Monetary Theory and
Policy
CHAPTER
30
© 2003 South-Western/Thomson Learning
1
Demand for Money
The demand for money refers to the
relationship between how much money
people want to hold and the interest
rate
Distinction between income and money
Money is a stock and people express their
demand for money by holding some of their
wealth as money
Income is a flow and people express their
demand for income by selling their labor
and other resources
2
Demand for Money
The most obvious reason why people
demand money is to carry out
transactions
The greater the value of transactions to be
financed in a given period, the greater the
demand for money  the greater the
volume of exchange of goods and services
as reflected by the level of real output, the
greater the demand for money
The demand for money also supports
expenditures people expect to make in the
course of normal economic affairs plus
various unexpected expenditures
Focus here is on money as a medium of
exchange
3
Demand for Money
Additionally, money serves as a store of
value  people can store their
purchasing power as money or in the
form of other financial assets – stocks,
bonds, etc
When people purchase bonds and other
financial assets, they are lending their
money and are paid interest for doing
so or are paid dividends or expect stock
prices to yield gains
4
Demand for Money
The demand for any asset is based on
the flow of services it provides
The big advantage of money is its
liquidity  it can be immediately
exchanged for whatever needs to be
purchased
By way of contrast, other financial
assets must first be liquidated, or
exchanged for money
5
Demand for Money
Money, however, has one major
disadvantage when compared to other
financial assets
Money held as currency or as travelers
checks earns no interest and checkable
deposits earn interest that is typically
below that which could be earned on
other financial assets  the interest
forgone is the opportunity cost of
holding money
6
Money Demand and Interest Rates
When the market rate of interest is low,
other things constant, the cost of
holding money (liquidity) is low 
people hold a larger fraction of their
wealth in the form of money
Conversely, when the market rate of
interest is high, the cost of holding
money is high  people hold less of
their wealth in money and more in other
financial assets
Thus, other things constant, the
quantity of money demanded varies
inversely with the market interest rate
7
Supply of Money and Interest Rate
The supply of money – the stock of
money available in the economy at a
particular time – is determined
primarily by the Fed through its control
over currency and over excess reserves
The supply of money is shown in Exhibit
2 as a vertical line  the quantity of
money supplied is independent of the
interest rate
8
Interest Rates and Planned Investment
Money affects the economy through
changes in the interest rate
Suppose the Fed believes the economy
is operating below its potential output
and decides to increase the money
supply in order to stimulate output and
employment by either
Purchasing U.S. government securities
Lowering the discount rate
Lowering the reserve requirement
9
Summary
The sequence of events in Exhibit 3 can be
summarized as follows
M  i  I  AD  Y
An increase in the money supply, M, reduces
the interest rate, i. The lower interest rate
stimulates investment spending, I, which leads
to an increase in aggregate demand from AD
to AD'. At a given price level, real GDP
demanded increases. The entire sequence is
traced out in Exhibit 3 by the movement from
point a to b
10
Decrease in the Interest Rate
Consider the effect of a Fedorchestrated increase in interest rates
This would be illustrated graphically by
a movement from point b to point a in
each of the panels in Exhibit 3
A decrease in the money supply would
create an excess demand for money at
the initial interest rate,  people will
attempt to exchange other financial
assets for money
11
Decrease in the Interest Rate
These efforts to get more money result
in an increase in the market interest
rate which will increase until the
quantity of money demanded declines
just enough to equal the now-lower
quantity of money supplied
At the higher interest rate, businesses
find it more costly to finance investment
plans and households find it more costly
to finance new homes
12
Decrease in the Interest Rate
The resulting decline in investment
leads to a magnified decrease in
aggregate expenditures which in turn
leads to a decline in aggregate demand
As long as the interest rate is sensitive
to changes in the money supply and as
long as investment is sensitive to
changes in the interest rate, changes in
the supply of money affect planned
investment
13
Adding Short-Run Aggregate Supply
To determine the complete effects of
monetary policy on the equilibrium level
of real GDP we need the supply side
An aggregate supply curve can help
show how a given shift in the aggregate
demand curve affects real GDP and the
price level
In the short run, the aggregate supply
curve slopes upward  the quantity
supplied will expand only if the price
level increases
14
Adding Short-Run Aggregate Supply
For a given shift of the aggregate
demand curve, the steeper the short-run
aggregate supply curve, the smaller the
increase in real GDP and the larger the
increase in the price level
15
Fiscal Policy with Money
Previously we found that an increase in
government purchases increases
aggregate demand, leading in the short
run to both a greater output and a
higher price level
However, once money enters the
picture, we must recognize that an
increase in either real output or the
price level increases the demand for
money since more money is needed for
the additional spending
16
Fiscal Policy with Money
For a given supply of money, an
increase in the demand for money leads
to a higher interest rate  reduces
investment spending  that the fiscal
stimulus of government purchases
crowds out some investment
This reduction in investment dampens
the expansionary effects of fiscal policy
 the simple spending multiplier
overstates the impact arising from any
given fiscal stimulus
17
Fiscal Policy with Money
Likewise, monetary effects will temper
any fiscal policy designed to reduce
aggregate demand
Suppose in an attempt to cool inflation,
income taxes are increases, which
reduces consumption  reduces
aggregate expenditures and aggregate
demand  equilibrium output and the
price level fall in the short run  less
money is needed to carry out
transactions  demand for money
declines
18
Fiscal Policy with Money
So long as the supply of money remains
unchanged, a decline in the demand for
money leads to a lower interest rate
which stimulates investment spending,
to some extent offsetting the effects of
higher taxes
Thus, given the supply of money, the
impact of changes in the demand for
money on interest rates reduces the
effectiveness of fiscal policy
19
Money in the Long Run
The long-run view of money is more
direct in that if the central bank
supplies more money to the economy,
people eventually spend more
However, since long-run aggregate
supply is fixed at the economy’s
potential output, this greater spending
simply increases the price level
It is to this explanation that we now
turn
20
Equation of Exchange
Recall that one of the implications of
the circular flow is that every
transaction in the economy involves a
two-way swap
The seller surrenders for money, and
the buyer surrenders money for goods
One way of expressing this relationship
among key variables in the economy is
the equation of exchange
21
Equation of Exchange
The basic version of the equation of
exchange
MxV=PxY
M is the quantity of money in the economy
V is the velocity of money, or the average
number of times per year each dollar is used
to purchase final goods and services
P is the price level
Y is real national output, or real GDP
Thus, the quantity of money in circulation
multiplied by the number of times that
money turns over equals the average price
times real output  P times Y equals
nominal GDP
22
Equation of Exchange
By rearranging the equation of
exchange, we would find that velocity
equals nominal GDP divided by the
money stock
V = (P x Y) / M
The velocity of money indicates how
often each dollar is used on average to
pay for final goods and services during
the year
23
Equation of Exchange
Given the value of total output and the
money supply in 2001, each dollar was
spent approximately 9 times on average
to pay for final goods and services
Classical economists developed the
equation of exchange as a way of
explaining the economy’s price level
The equation of exchange is simply an
identity  a relationship in such a way
that it is true by definition
24
Quantity Theory of Money
If velocity is relatively stable over time,
or at least predictable, the equation of
exchange turns from an identity into a
theory – the quantity theory of money –
which can be used to predict the effects
of changes in the money supply on
nominal GDP, P x Y
For example, if M is increased by 5%
and if V remains constant, then P x Y
must also increase by 5%
25
Quantity Theory of Money
How this increase in P x Y is divided
between changes in the price level and
changes in real GDP is not answered by
the quantity theory of money
The answer lies in the shape of the
aggregate supply curve
Recall that the long-run aggregate
supply curve is vertical at the economy’s
potential level of output
26
Quantity Theory of Money
Thus, with output, Y, fixed, and the
velocity of money, V, relatively stable or
at least predictable, then an increase in
the stock / supply of money translates
directly into a higher price level
27
Velocity of Money
Velocity depends on the customs and
conventions of commerce
The electronic transmission of funds takes
only seconds  the same stock of money
can move around much more quickly to
finance many more transactions
The velocity of money has also been
increased by a variety of commercial
innovations – wider range of charge
accounts and credit cards – that have
facilitated exchange
28
Velocity of Money
Another institutional factor influencing
velocity is the frequency with which workers
get paid,
• e.g., the more often workers get paid, other things
constant, the lower their average money balance
• so the more active the money supply  the greater
the velocity
The better money serves as a store of value,
the more of it people want to hold
• so the lower its velocity
– For example, during a period of inflation, money turns
out to be a poor store of value  velocity increases
with a rise in the inflation rate, other things constant
29
How Stable is Velocity?
Between 1960 and 1980 M1 velocity
increased steadily but in a rather
predictable fashion
However, during the 1980s, it bounced
around in a rather unpredictable fashion
During the last decade, more and more
banks began offering money market
funds that included check writing
privileges and people began using their
ATM or debit cards
30
How Stable is Velocity?
Thus, M2 might provide a better
perspective on the velocity of money
The velocity of M2 has been much more
stable
However, even the M2 velocity became
more volatile in the early 1990s
Since 1993, the equation of exchange
has been considered more of a rough
guide linking changes in the money
supply to inflation in the long run
31
Targets for Monetary Policy
The principal implication of the
preceding discussions is that monetary
policy affects the economy largely by
influencing the interest rate
However, in the long run, changes in the
money supply affect the price level,
though with an uncertain lag
Should monetary authorities focus on
interest rates in the short run or the
supply of money in the long run?
32
Contrasting Policies
A growing economy needs a growing
money supply to pay for the increase in
aggregate output
If monetary authorities maintain a
constant growth in the money supply,
and if velocity remains stable, the
interest rate will fluctuate unless the
growth in the supply of money each
period just happens to match the
growth in the demand for money
33
Contrasting Policies
Alternatively, monetary authorities
could try to adjust the money supply
each period by the amount needed to
keep the interest rate stable  changes
in the money supply each period would
have to offset any changes in the
demand for money
This is essentially what the Fed does
when it holds the federal funds target
constant
34
Contrasting Policies
Interest rate fluctuations could be
harmful if they created undesirable
fluctuations in investment
For interest rates to remain stable
during economic expansions, the money
supply would have to grow at the same
rate as the demand for money
Likewise, for interest rates to remain
stable during contractions, the money
supply would have to shrink at the same
rate as the demand for money
35
Contrasting Policies
That is, for monetary authorities to
maintain the interest rate at some
specified level, the money supply must
increase during economic expansions
and decrease during contractions
However, an increase in the money
supply during an expansion would
increase aggregate demand even more,
and a decrease in the money supply
during a contraction would reduce
aggregate demand even more  Fed
adding more instability to the economy
36
Targets
Between World War II and October
1979, the Fed attempted to stabilize
interest rates
During this period, Milton Friedman
argued that this exclusive attention to
interest rates made monetary policy a
source of instability in the economy
because changes in the money supply
reinforced fluctuations in the economy
 Fed should focus more on a steady
and predictable growth in the money
supply
37
Targets
In October 1979, the Fed announced
that it would de-emphasize interest
rates and would instead target the
growth in specific money aggregates
with the result that the interest rate
became more volatile
In October 1982, the Fed announced in
would again pay more attention to
interest rates
38
Targets
The rapid pace of financial innovations
and deregulation during the 1980s
made the definition and measurement
of the money supply more difficult
In 1987, the Fed announced it would no
longer target M1 growth and switched
to a M2
However, by the early 1990s, the link
between M2 and nominal GDP had also
deteriorated
39
Targets
In recent years, under Alan Greenspan,
the Fed has targeted the federal funds
rate
No central bank in a major economy
now makes significant use of money
aggregates to guide policy in the short
run
The Fed has less control over long-term
interest rates
40