Money, Output, and PricesMoney, Output, and Prices

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M1P

M1 Money Supply CPI (1987=100)

Over the long term, money is highly positively correlated with prices, but uncorrelated with income

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

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1YR TBILL

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

tiyMP

M d

,,

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:

ytikP

M d

),(

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 can’t control this, but can influence it

MB

M3M2

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 DepositsCash

DepositsReserves Deposits

+

M2-M1 Deposits

+

The Fed can influence total bank reserves, which affects the multipliers!

In equilibrium, prices adjust so that demand equals supply…

ytikP

M

P

M ds

),(

Determined by the Fed & Banks

However, we have two prices (the price level and the interest rate) ….which one adjusts to clear the market?

ytikP

M s

),(

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

ytikP

M s

),(

In the short run, Prices are considered fixed.

Constant Adjusts 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 MoneyM

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 MoneyM

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 MoneyM

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 level4%

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 can’t do this by itself!!

Capital/Money Markets – Short Runi

S

I + (G-T)

5%

Loanable Funds

Initially, both markets are in equilibrium. Now, suppose that the Fed increases the money supply by 10%.

iMs

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 Runi

S

I + (G-T)

5%

Loanable Funds

iMs

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 increaseHigher 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 Phillip’s curve

In Theory In Practice

Money Demand Shocksi

S

I + (G-T)

5%

Loanable Funds

iMs

5%

M

P

Md

Suppose that ATMs lower demand for money

As demand for cash falls relative to supply, interest rates start to fallLower interest rates promote spending (both consumer and investment) which raises employment and incomeEventually, the increase in demand raises prices. As consumer goods become more expensive, savings drops, real money supply drops and interest rates rise

Demand Shocksi S

I + (G-T)

5%

Loanable Funds

iMs

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 riseHigher 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 Shocksi

S

I + (G-T)

5%

Loanable Funds

iMs

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 RunCommodity prices are slow to adjust

Interest rates are determined in money/capital markets

Interest rates determine demand, which determines supply

Long RunReal 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

iMs

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 incomeHigher 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

iMs

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

iMs

5%

M

P

Md

Case #2: High oil prices generates inflationary expectations