? ο§ Say, in country A, the government uses price control to stem inflation. Price ceilings (price control mechanism) are always set below equilibrium price. ο§ So, if the government has set up price ceiling say for good π at $8 where the equilibrium price is $4 then there will be a shortage for good π, and very likely, people will line up to buy it. Letβs say that, on average, 25 people stand in line. If the price goes up to say $12 but the price ceiling for the good remains set at $4, people will continue to line up to buy the good, but now the lines will be longer. The average line may stretch out to, say, 50 people. ο§ So how is inflation felt in a country that imposes and maintains price ceilings? The answer is in the length of the lines of people: the longer the lines, the higher the inflation rate. Money and Interest Rates What Economic Variables Does a Change in the Money Supply Affect? ο§ Money supply can affect interest rates, but to understand how, we need to review how the money supply affects different economic variables. ο§ Changes in the money supply (or changes in the rate of growth of the money supply) can affect: 1. 2. 3. 4. The supply of loans. Real GDP. The price level. The expected inflation rate. Money and Interest Rates What Economic Variables Does a Change in the Money Supply Affect? 1. Money and the Supply of Loans When the Central Bank (CB) undertakes an open market purchase (buy government bonds from commercial banks), reserves in the banking system increase. With greater reserves, banks can extend more loans raising money supply. In other words, as a result of the CBβs conducting an open market purchase, the supply of loans rises. Similarly, when the Fed conducts an open market sale (sell government bonds to commercial banks), the supply of loans decreases, i.e., money supply decreases. So, money supply and supply of loans go hand in hand. Money and Interest Rates What Economic Variables Does a Change in the Money Supply Affect? 2. Money and Real GDP In the short run, an increase in the money supply shifts the AD curve rightward increasing real GDP. Similarly, in the short run, a decrease in the money supply produces a lower level of Real GDP Money and Interest Rates What Economic Variables Does a Change in the Money Supply Affect? 3. Money and the Price Level An increase in the money supply shifts the π΄π· curve rightward from π΄π·1 to π΄π·2 . In the short run, the price level in the economy moves from π1 to π2 . In the long run, the economy is at point 3, and the price level is π3 . Panel (b) shows how a decrease in the money supply affects the price level. Money and Interest Rates What Economic Variables Does a Change in the Money Supply Affect? 4. Money and the Expected Inflation Rate Many economists say that because the money supply affects the price level, it also affects the expected inflation rate, which is the inflation rate that you expect. Changes in the money supply affect the expected inflation rate, either directly or indirectly. The equation of exchange indicates that the greater the increase in the money supply is, the greater the rise in the price level will be. And we would expect that the greater the rise in the price level is, the higher the expected inflation rate will be, ceteris paribus. For example, we would predict that a money supply growth rate of, say, 10 percent a year generates a greater actual inflation rate and a larger expected inflation rate than a money supply growth rate of 2 percent a year. Money and Interest Rates The Money Supply, the Loanable Funds Market, and Interest Rates The demand for loanable funds (π·πΏπΉ ) is downward sloping, indicating that borrowers will borrow more funds as the interest rate declines. The supply of loanable funds (ππΏπΉ ) is upward sloping, indicating that lenders will lend more funds as the interest rate rises. The equilibrium interest rate (π1 ) is determined through the forces of supply and demand. If there is a surplus of loanable funds, the interest rate falls; if there is a shortage of loanable funds, the interest rate rises. Money and Interest Rates The Money Supply, the Loanable Funds Market, and Interest Rates Anything that affects either the supply of or the demand for loanable funds will obviously affect the interest rate. All four of the factors that are affected by changes in the money supplyβthe supply of loans, Real GDP, the price level, and the expected inflation rateβaffect either the supply of or demand for loanable funds. Money and Interest Rates The Money Supply, the Loanable Funds Market, and Interest Rates The Supply of Loans: A CB open market purchase increases reserves in the banking system and therefore increases the supply of loanable funds. As a result, the interest rate declines. This change in the interest rate due to a change in the supply of loanable funds is called the liquidity effect. Money and Interest Rates The Money Supply, the Loanable Funds Market, and Interest Rates Real GDP: ο§ A change in Real GDP affects both the supply of and the demand for loanable funds. When Real GDP rises, peopleβs wealth is greater. When people became wealthier, they often demand more bonds. Demanding more bonds (buying more bonds), however, is nothing more than lending more money to others. So, as Real GDP rises, the supply of loanable funds increases. ο§ When Real GDP rises, profitable business opportunities arise all around, and businesses issue or supply more bonds to take advantage of those opportunities. But supplying more bonds is nothing more than demanding more loanable funds. So, when Real GDP rises, corporations issue or supply more bonds, thereby demanding more loanable funds. Money and Interest Rates The Money Supply, the Loanable Funds Market, and Interest Rates Real GDP: In summary, when Real GDP increases, both the supply of and the demand for loanable funds increase. The overall effect on the interest rate is that, usually, the demand for loanable funds increases by more than the supply so that the interest rate rises. The change in the interest rate due to a change in Real GDP is called the income effect. Money and Interest Rates The Money Supply, the Loanable Funds Market, and Interest Rates The Price Level: When the price level rises, the purchasing power of money falls. People may therefore increase their demand for credit or loanable funds to borrow the funds necessary to buy a fixed bundle of goods. This change in the interest rate due to a change in the price level is called the price-level effect. Money and Interest Rates The Money Supply, the Loanable Funds Market, and Interest Rates The Expected Inflation Rate: Suppose the expected inflation rate is zero and that when the expected inflation rate is zero, the equilibrium interest rate is 6%. Now suppose the expected inflation rate rises from 0% to 4%. What will this rise in the expected inflation rate do to the demand for and supply of loanable funds? As inflation is expected to rise in the future, households and firms will want to buy more goods and services now, thus raising demand for loanable funds β π·πΏπΉ shifts to the right. Lenders on the other hand will know that if they lend today and price level increases tomorrow then the money they will get back tomorrow will have less value than today. Therefore, they will be willing to lend each dollar (or taka) at higher interest rate β ππΏπΉ shifts to the left. Money and Interest Rates The Money Supply, the Loanable Funds Market, and Interest Rates The Expected Inflation Rate: Thus an expected inflation rate of 4 percent increases the demand for loanable funds and decreases the supply of loanable funds. So the interest rate is 4 percent higher than it was when the expected inflation rate was zero. A change in the interest rate due to a change in the expected inflation rate is referred to as the expectations effect or Fisher effect, after economist Irving Fisher. Money and Interest Rates Money and Interest Rates What Happens to the Interest Rate as the Money Supply Changes? Suppose: ο§ Point 1 in Time: CB says it will increase the growth rate of the money supply. ο§ Point 2 in Time: If the expectations effect kicks in immediately, thenβ¦ ο§ Point 3 in Time: Interest rates rise. At point 3 in time, a natural conclusion is that an increase in the rate of growth in the money supply raises the interest rate. The problem with this conclusion, though, is that not all the effects (liquidity, income, etc.) have occurred yet. Money and Interest Rates What Happens to the Interest Rate as the Money Supply Changes? In time, the liquidity effect puts downward pressure on the interest rate. Suppose, ο§ Point 4 in Time: Liquidity effect kicks in. ο§ Point 5 in Time: As a result of what happened at point 4, the interest rate drops. The interest rate is now lower than it was at point 3. Then, someone at point 5 in time could say, βObviously, an increase in the rate of growth of the money supply lowers interest rates.β The main idea is that a change in the money supply affects the economy in many ways. The timing and magnitude of these effects determine the changes in the interest rate. Money and Interest Rates The Nominal and Real Interest Rates Nominal interest rate is the growth rate of your money whereas Real interest rate is the growth rate of your purchasing power. Fisher effect: Approximation nominal interest rate = real interest rate + expected inflation rate π = π + π or π = π β π Example: π = 9%, π = 6% π = π β π = 9% β 6% = 3% In words, the real rate of interest is the nominal rate reduced by the loss of purchasing power resulting from inflation. Money and Interest Rates Fisher effect: Exact Growth factor of your purchasing power, 1 + π, equals the growth factor of you money, 1 + π, divided by the new price level, that is, 1 + π times its value in the previous period. Therefore, the exact relationship would be 1 + π = (1 + π)/(1 + π) π = (π β π) / (1 + π) = (9% β 6%) / (1.06) = 2.83% Empirical Relationship Inflation and interest rates move closely together.
