Ec 123 Section 1 1

Ec 123 Section 1

• THIS SECTION

– The Quantity Equation of Money

– Case: The U.S. Financial Crisis of 1931

• NEXT

– National Income Accounting

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The Quantity Theory of Money

The quantity equation of money relates the money in circulation (M) to the price level (P) and annual output (Q).

MV PQ

V is known as the velocity of money. It is equal to the average number of times a dollar is used during the year.

The quantity equation is an accounting identity (true by definition) but what you use for M (M1 or M2) can affect V number.

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Monetarism

• Monetarist's view of money's impact on economy can be represented in the quantity equation framework

MV = PQ,

• Increases in V imply individuals and firms are less willing to hold cash. Opposite for decrease in V.

• Monetarists claim that, under normal circumstances, V is stable (or grows at predictable rate).

• Changes in V can be attributed to

– financial innovation– change in interest rates

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Monetarism

Big policy implication: If V is stable, then the only way to change nominal GDP (=PQ) is through changes in the money supply.

• In the long run, changes in M effect only the price level, P.

• BUT in the short run changes can effect both P and real income, Q, because it takes people time to adjust their decisions to changes in the money supply.

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The Fed: Institutional overview

• Federal Reserve System created in 1913.

• Decentralized power structure

– 12 Districts

– New York has dominant position on FOMC

• Major responsibilities

“…to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.”

- Federal Reserve Act, 1913

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The Fed: Monetary Policy (Pre 1933)

• Real Bills Doctrine

– 40% of assets must be GOLD

– Other assets must be “productive credit”

• Discount Window Borrowing

– At the discretion of the regional Fed

– Primary monetary policy tool

What is the motivation for these policies?

What is the cost of these policies?

The Fed’s Balance Sheet and the Real Bills Doctrine

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GOLD

Productive Loans

Assets

40% Required

Free Gold

Currency in Circulation

Liabilities

Currency in Circulation

Demand Deposits

M1Determined by multiplier

Govt. Sec.

GOLD

Productive Loans

Assets

Govt. Sec.

40% Required

Currency in Circulation

Liabilities

Currency in Circulation

Demand Deposits

M1Determined by multiplier

Currency in Circulation

Demand Deposits

M1Determined by multiplier

External GOLD drain

Drop in M1 due to external drain

Drop in M1 due to internal drain

Internal drain due to increased leakages lowering the multiplier

Monetary policy tools available to the Fed(Pre 2008)

• Change reserve requirement ratio (hardly ever used)

• Change discount rate (sometimes)

– Short term, secured loans to banks (1 day but now can be 30 days)

– At a higher interest rate than the Fed Funds rate (lowered difference)

– Negative Stigma associated with bank usage

• Open market operations (most commonly used today)

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Open Market Operations

Securities

Fed Public thus M increasesMoney

Securities

Open Market Purchase

Fed Public thus M decreasesMoney

Open Market Sale

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The Fed’s experience during the 1920’s

• In response to a severe 1920 recession the Fed raised the discount rate to stem the loss of “free gold.” In the Fed’s view

– the recession was caused by international forces beyond Fed control

– recession “cleansed” the economy for vigorous expansion.

• In 1927, the Fed helped the U.K. back to a gold standard

– used open market operations to expand the money supply

– lead to higher inflation and lower interest rates

– sterling pound appreciated relative to the dollar

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Changes in the money supply 1928-33

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The role of money in causing the Great Depression

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Monetary policy tools available to the Fed(TODAY)

• Change reserve requirement ratio (hardly ever used)

• Change discount rate (sometimes)

• Open market operations (most commonly used today)

• Term Auction Facility

– Auction for short term (30 day) secured loans to banks

– Bidding starts at the Fed Funds interest rate.

– First auction was December 2008.

• The kitchen sink….

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U.S. Financial Crisis of 1931: Summary

• The quantity equation of money is an accounting identity linking money to the larger economy.

• Monetarism implies that careful control of the money supply is sufficient to stabilize the economy (PQ).

• Money multiplier story. Fed doesn't set the money supply, but does have a heavy influence.

• The goals and organization of the Fed are critical to the conduct of monetary policy.

• One’s understanding of how the money supply influences the economy is crucial to the evaluation of monetary policy.