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Money and Banking

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Money & Banking ­ MGT411
VU
Lesson 37
WHY DO WE CARE ABOUT MONETARY AGGREGATES?
Every country with high inflation has high money growth; thus to avoid sustained episodes of
high inflation, a central bank must be concerned with money growth.
It is impossible to have high, sustained inflation without monetary accommodation.
Monetary Aggregates
Figure: Inflation and Money Growth:
Moderate-Inflation Countries, 1981-2003
50
45 Line
40
30
20
10
0
10
20
30
40
50
Average Annual Money Growth (%)
Figure: Money, Growth and Inflation
45 Line
Inflation>Money Growth
Money Growth <Inflation
Average Annual Money Growth
When the currency that people are holding loses value much rapidly, they will work to spend
what they have as quickly as possible
This will have the same effect on inflation as an increase in money growth
It is impossible to have high, sustained inflation without monetary accommodation.
Something beyond just differences in money growth accounts for the differences in inflation
across countries.
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Money & Banking ­ MGT411
VU
Velocity and the Equation of Exchange
To understand the relationship between inflation and money growth we need to focus on money
as a means of payment.
Consider an example of four students
Ali has Rs. 100 in cash
Bilal has a Rs. 100 calculator
Chohan has 2 tickets worth Rs. 50 each for a cricket match
Dilawer has a set of 25 drawing pencils worth Rs. 4 each
Ali needs a calculator which he buys from Bilal.
Bilal wishes to see the match so he buys the tickets from Chohan
Chohan uses the proceeds to purchase the drawing pencils from Dilawer
Total Value of the transactions is
(Rs. 100 x 1 calculator) + (Rs. 50 x 2 tickets) + (Rs. 4 x 25 pencils) = Rs. 300
Generally
No. of Rupees x No. of time each Re is used = Rs. Value of Transactions
The number of times each rupee is used (per unit of time) in making payments is called the
velocity of money; the more frequently each rupee is used, the higher the velocity of money
Applying to economy wide transactions:
Quantity of Money x Velocity of Money = Nominal GDP
Using data on the quantity of money and nominal GDP we can compute the velocity of money;
each monetary aggregate has its own velocity
If we represent
Money with M
Velocity with V
Price level with P
Real GDP with Y
Nominal GDP = P x Y
Substituting, we get
MxV=PxY
The equation of exchange, MV=PY provides the link between money and prices if we rewrite it
in terms of percentage changes
The Quantity Theory and the Velocity of Money
MV = PY
or
% ΔM + % ΔV = % ΔP + % ΔY
Money Growth + Velocity Growth = Inflation + Output Growth
In the early 20th century, Irving Fisher wrote down the equation of exchange and derived the
implication that
Money growth + velocity growth = inflation + real growth
Assuming
No important changes occur in payment methods or the cost of holding money,
Real output is determined solely by economic resources and production technology,
Then changes in the aggregate price level are caused solely by changes in the quantity of
money.
In other words
Assume that %ΔV = 0 and %ΔY = 0.
Doubling the quantity of money doubles the price level.
Inflation is a monetary phenomenon (Milton Friedman).
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Money & Banking ­ MGT411
VU
In our example of four students, number of rupees needed equaled total rupee value of the
transaction divided by no. of times each rupee was used
Money demand = Total value of transaction
Velocity of Money
For the economy as a whole,
Money demand = Nominal GDP
Velocity
Md = 1/V x PY
Money Supply (Ms) is determined by central bank and the behavior of the banking system
Equilibrium means Md = Ms = M
Rearranging the Money demand function gives MV = PY
The quantity theory of money tells us why high inflation and high money growth go together,
and explains why countries can have money growth that is higher than inflation (because they
are experiencing real growth).
The Facts about Velocity
Fisher's logic led Milton Friedman to conclude that central banks should simply set money
growth at a constant rate.
Policymakers should strive to ensure that the monetary aggregates grow at a rate equal to the
rate of real growth plus the desired level of inflation.
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Table of Contents:
  1. TEXT AND REFERENCE MATERIAL & FIVE PARTS OF THE FINANCIAL SYSTEM
  2. FIVE CORE PRINCIPLES OF MONEY AND BANKING:Time has Value
  3. MONEY & THE PAYMENT SYSTEM:Distinctions among Money, Wealth, and Income
  4. OTHER FORMS OF PAYMENTS:Electronic Funds Transfer, E-money
  5. FINANCIAL INTERMEDIARIES:Indirect Finance, Financial and Economic Development
  6. FINANCIAL INSTRUMENTS & FINANCIAL MARKETS:Primarily Stores of Value
  7. FINANCIAL INSTITUTIONS:The structure of the financial industry
  8. TIME VALUE OF MONEY:Future Value, Present Value
  9. APPLICATION OF PRESENT VALUE CONCEPTS:Compound Annual Rates
  10. BOND PRICING & RISK:Valuing the Principal Payment, Risk
  11. MEASURING RISK:Variance, Standard Deviation, Value at Risk, Risk Aversion
  12. EVALUATING RISK:Deciding if a risk is worth taking, Sources of Risk
  13. BONDS & BONDS PRICING:Zero-Coupon Bonds, Fixed Payment Loans
  14. YIELD TO MATURIRY:Current Yield, Holding Period Returns
  15. SHIFTS IN EQUILIBRIUM IN THE BOND MARKET & RISK
  16. BONDS & SOURCES OF BOND RISK:Inflation Risk, Bond Ratings
  17. TAX EFFECT & TERM STRUCTURE OF INTEREST RATE:Expectations Hypothesis
  18. THE LIQUIDITY PREMIUM THEORY:Essential Characteristics of Common Stock
  19. VALUING STOCKS:Fundamental Value and the Dividend-Discount Model
  20. RISK AND VALUE OF STOCKS:The Theory of Efficient Markets
  21. ROLE OF FINANCIAL INTERMEDIARIES:Pooling Savings
  22. ROLE OF FINANCIAL INTERMEDIARIES (CONTINUED):Providing Liquidity
  23. BANKING:The Balance Sheet of Commercial Banks, Assets: Uses of Funds
  24. BALANCE SHEET OF COMMERCIAL BANKS:Bank Capital and Profitability
  25. BANK RISK:Liquidity Risk, Credit Risk, Interest-Rate Risk
  26. INTEREST RATE RISK:Trading Risk, Other Risks, The Globalization of Banking
  27. NON- DEPOSITORY INSTITUTIONS:Insurance Companies, Securities Firms
  28. SECURITIES FIRMS (Continued):Finance Companies, Banking Crisis
  29. THE GOVERNMENT SAFETY NET:Supervision and Examination
  30. THE GOVERNMENT'S BANK:The Bankers' Bank, Low, Stable Inflation
  31. LOW, STABLE INFLATION:High, Stable Real Growth
  32. MEETING THE CHALLENGE: CREATING A SUCCESSFUL CENTRAL BANK
  33. THE MONETARY BASE:Changing the Size and Composition of the Balance Sheet
  34. DEPOSIT CREATION IN A SINGLE BANK:Types of Reserves
  35. MONEY MULTIPLIER:The Quantity of Money (M) Depends on
  36. TARGET FEDERAL FUNDS RATE AND OPEN MARKET OPERATION
  37. WHY DO WE CARE ABOUT MONETARY AGGREGATES?The Facts about Velocity
  38. THE FACTS ABOUT VELOCITY:Money Growth + Velocity Growth = Inflation + Real Growth
  39. THE PORTFOLIO DEMAND FOR MONEY:Output and Inflation in the Long Run
  40. MONEY GROWTH, INFLATION, AND AGGREGATE DEMAND
  41. DERIVING THE MONETARY POLICY REACTION CURVE
  42. THE AGGREGATE DEMAND CURVE:Shifting the Aggregate Demand Curve
  43. THE AGGREGATE SUPPLY CURVE:Inflation Shocks
  44. EQUILIBRIUM AND THE DETERMINATION OF OUTPUT AND INFLATION
  45. SHIFTS IN POTENTIAL OUTPUT AND REAL BUSINESS CYCLE THEORY