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ECO 104: Introduction to Macroeconomics

Lecture 8Chapter 14: Money and the Economy

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Money Supply

• This chapter is based on the Classical Economist’s Theory of Money Supply.

• This theory supports the notion that money supply affects the price level in the economy.

• The theory is based on the Equation of Exchange and the Simple Quantity Theory of Money.

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The Equation of Exchange

• The Equation of Exchange states that the product of Money Supply (M) and Velocity (V) must equal to the product of Price Level (P) and Real GDP (Q).

• Recall that Velocity is the number of times a dollar is spent to buy final goods and services in a year

• MV ≡ PQ ( ≡ means must be equal to)

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The Equation of Exchange (cont.)

• Recall Money Supply × Velocity = Total Spending

• In a real economy, money supply is some thousand billion dollars, so naturally it is not possible to measure velocity of each of those dollars. Hence a different method to calculating velocity is applied.

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The Equation of Exchange (cont.)

• Alternative method to calculating Velocity• Step 1: Calculate the GDP• Recall that GDP is the value of all final goods and services, representative

of total spending on final goods and services in the economy• For example,

• GDP= ∑PQ• GDP = (10 X $2) + (20 X $3) + (30 X $5) = $230

GoodsQuantities

Produced of Each Good

Price of Each Good ($)

A 10 2

B 20 3

C 30 5

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The Equation of Exchange (cont.)

• Step 2: Calculate the Average Money Supply (M)• Step 3: Divide GDP by Average Money Supply to get Velocity

• For example, if a $4800 billion transaction on final goods and services take place in one year, then that is equal to GDP. Suppose during this year the money supply was equal to $800 billion. Then

• GDP = P × Q, hence

• Hence, multiplying both sides by M gives us, MV ≡PQ

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The Equation of Exchange (cont.)

• MV ≡PQ is known as the Equation of ExchangeHow to interpret the Equation of Exchange?• The money supply multiplied by velocity must

equal the price level times Real GDP; M×V≡P×Q

• The money supply times velocity must equal GDP because GDP ≡ P×Q

• Total spending or expenditures (measured by MV) must equal the total sales revenue of business firms (measured by PQ): MV ≡ PQ

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Quantity theory of money• Assumptions:1) Changes in velocity are so small that for all practical purposes velocity can be

assumed to be constant, over short periods of time. 2) Real GDP, or Q, is fixed in the short-run• Therefore, with V and Q fixed, any changes in money supply M will cause a

proportional change in price P.

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Quantity theory of money (cont.)

Quantity Theory of Money in the AD-AS Framework• Recall that Total Expenditures (MV) is equal to Total Sales (PQ)• So, MV = Total Expenditure (TE)• Recall that TE = C + I + G + NX• Hence, MV = C + I + G + NX

• We know that any changes in C, I, G or NX causes a change in Aggregate Demand (AD). Therefore any changes in money supply (M) of velocity (V) will cause a corresponding change in AD.

This leads us to conclude that:• An increase in money supply will increase aggregate demand and shift the

AD curve to the right. • A decrease in the money supply will decrease aggregate demand and shift

the AD curve to the left.• An increase in velocity will shift AD to the right• A decrease in velocity will shift the AD curve to the left

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Quantity theory of money (cont.)• Recall by the Simple Quantity Theory of Money, V is constant, so only

changes in Money Supply can shift the AD curve. • Recall that Simple Quantity Theory of Money assumes that Real GDP is

constant. This is represented by a perfectly vertical AS curve fixed at the constant level of Real GDP.

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Relaxing V and Q

• If we drop the assumption that V and Q must remain constant, then M × V ≡ P × Q

• Rearranged as

• It shows that Money Supply, Velocity and Real GDP determine the price level. An increase in M or V and a decrease in Q leads to increases in price level i.e. creates inflationary tendencies.

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Monetarism

• Monetarists are a group of economists who believe that neither the velocity nor output is constant.

They have four assumptions:1. Velocity changes in a predictable way since it is dependent on certain

factors such as interest rate, expected inflation rate, frequency of receiving salaries etc. Changes in these factors allows us to predict which way velocity will change.

2. Recall MV = C + I + G + NX. While Keynesians strongly believe that C,I,G and NX causes AD to change, Monetarists believe M and V are more responsible for changes in AD.

3. Monetarists do not believe Q is constant – rather AS 4. Monetarists also believe that the economy is self-regulating, and have

a tendency to naturally move towards long-run equilibrium when in an inflationary or recessionary gap.

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Monetarism (cont.)

• The economy is initially in long-run equilibrium. An increase in Money Supply (keeping Velocity constant) pushes AD to the right and takes the economy to an Inflationary Gap. Since Monetarists believe that the economy is self-regulating, wages will soon bid up, shifting the SRAS curve to the left and restoring long-run equilibrium. Hence in the short-run both price level and Real GDP increases. In the long-run, only price level increases.

• Initially, the economy is in long-run equilibrium. Money supply decreases (keeping Velocity constant), causing the AD curve to shift to the left. This creates a recessionary gap. Wages eventually fall, shifting the SRAS curve to the right and restoring long-run equilibrium. In the short-run Real GDP and Price level decreases. In the long-run, only Price level decreases further.

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Monetarism (cont.)

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Monetarism (cont.)• Similarly, an increase in Velocity (keeping Money Supply constant) can

cause a short-run Inflationary Gap, which is eventually restored to long-run equilibrium by a self-regulating economy. Also, a decrease in Velocity (keeping Money Supply constant) can cause a short-run Recessionary Gap, which is also eventually recovered in the long-run.

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Monetarism (cont.)

• Three important conclusions can be derived from the Monetarist View:

• The economy is self-regulating• Changes in velocity and money supply can

change aggregate demand• Changes in velocity and the money supply will

change the price level and Real GDP in the short-run but only price level in the long-run

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Monetarism (cont.)• Is it possible for a change in velocity to have a stronger effect

than the change in money supply?• Suppose that money supply increases which pushed AD to the

right and velocity decreases which pushes AD to the left. Can it be possible that change in velocity is just as strong as a change in money supply such that the net effect is 0?

• Monetarists do not believe that the effect of a change in velocity can match the effect of a change in money supply. This is because (A) velocity does not change much from one period to the next and (B) changes in velocity are predictable (by changes in interest rates etc.)

• Therefore, change in money supply has the upper hand – changes in the money supply will largely determine changes in aggregate demand and thus changes in Real GDP and the price level.

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Inflation

• Inflation refers to any increase in price level. There are two types of increases in price level – (a) a one-shot increase and (b) a continued increase.

• One-Shot Inflation: This is a one-time increase in the price level.

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One-Shot Inflation: Demand Induced

• The economy is initially at long-run equilibrium. AD curve shifts to the right and causes the price-level to increase. The economy is an inflationary gap, so there is a shortage in the labor-market. This causes wages to increase and push the SRAS curve to the left. Once it reached P3, prices stabilize.

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One-Shot Inflation: Supply Induced

• The economy is initially at long-run equilibrium. The SRAS curve shifts leftward (due to an oil crisis) which causes a recessionary gap. This creates a surplus in the labor market, and pushes wages down. As a result, the SRAS curve shifts to the right and once again return the economy to long-run equilibrium. Prices stabilize at P1.

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Continued Inflation• Continued Inflation occurs when there is a continuous increase in price

level.

• Demand-induced: The process of a rightward shift in AD results in a leftward shift in SRAS, and the process keep continuing over several short-run periods.

• Supply-induced: In a one-shot supply-induced inflation, when SRAS shifts left, in the next period it simply shifts back right. However, in continuous inflation, this natural tendency to return to the original equilibrium is off-set by a rightward shift in AD. The process continues over a couple of short-run periods.

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Continued Inflation

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Analytical questions• Can SRAS curve continuously decline if labor unions

consistently insist upon being paid higher?• Ans: Is it possible for SRAS curve to keep shifting

leftward indefinitely and keep reducing Real GDP? Not exactly. Recall that every time Real GDP decreases due to a leftward shift in SRAS curve, unemployment increases as well because fewer people are required to produce a lower Real GDP level.

• Is there anything that can make Aggregate Demand curve continuously shift rightward?

• Ans: Only persistent increase in money supply has the ability to do this.

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Money and Interest Rate• Money supply affects different economic variables through

which interest rate is affected:(a) Money and the Supply of Loans: Recall that the Central Bank

can use open-market purchases to increase the money supply which allows that banks reserves to increase. With more reserves, banks can extend more loans. As a result, the money supply increases.

(b) Money and Real GDP: Recall that money supply affects Total Expenditure, which is directly related to Aggregate Demand. If money supply increases, Total Expenditure increases, AD shifts rightward and increases Real GDP in the short-run

(c) Money and Price Level: When the AD curve shifts to the right due to an increase in Total Expenditure, price level increases as well.

(d) Money Supply and Expected Inflation Rate

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Money and Interest Rate (cont.)

• Demand for loanable funds is downward sloping due to the negative relationship with interest rate. Supply of loanable funds is upward sloping due to the positive relationship with interest rate.

• If there is a surplus of loanable funds, interest rate fall. • If there is a shortage of loanable funds, interest rates rise. • Anything that affects the demand and supply of loanable funds, affects the interest

rate.

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Effects upon interest rate

1) The Supply of Loans: Open-market purchases increases bank reserves and increases the supply of loanable funds. This shifts the supply of loanable funds curve to the right and decreases the interest rate. A change in interest rate due to change in the supply of loanable funds is called the Liquidity Effect.

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Effects upon interest rate (cont.)

2) Real GDP affects both the supply and demand for loanable funds. When Real GDP increases, people’s wealth increases in general. People’s demand for bonds increases as well, because bonds, like cars and houses, is a type of asset. When purchase of bonds increases, the supply of loanable funds increases.

When Real GDP increases, business profitability increases. Businesses are keen to take advantage of this profitability and hence are eager to invest more. When they want to invest, they need money, which causes them to issue more bonds. This increases the demand for loanable funds.

The change in interest rate due to a change in Real GDP is known as Income Effect.

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Effects upon interest rate (cont.)3) The Price Level: Recall that AD is downward sloping due to (a) real Balance

effect, (b) the interest rate effect and (c) the international trade effect. With respect to interest rate effect, an increase in price level causes purchasing power of money to fall, and therefore people take out loans to finance expenditure of a fixed bundle of goods. This causes interest rate in increase. Similarly, if price level falls, people save money on the purchase of a fixed bundle of goods, and this increases the supply of loans which reduces interest rate. The change in interest rate that occurs due to a change in price level is called the Price Level Effect.

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Effects upon interest rate (cont.)4) The Expected Inflation Rate: Expected Inflation Rate affects both the demand and supply

for loanable funds. Suppose, expected inflation rate is currently 0. At this time, interest rate is 6%. If expected inflation rate increases to 4%, this means Borrowes (demanders of loans) will be willing to pay 4% more interest on their loans, because they expect to pay back money that will have 4% less buying power. They will demand more loans now before the inflation rate actually increases and depleted their purchasing power.

On the other hand, Lenders (suppliers of loanable funds) are aware that an expected inflation will reduce the value of their money, hence the supply of loanable funds decreases. The change in interest rate due to Expected Inflation is known as the Fisher Effect.

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Changes to the Money Supply• When Central Bank increases the money supply, what happens

to the supply and demand for loanable funds?• In Month 1, the government announced that money supply will

increase at the rate of 2% through open-market operations. This will increase the supply of money and put a downward pressure on interest rate through the Liquidity Effect.

• In Month 2, the government announces a further increase in money supply. As money supply and price level are directly related, expectations of inflation starts to bubble in the economy, and by the Fisher Effect, this puts an upward pressure on interest rate.

• By mid-Month 2, the increase in money supply triggers the Liquidity Effect again and brings down the interest rate.

• Therefore, the timing and effect of these individual effects determine the ultimate effect on interest rates,

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Nominal vs. Real Interest Rate

• When you go to the bank, and ask for a loan, the interest rate that you would pay on the loan is called a Nominal Interest Rate. The interest rate is determined through the demand and supply interactions of loanable funds.

• Nominal Interest Rate however contains the effect of expected inflation rate (through the Fisher effect), and hence might not be an accurate measure of the price of loans.

• For example: In Month 1, you borrow funds of $10,000 from the bank at 9% interest rate. The expected inflation rate was 2%. You have to repay the loan in 6 months. This means when you return the money, you have to give them $10,000 + $900 = $10,900 back.

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Nominal vs. Real Interest Rate

• In Month 6, when it is time to return the loan, expected inflation rate of 2% is now the actual inflation rate 2%. This means you are returning back money that is 2% less in worth than the money you originally took at loan.

• The Real cost of borrowing is not the 9% interest rate, but rather 9% − 2% = 7%. This real cost of borrowing is called the Real Interest Rate.

• Real Interest Rate = Nominal Interest Rate – Expected Inflation Rate.

• Therefore, Real Interest Rate = Nominal Interest Rate, when Expected Inflation Rate is 0.