the quantity theory of money

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Tutorial of Quantity theory of Money and the Money Transmission Mechanism

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Quantity Theory of Money / Monetary Transmission Mechanism :

Quantity Theory of Money / Monetary Transmission Mechanism

Slide 2:

Quantity Theory of Money Devised by Irving Fisher to explain the link between money and the general price level Based on the Fisher equation or the equation of exchange This is the mathematical identity which relates aggregate demand to the total value of output (GDP) M x V≡ P x T or (MV≡PY) M is the money supply V is the velocity of circulation (e.g. how many times a £20 note is used to buy goods and services in year) P is the general price level T stands for transactions and is equivalent to output Y is the real value of national output (real GDP) Quantity Theory of Money: the theory that increase in the money supply will lead to increases in the price level Velocity of circulation: the number of times the money supply changes hands in a year

Slide 3:

Quantity Theory of Money Monetarists argue that the velocity of circulation of money is broadly predictable and therefore assumed to be constant T and Y (real GDP) tends to increase slowly over time and thus is assumed to be constant in any one year If V and T (Y) are held constant then changes in the rate of growth of the money supply will lead directly to changes in the general price level So as money supply increases so does inflation Quantity Theory of Money: the theory that increase in the money supply will lead to increases in the price level Velocity of circulation: the number of times the money supply changes hands in a year

Slide 4:

Monetary Transmission Mechanism Monetarists argue that inflation is demand-pull in nature Increases in money supply lead to increases in AD which in turn leads to increases in price level The link between an increase in the money supply and inflation is known as the Monetary Transmission Mechanism This is illustrated in the diagram here

Slide 5:

Monetary Transmission Mechanism At a point in time t1 there is an increase in the money supply from M1 to M2 The immediate effect is a fall in the velocity of circulation As time goes on money begins to be spend leading to a rise in real output and income (Y) This leads to demand pull inflation and prices begin to rise Rising prices lead to less real spending as consumers can buy less with their money Income (Y) becomes to fall Equilibrium is restored when y and V are back to their original levels Prices have risen from P1 to P2

Slide 6:

Monetary Transmission Mechanism The exact links between a rise in the money supply and a rise in prices are complex Figure 3 summarises

Slide 7:

Monetary Transmission Mechanism Interest rates are the main instrument of monetary policy rather than the money supply over which they have far less control a fall in interest rates has an impact on demand in the economy in four main ways A fall in money market interest rates should lead to changes in other banks and building lending/borrowing rates This fall will encourage consumers and firms to borrow and increase AD It will also increase disposable income (because less is being spend on variable mortgages)

Slide 8:

Monetary Transmission Mechanism A fall in interest rates may increase asset prices Lower interest rates will encourage people to buy larger houses or their first house Higher demand for houses leads to higher house prices Rising house prices can lead to equity withdrawal – people remortgage and use the money to buy cars, house extensions, foreign holidays etc Falling interest rates also increase share prices Higher spending leads to raising sales and higher profits for firms Rising share prices lead to greater consumer confidence and greater spending

Slide 9:

Monetary Transmission Mechanism Falling interest rates change the expectations of economic agents in the market They are likely to lead to higher demand, higher pay and lower unemployment Consumer and business confidence leads to higher consumption and investment Falling interest rates also leads to a fall in the pound – less demand for the pound reduces its value WIDEC Exports increase; Imports decrease AD increases

Slide 10:

Monetary Transmission Mechanism All of these 4 factors combined increase AD which in turn leads to a rise in prices There is also a cost push element in the transmission mechanism The fall in the value of the £ leads to more expensive imports This will increase firm’s costs These may be passed on to the consumer leading to a rise in domestic prices

Slide 11:

Monetary Transmission Mechanism The transmission mechanism can be illustrated using AD/AS as seen below Insert fig 4 P506

Slide 12:

Monetary Accommodation and Validation Individual economies are constantly being buffeted by both demand-side and supply-side shocks Governments and central banks can react in a variety of ways They can accommodate for supply side shocks and Validate for demand side shocks They accommodate or validate the inflationary pressures by allowing the money supply to expand and interest rates to remain relatively low Monetary policy accommodation – a change in the nominal money supply which the government permits following a supply side shock in order to keep the real money supply constant Monetary policy validation – a change in the nominal money supply which the government permits following a change in aggregate demand in order to keep the real money supply constant

Slide 13:

Monetary Accommodation and Validation This can be illustrated in this diagram Economy starts in long run equilibrium at point A There is then a supply side shock like a large rise in international commodity prices This shifts the SRAS curve upwards to SRAS2 and SRAS3 At point C there are higher prices, a negative output gap and unemployment The economy is in recession This combination of rising inflation and unemployment is known as stagflation Stagflation / Slumpflation – a situation where an economy faces both rising inflation and rising unemployment

Slide 14:

Monetary Accommodation and Validation Government can chose to Spend their way out of the recession by increasing AD Reduce interest rates or keep them low Increase government borrowing through effectively printing money and increasing the money supply The monetary accommodation shifts the AD curve to the right from AD1 to AD2 Short run equilibrium is now at E Workers are likely to be demanding higher pay This moves the equilibrium to F This could be the start of wage price spiral If government constantly accommodates this by raising the money supply prices will carry on rising

Slide 15:

Monetary Accommodation and Validation The reason why governments accommodate or validate economic shocks is that they want to keep unemployment low and get the economy growing again The alternative is not to increase the money supply Unemployment will rise as output falls AD falls from C to A The recession will lead to firms cutting their prices to maintain sales Inflation will fall The economy will begin to recover as it moves to point B Eventually the economy will return to full employment at A with the original level of prices

Slide 16:

Monetary Accommodation and Validation Monetarists argue that inflation should not be accommodated or validated They say the inflation is not caused by demand or supply side shocks but increasing the money supply Most central banks operate monetary policy by changing interest rates There is general acceptance that demand and supply shocks which cause rises inflation should be met with interest rate rises. This effectively reduces money supply The bank of England also argue that the link between money supply and inflation is unclear Milton Friedman said ‘inflation is always and everywhere a monetary phenomenon’ The debate goes on

Slide 17:

Monetarist versus Keynesian views (evaluation) The monetarist argument that increases in money supply cause inflation are dependent on the following assumptions The velocity of circulation of money is constant Income (transactions) changes slowly over time Keynesians argue that the demand for money is unstable and therefore V is unstable too They also point out that monetarists assume that causality runs from M to P Logically it could equally be true that it works the other way; price increases could lead to an increase in the money supply There are 2 ways this could happen

Slide 18:

Monetarist versus Keynesian views Assume that the money supply is endogenous (generated within the system and not controlled by the central bank) Rise in wages leads to increase in demand for money from banks Firms need more money to pay workers An increased demand for money will up interest rates Banks will find it more profitable to create money The money supply will expand If the money supply is exogenous (controlled by the central bank) Central bank may not choose to restrict the growth of money supply It may allow the supply to expand rather than accept the consequences of restricting its growth

Slide 19:

Monetarist versus Keynesian views Economists are agreed that very large increases in the money supply will inevitably lead to high inflation If the money supply increases by 200 % over a year it would be impossible for either V or Y to change sufficiently for P to be unaffected The debate centres round the effects of relatively small increases Are money supply increases of 5, 10, or 20% necessarily inflationary?

Slide 20:

Assessment Read through the slides now/for homework Make sure you can draw the diagrams Assessment first thing next lesson

Slide 22:

Do some research on what has been happening In the UK where inflation and interest rates are concerned http://www.guardian.co.uk/business/interest-rates Think back to Omran and Raneem’s presentation (see slides) Someone will be picked to explain to the class Then use this information to answer the questions below Change 20 for 15 and 30 for 25 marks. Complete by Tuesday 15 th March