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Quantity Theory Identity of Money
Money× Velocity ≡ Price× Transactions
M × V ≡ P × T
How many dollars we need for our purchases depends on howquickly dollars move around
Example
I Buy 10 hats
I at $2 each
I Have $5 of money in the economy
I What is V ?
Quantity Theory Identity of Money
Money× Velocity ≡ Price× Transactions
M × V ≡ P × T
How many dollars we need for our purchases depends on howquickly dollars move around
Example
I Buy 10 hats
I at $2 each
I Have $5 of money in the economy
I What is V ?
Quantity Theory Identity of Money
Money× Velocity ≡ Price× Transactions
M × V ≡ P × T
How many dollars we need for our purchases depends on howquickly dollars move around
Example
I Buy 10 hats
I at $2 each
I Have $5 of money in the economy
I What is V ?
Quantity Theory of Money
Transactions are hard to measure
Output is similar but includes used goods
Money× Velocity = Price× Output (1)
M × V = P × Y (2)
This V : “income velocity of money”
Quantity Theory of Money
Transactions are hard to measure
Output is similar but includes used goods
Money× Velocity = Price× Output (1)
M × V = P × Y (2)
This V : “income velocity of money”
Quantity Theory of Money
Transactions are hard to measure
Output is similar but includes used goods
Money× Velocity = Price× Output (1)
M × V = P × Y (2)
This V : “income velocity of money”
Quantity Theory of Money
Transactions are hard to measure
Output is similar but includes used goods
Money× Velocity = Price× Output (1)
M × V = P × Y (2)
This V : “income velocity of money”
Quantity Theory of Money
Real money balances: MP :
how much stuff the money can buy
Money demand: function that tells us how much real moneypeople want to hold. For instance:(
M
P
)d
= kY (3)
Money demand consists of a theory about V(M
P
)d
= kY ⇐⇒M1
k= PY ⇐⇒ V =
1
k(4)
High k =⇒
{High demand for money
Low velocity
Quantity Theory of Money
Real money balances: MP : how much stuff the money can buy
Money demand: function that tells us how much real moneypeople want to hold. For instance:(
M
P
)d
= kY (3)
Money demand consists of a theory about V(M
P
)d
= kY ⇐⇒M1
k= PY ⇐⇒ V =
1
k(4)
High k =⇒
{High demand for money
Low velocity
Quantity Theory of Money
Real money balances: MP : how much stuff the money can buy
Money demand: function that tells us how much real moneypeople want to hold. For instance:(
M
P
)d
= kY (3)
Money demand consists of a theory about V(M
P
)d
= kY ⇐⇒M1
k= PY ⇐⇒ V =
1
k(4)
High k =⇒
{High demand for money
Low velocity
Quantity Theory of Money
Real money balances: MP : how much stuff the money can buy
Money demand: function that tells us how much real moneypeople want to hold. For instance:(
M
P
)d
= kY (3)
Money demand consists of a theory about V
(M
P
)d
= kY ⇐⇒M1
k= PY ⇐⇒ V =
1
k(4)
High k =⇒
{High demand for money
Low velocity
Quantity Theory of Money
Real money balances: MP : how much stuff the money can buy
Money demand: function that tells us how much real moneypeople want to hold. For instance:(
M
P
)d
= kY (3)
Money demand consists of a theory about V(M
P
)d
= kY ⇐⇒M1
k= PY ⇐⇒ V =
1
k(4)
High k =⇒
{High demand for money
Low velocity
Quantity Theory of Money
Real money balances: MP : how much stuff the money can buy
Money demand: function that tells us how much real moneypeople want to hold. For instance:(
M
P
)d
= kY (3)
Money demand consists of a theory about V(M
P
)d
= kY ⇐⇒M1
k= PY ⇐⇒ V =
1
k(4)
High k =⇒
{High demand for money
Low velocity
Quantity Theory of Money
Constant V is a simplifying theory
We know of many things that will change V
I ATMs
I Credit cards
I Other changes in payment technologies
But what is the purpose of the theory? To answer questions like
I What will happen if the CB increases the money supply?
I What will happen to prices if incomes increase and the CBdoes not change the money supply?
I What are the sources of long-run inflation?
Valid theory as long as V does not change in response to Y , P , orM in the times we are studying
Quantity Theory of Money
Constant V is a simplifying theory
We know of many things that will change V
I ATMs
I Credit cards
I Other changes in payment technologies
But what is the purpose of the theory? To answer questions like
I What will happen if the CB increases the money supply?
I What will happen to prices if incomes increase and the CBdoes not change the money supply?
I What are the sources of long-run inflation?
Valid theory as long as V does not change in response to Y , P , orM in the times we are studying
Quantity Theory of Money
Constant V is a simplifying theory
We know of many things that will change V
I ATMs
I Credit cards
I Other changes in payment technologies
But what is the purpose of the theory? To answer questions like
I What will happen if the CB increases the money supply?
I What will happen to prices if incomes increase and the CBdoes not change the money supply?
I What are the sources of long-run inflation?
Valid theory as long as V does not change in response to Y , P , orM in the times we are studying
Quantity Theory of Money
Constant V is a simplifying theory
We know of many things that will change V
I ATMs
I Credit cards
I Other changes in payment technologies
But what is the purpose of the theory? To answer questions like
I What will happen if the CB increases the money supply?
I What will happen to prices if incomes increase and the CBdoes not change the money supply?
I What are the sources of long-run inflation?
Valid theory as long as V does not change in response to Y , P , orM in the times we are studying
Quantity Theory of Money
Constant V is a simplifying theory
We know of many things that will change V
I ATMs
I Credit cards
I Other changes in payment technologies
But what is the purpose of the theory? To answer questions like
I What will happen if the CB increases the money supply?
I What will happen to prices if incomes increase and the CBdoes not change the money supply?
I What are the sources of long-run inflation?
Valid theory as long as V does not change in response to Y , P , orM in the times we are studying
Quantity Theory of Money
Constant V is a simplifying theory
We know of many things that will change V
I ATMs
I Credit cards
I Other changes in payment technologies
But what is the purpose of the theory?
To answer questions like
I What will happen if the CB increases the money supply?
I What will happen to prices if incomes increase and the CBdoes not change the money supply?
I What are the sources of long-run inflation?
Valid theory as long as V does not change in response to Y , P , orM in the times we are studying
Quantity Theory of Money
Constant V is a simplifying theory
We know of many things that will change V
I ATMs
I Credit cards
I Other changes in payment technologies
But what is the purpose of the theory? To answer questions like
I What will happen if the CB increases the money supply?
I What will happen to prices if incomes increase and the CBdoes not change the money supply?
I What are the sources of long-run inflation?
Valid theory as long as V does not change in response to Y , P , orM in the times we are studying
Quantity Theory of Money
Constant V is a simplifying theory
We know of many things that will change V
I ATMs
I Credit cards
I Other changes in payment technologies
But what is the purpose of the theory? To answer questions like
I What will happen if the CB increases the money supply?
I What will happen to prices if incomes increase and the CBdoes not change the money supply?
I What are the sources of long-run inflation?
Valid theory as long as V does not change in response to Y , P , orM in the times we are studying
Quantity Theory of Money
Constant V is a simplifying theory
We know of many things that will change V
I ATMs
I Credit cards
I Other changes in payment technologies
But what is the purpose of the theory? To answer questions like
I What will happen if the CB increases the money supply?
I What will happen to prices if incomes increase and the CBdoes not change the money supply?
I What are the sources of long-run inflation?
Valid theory as long as V does not change in response to Y , P , orM in the times we are studying
Quantity Theory of Money
Constant V is a simplifying theory
We know of many things that will change V
I ATMs
I Credit cards
I Other changes in payment technologies
But what is the purpose of the theory? To answer questions like
I What will happen if the CB increases the money supply?
I What will happen to prices if incomes increase and the CBdoes not change the money supply?
I What are the sources of long-run inflation?
Valid theory as long as V does not change in response to Y , P , orM in the times we are studying
Quantity Theory of Money
Constant V is a simplifying theory
We know of many things that will change V
I ATMs
I Credit cards
I Other changes in payment technologies
But what is the purpose of the theory? To answer questions like
I What will happen if the CB increases the money supply?
I What will happen to prices if incomes increase and the CBdoes not change the money supply?
I What are the sources of long-run inflation?
Valid theory as long as V does not change in response to Y , P , orM in the times we are studying
Quantity Theory of Money
(M
P
)d
V = Y (5)
What determines Y ? Factors of production and techWhat determines M? Central bankWhat determines V ? Fixed by assumption
What happens when the CB increases M by 10%?
MV = PY
⇒ %∆M + %∆V = %∆P + %∆Y
⇒ %∆P = %∆V + %∆M −%∆Y
⇒ π = %∆V + %∆M − g (6)
Quantity Theory of Money
(M
P
)d
V = Y (5)
What determines Y ?
Factors of production and techWhat determines M? Central bankWhat determines V ? Fixed by assumption
What happens when the CB increases M by 10%?
MV = PY
⇒ %∆M + %∆V = %∆P + %∆Y
⇒ %∆P = %∆V + %∆M −%∆Y
⇒ π = %∆V + %∆M − g (6)
Quantity Theory of Money
(M
P
)d
V = Y (5)
What determines Y ? Factors of production and tech
What determines M? Central bankWhat determines V ? Fixed by assumption
What happens when the CB increases M by 10%?
MV = PY
⇒ %∆M + %∆V = %∆P + %∆Y
⇒ %∆P = %∆V + %∆M −%∆Y
⇒ π = %∆V + %∆M − g (6)
Quantity Theory of Money
(M
P
)d
V = Y (5)
What determines Y ? Factors of production and techWhat determines M?
Central bankWhat determines V ? Fixed by assumption
What happens when the CB increases M by 10%?
MV = PY
⇒ %∆M + %∆V = %∆P + %∆Y
⇒ %∆P = %∆V + %∆M −%∆Y
⇒ π = %∆V + %∆M − g (6)
Quantity Theory of Money
(M
P
)d
V = Y (5)
What determines Y ? Factors of production and techWhat determines M? Central bank
What determines V ? Fixed by assumption
What happens when the CB increases M by 10%?
MV = PY
⇒ %∆M + %∆V = %∆P + %∆Y
⇒ %∆P = %∆V + %∆M −%∆Y
⇒ π = %∆V + %∆M − g (6)
Quantity Theory of Money
(M
P
)d
V = Y (5)
What determines Y ? Factors of production and techWhat determines M? Central bankWhat determines V ?
Fixed by assumption
What happens when the CB increases M by 10%?
MV = PY
⇒ %∆M + %∆V = %∆P + %∆Y
⇒ %∆P = %∆V + %∆M −%∆Y
⇒ π = %∆V + %∆M − g (6)
Quantity Theory of Money
(M
P
)d
V = Y (5)
What determines Y ? Factors of production and techWhat determines M? Central bankWhat determines V ? Fixed by assumption
What happens when the CB increases M by 10%?
MV = PY
⇒ %∆M + %∆V = %∆P + %∆Y
⇒ %∆P = %∆V + %∆M −%∆Y
⇒ π = %∆V + %∆M − g (6)
Quantity Theory of Money
(M
P
)d
V = Y (5)
What determines Y ? Factors of production and techWhat determines M? Central bankWhat determines V ? Fixed by assumption
What happens when the CB increases M by 10%?
MV = PY
⇒ %∆M + %∆V = %∆P + %∆Y
⇒ %∆P = %∆V + %∆M −%∆Y
⇒ π = %∆V + %∆M − g (6)
Quantity Theory of Money
(M
P
)d
V = Y (5)
What determines Y ? Factors of production and techWhat determines M? Central bankWhat determines V ? Fixed by assumption
What happens when the CB increases M by 10%?
MV = PY
⇒ %∆M + %∆V = %∆P + %∆Y
⇒ %∆P = %∆V + %∆M −%∆Y
⇒ π = %∆V + %∆M − g (6)
Quantity Theory of Money
(M
P
)d
V = Y (5)
What determines Y ? Factors of production and techWhat determines M? Central bankWhat determines V ? Fixed by assumption
What happens when the CB increases M by 10%?
MV = PY
⇒ %∆M + %∆V = %∆P + %∆Y
⇒ %∆P = %∆V + %∆M −%∆Y
⇒ π = %∆V + %∆M − g (6)
Quantity Theory of Money
(M
P
)d
V = Y (5)
What determines Y ? Factors of production and techWhat determines M? Central bankWhat determines V ? Fixed by assumption
What happens when the CB increases M by 10%?
MV = PY
⇒ %∆M + %∆V = %∆P + %∆Y
⇒ %∆P = %∆V + %∆M −%∆Y
⇒ π = %∆V + %∆M − g (6)
Quantity Theory of Money
(M
P
)d
V = Y (5)
What determines Y ? Factors of production and techWhat determines M? Central bankWhat determines V ? Fixed by assumption
What happens when the CB increases M by 10%?
MV = PY
⇒ %∆M + %∆V = %∆P + %∆Y
⇒ %∆P = %∆V + %∆M −%∆Y
⇒ π = %∆V + %∆M − g (6)
Quantity Theory of Money
What causes inflation?
π = %∆M + %∆V − g (7)
Facts:
I π ranges from -10% to trillions of percent per year
I g is usually between -2% and 10%
I V is fairly constant over time (%∆V ≈ 0)
Conclusion: “Inflation [in the long-run] is always and everywhere amonetary phenomenon” –Milton Friedman
Quantity Theory of Money
What causes inflation?
π = %∆M + %∆V − g (7)
Facts:
I π ranges from -10% to trillions of percent per year
I g is usually between -2% and 10%
I V is fairly constant over time (%∆V ≈ 0)
Conclusion: “Inflation [in the long-run] is always and everywhere amonetary phenomenon” –Milton Friedman
Quantity Theory of Money
What causes inflation?
π = %∆M + %∆V − g (7)
Facts:
I π ranges from -10% to trillions of percent per year
I g is usually between -2% and 10%
I V is fairly constant over time (%∆V ≈ 0)
Conclusion: “Inflation [in the long-run] is always and everywhere amonetary phenomenon” –Milton Friedman
Quantity Theory of Money
What causes inflation?
π = %∆M + %∆V − g (7)
Facts:
I π ranges from -10% to trillions of percent per year
I g is usually between -2% and 10%
I V is fairly constant over time (%∆V ≈ 0)
Conclusion: “Inflation [in the long-run] is always and everywhere amonetary phenomenon” –Milton Friedman
Quantity Theory of Money
What causes inflation?
π = %∆M + %∆V − g (7)
Facts:
I π ranges from -10% to trillions of percent per year
I g is usually between -2% and 10%
I V is fairly constant over time (%∆V ≈ 0)
Conclusion: “Inflation [in the long-run] is always and everywhere amonetary phenomenon” –Milton Friedman
Financial markets
Interest rates and bond prices are related
If the Fed buys more bonds, what happens to interest rates?
Financial markets
Interest rates and bond prices are related
If the Fed buys more bonds, what happens to interest rates?
Financial markets
Interest rates and bond prices are related
If the Fed buys more bonds, what happens to interest rates?
Demand for investment
What is the opportunity cost of buying capital?
Next best alternative is to hold another financial asset (earns r)
I = I(r)
Investment Demand
I,S
r
Demand for investment
What is the opportunity cost of buying capital?
Next best alternative is to hold another financial asset (earns r)
I = I(r)
Investment Demand
I,S
r
Demand for investment
What is the opportunity cost of buying capital?
Next best alternative is to hold another financial asset (earns r)
I = I(r)
Investment Demand
I,S
r
Demand for investment
What is the opportunity cost of buying capital?
Next best alternative is to hold another financial asset (earns r)
I = I(r)
Investment Demand
I,S
r
Supply of savingsSolow model assumed S = sY
But what is the marginal benefit of loaning money to someone tobuy capital?
Return on the loan (savings) is r
S = S(r)
Supply of Savings
I,S
r
Supply of savingsSolow model assumed S = sY
But what is the marginal benefit of loaning money to someone tobuy capital?
Return on the loan (savings) is r
S = S(r)
Supply of Savings
I,S
r
Supply of savingsSolow model assumed S = sY
But what is the marginal benefit of loaning money to someone tobuy capital?
Return on the loan (savings) is r
S = S(r)
Supply of Savings
I,S
r
Supply of savingsSolow model assumed S = sY
But what is the marginal benefit of loaning money to someone tobuy capital?
Return on the loan (savings) is r
S = S(r)
Supply of Savings
I,S
r
Supply of savingsSolow model assumed S = sY
But what is the marginal benefit of loaning money to someone tobuy capital?
Return on the loan (savings) is r
S = S(r)
Supply of Savings
I,S
r
Interest rates
You buy a bond for $100
It pays out $110 in a month
The interest rate was 10% per month
i =Pricef − Pricei
Pricei(8)
This is a nominal interest rate
A real interest rate corrects for inflation
Interest rates
You buy a bond for $100
It pays out $110 in a month
The interest rate was 10% per month
i =Pricef − Pricei
Pricei(8)
This is a nominal interest rate
A real interest rate corrects for inflation
Interest rates
You buy a bond for $100
It pays out $110 in a month
The interest rate was
10% per month
i =Pricef − Pricei
Pricei(8)
This is a nominal interest rate
A real interest rate corrects for inflation
Interest rates
You buy a bond for $100
It pays out $110 in a month
The interest rate was 10% per month
i =Pricef − Pricei
Pricei(8)
This is a nominal interest rate
A real interest rate corrects for inflation
Interest rates
You buy a bond for $100
It pays out $110 in a month
The interest rate was 10% per month
i =Pricef − Pricei
Pricei(8)
This is a nominal interest rate
A real interest rate corrects for inflation
Interest rates
You buy a bond for $100
It pays out $110 in a month
The interest rate was 10% per month
i =Pricef − Pricei
Pricei(8)
This is a nominal interest rate
A real interest rate corrects for inflation
Ex ante (before) and ex post (after)
i = r + π (10)
Investors and lenders know what r they want
They try to choose i to get that r
But do you know what π will be this year?
Ex ante (before) and ex post (after)
i = r + π (10)
Investors and lenders know what r they want
They try to choose i to get that r
But do you know what π will be this year?
Ex ante (before) and ex post (after)
i = r + π (10)
Investors and lenders know what r they want
They try to choose i to get that r
But do you know what π will be this year?
Ex ante (before) and ex post (after)
i = r + π (10)
Investors and lenders know what r they want
They try to choose i to get that r
But do you know what π will be this year?
In groups
i = r + π (11)
Suppose
I You and your friend agree that 10% is a reasonable rate ofinterest on a loan you will give him
I You expect inflation to be 3%
1. What nominal interest rate will you choose?
2. If inflation ends up being 5%, what will be the ex post realinterest rate?
3. If inflation ends up being 5%, who loses?
If inflation is higher than expected, i is too low
If inflation is lower than expected, i is too high
In groups
i = r + π (11)
Suppose
I You and your friend agree that 10% is a reasonable rate ofinterest on a loan you will give him
I You expect inflation to be 3%
1. What nominal interest rate will you choose?
2. If inflation ends up being 5%, what will be the ex post realinterest rate?
3. If inflation ends up being 5%, who loses?
If inflation is higher than expected, i is too low
If inflation is lower than expected, i is too high
In groups
i = r + π (11)
Suppose
I You and your friend agree that 10% is a reasonable rate ofinterest on a loan you will give him
I You expect inflation to be 3%
1. What nominal interest rate will you choose?
2. If inflation ends up being 5%, what will be the ex post realinterest rate?
3. If inflation ends up being 5%, who loses?
If inflation is higher than expected, i is too low
If inflation is lower than expected, i is too high
Keynesian theories of money demand
Why do people hold money?
I Transactions motive
I Need real money balancesI Increases with income
I Precautionary motive
I Need real money balancesI Increases with income
I Speculative motive (store of wealth)
I Store of wealthI Opportunity cost: i
Keynesian theories of money demand
Why do people hold money?I Transactions motive
I Need real money balancesI Increases with income
I Precautionary motiveI Need real money balancesI Increases with income
I Speculative motive (store of wealth)
I Store of wealthI Opportunity cost: i
Keynesian theories of money demand
Why do people hold money?I Transactions motive
I Need real money balancesI Increases with income
I Precautionary motiveI Need real money balancesI Increases with income
I Speculative motive (store of wealth)
I Store of wealthI Opportunity cost: i
Keynesian theories of money demand
Why do people hold money?I Transactions motive
I Need real money balancesI Increases with income
I Precautionary motiveI Need real money balancesI Increases with income
I Speculative motive (store of wealth)I Store of wealthI Opportunity cost: i
The opportunity cost of holding money
i is the opportunity cost of holding money
Expected return on money: −Eπ
Expected return on a bond: r
By holding money, we lose the difference: r− (−Eπ) = r+Eπ = i
The opportunity cost of holding money
i is the opportunity cost of holding money
Expected return on money:
−Eπ
Expected return on a bond: r
By holding money, we lose the difference: r− (−Eπ) = r+Eπ = i
The opportunity cost of holding money
i is the opportunity cost of holding money
Expected return on money: −Eπ
Expected return on a bond: r
By holding money, we lose the difference: r− (−Eπ) = r+Eπ = i
The opportunity cost of holding money
i is the opportunity cost of holding money
Expected return on money: −Eπ
Expected return on a bond:
r
By holding money, we lose the difference: r− (−Eπ) = r+Eπ = i
The opportunity cost of holding money
i is the opportunity cost of holding money
Expected return on money: −Eπ
Expected return on a bond: r
By holding money, we lose the difference: r− (−Eπ) = r+Eπ = i
The opportunity cost of holding money
i is the opportunity cost of holding money
Expected return on money: −Eπ
Expected return on a bond: r
By holding money, we lose the difference:
r− (−Eπ) = r+Eπ = i
The opportunity cost of holding money
i is the opportunity cost of holding money
Expected return on money: −Eπ
Expected return on a bond: r
By holding money, we lose the difference: r− (−Eπ) = r+Eπ = i
Money market equilibirum
Money demand: (M
P
)d
= L (i, Y ) (13)
Equilibrium:M
P= L (i, Y ) (14)
⇒ M
P= L (r + Eπ, Y ) (15)
Money market equilibirum
Money demand: (M
P
)d
= L (i, Y ) (13)
Equilibrium:M
P= L (i, Y ) (14)
⇒ M
P= L (r + Eπ, Y ) (15)
Money market equilibirum
Money demand: (M
P
)d
= L (i, Y ) (13)
Equilibrium:M
P= L (i, Y ) (14)
⇒ M
P= L (r + Eπ, Y ) (15)
M
P= L (r + Eπ, Y ) (16)
Quantity theory: price level changes determined by money stockchanges
Now: price level changes with expected inflation
If the Fed tells us that there will be more inflation
I Demand for real money balances will fall
(opp. cost of money, i, increased)
I Supply of real money balances must fall in equil.
I The price level will rise
One way to fight inflation: convince people it is not happening
M
P= L (r + Eπ, Y ) (16)
Quantity theory: price level changes determined by money stockchanges
Now: price level changes with expected inflation
If the Fed tells us that there will be more inflation
I Demand for real money balances will fall
(opp. cost of money, i, increased)
I Supply of real money balances must fall in equil.
I The price level will rise
One way to fight inflation: convince people it is not happening
M
P= L (r + Eπ, Y ) (16)
Quantity theory: price level changes determined by money stockchanges
Now: price level changes with expected inflation
If the Fed tells us that there will be more inflation
I Demand for real money balances will fall
(opp. cost of money, i, increased)
I Supply of real money balances must fall in equil.
I The price level will rise
One way to fight inflation: convince people it is not happening
M
P= L (r + Eπ, Y ) (16)
Quantity theory: price level changes determined by money stockchanges
Now: price level changes with expected inflation
If the Fed tells us that there will be more inflation
I Demand for real money balances will fall
(opp. cost of money, i, increased)
I Supply of real money balances must fall in equil.
I The price level will rise
One way to fight inflation: convince people it is not happening
M
P= L (r + Eπ, Y ) (16)
Quantity theory: price level changes determined by money stockchanges
Now: price level changes with expected inflation
If the Fed tells us that there will be more inflation
I Demand for real money balances will fall
(opp. cost of money, i, increased)
I Supply of real money balances must fall in equil.
I The price level will rise
One way to fight inflation: convince people it is not happening
M
P= L (r + Eπ, Y ) (16)
Quantity theory: price level changes determined by money stockchanges
Now: price level changes with expected inflation
If the Fed tells us that there will be more inflation
I Demand for real money balances will fall
(opp. cost of money, i, increased)
I Supply of real money balances must fall in equil.
I The price level will rise
One way to fight inflation: convince people it is not happening
M
P= L (r + Eπ, Y ) (16)
Quantity theory: price level changes determined by money stockchanges
Now: price level changes with expected inflation
If the Fed tells us that there will be more inflation
I Demand for real money balances will fall
(opp. cost of money, i, increased)
I Supply of real money balances must fall in equil.
I The price level will rise
One way to fight inflation: convince people it is not happening
M
P= L (r + Eπ, Y ) (16)
Quantity theory: price level changes determined by money stockchanges
Now: price level changes with expected inflation
If the Fed tells us that there will be more inflation
I Demand for real money balances will fall
(opp. cost of money, i, increased)
I Supply of real money balances must fall in equil.
I The price level will rise
One way to fight inflation: convince people it is not happening
Portfolio theory of money demand
(M
P
)d
= L (i, Y ) (17)
This is missing some pieces
I Wealth
I Wealth 6= incomeI Mishkin claims that increase in wealth has a smaller impact in
money demand than increase in income
I Risk
I How safe is money?I ↑Risk ⇐= ↓money demandI ↑Riskiness of other assets ⇐= ↑money demand
I Relative liquidity
Portfolio theory of money demand
(M
P
)d
= L (i, Y ) (17)
This is missing some piecesI Wealth
I Wealth 6= incomeI Mishkin claims that increase in wealth has a smaller impact in
money demand than increase in income
I Risk
I How safe is money?I ↑Risk ⇐= ↓money demandI ↑Riskiness of other assets ⇐= ↑money demand
I Relative liquidity
Portfolio theory of money demand
(M
P
)d
= L (i, Y ) (17)
This is missing some piecesI Wealth
I Wealth 6= incomeI Mishkin claims that increase in wealth has a smaller impact in
money demand than increase in income
I RiskI How safe is money?
I ↑Risk ⇐= ↓money demandI ↑Riskiness of other assets ⇐= ↑money demand
I Relative liquidity
Portfolio theory of money demand
(M
P
)d
= L (i, Y ) (17)
This is missing some piecesI Wealth
I Wealth 6= incomeI Mishkin claims that increase in wealth has a smaller impact in
money demand than increase in income
I RiskI How safe is money?I ↑Risk ⇐= ↓money demandI ↑Riskiness of other assets ⇐= ↑money demand
I Relative liquidity
Portfolio theory of money demand
(M
P
)d
= L (i, Y ) (17)
This is missing some piecesI Wealth
I Wealth 6= incomeI Mishkin claims that increase in wealth has a smaller impact in
money demand than increase in income
I RiskI How safe is money?I ↑Risk ⇐= ↓money demandI ↑Riskiness of other assets ⇐= ↑money demand
I Relative liquidity
Comparing theories
Quantity theory
i has no effect and v is constant
L (i, Y )
Changes in i change v
General portfolio theories
More things to change v
Another way to put the question: does the money supplydetermine aggregate spending (PY )?
I If v is constant, then increases in money supply increase PY
I If v responds a lot to i or r, then ↑M s ⇒ ↓r will have lesseffect on aggregate spening
Comparing theories
Quantity theory i has no effect and v is constantL (i, Y )
Changes in i change v
General portfolio theories
More things to change v
Another way to put the question: does the money supplydetermine aggregate spending (PY )?
I If v is constant, then increases in money supply increase PY
I If v responds a lot to i or r, then ↑M s ⇒ ↓r will have lesseffect on aggregate spening
Comparing theories
Quantity theory i has no effect and v is constantL (i, Y ) Changes in i change vGeneral portfolio theories
More things to change v
Another way to put the question: does the money supplydetermine aggregate spending (PY )?
I If v is constant, then increases in money supply increase PY
I If v responds a lot to i or r, then ↑M s ⇒ ↓r will have lesseffect on aggregate spening
Comparing theories
Quantity theory i has no effect and v is constantL (i, Y ) Changes in i change vGeneral portfolio theories More things to change v
Another way to put the question: does the money supplydetermine aggregate spending (PY )?
I If v is constant, then increases in money supply increase PY
I If v responds a lot to i or r, then ↑M s ⇒ ↓r will have lesseffect on aggregate spening
Comparing theories
Quantity theory i has no effect and v is constantL (i, Y ) Changes in i change vGeneral portfolio theories More things to change v
Another way to put the question: does the money supplydetermine aggregate spending (PY )?
I If v is constant, then increases in money supply increase PY
I If v responds a lot to i or r, then ↑M s ⇒ ↓r will have lesseffect on aggregate spening
Comparing theories
Quantity theory i has no effect and v is constantL (i, Y ) Changes in i change vGeneral portfolio theories More things to change v
Another way to put the question: does the money supplydetermine aggregate spending (PY )?
I If v is constant, then increases in money supply increase PY
I If v responds a lot to i or r, then ↑M s ⇒ ↓r will have lesseffect on aggregate spening
Comparing theories
Quantity theory i has no effect and v is constantL (i, Y ) Changes in i change vGeneral portfolio theories More things to change v
Another way to put the question: does the money supplydetermine aggregate spending (PY )?
I If v is constant, then increases in money supply increase PY
I If v responds a lot to i or r, then ↑M s ⇒ ↓r will have lesseffect on aggregate spening
Practice questions
In groups:
I Graph L (i, Y ) w.r.t. i and Y
I What happens to velocity of money when i increases?
I What would happen to money demand and velocity of moneyif grocery stores started accepting treasury bills as payment?How would this change the definition of money?
I True, false, or uncertain: having more buyers and sellers in themarket for commercial paper would make commercial paperless liquid because sellers would have to compete more.
I Debit card fees get lowered because of better technologies forprocessing the transactions
I Bankers become worried about potential bank runs
I The ECB buys more bonds