Money, Output, and Prices

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Money, Output, and Prices
Over the long term, money is highly positively correlated with
prices, but uncorrelated with income
M1 Money Supply
CPI (1987=100)
1400
200
180
160
140
120
100
80
60
40
20
0
1200
1000
800
600
400
200
1/1/98
1/1/95
1/1/92
1/1/89
1/1/86
1/1/83
1/1/80
1/1/77
1/1/74
1/1/71
1/1/68
1/1/65
1/1/62
1/1/59
0
M1
P
Over shorter time frames, money is highly positively correlated with
income, but less so with prices
% Deviations
from Trend
8
6
4
2
1/
1/
19
82
1/
1/
19
84
1/
1/
19
86
1/
1/
19
88
1/
1/
19
90
1/
1/
19
92
1/
1/
19
94
1/
1/
19
96
1/
1/
19
98
1/
1/
20
00
0
-2
-4
-6
-8
-10
15
10
5
0
-5
-10
-15
Real Income
M2/P
Over shorter time frames, money is highly negatively correlated
with interest rates,
5
14
4
12
2
1/1/2004
1/1/2002
1/1/2000
1/1/1998
1/1/1996
1/1/1994
-1
1/1/1992
6
1/1/1990
0
1/1/1988
8
1/1/1986
1
4
-2
-3
-4
2
0
Annual Yield
10
1/1/1984
Annual Growth
3
M1
1YR TBILL
Generally Speaking…. Money
demand is a function of income,
interest rates, and transactions
costs
d
M
 M  y, i, t 
P
Real Income (+)
Transactions Costs
(Cost of obtaining
money) (+)
Real Money Demand
Nominal Interest
Rate (-)
A common form of money demand
can be written as follows:
d
M
 k (i, t ) y
P
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 Federal Reserve can perfectly control the monetary
base (cash + bank reserves)
Discount Window
Loans
MB
Open Market
Operations
M3
M1
Reserve
Requirement
M2
Once those reserves enter the banking sector, they are used as the basis
for creating loans. These loans make up the rest of the money supply.
The fed can’t control this, but can influence it
The Money multipliers describe the relationship between a
change in the monetary base (controlled by the Fed) and the
broader aggregates
Change in M1 = mm1 * Change in MB
Cash
1 + Deposits
mm =
Cash
Reserves
+
Deposits
Deposits
Change in M2 = mm2 * Change in MB
Cash
+ M2-M1
1 + Deposits
Deposits
mm2 =
Cash
Reserves
+
Deposits
Deposits
The Fed can influence total bank reserves, which affects the multipliers!
In equilibrium, prices adjust so that
demand equals supply…
Determined by the
Fed & Banks
s
d
M
M

 k (i, t ) y
P
P
However, we have two prices (the price level and the interest
rate) ….which one adjusts to clear the market?
In the long run, the interest rate is mean reverting (i.e. constant).
Further, real economic growth is independent of money (money
is neutral in the long run)
s
M
 k (i, t ) y
P
Money growth
determined by the
Fed/Banks
Usually
assumed
Constant
Grows at a constant
rate independent of
money supply
Therefore, in the long run,
Inflation Rate = Money Growth – Economic Growth
In the short run, Prices are considered
fixed.
s
M
 k (i, t ) y
P
Money growth
determined by the
Fed/Banks
Constant
Adjusts to changing
money supply
Now, the interest rate and income will need to adjust (given values
for income and transaction costs) to clear the money market.
Money Market Equilibrium
Suppose that the Fed increases
the supply of money by 10%
Interest Rate (i)
In the short run, prices
remain constant, while
the interest rate drops.
Ms
10%
In the long run, prices
rise by 10%, returning
real money supply to its
initial level
5%
4%
10%
Md(y,t)
Real Money
M
P
Changes in income…
Suppose that an increase in
productivity raises household
incomes by 10%
Interest Rate (i)
In the short run, while
prices remain fixed, the
increase in money
demand raises interest
rates
Ms
6%
In the long run, falling
prices raises real
money supply lowering
interest rates
5%
Md(y,t)
Real Money
How could the Fed prevent this drop in prices?
M
P
Changes in transaction costs…
Suppose that ATMs reduce the
demand for money
Interest Rate (i)
In the short run, the drop
in money demand lowers
interest rates
Ms
In the long run, prices rise
– lowering real money
supply and returning
interest rates to their long
run level
5%
4%
Md(y,t)
Real Money
How could the Fed prevent this rise in prices?
M
P
Adding capital markets…
Household savings
provides the supply of
funds
Interest Rate (i)
S
5%
Investment plus the
government deficit represent
the demand for funds
I + (G-T)
Loanable Funds
We need both capital markets AND money markets to clear at the
same time….the interest rate can’t do this by itself!!
Capital/Money Markets – Short Run
i
i
Ms
S
5%
5%
I + (G-T)
Md
M
Loanable
Funds
P
Initially, both markets are in equilibrium. Now, suppose that the
Fed increases the money supply by 10%.
With prices fixed in the short run, real money supply increases
– this pushes interest rates down
Lower interest rates raise consumer expenditures (savings
rate falls) and raises investment expenditures
Higher demand for goods/services raises employment &
income – higher income increases total savings
Capital/Money Markets – Long Run
i
i
Ms
S
5%
5%
I + (G-T)
Md
M
Loanable
Funds
P
Eventually, increased demand for goods/services will raise prices.
Higher prices lowers savings (you need more money to buy
the same amount of goods) – interest rates increase
Higher interest rates lowers investment demand
Higher prices lowers real money supply
The tradeoff between short run
employment/output and long run prices is
known as the Phillip’s curve
In Theory
In Practice
Money Demand Shocks
i
i
Ms
S
5%
5%
I + (G-T)
Md
M
Loanable
Funds
P
Suppose that ATMs lower demand for money
As demand for cash falls relative to supply, interest rates
start to fall
Lower interest rates promote spending (both consumer and
investment) which raises employment and income
Eventually, the increase in demand raises prices. As
consumer goods become more expensive, savings drops, real
money supply drops and interest rates rise
Demand Shocks
i
i
S
Ms
5%
5%
I + (G-T)
Md
M
Loanable
Funds
P
Suppose that an increase in the investment tax credit raises
corporate capital expenditures
As demand for investment increases, employment and
output rise to meet the new demand and interest rates rise
Higher income raises money demand
Eventually, demand outpaces supply and prices start to rise. The
corresponding drop in real money supply pushes interest rates up
even higher.
Supply Shocks
i
i
Ms
S
5%
5%
I + (G-T)
Md
M
Loanable
Funds
P
Suppose that an increase in productivity increases our ability to
produce goods and services
Initially, nothing happens. While our ability to produce
goods and services has risen, there is no incentive for
households/firms to buy them!
Eventually, the excess supply lowers prices. The corresponding rise
in real money supply pushes down interest rates which raises both
consumer and investment demand
Money Markets, Capital Markets and the
Economy
Short Run
Long Run
Commodity prices
are slow to adjust
Real Interest rates
tend to be constant
 Interest rates are
determined in
money/capital
markets
 Demand is
determined by supply
Interest rates
determine demand,
which determines
supply
Prices reflect the
difference between
economic growth and
money growth
Does the economy
have a “speed
limit”?
Economic Growth can be broken into three components:
GDP
= Productivity Growth + (2/3)Employment Growth + (1/3)Capital Growth
Growth
In the Long Run, Capital Growth = Employment Growth
2%
1.5%
GDP
= Productivity Growth + Employment Growth
Growth
Supply, Demand, and Inflation
2%
1.5%
GDP
= Productivity Growth + Employment Growth
Growth
If demand grows faster than 3.5%, the one (or both) of the following
occurs:
Demand Pull Inflation
Cost Push Inflation
As demand for goods
outpaces supply, prices
start to rise. Labor
demands higher wages
to adjust for the higher
cost of living, higher
wages are reflected in
higher prices……
As demand for goods
continues to rise,
demand for labor rises –
eventually bidding up
wages. Higher wages
are reflected in higher
prices….
Expectations Matter!!!
i
i
Ms
S
5%
5%
I + (G-T)
Md
M
Loanable
Funds
P
Suppose that consumers anticipate rising inflation in the near future
Households increase consumer spending (i.e. buy things
before they become more expensive) – savings falls,
increased demand raises employment and increases income
Higher income raises money demand
Eventually, demand outpaces supply. Higher prices lower
real money supply – interest rates continue to rise
Currently, OPEC is operating at very near full capacity. As demand for
petroleum continues to rise, so do oil prices. How will this impact the
economy?
Case #1: High oil prices lowers demand (consumer and investment)
i
i
Ms
S
5%
5%
I + (G-T)
Md
M
P
Loanable
Funds
Currently, OPEC is operating at very near full capacity. As demand for
petroleum continues to rise, so do oil prices. How will this impact the
economy?
Case #2: High oil prices generates inflationary expectations
i
i
Ms
S
5%
5%
I + (G-T)
Md
M
P
Loanable
Funds
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