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Tools of Analysis

Exploring • velocity of • quantity theory of money • equation of exchange (effects of increased )

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Quantity Theory of Money The Tools of Analyses AKA: Crude Quantity Theory of Money Naïve Theory of Money GDP Velocity of Money: V = This is a classical perspective regarding the value of m money supply money. Example: Imagine the The Theory GDP is $500.00, 500 V = yet the money supply 50 Price levels are directly proportional to the money is only $50.00… Therefore, supply. As more money becomes available, prices will Each dollar MUST have simply increase. V = 10 been spent 10 times! Ergo… if the money supply doubles, prices will double.

supplemental supplemental Fisher Equation of Exchange The Perspective AKA “Equation of Exchange”

Recall that classical economists believed the economy Irving Fisher would tend to operate at, or near, full capacity. MV = PQ Average Price Money Supply times the Therefore, classical economists did not consider the times the Quantity of Units level of economic activity to be a variable factor that Velocity of Money Sold might influence prices. Thus, $50.00 spent 10 times each is sufficient to buy Thus, classical economists had no choice other than to $5.00 items that are purchased 100 times believe that price changes that endure over the long-run $50.00 x 10 = $5.00 x 100 must be the result of changes in the money supply! $500.00 = $500.00

The Equation of However, the interesting question is this: If we In other words, Exchange is in fact increase the money supply (on the left side of will nominal a tautology… the equation), then what will change on the GDP increase, right side of the equation? Will prices increase, or will real … it must be true. will the quantity of units sold increase, or GDP increase? perhaps a bit of both?

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To illustrate, imagine a small island nation with a money Scenario A Scenario B Scenario C supply of $5 and a velocity of 2. It would have a GDP of $10 ($5 x 2). Price Price Price Level Level Level Let us also assume that only one item is produced on this island ( SRAS SRAS SRAS

hmmm…let’s say margaritas), at $1 a piece. That means 10 were made P2 ($1 x 10 units equals our $10 GDP). P AD 1 2

If the money supply were increased to $6 and velocity is unchanged, P2 AD1 P P 1 then economic activity would have to move to $12 ($6 x 2). 1&2

AD1 AD2 AD1 AD2 So then, what are the possible results? Y Y Y Y 1 2 Y* Real 1 2 Y* Real Y1&2 Real GDP GDP GDP A) 12 margaritas are sold at $1.00 each, producing $12 of GDP In scenario A: where national income is within the horizontal (aka Keynesian) B) 11 margaritas are sold at $1.09 each, producing $12 of GDP range, the economy can expand without driving up input or output prices. Thus, real GDP increases while prices stay constant. C) 10 margaritas are sold at $1.20 each, producing $12 of GDP In scenario B, where national income is within the intermediate range, there Thus, there are three ways P and Q can respond to a change in the money is some room for more production but some markets are so tight that prices supply: rise. Thus, real GDP increases a little while prices increase a little as well. 1. output can change in isolation, 2. both prices and output can change to varying degrees, or In scenario C, where national income is within the vertical (aka classical 3. prices can change in isolation. range) output is at full employment GDP (Y*). Therefore, additional demand will only drive prices up, while real GDP will remain unchanged. Why three possible outcomes? Let’s look at three different AS curves.

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Scenario A Easy money? Keynes’ Liquidity Trap! Price MS1 MS2 MS3 Level SRAS It’s not that Interest Keynes believed that in times of low easy! economic output the government could actually shoot itself in the foot by NominalRate of increasing the money supply. Why? 1. Yes, it is true that increasing the P1&2 MD money supply will indeed reduce interest AD AD 1 2 rates. Y Y 1 2 Y* Real John Maynard Keynes GDP 2. However, lower interest rates (in times Quantity of of very low output) will just encourage Money So then, it looks like Keynes should support monetary expansion people to hold their money – neither during times of recession. spending nor saving (in banks or bonds).

But he doesn’t! Keynes supported fiscal policy to stimulate the If interest rates are too low, people will just hold their money! economy, not ! That’s right! If interest rates fell low enough the economy could fall into a partial liquidity trap, where decreased interest rates just encourage more Why? holding of money, or even a complete liquidity trap – where the money demand curve becomes completely elastic (horizontal), and people We will need to look at his liquidity preference model (aka the will hold all quantities of money at such a low . money market model) to understand why.

supplemental supplemental Classical Crowding Out Scenario C Market for Loanable Funds S Price Leave the 2 Classical economists believe that Level SRAS economy alone, S if the government tries to stimulate

P Interest 2 you’ll just make aggregate demand by spending then things worse! RealRate of they will essentially drive up interest P1 AD2 r rates, thus crowding out consumption AD 2 1 and investment spending. Why?

r Adam Smith 1 1. Yes, it is true that government spending will indeed increase GDP. D2 Y1&2 Real GDP 2. However, higher output will create D greater demand for money (to buy Clearly, classical economists would be against monetary things). Q expansion because they felt it would just cause . Quantity of 3. This higher output will also create Loanable Funds sudden inflation, reducing the “real” However, they didn’t like Keynes’ idea of fiscal stimulation either! money supply.

Why? Thus, the increased demand for money combined with the decreased “real” money supply will cause an increase in interest rates that will be We will need to look at the classical loanable funds model to severe enough to reduce consumption and investment spending by either a portion of the government spending (partial crowding out) or even by understand why. as much as the original government spending (complete crowding out).

2 supplemental supplemental A Critical Spectrum Monetarism Adam While KeynesianJohn AKA: New Quantity Theory of Money Thus, classicalSmith thinkers thinkers will tendMaynard to will tend to focus on focus on fiscal policy monetary policy because because they believeKeynes This is the renewed classical perspective regarding the they believe fiscal policy monetary policy will will just cause just cause a value of money, but it takes changing domestic income crowding out! liquidity trap! AND a changing velocity of money into consideration. Wow! So monetarists believe the money supply will actually influence Classical View of Fiscal Policy Keynes’ View of Monetary Policy the size of the GDP!!! The Theoretical Perspective If the government tries to stimulate If the government tries to stimulate Monetarism is a school of economic thought aggregate output by increasing the aggregate output by spending: that holds that the money supply is the main money supply: Born 1912, • GDP will increase by even more because Brooklyn, N.Y. determinant of economic activity. In other of the multiplier • the increased money supply may lower Laissez-faire interest rates, but this will just cause economist, words, if the money supply is growing, the • higher output creates greater demand for people to hold onto their money professor at the entire economy will grow in nominal terms. money (to buy things) University of • the interest rates will fall so low that the Chicago, Therefore, if the money-supply is accelerating, • higher output creates sudden inflation, awarded the economy will fall into a liquidity trap – Nobel Prize for then so will nominal economic growth. reducing “real” money supply where the demand for money becomes Economics in 1976. • á demand for money and â real money completely elastic (horizontal), and Monetarism stresses the relationship between supply causes such high interest rates that people will hold all quantities of money at interest-sensitive expenditure decreases by such a low interest rate. Monetarism's leading the money supply and nominal income instead as much (or more) than the government advocate is economist of the relationship between the money supply • thus, changing the money supply will no . spending (complete “crowding out”) longer affect the interest rate and price level.

supplemental supplemental Friedman's k-Percent Rule Monetarist Equation of Exchange: Central to monetarism is the equation MV = PQ. Friedman's k-percent rule is the monetarist proposal that the M is the money supply; V is velocity (the number of times per year the money supply should be increased by the by a constant average dollar is spent); P is prices of goods and services; and Q is percentage rate every year, irrespective of fluctuations in the quantity of goods and services. business cycle! The equation suggests that if V is constant and M is increasing, then According to Milton Friedman, "The stock of money [should be] there must be an increase in either Q or P. Accordingly, monetary policy makers can control inflation by allowing the money supply (M) to grow increased at a fixed rate year-in and year-out without any variation in no faster than the desired rate of economic growth (Q). the rate of increase to meet cyclical needs." Milton Friedman (1960), A Program for Monetary Stability (New York: Fordham University Press). Average Price Money M = (1/V) (P x Q) times the Supply Quantity of Units

Giving governments any flexibility in setting money growth will lead to Produced inflation according to Friedman. The main policy to be avoided is countercyclical monetary policy which was the standard Keynesian 1 divided by the policy recommendation at the time (i.e. automatic or discretionary velocity of money stabilizers that would cool the economy down when it’s hot or heat it Income (Simply = (1/V) (P x Q) up when it’s cold). Money M = k Y Average Price Supply times the 00 Quantity of Units = (1/10) (5 x 100. ) For this reason, the central bank should be forced to expand the Produced 00 money supply at a constant rate that is equivalent to the rate of The proportion that = (0.1) ($500. ) money is of national growth of real GDP. income. 00 Not to be confused with the “Friedman Rule,” which is a policy of zero nominal interest rates. = $50.

supplemental supplemental Monetarism: What’s the Difference between the Crude Quantity Theory of Money (Fisher’s Equation of Exchange) and the Monetarist’s A Mild Retreat – Not a Complete Defeat Equation of Exchange? This renewed classical perspective does not represent a In the final analyses, the equation of exchange emphasizes the effect that the money supply will have on Net Income… complete about-face from the previous classical perspective (ie. crude quantity theory of money). Income (Simply Money M = k Y Average Price Supply times the Whereas the crude quantity theory of money stated that Equation of Quantity of Units Produced increases in the money supply would simply increase Exchange: The proportion that inflation, monetarism suggests that, along with inflation, money is of national income. nominal income will also grow - thus mitigating the ill effects of inflation. as opposed to emphasizing the effect that the money supply will have on prices…

MV = PQ Average Price Fisher Money Supply times the Equation times the Quantity of Units of Velocity of Money M = P Produced Exchange:

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