1. Stephen G. CECCHETTI Kermit L. SCHOENHOLTZ Money Growth, Money Demand, and Modern Monetary Policy Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter Twenty

2. 20-2 Introduction It would be easy to form a clear impression that 21st-century monetary policy has very little to do with money, despite its focus on inflation. Everyone talks about interest rates and exchange rates; no one talks about money. But you will find that central bankers and monetary economists do care about money. We see concern for money, too, in statements made by officials of the ECB.

3. 20-3 Introduction The FOMC, in July 2000, decided to stop publishing target ranges for the monetary aggregates. They explained that “these ranges [no longer] provide useful benchmarks for monetary policy.” The FOMC rarely makes any references to money in public announcements of the federal funds target rate.

4. 20-4 Introduction What accounts for the distinctly different treatment of money growth in the two largest central banks in the world? The goal of this chapter is twofold: 1.To examine the link between money growth and inflation in order to clarify the role of money in monetary policy, and 2.To explain the logic underlying central bankers’ focus on interest rates.

5. 20-5 Why We Care about Monetary Aggregates The single most important fact in monetary economics: The relationship between money growth and inflation rates. Panel A of figure 20.1 shows the average annual inflation and money growth in 150 countries over the 2 1/2 decades from 1981 to 2005.

6. 20-6 Why We Care about Monetary Aggregates Two things are striking: 1.Some countries suffered inflation of more than 500 percent a year for two decades. 2.Every country with high inflation has high money growth. Panel B shows the large number of countries with low inflation and low money growth. To avoid sustained episodes of high inflation, a central bank must be concerned with money growth. Avoiding high inflation means avoiding persistent rapid money growth.

7. 20-7 Why We Care about Monetary Aggregates

8. 20-8 Why We Care about Monetary Aggregates Figure 20.2 shows: Points lying about the 45-degree line represent countries where average inflation exceeds average money growth. Points lying below the 45-degree line represent countries where money growth exceeds inflation. In general, countries with very high inflation tend to lie above the line and countries with moderate to low inflation tend to fall below it.

9. 20-9 Why We Care about Monetary Aggregates

10. 20-10 Why We Care about Monetary Aggregates When the currency that people are holding loses value very rapidly, they will work to spend what they have as quickly as possible. Spending money more quickly has the same effect on inflation as an increase in money growth. By limiting the rate at which they purchase securities, policymakers can control the rate at which aggregates like M2 grow. It is impossible to have high, sustained inflation without monetary accommodation.

11. 20-11 Why We Care about Monetary Aggregates This is why the ECB pays close attention to growth in the money aggregates. But all money growth is not created equally. Something beyond just differences in money growth accounts for the differences in inflation across countries. Figure 20.1 suggests that money growth is a useful guide to understanding long-term movements in inflation. But what happens over shorter periods of a few months or years?

12. 20-12 A number of countries that were created following the collapse of the Soviet Union experienced very high levels of inflation. Because they had command economies, the state was involved in every aspect of economic life. Government expenditures were financed by printing money. To bring inflation under control, the authority to print money was turned over to an independent central bank.

13. 20-13 The CPI is the most commonly used and closely watched measure of inflation in the U.S. It tells us how much more it would cost today to purchase the same basket of goods and services that was bought on a fixed date in the past. However, the CPI systematically overstates inflation: By about 1 percentage point a year. This is a lot at low levels of inflation.

14. 20-14 What are the biases in the CPI? 1.Consumers’ buying patterns change all the time. Consumers shift their purchases away from goods that are relatively more expensive to those that are relatively cheaper. 2.There is significant difficulty taking into account improvements in the quality of goods and services included in the CPI.

15. 20-15

16. 20-16 The Quantity Theory and the Velocity of Money Thinking about the value or purchasing power of money in terms of the goods needed to get money makes the impact of inflation clear. We can think about how many dollars we need to buy a cup of coffee or a sandwich. We can turn the question around an ask: how many cups of coffee or sandwiches a person needs to buy one dollar. A fall in the number of cups of coffee it takes to buy one dollar represents a decline in the price, or value, of money.

17. 20-17 The Quantity Theory and the Velocity of Money The price of money is determined by supply and demand. Given steady demand, an increase in the supply of money drives the price of money down. That’s inflation. If the central bank continuously floods the economy with large amounts of money, inflation will reach very high levels.

18. 20-18 Velocity and the Equation of Exchange We need to focus on money as a means of payment. Consider 4 college students: One has $100 in currency; One has two tickets to the weekend football game, worth $50 each; One has $100 calculator; and One has a set of 25 high quality drawing pencils that sell for $4 each.

19. 20-19 Velocity and the Equation of Exchange The one with $100 buys the calculator. The person with the calculator now uses the $100 to buy the football tickets. The person with the football tickets now uses the $100 to buy the 25 pencils. The total value of the transactions is $300. In this 4-person economy, the $100 was used 3 times resulting in $300 worth of transactions.

20. 20-20 Velocity and the Equation of Exchange We can say that: the number of dollars used is the quantity of money in the economy; the number of times each dollar is used (per unit of time) is called the velocity of money; and the first times the second is the dollar value of transactions. The more frequently each dollar is used, the higher the velocity of money.

21. 20-21 Velocity and the Equation of Exchange We will focus on nominal gross domestic product (GDP). Every one of the purchases counted in nominal GDP requires the use of money. M is the quantity of money, V is the velocity and nominal GDP can be divided into two parts: The price level, P and the quantity of real output, Y.

22. 20-22 Velocity and the Equation of Exchange We can rewrite the previous equation as: This is called the equation of exchange, and tells us that the quantity of money multiplied by its velocity equals the level of nominal GDP. This provides the link between prices and money that we are looking for. However, we care about inflation and money growth.

23. 20-23 Velocity and the Equation of Exchange We can rewrite the equation to allow for the percentage change in each factor. Money growth plus velocity growth equals inflation plus real growth.

24. 20-24 The Quantity Theory of Money Irving Fisher wrote the equation of exchange and derived the implication above. He assumed that no important changes occur in payment methods or the cost of holding money. If the interest rate is fixed and there is no financial innovation, then velocity will be constant. He also assumed that real output is determined solely by economic resources and production technology, so it too is fixed in the short run.

25. 20-25 The Quantity Theory of Money He concludes that money growth translates directly into inflation, an assertion that is termed the quantity theory of money. We can reinterpret the quantity theory of money to describe the equilibrium between money demand and money supply. Money demanded (M d ) equals the total value of transactions divided by the velocity of money (V).

26. 20-26 The Quantity Theory of Money For the economy as a whole, the demand for money equals nominal GDP divided by velocity: The supply of money (M S )is determined by the central bank and the behavior of the banking system. Assuming velocity and real output are constant, we can conclude that money growth equals inflation.

27. 20-27 The Quantity Theory of Money The quantity theory of money accounts for some important characteristics of the patterns shown in Figure 20.1. 1.It tells us why high inflation and high money growth go together. 2.It explains the tendency for moderate- and low-inflation countries to fall below the 45- degree line in Panel B of Figure 20.1.

28. 20-28 The Quantity Theory of Money Money growth tends to be higher than inflation in those countries because they are experiencing real growth. If velocity is constant, then money growth equals the sum of inflation and real growth. At a given level of money growth, the higher the level of real growth, the lower the level of inflation. In countries that are growing, inflation will be lower than money growth, causing their economies to fall below the 45-degree line.

29. 20-29 The Facts about Velocity If the velocity of money is constant, it means the trend in real growth is determined by the structure of the economy and the rate of technological process. This means countries could control inflation directly by limiting money growth. This logic led Milton Freidman to conclude that central banks should simply set money growth at a constant rate. M1 and M2 should grow at a rate equal to the rate of real growth plus the desired level of inflation.

30. 20-30 The Facts about Velocity To make the rule viable, he suggested changes in regulations that would: Limit banks’ discretion in creating money, and Tighten the relationship between the monetary aggregates and the monetary base, reducing fluctuations in the money multiplier. For example, an increase in the reserve requirement or restrictions on the number and types of loans banks could make.

31. 20-31 The Facts about Velocity But Friedman’s recommendation that the central bank should keep money growth constant would stabilize inflation only if velocity were constant. In countries with high levels of inflation, changes in velocity can probably be safely ignored. But in countries where inflation rate is below 10% per year, changes in velocity could have a significant impact on the relationship between money growth and inflation.

32. 20-32 The Facts about Velocity Panel A of Figure 20.4 shows the velocity of M2 from 1959 to 2009. Over the long run, the velocity of M2 looks stable, ending at 1.72 - precisely where it began 50 years earlier. This confirms Fisher’s conclusion: in the long run, the velocity of money is stable, so that controlling inflation means controlling the growth of the money aggregates.

33. 20-33

34. 20-34 The Facts about Velocity But central bankers are concerned about inflation over months and quarters, not years. The monetary aggregates, even broad ones, can be useful guides to short-term policy only to the extent that they signal changes in inflation during the periods monetary policymakers care about. We can look at the four-quarter (short-run) percentage change in M2 velocity, shown in Panel B of Figure 20.4.

35. 20-35 The Facts about Velocity The shaded bars in the figure represent recessions. In the short run, velocity fluctuates quite a bit. The scale of the figure runs from -12 to +8 percent.

36. 20-36

37. 20-37 The Facts about Velocity Notice the increase in velocity in the late 1970s and early 1980s. This was a period of both high nominal interest rates and significant financial innovations. This included the introduction of stock and bond mutual funds that allow investors checking privileges. Together these reduced the amount of money individuals held for a given level of transactions, raising the velocity of money.

38. 20-38 The Facts about Velocity These data clearly suggest that fluctuations in the velocity of money are tied to changes in people’s desire to hold money. Policymakers must understand the demand for money.

39. 20-39 When it was first started, the ECB looked at money growth closely. Velocity appeared relatively stable. It created a reference value for money growth: Inflation = 1 to 2% Real Growth = 2 to 2½ % Velocity Growth =  ½ to -1% Money growth = 1½ % + 2¼ % - (-¾ %) = 4½ %. In 2003 the reference value was downgraded and today it is a long-run guide.

40. 20-40 The Transactions Demand for Money The quantity of money people hold for transactions purposes depends on their Nominal income, The cost of holding money, and The availability of substitutes. The higher people’s nominal income, the more they will spend, needing more money. The higher nominal income is, the higher nominal money demand will be.

41. 20-41 The Transactions Demand for Money Deciding how much money to hold depends on the costs and benefits. Benefits: Holding money allows people to make payments. The cost is based on opportunity cost. The interest that people lose in not buying an interest-bearing bond is the opportunity cost of holding money. The decision to hold money depends on how high the bond yield is and how costly it is to switch bank and forth.

42. 20-42 The Transactions Demand for Money For a given cost of switching, as the nominal interest rate rises, people reduce their checking account balance, shifting funds into and out of higher-yield investments. The higher the nominal interest rate, the higher the opportunity cost of holding money, the less money individuals will hold for a given level of transactions, and the higher the velocity of money.

43. 20-43 The Transactions Demand for Money This relationship explains why inflation tends to exceed money growth in the high-inflation countries shows in Panel A of Figure 20.1. At high levels of inflation, money is losing value very quickly. People respond to the high cost of holding money by keeping as little of it as possible. They purchase durable goods that have zero real return - better than negative return on currency.

44. 20-44 The Transactions Demand for Money Their frantic spending drives up the velocity of money. Because high inflation brings an increase in velocity, inflation must be higher than money growth in those countries. This places them above the 45-degree line in Panel A of Figure 20.1.

45. 20-45 The Transactions Demand for Money The transactions demand for money is affected by technology. Financial innovation allows people to limit the amount of money they hold. It reduces the cost of shifting funds from an interest-bearing bond to a checking account. This lowers the money holdings at a given level of income. This increases the velocity of your money.

46. 20-46 The Transactions Demand for Money Finally, we all hold money to insure ourselves against unexpected expenses. We call this the precautionary demand for money, as part of transactions demand. This rises with risk. The higher the level of uncertainty about the future, the higher the demand for money and the lower the velocity of money will be.

47. 20-47 Bankers joke that “free checking” is really “fee checking”. If you sign up for a bank account that is supposed to be free, be sure you know when you pay fees and when you don’t.

48. 20-48 The Portfolio Demand for Money As a store of value, money provides diversification when held along with a wide variety of other assets. The demand for bonds depends on several factors including: Wealth, The return relative to alternative investments, Expected future interest rates on bonds, Risk relative to alternative investments, and Liquidity relative to alternative investments.

49. 20-49 The Portfolio Demand for Money As wealth rises, the quantity of all these investments, including money, rises with it. A decline in bond yields will increase the portfolio demand for money. When interest rates rise, bond prices drop and bondholders suffer a capital loss. If you think interest rates are likely to rise, bonds will become less attractive than money to you. When interest rates are expected to rise, money demand goes up.

50. 20-50 The Portfolio Demand for Money If a sudden decrease in the liquidity of stocks, bonds, or other assets occurred, we would expect to see an increase in the demand for money. Table 20.1 summarizes all of the factors that increase the demand for money.

51. 20-51 The Demand for Money

52. 20-52 Targeting Money Growth in a Low-Inflation Environment The only solution to high inflation is to reduce money growth. In a low-inflation environment, controlling inflation is not so simple. The quantity theory of money tells us that our ability to use money growth as a policy guide depends on the stability of the velocity of money. Velocity is stable in the long-run but not in the short-run.

53. 20-53 Targeting Money Growth in a Low-Inflation Environment There are two criteria for the use of money growth as a direct monetary policy target: 1.A stable link between the monetary base and the quantity of money and 2.A predictable relationship between the quantity of money and inflation. The first of these allows policymakers to predict the impact of change in the central bank’s balance sheet on the quantity of money.

54. 20-54 Targeting Money Growth in a Low-Inflation Environment The second allows them to translate changes in money growth into changes in inflation. Central bankers need numerical estimates of these relationships. The relationship between money demand and its determinants listed in Table 20.1 must be stable and predictable -- a problem for U.S. policymakers.

55. 20-55 The Instability of U.S. Money Demand To study the demand for money quantitatively, we will focus on the impact of the two factors that affect the transactions demand for money: Nominal income, and Interest rates. Nominal income is roughly proportional to money demand. Double nominal income means doubling the dollar value of the transactions they engage in, so doubling the original amount of money.

56. 20-56 The Instability of U.S. Money Demand Is there a stable relationship between the velocity of money and the opportunity cost of holding it? Figure 20.5 shows the velocity of M2 on the vertical axis and the opportunity cost of holding M2 on the horizontal axis. The opportunity cost of M2 is defined as the yield on three-month U.S. Treasury bill minus the return on holding M2.

57. 20-57 The Instability of U.S. Money Demand The opportunity cost is a measure of the real return that individuals give up when they decide to hold M2 rather than a three-month Treasury bill. They fall into two distinct groups. 1.The first covers the decade of the 1980s. 2.The second covers the 1990s through 2009.

58. 20-58 The Instability of U.S. Money Demand

59. 20-59 The Instability of U.S. Money Demand There is a relationship between the velocity of money and the opportunity cost of holding money. But the relationship shifted quite a bit between the two decades. Using the relationship from the 1980s as a basis for policymaking in the1990s and thereafter would not have produced the desired result.

60. 20-60 The Instability of U.S. Money Demand What caused the instability of money demand over these three decades? One reason has to do with the introduction of financial instruments that paid higher returns than money but could still be used as a means of payment. While officials have tried to account for the new instruments by changing the composition of the monetary aggregates, money demand continues to appear unstable.

61. 20-61 Making policy is about numbers. This means using statistical models. The problem is that when policymakers change the way they make policy, everyone changes the way they act: the Lucas critique. Following changes in policy regime, old models may be a poor guide for future policy.

62. 20-62 Financial innovations influence the velocity of money by changing the amount of money people need to hold at a given level of income. This creates serious difficulties for statisticians who are trying to construct useful definitions of the monetary aggregates. The real difficulty is calculating the impact of such changes as they are occurring so that the information can be used for short-run policymaking.

63. 20-63

64. 20-64 The Instability of U.S. Money Demand A second explanation has to do with changes in mortgage refinancing rates. As long-term interest rates fell throughout the 1900s, they spurred periods of intense activity in the mortgage market. When mortgage interest rates fall dramatically, large numbers of people pay off their old, high- interest rate mortgages and replace them with new, low-interest mortgages.

65. 20-65 The Instability of U.S. Money Demand When a mortgage is refinanced, it created demand for money in several ways. Some of their equity in the home is removed the proceeds of which go into liquid deposit accounts. Funds for the new mortgage must be collected from investors and transferred to holders of the old mortgage. They flow through an account that is part of M2. Once interest rates stabilize, M2 settles down but in the meantime velocity fluctuates.

66. 20-66 Targeting Money Growth: The Fed and the ECB Though today virtually no central bank targets money growth, the practice was common in the 1970s. In the U.S., the Federal Reserve Board had to make quarterly appearances to testify to the Fed’s money growth targets for the coming year. But announcing an objective is one things; achieving it is something else. The FOMC rarely hit its money growth targets.

67. 20-67 Targeting Money Growth: The Fed and the ECB Finally in July 2000, the committee stopped publishing them. Policymakers could have hit their money growth targets, but doing so would have meant adjusting the federal funds rate target frequently, and by large amounts. This is something policymakers are unwilling to do.

68. 20-68 Targeting Money Growth: The Fed and the ECB The ECB’s Governing Council periodically announces a money growth rate that is intended to serve as a long-run reference value. The difference of opinion between the Fed and the ECB on this matter can be traced to their divergent views on the stability of money demand. Researchers who study the demand for money in the euro-area have concluded that it is stable, which implies that changes in velocity are predictable.

69. 20-69 Targeting Money Growth: The Fed and the ECB

70. 20-70 Targeting Money Growth: The Fed and the ECB While short-run fluctuations in velocity were significant, European policymakers point to the tendency of velocity to return to its long-run downward trend over periods of a few years. The ECB and the Fed have both chosen interest rates as their operating target. Interest rates are the link between the financial system and the real economy.

71. 20-71 Targeting Money Growth: The Fed and the ECB By keeping interest rates stable, policymakers can insulate the real economy from disturbances that arise in the financial system. While inflation is tied to money growth in the long run, interest rates are the tool policymakers use to stabilize inflation in the short-run.

72. 20-72 Targeting Money Growth: The Fed and the ECB Figure 20.8 shows a period of time when the FOMC used reserves to target money growth, allowing the federal funds rate to fluctuate. The shaded area represents the period when the FOMC targeted the quantity of money. Notice how volatile the interest rate was during that three-year period. Realizing this, policymakers have turned to the only variable alternative - targeting and smoothing fluctuations in interest rates.

73. 20-73 Targeting Money Growth: The Fed and the ECB

74. 20-74 Does money have a role in monetary policy? The Fed says no, while the ECB says yes. This article suggest that even in low-inflation economies, money growth can provide information about stress in the financial system. This debate over the role of money in monetary policy will likely continue for some time.

75. Stephen G. CECCHETTI Kermit L. SCHOENHOLTZ Money Growth, Money Demand, and Modern Monetary Policy Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin End of Chapter Twenty