1. Monetary Policy and the Economy
Quantity Theory of Money
Aggregate Demand Approach
Monetary Policy and the Long-Run
The Policy Debate

2. Question: How does changes in the nation’s money supply affect macroeconomic conditions (GDP, inflation, unemployment)?
Two approaches to thinking about this:
(i) Quantity theory of money (“Monetarism”)
(ii) Demand-Side (“Keynesian”)

3. Quantity Theory Approach
The equation of exchange is always true:
MV = PY
M = nominal money supply
P = price level
Y = real GDP
V = velocity of money 

4. The velocity of money is the average number of times a dollar is spent to buy goods and services:
M x V = $ value transactions
 V = $ value transactions/M
For the entire economy, $ value of transactions can be approximated by nominal GDP = PY:
V = PY/M

5. The quantity theory of money says that if V is constant, then there is a direct relationship between nominal GDP and the nominal money supply:
Nominal GDP = M x (constant)
PY = M x (constant)
If there is an M, then do we get
Case (1): Y?
Case (2): P?

6. Problems:
(1) How can we distinguish between effect of M on Y versus P?
(2) Historically V is not constant (for M1).

7. The Velocity of Circulation in the United States: 1930–1999
Instructor Notes:
1) The velocity of circulation of M1 has increased over the years because financial innovation has developed M1 substitutes.
2) The velocity of circulation of M2 has been relatively stable because the M1 substitutes that have resulted from financial innovation are new types of deposits that are part of M2. 86

8. Aggregate Demand Approach
Question: How does monetary policy affect aggregate demand?
Answer: Interest rates (r):
MS  r
 opportunity cost of investment
 ID
 Y
DY = (spending multiplier)DID

9. An increase in MS shifts AD curve to the right.
There will be a combination of Case (1) and (2):
MS  Shifts AD right  Y and P
Monetary policy can be a powerful tool to fight recessions:
- Recession is caused by lack of demand
- AD shifts left, Y and P.
- MS  r and ID  shifts AD back right

10. Question: If MS is so powerful, why doesn’t the Fed just keep MS growing and r at or very near 0%?
Answer: INFLATION

11. Monetary Policy in the Long-Run
Recall the in LR, the adjustment of prices and wages will cause the economy to gravitate back towards potential GDP (YP).
Monetary policy has no effect on YP (only labor productivity and labor force).
MS  Y > YP
 inflationary gap
 W and P
 Y returns to YP

12. How much does P? The quantity theory tells us the answer is Case (2):
MV = PY
 %DM + %DV = %DP + %DY
In the long-run, Y = YP and V is constant:
 %DM = %DP
money supply growth = inflation rate
In the long-run inflation is caused by growth in the nation’s money supply

13. Money Growth and Inflation in the United States
Instructor Notes:
1) Year-to-year fluctuations in money growth and inflation are loosely correlated but decade average fluctuations in money growth and inflation are closely correlated.
2) The burst of postwar inflation was caused by rapid money growth during World War II, and the rise in inflation during the 1970s was caused by more rapid money growth during the 1960s. 97

14. International evidence of hyperinflation:
Post WWI Poland 522%
Russia 684%
Germany 3,800%
1980s Israel 370%
Argentina 1,110%
Bolivia 8000%

15. German Hyperinflation (1/22 – 12/23, 4000%)
Daily Newspaper Price
$ (1/21)
$1,000,000 (10/23)
$7,000,000 (11/23)
Why print so much money?
To finance government spending.

16. “Inflation is almost everywhere a monetary phenomena” – Milton Friedman (1976 Nobel Winner in Economics)
Demand-Supply Interpretation: Lack of scarcity lowers value.
Even if wages are keeping up with inflation there are still costs:
(i) Shoe-leather
(ii) Tax distortions
(iii) Re-distribution of wealth

17. Classic Example – Wizard of Oz
Post Civil War Era ( ) depression, bank panics, deflation. Debtors hurt.
Money tied to Gold Standard
1896 Presidential Election: William Jennings Bryant versus William McKinnley
Bryant – populist, bimetallic gold-silver standard (“Cross of Gold Speech”)
McKinnley – Preservation of gold standard.

18. Wizard of Oz (1900) – L. Frank Baum
(MGM Movie – 1939)
Dorothy, Scarecrow, Tin Woodsman
Cowardly Lion
Yellow Brick Road leads to the Emerald City
“OZ” – Ounce of Gold
The Wizard – man behind the curtain.
Powers of the Magical Silver Slippers
Wicked Witch of the West
Eventually gold discovered in Alaska and South Africa provided relief.

19. “The Wizard of Oz: Parable on Populism,” by Henry Littlefield, American Quarterly 16, (Spring 1964)
“The Wizard of Oz as a Monetary Allegory,” Hugh Rockoff, Journal of Political Economy 98 (Aug 1990)

20. Fed needs to balance off the short-run gains of more GDP with long-run costs of more inflation:
(i) Disinflation policy of
(ii) Loose Monetary Policy:
(iii) Recent Tightening: present

21. Monetary Policy: