Money, Output, and Prices

M1 Money SupplyCPI (1987=100) Over the long term, money is highly positively correlated with prices, but uncorrelated with income

% Deviations from Trend Over shorter time frames, money is highly positively correlated with income, but less so with prices

Over shorter time frames, money is highly negatively correlated with interest rates,

Generally Speaking…. Money demand is a function of income, interest rates, and transactions costs Real Money Demand Real Income (+) Nominal Interest Rate (-) Transactions Costs (Cost of obtaining money) (+)

A common form of money demand can be written as follows: 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

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 cant control this, but can influence it MB M3 M2 M1 The Federal Reserve can perfectly control the monetary base (cash + bank reserves) Discount Window Loans Open Market Operations Reserve Requirement

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 mm = 1 + Cash Deposits Cash Deposits Reserves Deposits + Change in M2= mm2 * Change in MB mm2 = 1 + Cash Deposits Cash Deposits Reserves Deposits + M2-M1 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 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) Usually assumed Constant Grows at a constant rate independent of money supply Money growth determined by the Fed/Banks Therefore, in the long run, Inflation Rate = Money Growth – Economic Growth

In the short run, Prices are considered fixed. ConstantAdjusts to changing money supply Money growth determined by the Fed/Banks 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 Interest Rate (i) Ms Real Money M P Md(y,t) 5% Suppose that the Fed increases the supply of money by 10% 10% 4% In the short run, prices remain constant, while the interest rate drops. 10% In the long run, prices rise by 10%, returning real money supply to its initial level

Changes in income… Interest Rate (i) Ms Real Money M P Md(y,t) 5% Suppose that an increase in productivity raises household incomes by 10% 6% In the short run, while prices remain fixed, the increase in money demand raises interest rates In the long run, falling prices raises real money supply lowering interest rates How could the Fed prevent this drop in prices?

Changes in transaction costs… Interest Rate (i) Ms Real Money M P Md(y,t) 5% Suppose that ATMs reduce the demand for money In the short run, the drop in money demand lowers interest rates How could the Fed prevent this rise in prices? In the long run, prices rise – lowering real money supply and returning interest rates to their long run level 4%

Adding capital markets… Interest Rate (i) S I + (G-T) 5% Loanable Funds Household savings provides the supply of funds Investment plus the government deficit represent the demand for funds We need both capital markets AND money markets to clear at the same time….the interest rate cant do this by itself!!

Capital/Money Markets – Short Run i S I + (G-T) 5% Loanable Funds Initially, both markets are in equilibrium. Now, suppose that the Fed increases the money supply by 10%. i Ms 5% M P Md 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 S I + (G-T) 5% Loanable Funds i Ms 5% M P Md 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 Phillips curve In TheoryIn Practice

Money Demand Shocks i S I + (G-T) 5% Loanable Funds i Ms 5% M P Md 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 S I + (G-T) 5% Loanable Funds i Ms 5% M P Md 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 S I + (G-T) 5% Loanable Funds i Ms 5% M P Md 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 Commodity prices are slow to adjust Interest rates are determined in money/capital markets Interest rates determine demand, which determines supply Long Run Real Interest rates tend to be constant Demand is determined by 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 Growth = Productivity Growth + (2/3)Employment Growth + (1/3)Capital Growth In the Long Run, Capital Growth = Employment Growth GDP Growth = Productivity Growth + Employment Growth 2%1.5%

GDP Growth = Productivity Growth + Employment Growth 2%1.5% Supply, Demand, and Inflation If demand grows faster than 3.5%, the one (or both) of the following occurs: Demand Pull 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…… Cost Push Inflation 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 S I + (G-T) 5% Loanable Funds i Ms 5% M P Md 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? i S I + (G-T) 5% Loanable Funds i Ms 5% M P Md Case #1: High oil prices lowers demand (consumer and investment)

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? i S I + (G-T) 5% Loanable Funds i Ms 5% M P Md Case #2: High oil prices generates inflationary expectations