Money and Banking

<<< Previous WHY DO WE CARE ABOUT MONETARY AGGREGATES?The Facts about Velocity Next >>>

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.
116
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).
117
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).