Chapter 22
Quantity Theory of Money,
Inflation and the Demand for
Money
Inflation and Money Growth
• How is inflation linked to money growth?
• The Quantity Theory of Money and the
Velocity of Money
Inflation and Money Growth
Inflation and Money Growth
• Previous slide shows can’t have high, sustained
inflation without monetary accommodation
• To avoid sustained high inflation, central bank must
watch money growth
• Something beyond just differences in money
growth accounts for the differences in inflation
across countries. We need to study the velocity
of money.
The Equation of Exchange: M x V = P x Y
Nominal GDP = Price level (P) x Real Output (Y)
Quantity of Money (M) x Velocity (V) = Nominal GDP
MxV =P xY
Velocity of Money (V):
PxY
Velocity(V ) 
M
These relationships are definitions
http://research.stlouisfed.org/fred2/categories/24
The Equation of Exchange – Dynamic Form
From M x V  P x Y
we can derive
%M  %V  %P  %Y
or
M V P Y



M
V
P
Y
Money Growth + Velocity Growth = Inflation + Output Growth
From the Equation of Exchange to the
Quantity Theory of Money
The Quantity Theory of Money (Irving
Fisher)
• assume velocity is constant => %ΔV = 0
• Or at least stable
• economy at full employment.
• Strong condition %ΔY = 0.
• Double M => Double P
• Inflation is a monetary phenomenon (Milton
Friedman).
Quantity Theory of Money and Inflation
P M Y


P
M
Y
If V is constant, the rate of Inflation = the
rate of growth in the money supply minus
the rate of growth in aggregate output
Average Inflation Rate Versus Average Rate of Money
Growth for Selected Countries, 1997–2007
Source: International Financial Statistics.
M2 Money Growth and Inflation - US
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,
but the United States has been spared such turmoil
• One of the most extreme examples of
hyperinflation throughout world history occurred
recently in Zimbabwe in the 2000s
Examples of Hyperinflation:1980s and
Early 1990s
Is Velocity Stable?
The Scale obscures the short-run movements in M2
Velocity of Money
Substantial short-run fluctuations in M2 velocity.
But the long-run trend is a modest increase from 1.72 to 1.82
over 45 years.
Velocity of Money
• The data tend to confirm Fisher’s conclusion
that in the long run (40 to 50 years) the
velocity of money (M2) is stable
• However, central banker’s are concerned
with inflation over quarters and years.
• Velocity is volatile in the short-run, as shown
on the previous chart and on the next chart.
Change in the Velocity of M1 and M2
from Year to Year, 1915–2008
To understand the velocity of money, must understand the
demand for money.
Annual U.S. Inflation and Money Growth Rates,
1965–2010
The Demand for Money
• Two motives:
• Transactions demand
• Speculative or Portfolio demand
Transactions Demand for Money
• The quantity of money the public holds for
transactions purposes depends
• on nominal income – P x Y
• the cost of holding money
• and the availability of substitutes
• As P and/or Y increase => money demand
will increases
• As opportunity cost increases => money
demand will decrease
Demand for Money
i
Md
Transactions Demand for Money
• Higher nominal interest rate => higher
opportunity cost of holding money => the less
money individuals and businesses will hold for a
given level of transactions => higher velocity of
money.
• In high inflation countries, the opportunity cost of
holding money is high.
• M and V are increasing, so the increase in P is greater
than the increase in M.
Further Developments in the Keynesian Approach
• Transactions demand
• Baumol - Tobin model
• There is an opportunity cost and benefit
to holding money
• The transaction component of the
demand for money is negatively related
to the level of interest rates
Cash Balances in the Baumol-Tobin Model
Non-synchronization of income and
spending
The mismatch between the timing of
money inflow to the household and the
timing of money outflow for household
expenses.
Cash Balances in the Baumol-Tobin Model
Income arrives only once a month, but spending takes place
at a constant rate.
Cash Balances in the Baumol-Tobin Model
Individual earns $1,200 per month. Paid on the 1st day of the month
and spends at a constant rate during the month.
Could decide to deposit entire paycheck ($1,200) into checking account
at the start of the month and run balance down to zero by the end of the
month. In this case, average balance would be $600. Velocity of money is
$14,400/ $600 = 24.
Cash Balances in the Baumol-Tobin Model
Alternatively, could also choose to put half paycheck into checking
account and buy a bond with the other half of income.
At midmonth, would sell the bond and deposit the $600 into checking account
to pay the second half of the month’s bills. Following this strategy, average
money holdings would be $300 and the velocity of money = $14,000/ $300 =
48.
Benefit and cost
•
Benefit - If the monthly interest rate is 1%, earn ½ X
$600 x .01 = $3.00
•
Cost - transactions cost
•
For a given level of transactions cost, as i increases
hold less money and more bonds.
Portfolio or Speculative Demand for Money
• As a store of value, money provides diversification when
held with a wide variety of other assets, including stocks
and bonds
• Portfolio demand depends on
•
•
•
•
•
Wealth
the expected return relative to the alternatives
expectations that interest rates will change in the future
Risk
Liquidity
Factors That Determine the Demand for
Money
Velocity is not constant!
• The procyclical movement of interest rates
should induce procyclical movements in
velocity.
• Velocity will change as expectations about
future normal levels of interest rates change
• Interest rates   opportunity cost 
Demand for money   velocity 
We will come back to this -
Targeting Money Growth
Two criteria for the use of money growth as a
direct monetary policy target:
• A stable link between the monetary base and the
quantity of money: MB x m = M
• A predictable relationship between the quantity of
money and inflation: M x V = P x Y
(MB x m) x V =P x Y
• Possible explanation for the instability of U.S.
money demand over the last quarter of the 20th
century.
• Primary - The introduction of financial instruments
that paid higher returns than money.
• Most Central Banks use interest rates as
their operating instrument
• Interest rates are the link between the
financial system and the real economy
• While inflation is tied to money growth in
the long run, interest rates are the tool
policymakers use to stabilize inflation in
the short run.