1. Money & Banking Video 02--Money Demand What is Money? ( Chapter 3) Quantity Theory of Money (Chapter 20) Hal W. Snarr 8/20/2015

2. Chapter 3 What is money?

3.  In the absence of money, goods and services are exchanged in a barter system where individuals directly exchange the surplus from the fruits of their labor. – The following gives the number of barter prices there would be in an economy with N goods, with x = 2 because exchanges are done in pairs: – Among competing forms of money, the least marketable tend to be one by one rejected until at last only a single commodity remained, which was universally employed as a medium of exchange – Mises, 1953, pp. 32-33 – The winner of this contest is durable, divisible, transportable, and difficult to counterfeit. Money

4.  Commodity Money: Gold coins in 1776-Colonial America “Tiger Tongue” from Siam, Bronze Coin Stone Money, Island of Yap Money

5.  Paper Money is backed by something like Gold Money

6.  Paper Money is backed by something like Gold Money

7.  Fiat Money: gov’t decreed money backed by Gold Money

8.  Checks:  Electronic Payment  E-Money (electronic money):  Debit card  Stored-value card (smart card)  E-cash  Are We Headed for a Cashless Society?  Louisiana House Bill 195 bans cash on all second-hand transactions, which passed near unanimously with one nay vote in the senate. (www.forbes.com)www.forbes.com  http://www.youtube.com/watch?v=7ujgi4rXsiQ http://www.youtube.com/watch?v=7ujgi4rXsiQ  www.youtube.com/watch?v=yrGMgsJQGUE www.youtube.com/watch?v=yrGMgsJQGUE Money

9. Table 1 Money

10. www.federalreserve.gov/releases/h6/Current Figure 1 Growth Rates of M1 & M2 Money

11. http://research.stlouisfed.org/fred2/graph/?id=BOGMBASE# M1, M2 and the Monetary Base Money

12. Chapter 20 Quantity Theory of Money?

13. Fisher’s Equation of Exchange Irving Fisher’s equation of exchange Mainstream economics defines inflation as a general increase in the prices of products  = P is /P was – 1 > 0 Demand-pull inflation Cost-push inflation Excessive growth in the quantity of money > 0

14. Demand-pull inflation AD SRAS 15 LRAS 16 15.5 14.5  = 6.9%  = 15.5/14.5 – 1 Fisher’s Equation of Exchange

15. AD SRAS 15 LRAS 16.5 16 15.5 14.5  = 16.5/14.5 – 1 Demand-pull inflation = 14.8% Fisher’s Equation of Exchange

16. AD SRAS 15 LRAS 16 15.5 14.5  = 0%  = 14.5/14.5 – 1 Demand-pull inflation? 17 Fisher’s Equation of Exchange

17. Cost-push inflation AD SRAS 15 LRAS 14 15.5 14.5  = 6.9%  = 15.5/14.5 – 1 Fisher’s Equation of Exchange

18. AD SRAS 15 LRAS 15.5 14.5  = 0%  = 14.5/14.5 – 1 Cost-push inflation? 14 Fisher’s Equation of Exchange

19. If Velocity of money is fairly constant in short run and u = u n, an increase in the quantity of Money the Price level increases 16.5 A 15.5 SRAS AD LRAS 14.5 15 16 Fisher’s Equation of Exchange

20. Excessive growth in the quantity of money causes inflation Who agrees? Milton Friedman (The Counter-Revolution in Monetary Theory): Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output. Fisher’s Equation of Exchange

21. Assuming V is constant in the short run gives the quantity theory of money (QTM) Nominal income is determined by changes in the quantity of money The above can be written as follows Quantity Theory of Money +≈ +

22. Assuming V is constant in the short run gives the quantity theory of money (QTM) Nominal income is determined by changes in the quantity of money The above can be written as follows The quantity theory of money is also a theory of inflation  Quantity Theory of Money

23. Figure 1 Sources: For panel (a), Milton Friedman and Anna Schwartz, Monetary trends in the United States and the United Kingdom: Their Relation to Income, Prices, and Interest Rates, 1867–1975, Federal Reserve Economic Database (FRED), Federal Reserve Bank of St. Louis, http://research.stlouisfed.org/fred2/categories/25 and Bureau of Labor Statistics at http://data.bls.gov/cgi-bin/surveymost?cu. Source: IFS data for 120 countries, averaged over years 1996-2004 Quantity Theory of Money

24. Figure 2 Sources: FRED, Federal Reserve Economic Data, Federal Reserve Bank of St. Louis; Bureau of Labor Statistics, http://research.stlouisfed.org/fred2/categories/25; accessed September 30, 2010. High Money Growth & low inflation Quantity Theory of Money

25. … but high money growth is followed by accelerating inflation Sources: FRED, Federal Reserve Economic Data, Federal Reserve Bank of St. Louis; Bureau of Labor Statistics, http://research.stlouisfed.org/fred2/categories/25; accessed September 30, 2010. Quantity Theory of Money Figure 2

26. Government expenditures is paid for by Raising tax revenue Treasuries can print money ‒ In the U.S., the Fed buys bonds directly from Treasury Treasuries can sell more bonds ‒ If the deficit is financed by selling bonds to the public, there is no effect on the MB = R + C, and on the MS ‒ If the deficit is financed by the Fed buying bonds from banks, the MB and MS increase o $1 could buy 11% more goods in 1912 than in 1776 o $1 could buy 95% fewer goods in 2008 than in 1913 $1m held from 1913 to 2008 is worth $50k www.lewrockwell.com/2009/07/erik-voorhees/the-record-of-the-federal-reserve/ Quantity Theory of Money

27. Example – CPI data from the FRED Quantity Theory of Money

28. Hyperinflation is a period of high inflation (> 50% per month) Larry Allen’s The Encyclopedia of Money: Bolshevik Revolution Prior to 1917, prices rose 2 to 3 times faster than wages. After 1917, prices rose by  92,300% from 1913 to 1919  64,823,000,000% from 1913 to 1923 Post WWI Germany In 1914, there were 6,323 million marks in circulation By 1923 there were 17,393,000 million. A newspaper costing one mark in May 1922 cost 1,000 marks 16 months later, and 70 million marks a year and a half later. At its worst,  Customers rolled wheelbarrows full of money to the grocery store  Customers and restaurants negotiated the cost of meals in advance  Printed money was bailed like hay to heat one’s home.  It took about 4 days for prices to double Quantity Theory of Money

29. Hyperinflation is a period of high inflation (> 50% per month) Erich Maria Remarque’s The Black Obelisk: Workmen are given their pay twice a day now--in the morning and in the afternoon, with a recess of a half-hour each time so that they can rush out and buy things--for if they waited a few hours the value of their money would drop Steve Hanke’s R.I.P. Zimbabwe Dollar: The time it took for prices to double in o 1994 Yugoslavia, 33.6 hours o 2008 Zimbabwe, 24.7 hours o 1946 Hungary, 15.6 hours Quantity Theory of Money

30. The Fisher Effect: Rising inflation (caused by excessive money growth) raises the nominal rate of interest (i) Source: IFS data for 120 countries, averaged over years 1996-2004 Source: Federal Reserve Economic Data (FRED) i = r +  Quantity Theory of Money

31. Using current inflation assumes inflation does not change. Future r will be different from what it was expected to be when loans were signed. Borrowers do better and lenders do worse when loans are repaid with devalued money. In an uncertain world, the Fisher Effect must account for uncertainty  e is commonly estimated using ‒ the difference between the yields on TIPS and Treasuries (TIPS spread) i = r +  e The Fisher Effect: Rising inflation (caused by excessive money growth) raises the nominal rate of interest (i) Quantity Theory of Money

32. M Money Demand Fisher i billions $

33. Money Demand billions $ M i Example: P = 1, V = 1.5, Y = 15,000, r b = 2, r e = 4,  e = 3 Fisher

34. Money Demand M i billions $ Fisher Example: P = 1, V = 1.5, Y = 15,000, r b = 2, r e = 4,  e = 3

35. Money Demand M MD Fisher 10000 i billions $ Fisher Example: P = 1, V = 1.5, Y = 15,000, r b = 2, r e = 4,  e = 3

36. MD Fisher 2.5 Money Demand M 15 i 10000 billions $ Fisher Example: P = 1, V = 1.5, Y = 15,000, r b = 2, r e = 4,  e = 3

37. i Money Demand MD Fisher 2.5 M 10000 billions $ Keynes

38. Money Demand MD Fisher 2.5 M i 10000 billions $ Keynes Example: P = 1, V = 1.5, Y = 15,000, r b = 2, r e = 4,  e = 3

39. Money Demand MD Fisher 2.5 M i 10000 billions $ Keynes Example: P = 1, V = 1.5, Y = 15,000, r b = 2, r e = 4,  e = 3

40. Money Demand MD Fisher 2.5 M i 10000 billions $ Keynes Example: P = 1, V = 1.5, Y = 15,000, r b = 2, r e = 4,  e = 3

41. Money Demand MD Fisher 2.5 M i 10000 billions $ Keynes Example: P = 1, V = 1.5, Y = 15,000, r b = 2, r e = 4,  e = 3

42. Money Demand MD Fisher 2.5 M i 10000 billions $ Keynes Example: P = 1, V = 1.5, Y = 15,000, r b = 2, r e = 4,  e = 3

43. Money Demand MD Fisher 2.5 M i 10000 billions $ Keynes Example: P = 1, V = 1.5, Y = 15,000, r b = 2, r e = 4,  e = 3

44. Money Demand MD Fisher 2.5 M i 10000 billions $ MD Keynes Keynes

45. MD Keynes Money Demand MD Fisher M 2.5 i 10000 billions $ Friedman

46. Money Demand MD Keynes MD Fisher M 2.5 i 10000 billions $ Example: P = 1, V = 1.5, Y = 15,000, r b = 2, r e = 4,  e = 3 Friedman

47. Money Demand MD Keynes MD Fisher M 2.5 i 10000 billions $ Example: P = 1, V = 1.5, Y = 15,000, r b = 2, r e = 4,  e = 3 Friedman

48. Money Demand MD Keynes MD Fisher M 2.5 i 10000 billions $ Example: P = 1, V = 1.5, Y = 15,000, r b = 2, r e = 4,  e = 3 Friedman

49. Money Demand MD Keynes MD Fisher M 2.5 i 10000 billions $ Example: P = 1, V = 1.5, Y = 15,000, r b = 2, r e = 4,  e = 3 Friedman

50. MD Keynes Money Demand MD Fisher M 2.5 i 10000 billions $ Example: P = 1, V = 1.5, Y = 15,000, r b = 2, r e = 4,  e = 3 Friedman

51. MD Keynes Money Demand MD Fisher M 2.5 i 10000 billions $ Example: P = 1, V = 1.5, Y = 15,000, r b = 2, r e = 4,  e = 3 Friedman

52. MD Keynes Money Demand MD Fisher M 2.5 i 10000 billions $ Example: P = 1, V = 1.5, Y = 15,000, r b = 2, r e = 4,  e = 3 Friedman

53. MD Keynes Money Demand MD Fisher M 2.5 i 10000 billions $ Example: P = 1, V = 1.5, Y = 15,000, r b = 2, r e = 4,  e = 3 Friedman

54. MD Keynes Money Demand MD Fisher M 2.5 i 10000 billions $ Example: P = 1, V = 1.5, Y = 15,000, r b = 2, r e = 4,  e = 3 Friedman

55. MD Keynes Money Demand MD Fisher M 2.5 i 10000 billions $ Example: P = 1, V = 1.5, Y = 15,000, r b = 2, r e = 4,  e = 3 Friedman

56. MD Keynes Money Demand MD Fisher M i 10000 billions $ 2.5 Example: P = 1, V = 1.5, Y = 15,000, r b = 2, r e = 4,  e = 3 Friedman

57. MD Keynes Money Demand MD Fisher M 2.5 i 10000 billions $ Friedman MD Friedman

58. People and firms demand money because there are benefits to doing so because doing so makes it easier to pay for things. The marginal benefit of holding an additional dollar diminishes as the amount held increases. E.g., the benefit of holding $2 rather than $1 is greater than holding an additional dollar when one has $1000. Holding the additional dollar is also costly interest is forgone inflation reduces its buying power. i = r +  e is the price of holding money; as it rises, M d falls. Money Demand

59. i MD Empirical evidence: The quantity of money demanded increases as i falls. M Money Demand

60. i MD Empirical evidence: The quantity of money demanded increases as i falls. Money demand increases in income Wealth Risk of other assets M Money Demand

61. i M MD Empirical evidence (Table 1): The quantity of money demanded increases as i falls. Money demand increases in income Wealth Risk of other assets Money demand decreases in Payment technology Inflation risk Liquidity of other assets Money Demand

62. If Keynes is correct money demand fluctuates with i velocity oscillates and is unpredictable the link between M and aggregate spending is weak The Fed should target interest rates If Friedman is correct Money demand is relatively insensitive to changes i velocity is stable and predictable QTM’s view of aggregate spending being determined by M is more likely to be true The Fed should target MS Money Demand