Intermediate Macroeconomics
Chapter 8
Money Supply
Money Supply
1.
2.
3.
4.
Classical Theory of Money
Short-run Keynesian View
Friedman and the Monetarists
Fiscal and Monetary Policy and the
Great Depression
Intermediate Macroeconomics
1. Classical Theory of Money
U.S. long-run relationship
Percent change in GDP deflator
8
7
1970s
6
5
1980s
4
3
1990s
2
1960s
1
0
0
2
4
6
8
Percent change in M2
Intermediate Macroeconomics
10
12
1. Classical Theory of Money
International, 1993 - 2002
Annual Percent Change in
Consumer Price Index
1000
100
10
1
1
10
100
Annual Percent Change in Money Supply
Intermediate Macroeconomics
1000
1. Classical Theory of Money
Quantity theory of money
M•V=P•Q
M = money supply (M2)
V = velocity of money
P = average price level
Q = real output
P • Q ≡ nominal GDP ≡ national income
Intermediate Macroeconomics
1. Classical Theory of Money
Assumption 1: Velocity of money is constant
Velocity of Money
10
Velocity based on M1
8
6
4
Velocity based on M2
2
0
1959
1969
1979
1989
Source: Velocity of money = U.S. nominal GDP (www.bea.gov) divided by
U.S. money supply (www.federal reserve.org)
Intermediate Macroeconomics
1999
1. Classical Theory of Money
Assumption 2: Full-employment output
• Economy is always at full-employment
output.
• Q constant at full-employment output
Since by assumption 1: V is constant:
M•V=P•Q
A 1% increase in money supply, M, leads
to a 1% increase in the average level of
prices, P.
Intermediate Macroeconomics
1. Classical Theory of Money
Aggregate supply and aggregate demand
Long-run = Full-employment
Aggregate
Output
Supply
35
Average Price Level
30
25
20
15
10
Aggregate
Demand
Increase
in Average
Level of Prices
Increase
in Money Supply
AD1 (M1)
AD0 (M0)
5
0
0
2
4
Intermediate Macroeconomics
6
8
10
12
Real Output
14
16
18
2. Short-run Keynesian View
Prices and Velocity
To escape the classical assumption that
output was always at full-employment
Keynes’ assumed prices were “sticky”.
But, the quantity theory of money then
implies an increase in money supply with
velocity constant would lead to an increase
in output:
M•V=P•Q
Keynes also had to show that velocity was
not constant.
Intermediate Macroeconomics
2. Short-run Keynesian View
Real money demand
M = Real money balances
P
= Purchasing Power
Quantity theory real money demand:
M=1 Q
P V
With velocity, V, constant, real money
demand is a function output only –
hence, classical quantity theory is also
called transactions demand for money.
Intermediate Macroeconomics
2. Short-run Keynesian View
Speculative demand for money
Keynes proposed real money demand
is also a function of interest rates:
M=k•Q–h•i
P
Velocity of money no longer constant
Intermediate Macroeconomics
2. Short-run Keynesian View
Liquidity trap
• When the interest rate is so low (and
the price of bonds is high) people are
willing to hold onto money expecting
future interest rates to be higher (and
bond prices lower).
• Changes in money supply have no
effect on interest rates or the
economy.
Intermediate Macroeconomics
3. Friedman and the Monetarists
• Long and variable lags
• Policy rules versus discretion
Intermediate Macroeconomics
3. Friedman and the Monetarists
Long and variable lags
• Recognition lag
• Implementation lag
• Response lag
Intermediate Macroeconomics
3. Friedman and the Monetarists
Long and variable lags
Because of information problems and
lags between the implementation of
policies and their effects, the scope
for monetary policy should be
restricted.
Intermediate Macroeconomics
3. Friedman and the Monetarists
Policy rules versus discretion
• Monetarists - the Fed should be bound to
fixed rules. In particular, a money growth
rule: the growth rate of money supply should
equal the long-run growth rate of real GDP,
leaving the price level unchanged.
• Keynesians - the Fed should have discretion
in conducting policy because of the instability
of the velocity of money and the potential
instability of markets.
Intermediate Macroeconomics
3. Friedman and the Monetarists
Rules
Under rules, the central bank is required to
follow a simple predetermined rule for
money supply
Benefits:
- Better household forecasting
- Increased monetary discipline
Costs:
- Monetary policy can not adjust to economic
shocks
Intermediate Macroeconomics
3. Friedman and the Monetarists
Discretion
Under discretion, the central bank is expected
to monitor the economy and use monetary
policy to achieve macroeconomic goals
Benefits:
- Monetary policy can adjust be proactive,
adjusting to economic shocks
Costs:
- Harder for households to make good
forecasts
- Fed has incentives to deviate from
announced policies
Intermediate Macroeconomics
4. Policy and the Great Depression
Stock Market
Dow Jones Industrial Average
400
350
Sep - Nov 1929
37% decline
300
250
Aug - Nov 1929
37% decline
200
150
100
50
Between Sep 1929 and Jun 1932 the stock market fell 85%
0
Jan-28 Jan-30 Jan-32 Jan-34 Jan-36 Jan-38 Jan-40
Intermediate Macroeconomics
Source: National Bureau of Economic Research, Macro History Database,
http://www.nber.org/databases/macrohistory/contents/chapter11.html
4. Policy and the Great Depression
Factory Employment
Production Index, 1923-1925 = 100
Index of Factory Employment
1923 - 1925 = 100
250
Manufacturing employment began falling in March 1929
200
150
100
50
0
1925
1927
1929
Machinery
Clay and Glass Products
1931
1933
1935
Paper and Printing
Lumber and Products
1937
1941
Iron and Steel Products
Source: National Bureau of Economic Research, Macrohistory: VIII. Income and Employment,
http://www.nber.org/databases/macrohistory/contents/chapter08.html
Intermediate Macroeconomics
1939
4. Policy and the Great Depression
Income tax rate on highest bracket
100
Highest tax bracket
Income tax rate, percent
90
1931
1932
Lowest
Bracket
1.125%
4.0%
Highest
Bracket
25.0%
63.0%
80
70
60
50
40
30
Lowest tax bracket
20
10
0
1913 1922 1931 1940 1949 1958 1967 1976 1985 1994
Source: Internal Revenue Service, Personal Exemptions and Individual Income Tax Rates, 1913-2002,
http://www.irs.gov/pub/irs-soi/02inpetr.pdf
Intermediate Macroeconomics
4. Policy and the Great Depression
Money Supply
Money Supply (billions)
$60
$50
$40
$30
$20
Bank Holiday
March 1933
$10
$0
Jan-29
Jan-30
Jan-31
Jan-32
Jan-33
Jan-34
Jan-35
Jan-36
Source: National Bureayu of Economic Research, Macro History Database, series M14144a
<http://www.nber.org/databases/macrohistory/contents/chapter14.html>
Intermediate Macroeconomics
Jan-37
Jan-38