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This document summarizes key topics in Chapter 8 of an Intermediate Macroeconomics textbook, including the classical theory of money, Keynesian and monetarist views of money supply, and the role of fiscal and monetary policy during the Great Depression. It discusses the quantity theory of money, assumptions around velocity and full employment, and how Keynes challenged the classical view. It also outlines Friedman's perspective on long and variable lags in policy and the debate around rules versus discretion. Historical data on money supply, stock prices, employment, and tax rates during the Depression are presented.
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Ch8ppt
- 2. Intermediate Macroeconomics Money Supply 1. Classical Theory of Money 2. Short-run Keynesian View 3. Friedman and the Monetarists 4. Fiscal and Monetary Policy and the Great Depression
- 3. Intermediate Macroeconomics 1. Classical Theory of Money U.S. long-run relationship 0 1 2 3 4 5 6 7 8 0 2 4 6 8 10 12 Percent change in M2 PercentchangeinGDPdeflator 1990s 1960s 1980s 1970s
- 4. Intermediate Macroeconomics 1. Classical Theory of Money International, 1993 - 2002 1 10 100 1000 1 10 100 1000 Annual Percent Change in Money Supply AnnualPercentChangein ConsumerPriceIndex
- 5. Intermediate Macroeconomics 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
- 6. Intermediate Macroeconomics 1. Classical Theory of Money Assumption 1: Velocity of money is constant 0 2 4 6 8 10 1959 1969 1979 1989 1999 VelocityofMoney Velocity based on M1 Velocity based on M2 Source: Velocity of money = U.S. nominal GDP (www.bea.gov) divided by U.S. money supply (www.federal reserve.org)
- 7. Intermediate Macroeconomics 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.
- 8. Intermediate Macroeconomics 1. Classical Theory of Money Aggregate supply and aggregate demand 0 5 10 15 20 25 30 35 0 2 4 6 8 10 12 14 16 18 Real Output AveragePriceLevel Long-run Aggregate Supply Aggregate Demand AD0 (M0) AD1 (M1)Increase in Money Supply = Full-employment Output Increase in Average Level of Prices
- 9. Intermediate Macroeconomics 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.
- 10. 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.
- 11. 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
- 12. 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.
- 13. Intermediate Macroeconomics 3. Friedman and the Monetarists • Long and variable lags • Policy rules versus discretion
- 14. Intermediate Macroeconomics • Recognition lag • Implementation lag • Response lag 3. Friedman and the Monetarists Long and variable lags
- 15. Intermediate Macroeconomics Because of information problems and lags between the implementation of policies and their effects, the scope for monetary policy should be restricted. 3. Friedman and the Monetarists Long and variable lags
- 16. Intermediate Macroeconomics • 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. 3. Friedman and the Monetarists Policy rules versus discretion
- 17. Intermediate Macroeconomics 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 3. Friedman and the Monetarists Rules
- 18. Intermediate Macroeconomics 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 3. Friedman and the Monetarists Discretion
- 19. Intermediate Macroeconomics 4. Policy and the Great Depression Stock Market 0 50 100 150 200 250 300 350 400 Jan-28 Jan-30 Jan-32 Jan-34 Jan-36 Jan-38 Jan-40 DowJonesIndustrialAverage Sep - Nov 1929 37% decline Aug - Nov 1929 37% decline Source: National Bureau of Economic Research, Macro History Database, http://www.nber.org/databases/macrohistory/contents/chapter11.html Between Sep 1929 and Jun 1932 the stock market fell 85%
- 20. Intermediate Macroeconomics 4. Policy and the Great Depression Factory Employment Index of Factory Employment 1923 - 1925 = 100 0 50 100 150 200 250 1925 1927 1929 1931 1933 1935 1937 1939 1941 ProductionIndex,1923-1925=100 Machinery Paper and Printing Iron and Steel Products Clay and Glass Products Lumber and Products Source: National Bureau of Economic Research, Macrohistory: VIII. Income and Employment, http://www.nber.org/databases/macrohistory/contents/chapter08.html Manufacturing employment began falling in March 1929
- 21. Intermediate Macroeconomics 4. Policy and the Great Depression Income tax rate on highest bracket 0 10 20 30 40 50 60 70 80 90 100 1913 1922 1931 1940 1949 1958 1967 1976 1985 1994 Incometaxrate,percent Highest tax bracket Lowest tax bracket Lowest Highest Bracket Bracket 1931 1.125% 25.0% 1932 4.0% 63.0% Source: Internal Revenue Service, Personal Exemptions and Individual Income Tax Rates, 1913-2002, http://www.irs.gov/pub/irs-soi/02inpetr.pdf
- 22. Intermediate Macroeconomics 4. Policy and the Great Depression Money Supply $0 $10 $20 $30 $40 $50 $60 Jan-29 Jan-30 Jan-31 Jan-32 Jan-33 Jan-34 Jan-35 Jan-36 Jan-37 Jan-38 MoneySupply(billions) Source: National Bureayu of Economic Research, Macro History Database, series M14144a <http://www.nber.org/databases/macrohistory/contents/chapter14.html> Bank Holiday March 1933
Editor's Notes
- When money supply is growing at about 2 percent per year prices are stable with zero inflation. A 2 percent growth rate satisfies the long-run growth of the economy with increasing population and real income. For every 1 percent change in money supply above or below this baseline there is an almost matching 0.8 percent change in the inflation rate. Actually we should expect the relationship between changes in money supply and the inflation rate to be 1-for-1. For every 1 percent change in money supply above or below the baseline there should be a matching 1 percent change in the inflation rate. Differences in the baseline between decades such as from population growth, changes in technology, and so on skew the picture presented by our limited sample. As Nobel laureate Milton Friedman once wrote, “inflation is always and everywhere a monetary phenomenon.”
- In the 1980s the general pattern of the low inflation countries was just above the 45 degree line. For a given increase in money supply inflation was higher.
- The right-hand side of the equation can be seen as the definition of nominal GDP. The average price times the quantity of goods and services sold equals nominal GDP. In 2002, the total value of final goods and services sold to end users and measured as nominal GDP was $10,446 billion. The quantity of money used to purchase those goods and services is measured by the M1 (cash, checking accounts, and travelers checks), which averaged $1,213 billion in 2002. Each dollar measured by the M1 must have been spent 8.6 times ($10,446 / $1,213 = 8.6) to make the total value of purchases reported as nominal GDP. The number of times each dollar is spent during the course of a year is called the velocity of money (V).
- This accounting identity is transformed into a theory by making the simple assumption that the velocity of money is stable or constant. This assumption is based on the transactions demand for money. People hold money to make purchases. If they intend to increase the value of the purchases they make then they hold more money and vice versa. This graph shows the velocity of money calculated by dividing nominal GDP by both the M1 and M2 measures of money supply. The velocity of money based on the M1 has been far from stable, more than doubling over the last 40 years. The measure of velocity based on the M2, however, has slowly cycled around its average 1.8. This figure reveals why the M2 has overtaken the M1 as the preferred measure of money supply in economic analysis because of its stability, at least over the long run.
- The quantity theory of money provides the foundation for the Classical view of the relationship between money supply and the economy going back to Adam Smith. Put simply, money supply does not affect real output or employment. Changes in money supply translate directly to changes in prices only. If the growth rate of money supply is too high we have inflation. If the growth rate of money supply is too low (or contracting) we have deflation. A stable economy requires a controlled growth rate in money supply that matches the long-run growth rate of the economy. The quantity theory of money with the assumption that the velocity of money is constant reveals the proportional relationship between money supply and nominal GDP. With velocity (V) constant, a 10 percent increase in money supply (M) will lead to a 10 percent increase in nominal GDP (P • Q). So how do we arrive at the conclusion that changes in money supply should lead directly to changes in prices (P) and not output (Q)? We make a second assumption that over the long run the economy is operating on its production possibilities curve at full-employment output. While there are always short-run fluctuations in output (characterized as business cycles) these fluctuation occur around the long-run tendency for an economy to operate at full-employment. So, if the economy is growing at the long-run rate of 2 percent per year then any increase in the money supply growth rate above that level will translate straight to prices. The classical view of the relationship between money and prices and output is revealed in the aggregate supply and demand graph. The aggregate supply curve is vertical at full-employment output. An increase in money supply from M0 to M1, which causes an increase in aggregate demand (from AD0 to AD1), results in no change in output but simply an increase in the average level of prices. The aggregate demand curve shifts to the right because people now have more money to spend. However, the quantity of goods and services available do not increase because the economy is already at full-employment output. Because we have more dollars chasing the same quantity of output all we get is an increase prices.
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