Ec 123 Section 1
• THIS SECTION
– The Quantity Equation of Money
– Case: The U.S. Financial Crisis of 1931
• NEXT
– National Income Accounting
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The Quantity Theory of Money
The quantity equation of money relates the money in circulation (M) to the
price level (P) and annual output (Q).
MV = PQ
V is known as the velocity of money. It is equal to the average number of
times a dollar is used during the year.
The quantity equation is an accounting identity (true by definition) but what
you use for M (M1 or M2) can affect V number.
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Monetarism
• Monetarist's view of money's impact on economy can be
represented in the quantity equation framework
MV = PQ,
• Increases in V imply individuals and firms are less willing to hold
cash. Opposite for decrease in V.
• Monetarists claim that, under normal circumstances, V is stable
(or grows at predictable rate).
• Changes in V can be attributed to
– financial innovation
– change in interest rates
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Monetarism
Big policy implication: If V is stable, then the
only way to change nominal GDP (=PQ) is
through changes in the money supply.
• In the long run, changes in M effect only the price level, P.
• BUT in the short run changes can effect both P and real income,
Q, because it takes people time to adjust their decisions to
changes in the money supply.
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The Fed: Institutional overview
• Federal Reserve System created in 1913.
• Decentralized power structure
– 12 Districts
– New York has dominant position on FOMC
• Major responsibilities
“…to furnish an elastic currency, to afford means of
rediscounting commercial paper, to establish a more
effective supervision of banking in the United States, and for
other purposes.”
- Federal Reserve Act, 1913
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The Fed: Monetary Policy (Pre 1933)
• Real Bills Doctrine
– 40% of assets must be GOLD
– Other assets must be “productive credit”
• Discount Window Borrowing
– At the discretion of the regional Fed
– Primary monetary policy tool
What is the motivation for these policies?
What is the cost of these policies?
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The Fed’s Balance Sheet and the Real Bills
Doctrine
Internal drain due
to increased
leakages lowering
the multiplier
Assets
External
GOLD
drain
Free
Gold
40%
Required
Drop in M1 due to
external drain
Demand
Deposits
Demand
Deposits
Demand
Deposits
Currency in
Currency
in
Circulation
Currency
in
Circulation
Circulation
Liabilities
Govt. Sec.
Productive
Govt. Sec.
Loans
Productive
Loans
GOLD
GOLD
Currency in
Currency
in
Circulation
Circulation
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Drop in M1 due to
internal drain
M1
Determined
M1
by multiplier
Determined
by multiplier
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Monetary policy tools available to the Fed
(Pre 2008)
• Change reserve requirement ratio (hardly ever used)
• Change discount rate (sometimes)
– Short term, secured loans to banks (1 day but now can be
30 days)
– At a higher interest rate than the Fed Funds rate (lowered
difference)
– Negative Stigma associated with bank usage
• Open market operations (most commonly used
today)
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Open Market Operations
Open Market Purchase
Money
Fed
Public
thus M increases
Securities
Open Market Sale
Money
Fed
Public thus M decreases
Securities
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The Fed’s experience during the 1920’s
• In response to a severe 1920 recession the Fed raised the
discount rate to stem the loss of “free gold.” In the Fed’s view
– the recession was caused by international forces beyond
Fed control
– recession “cleansed” the economy for vigorous expansion.
• In 1927, the Fed helped the U.K. back to a gold standard
– used open market operations to expand the money supply
– lead to higher inflation and lower interest rates
– sterling pound appreciated relative to the dollar
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Changes in the money supply 1928-33
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The role of money in causing the Great
Depression
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Monetary policy tools available to the Fed
(TODAY)
• Change reserve requirement ratio (hardly ever used)
• Change discount rate (sometimes)
• Open market operations (most commonly used
today)
• Term Auction Facility
– Auction for short term (30 day) secured loans to banks
– Bidding starts at the Fed Funds interest rate.
– First auction was December 2008.
• The kitchen sink….
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U.S. Financial Crisis of 1931: Summary
• The quantity equation of money is an accounting identity linking
money to the larger economy.
• Monetarism implies that careful control of the money supply is
sufficient to stabilize the economy (PQ).
• Money multiplier story. Fed doesn't set the money supply, but
does have a heavy influence.
• The goals and organization of the Fed are critical to the conduct
of monetary policy.
• One’s understanding of how the money supply influences the
economy is crucial to the evaluation of monetary policy.
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