Money, Output, and Prices Classical vs. Keynesians

What is Money?

Is this money?

Is this money?

What is Money? We normally think of currency when we think of money. However, more generally speaking, money is any commodity which satisfies the following: –Unit of account

What is Money? We normally think of currency when we think of money. However, more generally speaking, money is any commodity which satisfies the following: –Unit of account –Store of Value

What is Money? We normally think of currency when we think of money. However, more generally speaking, money is any commodity which satisfies the following: –Unit of account –Store of Value –Medium exchange

Commodity money vs. Fiat Money

In a commodity money system, the chosen “medium of exchange” has real, intrinsic value (gold, silver, etc.)

Commodity money vs. Fiat Money In a commodity money system, the chosen “medium of exchange” has real, intrinsic value (gold, silver, etc.) With a fiat money system, the chosen medium of exchange has no intrinsic value (paper currency)

Commodity money vs. Fiat Money In a commodity money system, the chosen “medium of exchange” has real, intrinsic value (gold, silver, etc.) With a fiat money system, the chosen medium of exchange has no intrinsic value (paper currency) Fiat money is accepted because of faith!

Standard Definitions of Money

Monetary Base (M0): Direct liabilities of the central bank –Currency in circulation + Bank Reserves

Standard Definitions of Money Monetary Base (M0): Direct liabilities of the central bank –Currency in circulation + Bank Reserves M1: –Currency in circulation + Traveler's Checks + Checking accounts

Standard Definitions of Money Monetary Base (M0): Direct liabilities of the central bank –Currency in circulation + Bank Reserves M1: –Currency in circulation + Traveler's Checks + Checking accounts M2: –M1 + Savings accounts + Money Market Accounts + Small Time Deposits

Standard Definitions of Money Monetary Base (M0): Direct liabilities of the central bank –Currency in circulation + Bank Reserves M1: –Currency in circulation + Traveler's Checks + Checking accounts M2: –M1 + Savings accounts + Money Market Accounts + Small Time Deposits M3: –M2 + Large Time Deposits + Eurodollars

Money Supply in the US Currency in Circulation: $690B Monetary Base: $732B M1: $1.269T M2: $6.015T M3: $8.760T

Money Supply in the US

Money and Prices in the US

Real Personal Income

Real Personal Income & Monetary Base

Real Personal Income & M1

Real Personal Income & M2

Real Personal Income & M3

Money and the Business Cycle Money is procyclical and leads the cycle

Money and the Business Cycle Money is procyclical and leads the cycle The money/income relationship is probably the most widely debated issues in macroeconomics

Money and the Business Cycle Money is procyclical and leads the cycle The money/income relationship is probably the most widely debated issues in macroeconomics Keynesian economists argue that money causes output (ie, the Fed can stimulate the economy through monetary policy)

Money and the Business Cycle Money is procyclical and leads the cycle The money/income relationship is probably the most widely debated issues in macroeconomics Keynesian economists argue that money causes output (ie, the Fed can stimulate the economy through monetary policy) Classical economists (supply side) argue that output causes money (i.e., the Fed responds to the economy rather than the economy responding to the Fed)

Neoclassical Economics Classical economists assume that all prices are free to adjust to any new information and markets clear

Neoclassical Economics Classical economists assume that all prices are free to adjust to any new information and markets clear Therefore, output is completely determined by conditions in labor/capital markets (a.k.a, the real economy) – independent of money supply (i.e., “money is neutral” )

Neoclassical Economics Classical economists assume that all prices are free to adjust to any new information and markets clear Therefore, output is completely determined by conditions in labor/capital markets (a.k.a, the real economy) – independent of money supply (i.e., “money is neutral” ) Given a fixed level of output, along with money demand, the supply of money determines the price level

Neoclassical Money Demand It is assumed that households choose to hold a fraction of their nominal income in the form of cash (or a checking account)

Neoclassical Money Demand It is assumed that households choose to hold a fraction of their nominal income in the form of cash (or a checking account) Money Demand = k* PY

Neoclassical Money Demand It is assumed that households choose to hold a fraction of their nominal income in the form of cash (or a checking account) Money Demand = k* PY For example, suppose that National Income is $8T. If the average household chooses to hold 10% of their income in the form of cash, what is aggregate money demand?

Neoclassical Money Demand It is assumed that households choose to hold a fraction of their nominal income in the form of cash (or a checking account) Money Demand = k* PY For example, suppose that National Income is $8T. If the average household chooses to hold 10% of their income in the form of cash, what is aggregate money demand? Money Demand = (.1)($8T) = $800B

Money Market Equilibrium The aggregate price level will adjust so that money supply equal money demand

Money Market Equilibrium The aggregate price level will adjust so that money supply equal money demand M = Money Demand = k*PY

Money Market Equilibrium The aggregate price level will adjust so that money supply equal money demand M = Money Demand = k*PY Solving the above expression for price gives us P = M/(kY)

What affects ‘k’? Interest rates: Cash is a non interest bearing asset. As interest rates rise, households hold less cash (k decreases)

What affects ‘k’? Interest rates: Cash is a non interest bearing asset. As interest rates rise, households hold less cash (k decreases) Transaction costs: As the cost of acquiring cash rises, households hold more cash to economize on transaction costs.

Money Demand and the Quantity Theory of Money An alternative way of expressing the previous expression is MV = PY Where ‘V’ is the velocity of money (V = 1/k) This is known as quantity theory of money

Velocity of M1:

Velocity of M2:

Velocity of M3:

What caused the change in money velocity? Interest Rates

Fed Funds Rate:

What caused the change in money velocity? Interest Rates: –During the 80’s when interest rates were falling, consumers switched into checkable deposits. –During the 90’s as interest rates rose, consumers switched into interest bearing accounts

What caused the change in money velocity? Interest Rates: –During the 80’s when interest rates were falling, consumers switched into checkable deposits. –During the 90’s as interest rates rose, consumers switched into interest bearing accounts Financial innovation and deregulation significantly lowered the cost of holding less liquid assets

Implications of the Quantity Theory

In the long run, velocity is relatively constant. Therefore, a country’s inflation rate is equal to Inflation = Money Growth – Output Growth In the short run, the price level is equal to P = M/(kY)

Money and the Business Cycle Recall that money is procyclical (and leads the cycle). How would neoclassical economics explain this fact?

Money and the Business Cycle Recall that money is procyclical (and leads the cycle). How would neoclassical economics explain this fact? Given the formula P = M/(kY), if the money supply stays constant, prices would fall during an expansion.

Money and the Business Cycle Recall that money is procyclical (and leads the cycle). How would neoclassical economics explain this fact? Given the formula P = M/(kY), if the money supply stays constant, prices would fall during an expansion. Therefore, to maintain a constant price level, the fed reacts to rising output by increasing the money supply (hence, rising output causes an increase in money!)

Keynesian Economics Keynesian economists begin with the same money demand (MV = PY), but that money can influence real output in the short run.

Keynesian Economics Keynesian economists begin with the same money demand (MV = PY), but that money can influence real output in the short run For example, suppose that the federal reserve increases the money supply by 10%. (Assume that V is constant)

Keynesian Economics Keynesian economists begin with the same money demand (MV = PY), but that money can influence real output in the short run For example, suppose that the federal reserve increases the money supply by 10%. (Assume that V is constant) –Classical: Output remains constant, prices rise by 10%.

Keynesian Economics Keynesian economists begin with the same money demand (MV = PY), but that money can influence real output in the short run For example, suppose that the federal reserve increases the money supply by 10%. (Assume that V is constant) –Classical: Output remains constant, prices rise by 10%. –Keynesian: Output rises, prices rise by less than 10% in the short run.

Keynesian Economics Keynesian economists begin with the same money demand (MV = PY), but that money can influence real output in the short run For example, suppose that the federal reserve increases the money supply by 10%. (Assume that V is constant) –Classical: Output remains constant, prices rise by 10%. –Keynesian: Output rises prices rise by less than 10% in the short run The key to Keynesian economics is that some prices are fixed in the short run. This allows the fed to affect relative prices (in particular, the real wage)

“Sticky Wages” Suppose that nominal wages are fixed in the short run

“Sticky Wages” Suppose that nominal wages are fixed in the short run Most wage contracts are negotiated annually Minimum wage is adjusted infrequently Efficiency wages

“Sticky Wages” Suppose that nominal wages are fixed in the short run Most wage contracts are negotiated annually Minimum wage is adjusted infrequently Efficiency wages If the fed increases the money supply, prices rise, but the nominal wage remains constant.

“Sticky Wages” Suppose that nominal wages are fixed in the short run Most wage contracts are negotiated annually Minimum wage is adjusted infrequently Efficiency wages If the fed increases the money supply, prices rise, but the nominal wage remains constant. As the real wage (W/P) falls, labor becomes cheaper. Firms hire more labor – this raises employment and output.

“Sticky Prices” The classical model assume that producers respond to increases in money by instantly raising their prices. Suppose that it is costly to raise prices (menu costs)

“Sticky Prices” The classical model assume that producers respond to increases in money by instantly raising their prices. Suppose that it is costly to raise prices (menu costs) Therefore, when the fed increases the money supply, producers respond to this increase in demand by increasing production rather than increasing prices. To hire more labor, they must bid up the price (W increases).

“Sticky Prices” The classical model assume that producers respond to increases in money by instantly raising their prices. Suppose that it is costly to raise prices (menu costs) Therefore, when the fed increases the money supply, producers respond to this increase in demand by increasing production rather than increasing prices. To hire more labor, they must bid up the price (W increases). As with the previous example, employment and output rise. However, here the real wage (W/P) increases

Implications of Keynesian Economics In the long run, prices are flexible and, therefore, money is neutral. However, in the short run, some prices are fixed. This allows the fed to affect real output.

Implications of Keynesian Economics In the long run, prices are flexible and, therefore, money is neutral. However, in the short run, some prices are fixed. This allows the fed to affect real output. Note that there is a natural tradeoff between inflation and unemployment (the fed can lower unemployment in the short run by increasing the money supply, but ultimately, prices will rise). This is known as the Phillips curve

The Phillips Curve

Money and the Business Cycle Keynesian economics takes the exact opposite stance on the money/output relationship. Increases in output are caused by increases in the money supply.

Money and the Business Cycle Keynesian economics takes the exact opposite stance on the money/output relationship. Increases in output are caused by increases in the money supply. Which explanation is the correct one?

Money and the Business Cycle Keynesian economics takes the exact opposite stance on the money/output relationship. Increases in output are caused by increases in the money supply. Which explanation is the correct one? Probably both!

Money and the Business Cycle The sticky wage model has some real problems.

Money and the Business Cycle The sticky wage model has some real problems. –Most labor contracts are indexed for inflation –A very small fraction of the population is working for minimum wage (3% of all workers work for minimum wages) –The sticky wage model implies a countercyclical real wage which is counterfactual.

Money and the Business Cycle The sticky wage model has some real problems. –Most labor contracts are indexed for inflation –A very small fraction of the population is working for minimum wage (3% of all workers are at or below minimum wage) –The sticky wage model implies a countercyclical real wage which is counterfactual. The sticky price model is empirically valid (i.e., it predicts a procyclical real wage). However, it relies on excess capacity (i.e., when the fed increases the money supply there needs to be jobs available)

Capacity Utilization Capacity utilization measures the percentage of a country’s productive capacity that is currently in use.

Capacity utilization in the US

Money and the Business cycle An economy with a very low rate of capacity utilization would probably respond according to the Keynesian version of the world. (increasing the money supply increases employment) An economy with a very high rate of capacity utilization will probably respond like the classical version (increasing the money supply creates inflation).