FIN 30220: Macroeconomic
Analysis
Money, Output, and Prices
Why does this piece of paper
(cloth, actually)have value?
In the early 1920’s, Germany experienced a period where the monthly
inflation rate was 29,500% per month! Prices doubled roughly every
four days!!!
Money was more valuable
as the paper it was
printed on!
Using money to stoke a furnace!
All time top inflation rates
Hungary (1946)
• 13,600,000,000,000,000 %/mo.
• Prices double every 15 hours
Zimbabwe (2008)
• 79,000,000,000 %/mo.
• Prices double every 24.7
hours
Yugoslavia (1994)
• 313,000,000 %/mo.
• Prices double every 34
hours
What is Money?
ANY commodity that satisfies three basic
properties can be called money
Unit of Account
Store of Value
Medium of exchange
“I can’t define it, but I
know it when I see it!”
Throughout history, many different commodities have been used as
money
The earliest money was commodity money whose value comes from the
commodity itself
Cowrie Shells
Cocoa Beans
Animal Skins
Salt
Tobacco Leaves
Precious Metals
Coinage began with King Sadyattes of Lydia, most commonly dated to
630-620 BC.
While remaining a topic of debate by some, this type is now commonly
considered to be the first official coin, meeting all of the requirements
laid out in the dictionary definition: it is the first coin to have certified
markings which signify a specific exchange value and be issued by a
governmental authority for use as money.
The Chinese were also developing metal coins around 600BC
…and time marches on….
Leonidas I
Sparta
C. 480BC
Alexander the Great
C. 330BC
Julius Caesar
Romans
C. 120AD
Constantine I
Byzantine Empire
C. 330AD
Charlemagne
Franks
C. 800AD
Henry VIII
England
C. 1520AD
Can you guess who these
people are?
Cleopatra and Mark Antony
Egypt. 80-77BC
Elizabeth Taylor and Richard Burton from
the 1963 film “Cleopatra”
The English Penny was introduced around 785AD by King Offa of Mercer.
Originally, it was a coin of 1.3 - 1.5 grams of pure silver
The penny was eventually
standardized to 1/240 of a
Tower pound (350g) of 92.5%
silver (sterling silver)…this
was later switched to 1/240 of
a Troy pound (373g)
Note: Avoirdupois LB = 453G
From the time of King Offa, the penny was the only denomination of coin minted in
England for 500 years, until the gold coinage issue of King Henry III around 1257 AD.
Early on, the colonies (being British colonies) used British money
Pound (20 shillings)
Guineas or Sovereigns
were gold coins with a value
of one pound sterling
Shilling (12 pence)
All these coins are during the
reign of Charles I (1625 – 1649).
Inadequate supply of British
money put commerce in jeopardy
in the colonies.
Pence (Penny)
Taking matters into their own hand, Boston authorities allowed John Hull and Robert
Sanderson to set up a mint in 1652. “Pine Tree” shillings were minted until 1674
when the mint was shut down
All the coins bear the date 1652. Why? Coinage was the sole prerogative of the king,
but in 1652 there was no king (King Charles I had been beheaded three years earlier).
They kept the date so they could deny any illegality if and when a monarchy was once
again reestablished which it was in 1660.
Spain established a mint in what is now Mexico City in 1535. Spanish ships returning to
Europe would stop off in the colonies to buy supplies. This made Spanish money widely
available in the colonies.
Spanish dollar = 8 Reals (.88 ounces of silver) Doubloon = 4 dollars (1/5 oz. of gold)
2 Bits is still considered slang
for a quarter!
Spanish coins remained legal tender until the coinage act of
1857!
The Constitution (1787) gives the congress the right to “To coin Money,
regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights
and Measures” (Section 8, Clause 5)
On April 2, 1792 Congress passed the coinage act which
created the mint.
The Coinage Act of 1792 defined a US Dollar
as .0538 ounces of pure gold or .86 ounces of
pure silver (15:1 ratio) – same (almost) as the
Spanish dollar
The US mint began production in 1793
US coins made in 1792 were not
minted for circulation and are
EXTEMELY valuable. This 1792
penny sold for $603,750!
Where does the dollar sign come from?
US
Imagine a U and an S (for United
States overlapping)
The dollar was fashioned after the Spanish
peseta - the P stands for Peseta, the “s”
makes it plural (what if the P and S overlap),
the line indicates an abbreviation
S
PP
8
The back of a Spanish peseta had two
columns (the pillars of Hercules) wrapped
with a scroll that reads “plus ultra”beyond the pillars, there are other lands.
Could this be the origin of the dollar sign?
All American coins must have “an impression emblematic of liberty and the word
liberty as well as the year. On the reverse of copper coins was required the
denomination.
The first circulated penny was released in 1793
The “Chain link penny” caused a lot of
controversy..many believed that the
chains represented slavery!
The chain was immediately
replaced with a victory wreath.
Note that from 1793 to 1857, the cent
was larger than a modern quarter
Half penny 1793
On the reverse of gold and silver coins will be an eagle and “United states of
America” . Denominations didn’t begin showing up on silver coins until 1804
Half dime introduced in 1794
1794: US Half
dollar
The dime was first issued in
1796
Quarter: 1796
1794: US dollar (A gold
dollar was released in 1849)
Production of silver coins ceased in 1964
On the reverse of gold and silver coins will be an eagle an “United states of
America” . Denominations didn’t begin showing up on gold coins until 1807
1796: Quarter Eagle ($2.50)
US Half eagle ($5) - 1796
US eagle ($10) - 1795
US double eagle ($20) - 1849
Production of gold coins ceased in 1934
1909: Lincoln appeared on the cent
to commemorate the 100
anniversary of his birth
1932, George Washington
appears on the quarter
1938: Jefferson appears on the
nickel
1946: FDR appears on the dime due to
his big support for the march of dimes
1964: JFK appears on the half
dollar
Women finally made it onto US coins!
Susan B. Anthony was the
first non-mythical woman to
appear on a US coin in 1978
Sacagawea followed in
Susan’s footsteps in 2000
Currently, the US mint produces between 4B and 10B coins annually. As a self
funded agency, the mint generated 3.89B dollars of revenues in 2010.
The US mint has facilities in Washington DC, Philadelphia, West Point, Denver ,
San Francisco, and the bullion depository at Fort Knox.
None of our coins has any precious metal content
99% Zinc, 1%Copper
75% Copper, 25% Nickel
75% Copper, 25% Nickel
Annual Production: 6.8M
Annual Production: 1.4B
Annual Production: 2.5B
75% Copper, 25% Nickel
75% Copper, 25% Nickel
Annual Production: 2.4B
Annual Production: 5.8M
88% Copper, 6% Zinc,
3% Magnesium, 3% Nickel
Annual Production: 5.3M
Paper money first makes an appearance in China around 900AD
Due to a severe copper shortage, the
Chinese begin issuing paper currency.
Frequent reissues fuel inflation
Each of the colonies issued currency. Most of these were “bills of credit”
Beginning in 1775, the Continental congress issued currency to finance the
revolutionary war. Continentals were bills of credit – not backed by gold or silver.
Easily counterfeited, the notes quickly devalued, giving rise to the phrase “not
worth a continental!”
The founding fathers feared fiat money (for good reason with the
failure of the continental). In fact, the constitution forbids states from
issuing paper fiat money.
A private business chartered
by the confederation
congress. Was the first IPO in
the United States and the first
Private Commercial bank.
Later re-chartered as the Bank
of Pennsylvania. Eventually
acquired by Wells Fargo
Bank of North America (1782 – 1786)
The founding fathers feared fiat money (for good reason with the
failure of the continental). In fact, the constitution forbids states from
issuing paper fiat money.
The First bank of the US was
chartered in 1791. While officially a
private bank, the US government
controlled 25%. The charter was not
renewed in 1811.
The Second Bank of the US was
chartered in 1816. Its charter
renewal was vetoed by Andrew
Jackson in 1836
The second bank of the US existed for five more years until going bankrupt in 1841
Prior to 1838, a bank charter could be obtained only by a specific legislative act.
However laws passes by various states after 1838 allowed the automatic
chartering of banks by the states without any special legislative consent.
From 1840 – 1863 all banking business was done by state banks
Anyone who satisfied the chartering requirements could become a bank
and issue currency!
1837 – 1863 over 8,000 “brands of currency issued by banks, state
governments, private individuals, and private companies
The US began issuing United
States Notes in 1862 after
passing the legal tender act. US
Notes were not backed by gold,
but were “legal tender for all
debts public and private”
US Notes were
nicknamed
“greenbacks”
US notes were last placed
into circulation in 1971
The National Banking Act of 1863
allowed Nationally chartered banks
to distribute bank notes (deemed
legal tender) backed by US
Treasuries.
National banknotes were printed
by the US Treasury
State bank notes were subject to
very high taxes and soon
disappeared
The Federal Reserve was created in 1913 to as a solution to bank panics
(particularly, the banking panic of 1907)
William McKinley - $500
James Madison- $5,000
Grover Cleveland- $1,000
Salmon P. Chase - $10,000
(Treasury Secretary under Lincoln)
Denominations of $500, $1,000, $5,000, and $10,000 were no longer printed after 1946
for fear of German counterfeiting!!
The largest denomination ever printed was a $100,000
gold certificate. It was never circulated, but was used
for inter-bank transfers
The beginning of the end: 1934
During the great depression, US citizens were
converting paper currency into gold in large
quantities. The government didn’t have enough
gold to back up the currency, so FDR passed an
executive order that made it illegal for US
citizens to hold gold.
Only foreign central banks could convert
paper dollars into gold
This coin sold at auction in 1996 for
$7.5M!!
FDR put the Great Seal on US Currency in 1935
Old Version (prior to 1935)
New version (began in 1935)
Secretary of Agriculture (and later, vice president) Henry Wallace saw
the Latin phrase “Novus Ordo Seclorum” which means a new order of
the ages and thought it meant “The new deal of the ages” both were
freemasons and saw the symbol above the pyramid as the “all seeing
eye” – the Masonic symbol for the great architect of the universe.
In God We Trust was adopted officially as the motto of the United States in
1956 as an alternative or replacement to E Pluribus Unum.
In god we trust has
appeared
sporadically on
coins since 1864
In God we trust has appeared
on currency since 1957
Some atheists have been known to
mark out the motto with a custom
made stamp
On August 15, 1971, Nixon closes the gold window and the US dollar
ceases to be convertible into gold by anyone. This marks the beginning of
a truly anchorless system
The U.S. Department of the Treasury first issued
paper currency of the United States in 1862 as a result
of a shortage of coins and the need to finance the Civil
War.
Today, the BEP has facilities in Washington DC and
Fort Worth Texas
•Currently, the BEP produces around 38 million
notes per day with a face value of approximately
$500M (mostly to replace worn out currency)
•Average Lifetime
•
•
•
•
•
•
$ 1 ...............18 months
$ 5 ................ 2 Years
$ 10................ 3 Years
$ 20 .............. 4 Years
$ 50 ............... 9 Years
$100 ...............9 Years
•The average cost of a note is 9.1 cents
The BEP has had a contract with the Crane paper company to
supply the paper for our currency since 1879.
•The “paper” is 75% cotton and 25% linen with blue and red
silk threads running through it
• Have you ever wondered how many times you could fold a
piece of currency before it would tear? About 4,000 double
folds (first forward and then backwards) are required before a
note will tear.
All bills, regardless of denomination, utilize green on the backs.
Faces use black ink, color shifting ink, and metallic ink. Inks
are formulated and blended by the BEP
US currency utilizes a combination of offset and Intaglio
printing. In Intaglio printing, images are engraved on plates.
Ink is applied to the plate and then pressed into the paper
under great pressure.
Federal Reserve District Seal:
Seal of the US Treasury
A (1) = Boston, B (2) = New York, C (3) = Philadelphia,
Federal Reserve
D (4) = Cleveland, E (5) = Richmond, F (6) = Atlanta, G (7) = Chicago,
District Number
H (8) = St. Louis, I (9) = Minneapolis, J (10) = Kansas City,
K (11) = Dallas, L (12) = San Francisco
Signature of the Treasurer of the US
(Note: Every Treasurer of the US has
been a woman since 1949 under Truman)
Series
Date
Signature of the
Secretary of the
Treasury
Each printing plate has 32 objects. The plate, therefore, is divided into 32
locations…
A1
E1
A3
E3
00000001
00800001
03200001
04000001
B1
F1
B3
F3
00200001
01000001
03400001
04200001
C1
G1
C3
G3
00400001
01200001
03600001
04400001
D1
H1
C3
H3
00600001
01400001
03800001
04600001
A2
E2
A4
E4
01600001
02400001
04800001
05600001
B2
F2
B4
F4
01800001
02600001
05000001
05800001
C2
G2
C4
G4
02000001
02800001
05200001
06000001
D2
H2
D4
H4
02200001
03000001
05400001
06200001
One press run will be 200,000 sheets. The serial
numbers are applied use skip numbering. The
numbers are placed so that when the sheets are
stacked and cut, the stacks of bills will be
sequential.
This would be the serial number locations
for the first page of the first run of 200,000
sheets.
A1
E1
After the first run of
200,000, the process is
repeated starting with
06400001
06400001
07200001
B1
F1
06600001
07400001
C1
G1
06800001
07600001
D1
H1
07000001
07800001
After 15 runs of 200,000 (1 cycle) we are at serial number 96000000. At this
point, we go back to 00000001
Given the numbering system, each serial number is guaranteed to come from
one particular plate location. This gives currency an anti counterfeiting
device…
Plate position
Serial number
Federal Reserve District
Plate serial number
This letter identifies
the number of
“cycles”: Y = 25
Can you find the owl on the $1 Bill?
See it now?
Did you know that the owl is a Masonic symbol of wisdom?
Some argue that when looked at even closer, it’s a spider, not an owl.
The narrowest definition of money would be the Monetary Base
(also called M0, Inside Money, or High Power Money). The
monetary base is a direct liability of the Federal Reserve – that is,
cash!
Federal Reserve System (2006)
In Millions
Assets
$11,036 (Gold)
$792,581 (US Bonds)
$64 (Loans)
$78,968 (Other)
Total: $882,649
Liabilities
$793,705 (Currency in Circulation)
$12,346 (Reserve Deposits)
$15,275 (US Treasury Deposits)
$61,323 (Other)
Total: $882,649
Reserves
Monetary Base = Cash in Circulation + Vault Cash + Reserve Deposits
Needless to say, we are living in interesting times. This can be seen in the
Fed’s balance sheets
Federal Reserve System (2006)
In Millions
Assets
Liabilities
Federal Reserve System (2015)
In Millions
Assets
$11,041 (Gold)
$11,036 (Gold)
$793,705 (Currency in Circulation)
$792,581 (US Bonds)
$12,346 (Reserve Deposits)
$64 (Loans)
$15,275 (US Treasury Deposits)
$179 (Loans)
$78,968 (Other)
$61,323 (Other)
$2,068,658 (Other)
Total: $882,649
Total: $4,541,691
Total: $882,649
$2,461,813 (US Bonds)
Quantitative easing program
QE1 (Nov. 2008): $2.1T in Bank Debt, Mortgage Backed Securities and Treasuries
QE2 (Nov. 2010): $600B in Treasury Securities
QE3 (Sept. 2012): $40B per month (increased to $85B/mo. In Dec. 2012)
Liabilities
$1,392,478 (Currency in Circ.)
$2,657,762 (Reserve Deposits)
$226 (US Treasury Deposits)
$491,225 (Other)
Total: $4,541,691
Quantitative easing
QE1
QE2
QE3
Billions of dollars
$4T
$2.7T
$1.7T
Quantitative easing
QE1
QE2
QE3
Billions of dollars
$4T
$2.3T
$1.3T
Monetary Base
•
Normal Annual Growth: 7% per year
•
2006 – 2015 Growth: 21% per year
Currency in Circulation
•
Normal Annual Growth: 7% per year
•
2006 – 2015 Growth: 6% per year
The lack of inflation from QE is largely because the cash injected isn’t circulating!
M1 = Currency in Circulation + Checkable Deposits
(Note: Bank Reserves ARE NOT included in M1)
Billions of Dollars
$3T
$1.7T
$1.3T
M2 = M1 + Savings Deposits + MMM Funds + Small Time Deposits
Billions of Dollars
$11.8T
$7.7T
$3T
$600B
$500B
Money in the United States
“Quantitative
Easing”
M2 ($11.8T)
M0 ($4T)
M1 ($2.9T)
By purchasing and/or selling securities, the Fed can directly control the quantity
of M0. Suppose that the Federal Reserve wants to increase the Monetary Base.
The Fed credits the
reserve account of the
dealer’s bank
Federal Reserve
Dealers Sell bonds to
the Fed
Bond Dealer
This is called an open market purchase
Suppose that the Federal Reserve purchases a $10,000 Treasury. It pays for
it by crediting the bond dealer’s bank account at Citibank.
Assets
+ $10,000 (Treasuries)
Liabilities
+ $10,000 (Reserve Deposits)
Citigroup’s balance sheet is affected as follow:
Assets
+ $10,000 (Reserves Deposits)
Citigroup’s reserve
account
Liabilities
+ $10,000 (Deposits)
Bond dealer’s
checking account
The federal reserve requires that 5% of transaction deposits must be kept on
reserve with the federal reserve. The remainder, the bank is free to lend out.
Assets
+ $500 (Required Reserves)
Liabilities
+ $10,000 (Deposits)
+ $9,500 (Excess Reserves)
Suppose that Citibank makes a $9,500 car loan
Assets
+ $500 (Required Reserves)
+ $9,500 (Excess Reserves)
+ $9,500 (Car Loan)
Liabilities
+ $10,000 (Deposits)
+ $9,500 (Line of Credit)
Eventually, the $9,500 will end up in the bank account of the car dealership. At
that point, Citibank covers the credit line by a transfers a $9,500 credit into
Bank of America’s account
Assets
Liabilities
+ $500 (Required Reserves) + $10,000 (Deposits)
+ $9,500 (Car Loan)
Now, Bank of America has $9,500 in new reserves, 5% must be kept at
the Fed, the rest can be lent out.
Assets
+ $475 ( Required Reserves)
+ $9,025 (Excess Reserves)
Liabilities
+ $9,500 (Deposits)
Car dealer’s
checking account
The initial bond purchase creates a “ripple effect” through the banking
system
Assets
+ $10,000 (Treasuries)
Assets
+ $500 (Required Reserves)
Liabilities
+ $10,000 (Reserve Deposits)
Liabilities
+ $10,000 (Deposits)
+ $9,500 (Car Loan)
Assets
+ $475 ( Required Reserves)
+ $9,025 (Excess Reserves)
Change in
MB = $10,000
Change in
M1=$19,500
Liabilities
+ $9,500 (Deposits)
This process will continue as payments get passed from bank to bank.
$ Change in M1 = (mm)$ Change in MB
Cash
1 + Deposits
mm =
Cash
Reserves
+
Deposits
Deposits
Reserves
In our example,
Deposits
$ Change in M1 =
Cash
= 5%
Deposits
1
$10,000 = $200,000
.05
= 0%
Currently in the US….
• Currency in Circulation = $1.3T
• Reserves = $2.3T
• Checkable Deposits = $1.7T
1.3
C
1

1
1.7  .83
D 
mm 
C R 1.3 2.3


D D 1.7 1.7
Think of money demand as a portfolio allocation problem. You have a
fixed amount of income and you are allocating it over several assets.
More Liquid
Lower Return
Cash
$400
Income
$5,000/month
Checking Account
$2,000
Less Liquid
Higher Return
Savings Account
$600
M1
M2
Stock/Bonds
$2,000
Money Demand
Suppose that you are planning on spending $120 over the
coming month. You currently have all your money in a
savings account earning interest. To buy things you will need
cash.
As long as your money is in
a savings account it is
counted as M2, but not M1
The cash you withdraw is
included in M1
Suppose you go to the bank three times per month (every 10 days).
You withdraw $40 each time. More generally, if you make plan on
Spending PY dollars per month. If you make N trips to the ATM
ATM Withdrawals
PY
N
Cash Balance Hits Zero
Average Cash Balances
(Money Demand)
Real Money
Demand
PY
0
N
M d  P, Y , N  
2
M d Y , N  Y

P
2N
What determines N?
The objective here is to choose the number of times you go to the bank to
get money
There are two costs associated with money:
 Y 
Interest Cost  i 

 2N 
Transactio n Cost  tN
If you make very few
trips to the bank (N is
small), you will need
to withdraw more
cash – having more
cash entails more lost
interest
If you make a lot of
trips to the bank, you
will withdraw less
each time (less
interest cost), but you
will pay more in
transaction costs
 Yi

Minimize 
 tN 
N
 2N

Yi

t  0
2
2N
Yi
N
2t
Take the derivative with
respect to ‘N’
Solve for N
Money Demand
This is the optimal
behavior (i.e. trips to
the ATM per month)
Yi
N
2t
As the interest rate
goes up, you hold less
cash. Therefore, you
make more trips to the
bank
As ATM fees rise, you
make less trips to the
bank, but withdraw more
each time
Money Demand
Real Income
d
M
Y
Yt


P
2N
2i
Nominal
Interest Rate
Real Money Demand
Transaction
Costs
Generally Speaking….
“is a function of…”
d
M
 M Y , i, t 
P
Real Income (+)
Real Money Demand
Nominal Interest
Rate (-)
Remember,
i  r  e
Transactions Costs
(Cost of obtaining
money) (+)
A common form of money demand can be written as follows:
d
M
 k (i, t )Y
P
Constant between 0 and 1
Real money demand is equal to a fraction (k is between zero and one) of
real income. That fraction depends on interest rates (-) and transaction
costs (+)
The Quantity Theory of Money
MV  PY
Money Supply
Nominal Income
Velocity – Measures
the number of times a
dollar changes hands
Note: We could rewrite this as percentage changes…
%M  %V  %P  %Y
The Quantity Theory of Money and Money
Demand
MV  PY
Money Demand
S
M
 k (i, t )Y
P
Equilibrium condition in the
money market
1
M    PY
k
S
1
V
k
When money demand drops– velocity increases.
In 1995, we saw a dramatic change in household portfolio
decisions…why?
M1 Money Demand
falls dramatically
starting in 1995
M1 Demand Rises
from 1980 - 1993
Trend
As interest rates rose, households switched out of checking accounts and into
savings accounts….technology (online banking, ATMs, etc. made this transition
easier)
Falling demand
for M2
Rising Demand
for M2
When the money market is in equilibrium, real money supplied equals real money
demanded.
Nominal Money
Supply(determined by
the Fed)
real interest rate
r
r
S
r
I
Determined in capital
markets
Y  C  I G
SI
I
*
Ms
P
Price Level
real output
Transactions
(determined in the costs
labor market)
Expected
inflation

M d Y , t, e
M
P

real money
Suppose that the Fed increases the money supply by 10% (assume inflation
expectations are zero)
r
Nothing in the real
economy has changed
r
Ms
P
At the existing
interest rate,
there is excess
supply of money.
Now what?
S
r*
I
Determined in capital
markets
Y  C  I G
SI
I


M d Y , t, e
M
P
The price level increases by an equal 10%. The price increase returns real
money to its original level (Money is neutral)
r
r
Ms
P
S
r*
I
Determined in capital
markets
Y  C  I G
SI
I


M d y, t ,  e
M
P
This one time increase in the money supply creates no inflation…just a
one time adjustment in prices
M
10%
0% Growth
0% Growth
Time
P
10%
0% Growth
0% Growth
Time
Again, the real economy is unaffected and “money is neutral”
Suppose that prior to the 10% increase in the money supply, there was $100M
in circulation. Further, assume that there is only one good in the economy –
beer – six packs of beer initially cost $10.
Prior to the increase in money supply:
M $100M

 10M
P
$10
six packs
of beer
%P  %M  10
After the increase in money supply:
M $110M

 10M
P
$11
six packs
of beer
No net gain/loss, right? However, there is something going on here!
Remember, the government must use the newly printed currency to buy
something in order to send it into circulation. In this example, the only thing
available to buy is beer (Party at Janet’s house!!!).
M  $110M  $100M  $10M
P  $10
Janet uses the $10M in
newly created money to
buy 1M beers!
If there is zero net gain, or loss, then this 1M gain in beers by the government
must be offset somewhere!
M ' M ' $110M $110M
 ' 

 1M
P
P
$10
$11
Once prices rise, anyone
holding money sees a drop
in their purchasing power!!!
Really, we can think of an increase in the money supply as an invisible tax – the
inflation tax!
Now, lets repeat the example, but now assume that the money supply increase
alters households expectations. Suppose households believe that the fed will
increase the money supply by 10% every year
r
r
Ms
P
10%
S
5%
I
I
Determined in capital
markets
Y  C  I G
SI
Md
Now, prices increase by more than 10%

Y , t, 
M d Y , t, e  0
e

 10

The rise in inflation expectations creates an “overreaction” in prices
due to the drop in money demand
M
0% Growth
10% Growth
Time
P
20%
0% Growth
10% Growth
Time
Lets make this example a little more specific. Suppose that prior to the 10%
increase in the money supply, there was $100M in circulation. Further,
assume that there is only one good in the economy – beer – six packs of beer
initially cost $10.
Prior to the increase in money supply:
M $100M

 10M
P
$10
six packs
of beer
%P  %M  20
After the increase in money supply:
M $110M

 9.1M
P
$12
six packs
of beer
Now we have a very real loss…who pays here? Surely not the government!
Remember, the government must use the newly printed currency to buy
something in order to send it into circulation. In this example, the only thing
available to buy is beer (Party at Janet’s house!!!).
M  $110M  $100M  $10M
P  $10
Janet uses the $10M in
newly created money to
buy 1M beers!
If there is zero net gain, or loss, then this 1M gain in beers by the government
must be offset somewhere!
M ' M ' $110M $110 M
 ' 

 1.9M
P
P
$10
$12
Now, the households loss
is bigger than the
governments gain!
Essentially, the loss is coming from the fact that people are spending too much
time trying to avoid holding money and too little time making beer!!
Where do hyperinflations come from?
Yugoslavia (1994)
• 313,000,000 %/mo.
• Prices double every 34
hours
Hungary (1946)
• 13,600,000,000,000,000 %/mo.
• Prices double every 15 hours
Zimbabwe (2008)
• 79,000,000,000 %/mo.
• Prices double every 24.7
hours
MV  PY
Recall the quantity theory
Or, in percentages
%M  %V  %P  %Y
Inflation
%P   %M  %V   %Y
%P   %M  %V   %Y
For relative low rates
of money growth,
money demand is
relatively constant
(change in velocity is
close to zero)
For high rates of money
growth, money demand
falls(change in velocity is
close to positive)
Rising velocity creates more
inflation
%P  %M  %Y
%P   %M  %V   %Y
Rising inflation creates more
velocity
Money, Prices, and the Business Cycle….
Investment demand rises during
expansions due to the rise in
productivity. Anticipating the rise
in income to be temporary,
savings rises
r
r
S
r
I
I
The Real interest rate falls.
*
M
P
s
Prices need to fall to
increase the real value of
money circulating
The increase in
real output should
increase money
demand

M d y, t ,  e
M
P
At the new equilibrium real interest rate, we have
excess demand for real money

Money, Prices and the business cycle
Given the mechanics of the money market,
what relationships would we expect to see
between money supply, prices and output?
Just the facts ma’am.
Output
Money (Money is a policy variable)
0
Prices
-
% Deviation from Trend
The Price level vs. GDP
Correlation = -.21
% Deviation from Trend
M1 Money Supply vs. GDP
Correlation = -.02
% Deviation from Trend
M2 Money Supply vs. GDP
Correlation = .25
This is a problem
% Deviation from Trend
Real Interest Rate vs. M1
Correlation = -.09
Our model would also predict a zero
correlation between the money supply
and the real interest rate
% Deviation from Trend
Real Interest Rate vs. M2
Correlation = -.20
This is a problem
Example: Oil Price Shocks in the 1970’s
Dollars per Barrel
1979 Iranian
Revolution
(Temporary Shock)
1973 Arab Oil
Embargo
(Permanent Shock)
In prior analyses, we already determined that both events looked like declines
in productivity …
S Y ,W 
r
r
r*
S*  I *
The resulting decline
in investment lowers
the real interest rate
I  A, L
S, I
r
New
equilibrium
interest rate
*
Ms
P
Price needs to
increase so that the
real supply of money
equals the new
demand at the new
interest rate
The decrease in
real output should
lower money
demand

M d y, t ,  e
M
P

r
Ms
P
r
MD M
P
MD M
P
Price Level (% Dev. From trend)
1973 Arab Oil
Embargo
CPI (1972 – 1982)
Ms
P
1979 Iranian
Revolution