Ch. 14: Money and the Economy
Del Mar College
John Daly
©2003 South-Western Publishing, A Division of Thomson Learning
Money and the Price Level
• The Equation of Exchange is MV = PQ
• The money supply (M) multiplied by the
Velocity (V) must be equal to the price level
(P) times Real GDP (Q).
• Velocity is the average number of times a
dollar is spent to buy final goods and
services in a year.
The Equation of Exchange
• In a large economy
such as ours, it is
impossible to figure
out how many times
each dollar has
changed hands.
• Velocity must be equal
to GDP divided by the
average money supply.
Interpreting the Equation of Exchange
• The money supply multiplied by velocity
must equal the price level times Real GDP
MxVPxQ
• The money supply multiplied by velocity
must equal GDP: M x V GDP
• Total spending or expenditures (measured
by MV) must equal the total sales revenues
of business firms (measured by PQ):
MVPQ
From the Equation of Exchange to the
Simple Quantity Theory of Money
• Fisher and Marshall assumed changes in velocity are so
small that for all practical purposes velocity can be assumed
to be constant.
• Fisher and Marshall assumed Real GDP is fixed in the short
run.
• From these assumptions, we have the simple quantity theory
of money: changes in M will bring about proportional
changes in P.
The Simple Quantity Theory in
an AD-AS Framework
• MV is equal to total expenditures.
• Total expenditures is equal to
C+I+G+(EX-IM)
• Since MV=TE, MV=C+I+G+(EX-IM)
• A change in the money supply or a change in
velocity will change aggregate demand and
therefore lead to a shift in the AD curve.
• But, in the simple quantity theory of money,
velocity is assumed to be constant.
The Simple Quantity Theory in
an AD-AS Framework
Dropping the Assumptions that V
and Q are Constant
• Remember: M x V  P x Q, then
P=MxV
Q
• Money supply, velocity, and Real GDP
determine the Price Level.
• An increase in M or V or a decrease in Q
will cause prices to rise. This is inflation.
• A decrease in M or V or an increase in Q
will cause prices to fall. This is deflation.
Q&A
• If M times V increases, why does P times Q have
to rise?
• What is the difference between the equation of
exchange and the simple quantity theory of
money?
• Predict what will happen to the AD curve as a
result of each of the following: The money supply
rises; Velocity falls; The money supply rises by a
greater percentage than velocity falls; The money
supply falls.
Monetarism: Key Views
• Velocity changes in a
predictable way.
• Aggregate Demand
depends on the money
supply and on Velocity.
• The SRAS curve is
upward sloping.
• The Economy is SelfRegulating (Prices and
Wages are flexible)
Monetarism in an AD-AS Framework
The Monetarist View of the
Economy
• The economy is self-regulating
• Changes in velocity and the money supply
can change aggregate demand.
• 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.
The Monetarist View of the
Economy
• Changes in velocity are not likely to offset changes in the
money supply.
• Changes in the money supply will largely determine
changes in aggregate demand, and therefore changes in Real
GDP and the price level.
• An increase in the money supply will raise aggregate
demand and increase both Real GDP and the price level in
the short run and increase the price level in the long run.
• A decrease in the money supply will lower aggregate
demand and decrease both Real GDP and price level in the
short run and decrease price level in the long run.
Q&A
• What do monetarists predict will happen in
the short run and in the long run as a result
of each of the following: Velocity rises;
Velocity falls; The money supply rises; The
money supply falls.
• Can a change in velocity offset a change in
the money supply (on aggregate demand)?
Explain your answer.
Inflation
• Inflation refers to any
increase in the price
level
• One shot inflation is a
one time increase in
price level.
• There are several
theories on one-shot
inflation:
One-Shot Inflation: Demand Side Induced
One-Shot Inflation: Supply-Side Induced
Continued Inflation From OneShot Inflation
Continued increases in
aggregate demand
cause continued
increases in inflation,
or continued inflation.
Changing One Shot Inflation Into Continued Inflation
What Causes Continued
Increases In Aggregate Demand?
• The only factor that can change continually
in such a way as to bring about continued
increases in aggregate demand is the money
supply.
• 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.
Q&A
• The prices of houses, cars, and television sets
have increased. Has there been inflation?
• Is continued inflation likely to be supplysided? Explain your answer.
• What type of inflation is Milton Friedman
referring to when he says, “Inflation is always
and everywhere a monetary phenomenon”?
Money and Interest Rates
What economic variables are
affected by a change in the
money supply:
1. Money & the supply of
loans
2. Money & the Real GDP
3. Money & the Price Level
4. They can also affect the
expected inflation rate.
Money and Interest Rates
• Anything that affects either the supply of loanable
funds or the demand for loanable funds will
obviously affect the interest rate.
• A change in the interest rate due to a change in the
supply of loanable funds is called the liquidity
effect.
• When Real GDP increases, both the supply of and
demand for loanable funds increase. The demand
for loanable funds increases more than the supply
of loanable funds, so that the interest rate rises.
This change in interest rate is called the Income
effect.
Money and Interest Rates, cont.
• When the price level rises, the purchasing power
of money falls, and people may increase their
demand for credit or loanable funds in order 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.
• An expected inflation rate increases the demand
for loanable funds and decreases the supply of
loanable funds, so that the interest rate is higher.
This change in the interest rate is called the
expectations effect.
The Interest
Rate and the
Loanable
Funds
Market
What Happens to the Interest Rate
as the Money Supply Changes?
A change in the money
supply affects the
economy in many ways:
changing the supply of
loanable funds directly,
changing Real GDP and
therefore changing the
demand for and supply of
loanable funds, changing
the expected inflation rate,
and so on.
The Nominal and Real Interest Rates
• Nominal interest rate is the interest rate that
comes about through the interaction of the
demand for and supply of loanable funds.
• The nominal interest rate may not be the
true cost of borrowing because part of the
nominal interest rate is a reflection of the
expected inflation rate.
• The Real Interest Rate is equal to the
Nominal Interest Rate minus the Expected
Inflation Rate.
Q&A
• If the expected inflation rate is 4% and the
nominal interest rate is 7%, what is the real
interest rate?
• Is it possible for the nominal interest rate to
immediately rise following and increase in the
money supply? Explain your answer.
• “The Fed only affects the interest rate via the
liquidity effect.” Do you agree or disagree?
Explain your answer.
Ch. 15: Monetary Policy
Del Mar College
John Daly
©2003 South-Western Publishing, A Division of Thomson Learning
The Demand for Money
• The price of holding money balances is the
interest rate.
• The interest rate is the opportunity cost of
holding money.
• As the interest rate increases, the
opportunity cost of holding money
increases, and people choose to hold less
money.
Supply and Demand for Money
Equilibrium in the Money Supply
• The money supply is not
exclusively determined by
the Fed because both the
banks and the public are
important players the
money supply process.
• Equilibrium in the money
market exists when the
quantity demanded of
money equals the quantity
supplied.
Transmission Mechanisms
The impact that changes in
the money market have
on the goods and services
market and whether that
impact is direct or
indirect; and the routes
and ripple effects created
in the money market travel
to affect the goods and
services market are known
as the transmission
mechanism.
The Keynesian Transmission
Mechanism
• The Money Market
• The Investment Goods Market
• The Goods and Services Market (AD-AS
Framework)
• When the money supply increases, the Keynesian
transmission mechanism works as follows: an
increase in the money supply lowers the interest
rate, which causes investment to rise and the AD
curve to shift rightward. Real GDP increases and
the unemployment rate drops.
The Keynesian Transmission
Mechanism: Indirect
The Keynesian Mechanism May
Get Blocked
• Some Keynesian economists believe that
investment is not always responsive to interest
rates. The Keynesian transmission mechanism
would be short-circuited in the investment goods
market, and the link between the money market
and the goods and services market would be
broken.
• Keynesians have sometimes argued that the
demand curve for money could become horizontal
at some low interest rate. This is called the
Liquidity Trap.
Keynesian Transmission
Mechanisms
Because the Keynesian transmission mechanism is indirect,
both interest insensitive investment demand and the liquidity
trap may occur.
The Keynesian View of Monetary Policy
Bond Prices and Interest Rates
• As the price of a bond decreases, the actual
interest rate return, or simply the interest rate,
increases.
• The market interest rate is inversely related to the
price of old or existing bonds.
• Consider the Liquidity Trap: the reason an
increase in the money supply does not result in an
excess supply of money at a low interest rate is
that individuals believe bond prices are so high
that an investment in bonds is likely to turn out to
be a bad deal.
The Monetarist Transmission
Mechanism: Direct
• In the Monetarist theory, there is a direct link
between the money market and the goods and
services market.
• An increase in the money supply means increased
Aggregate Demand, Increased Real GDP,
increased Prices and a decrease in unemployment.
• A decrease in the money supply means decreased
Aggregate Demand, Decreased Real GDP,
decreased Prices and an increase in
unemployment.
The Monetarist Transmission
Mechanism: Direct
Q&A
• Explain the inverse relationship between bond
prices and interest rates.
• “According to the Keynesian transmission
mechanism, as the money supply rises, there is a
direct impact on the goods and services market.”
Do you agree or disagree with this statement.
Explain your answer.
• Explain how the monetarist transmission
mechanism works when the money supply rises.
Monetary Policy and the Problem of
Inflationary and Recessionary Gaps
Monetary Policy and an
Inflationary Gap
Keynesians, Recession, and
Inflation
• Most Keynesians believe that the natural forces of
the market economy work much faster and more
assuredly at eliminating an inflationary gap than a
recessionary gap.
• Keynesians are more likely to advocate
expansionary monetary policy to eliminate a
stubborn recessionary gap than contractionary
monetary policy to eliminate a not-so-stubborn
inflationary gap.
• It has been argued that Keynesian monetary policy
has an inflationary bias.
Monetary Policy and the
Activist–Nonactivist Debate
• Activists argue that
monetary and fiscal policies
should be deliberately used
to smooth out the business
cycle.
• They are in favor of
economic fine-tuning, which
is the frequent use of
monetary and fiscal policies
to counteract even small
undesirable movements in
economic activity.
• Nonactivists argue against
the use of deliberate fiscal
and monetary policies.
• They believe the
discretionary policies should
be replaced by a stable and
permanent monetary and
fiscal framework and the
rules should be established
in place of activist policies.
The Case for Activist Monetary
Policy
1. The economy does not always equilibrate
quickly enough at Natural Real GDP.
2. Activist monetary policy works; it is
effective at smoothing out the business
cycle.
3. Activist monetary policy is flexible;
nonactivist monetary policy, which is
based on rules, is not.
The Case for Nonactivist
Monetary Policy
1. In modern economies, wages and prices are
sufficiently flexible to allow the economy to
equilibrate at reasonable speed at Natural Real
GDP.
2. Activist monetary policies may not work.
3. Activist monetary policies are likely to be
destabilizing rather than stabilizing; they are
likely to make matters worse rather than better.
Expansionary Monetary Policy
and No Change in the Real GDP
If expansionary monetary
policy is anticipated,
workers may bargain for
and receive higher wage
rates. It is possible that
the SRAS curve will shift
leftward to the degree that
expansionary monetary
policy shifts the AD curve
rightward. Result: no
change in Real GDP.
Monetary Policy May Destabilize
In this scenario, the
the Economy
SRAS curve is shifting
rightward, but Fed
officials do not realize
this is happening.
They implement
expansionary
monetary policy, and
the AD curve ends up
intersecting SRAS2 at
point 2 instead of
SRAS1 at point 1’.
Fed officials end up
moving the economy
into an inflationary
gap and thus
destabilizing the
economy
Q&A
• Why are Keynesians more likely to advocate
expansionary monetary policy to eliminate a
recessionary gap than contractionary monetary
policy to eliminate an inflationary gap?
• How might monetary policy destabilize the
economy?
• If the economy is stuck in a recessionary gap, does
this make the case for activist monetary policy
stronger or weaker? Explain your answer.
Nonactivist Monetary Proposals
• A monetary rule describes monetary policy that is based on
a predetermined steady growth rate in the money supply.
• Some economists would like the monetary rule to read as
follows: The annual money supply growth rate will be
constant at the average annual growth rate of the Real
GDP.
• Others would like the monetary rule to read: The annual
growth rate in the money supply will be equal to the average
annual growth rate in Real GDP minus the growth rate in
velocity.
• Some Monetary rule proponents claim that even if a
monetary rule does not adjust for changes in velocity, there
is little cause for concern.
A Gold Standard
• The money supply would be tied to the stock of
gold.
• The government sets the price of gold at some
dollar amount.
• The government promises to buy and sell gold at
the official price.
• Critics charge that a gold standard is no guarantee
against inflation.
• Critics also charge that a reduction in national
output and an increase in unemployment will
result if prices do not fall in the same proportion
when the gold-backed money supply is reduced.
A Gold Standard
The Fed and The Taylor Rule
• There may be a middle ground between
activist and nonactivist monetary policy.
• The Taylor Rule specifies how policy
makers should set the target for the federal
funds rate.
Federal funds rate target = Inflation +
Equilibrium real federal funds rate +
½ (Inflation Gap) + ½ (Output Gap)
Q&A
• Would a monetary rule
produce price
stability? Explain
your answer.
• How would the gold
standard (described in
the text) work?