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Chapter 20 Money Growth, Money Demand, and Modern Monetary Policy Conceptual and Analytical Problems Why is inflation higher than money growth in high inflation countries and lower than money growth in low inflation countries? Answer: At very high levels of inflation, the velocity of money rises dramatically as people rush to spend their currency before it loses value; this causes inflation to be higher than money growth. Inflation is lower than money growth in low-inflation countries because part of the growth of money is offset by economic growth. Explain why giving an independent central bank control over the quantity of money in the economy should reduce the occurrences of periods of extremely high inflation, especially in developing economies. Answer: Inflation is a monetary phenomenon and independent central banks are more likely than governments (who may be looking for a way to finance spending for example) to consider the consequences for inflation when deciding how much money to print. Central bank independence may be difficult to maintain in developing economies, however, if government is unable to efficiently collect tax revenues. The central bank may face pressure to monetize government debt and risk high and rising inflation. If velocity were constant at 2 while M2 rose from $5 trillion to $6 trillion in a single year, what would happen to nominal GDP? If real GDP rose 3 percent, what would be the level of inflation? Answer: Money growth + velocity growth = growth of nominal GDP, so nominal GDP would rise by (6 – 5)/5 × 100 percent + 0 percent = 20 percent. Nominal GDP growth = inflation rate + real growth, so inflation = 20 percent – 3 percent = 17 percent. According to Irving Fisher, when velocity and output are fixed, the quantity theory of money implies that inflation equals money growth. What does the quantity theory imply for inflation in the long run in an economy with growing output and stable velocity? Answer: Using equation (4), %∆M + %∆V = %∆P + %∆Y, if velocity is constant, then inflation is the excess of money growth over real output growth: %∆P = %∆M - %∆Y. If velocity were predictable but not constant, would a monetary policy that fixed the growth rate of money work? Answer: We know that money growth + velocity growth = inflation + real growth. If velocity is not constant, then fixing the growth rate of money will result in either rising or falling inflation. However, if velocity is predictable, policymakers could increase money growth at the same rate that velocity is decreasing (or decrease money growth at the same rate that velocity is increasing) in order to stabilize inflation. Describe the impact of financial innovations on the demand for money and velocity. Answer: Financial innovations reduce the demand for money and increase velocity. By making alternatives to money more liquid, individuals need less money as a means of payment. By providing a broader array of financial instruments that can be used as stores of wealth; innovations have reduced the use of traditional money as a store of wealth. Since we never know exactly when the innovations will occur, it is difficult to predict the path of velocity over short-run periods of a year or two. Suppose that expected inflation rises by 3 percent at the same time that the yields on money and on nonmoney assets both rise by 3 percent. What will happen to the demand for money? What if expected inflation rose by only 2 percent? What if the yield on nonmoney assets rose by 4 percent? Answer: Money demand depends in part on its opportunity cost, the difference between the real yield on nonmoney assets and the real yield on money. If expected inflation rises by 3 percent as the yields on money and on nonmoney assets also rise by 3 percent, the expected real yields on money and on nonmoney assets are unchanged and the demand for money will not be affected. If expected inflation rises by 2 percent, the expected real yields on money and on nonmoney assets both rise by 1 percent and the demand for money will once again be unaffected. If the yield on nonmoney assets rises by 4 percent while the yield on money rises by only 3 percent, then the return to alternative investments relative to the return on money rises, regardless of the level of inflation. This reduces the portfolio demand for money. Explain how money growth reduces the purchasing power of money. Answer: By increasing the supply of money, holding demand for money constant, the value of each dollar relative to goods and services in the economy will fall. The price of money in terms of goods and services has fallen. Provide arguments both for and against the Federal Reserve’s adoption of a target growth rate for M2. What assumptions would be necessary to compute such a target rate? Answer: In the long run, inflation is tied to money growth. However, in the short run, the velocity of money is volatile, and controlling the growth rate of money does not necessarily translate to control over inflation. If the Fed were to compute a target rate, it would need to make assumptions about the velocity of money. It would also need to predict the behavior of both banks and consumers in order to make assumptions about the link—the money multiplier—between the monetary base and the quantity of M2. Explain why we observed a fall in the velocity of M2 during the financial crisis of 2007–2009. Answer: The increase in uncertainty during the financial crisis drove investors to hold a larger portion of their assets in the form of money. Increased money holding relative to the level of economic activity means that each dollar has to be used fewer times, lowering velocity. Comment on the role given to money in the monetary policy strategy of the ECB. Answer: Although the ECB has downgraded the role initially given to money in its monetary policy strategy, it still pays more attention to money than its U.S. counterpart, using it to “cross-check” other indicators of inflation prospects. While fluctuations in velocity limit the usefulness of the money growth rate for short-term policy making, money growth remains linked to inflation in the medium to long run. Countries A and B both have the same money growth rate and in both countries, real output is constant. In Country A velocity is constant while in Country B velocity has fallen. In which country will inflation be higher? Explain why. Answer: Using the equation of exchange: Money growth + Velocity growth = Inflation + Real growth, we see that inflation will be higher in Country A. The fall in velocity reflects an increase in money demand in Country B, which offsets some of the inflationary pressures from the rise in the stock of money. Consider a country where the level of excess reserves fluctuates widely and unpredictably. Would such a country be a good candidate for a money growth rule to guide monetary policy? Explain your answer. Answer: This country would not be a good candidate. One requirement for a money growth rule to be effective at controlling inflation is for there to be a stable link between the monetary base and monetary aggregates, such as M1 and M2. This would not be the case here, as the volatile excess reserve-deposit ratio would cause fluctuations in the money multiplier. Draw a graph of money demand and money supply with the nominal interest rate on the vertical axis and money balances on the horizontal axis. Assume the central bank is following a money growth rule where its sets the growth rate of money supply to zero. Use the graph to illustrate how fluctuations in velocity imply that targeting money growth results in greater volatility of interest rates. Answer: Changes in velocity are reflected in shifts in the money demand curve. For example, if financial innovation causes money demand to be lower (and so velocity to be higher) at a given interest rate, this will shift the demand curve to the left and the interest rate will decline. If velocity falls, the money demand curve will shift right and the interest rate will rise. If the central bank is following a zero growth rule for money supply, then the money supply curve does not respond to the changes in money demand, so the interest rate must adjust to maintain money market equilibrium. Using the same graph as that described in Problem 14, show how the central bank could use its control over the quantity of money to target a particular interest rate in the face of changes in velocity. Answer: Suppose that velocity falls, shifting the money demand curve to the right. The central bank could increase the stock of money in the economy to keep the interest rate at its target. Why might targeting the money supply lead to lower output growth than targeting the rate of interest? Consider your responses to Problems 14 and 15 before you answer. Answer: In your answer to Problem14, you found that targeting the money supply resulted in interest rate volatility (see Figure 20.8 for an example of increased interest rate volatility when the Fed targeted reserves), while the answer to Problem 15 shows that adjusting the money supply could avoid that volatility. Volatility of interest rates poses risks to investors in long-term assets that should be compensated in the form of a higher risk premium (Core Principle 2). That risk premium lowers the value of long-term assets, including bonds, stocks, business plant and equipment, and real estate. As a result, it tends to reduce investment and slow economic growth. Which of the following factors would increase the transactions demand for money? Explain your choices. Lower nominal interest rates. Rumors that a computer virus had invaded the ATM network. A fall in nominal income. Answer: Both (a) and (b) would increase the transactions demand for money. Lower nominal interest rates lower the opportunity cost of holding money and so money demand will be higher. A computer virus in the ATM network would lead to worries about the system closing down and so increase money demand. Option (c), a fall in nominal income, would lead to a fall in the transactions demand for money as people spend less on goods and services. Which of the following factors would increase the portfolio demand for money? Explain your choices. A new website allows you to liquidate your stock holdings quickly and cheaply. You expect future interest rates to rise. A financial crisis is looming. Answer: Both options (b) and (c) would increase the portfolio demand for money. If future interest rates are expected to rise, bond prices will drop, leading to a capital loss for bondholders. This makes money relatively more attractive. The prospect of a financial crisis will increase the relative riskiness of alternative assets, thus increasing the portfolio demand for money. Option (a) will increase the relative liquidity of alternative assets and so reduce the portfolio demand for money. Suppose a central bank is trying to decide whether to target money growth. Proponents of the move are confident that the new policy would be successful as, under the existing policy regime, they observed a stable statistical relationship between money growth and inflation. What warning might you issue to the central bank when they ask your advice? Answer: You should warn the central bank that altering its policy may alter people’s economic decisions and so the relationships observed under the old policy may not hold under a new one. Economic decisions are based on expectations about the future, which include what the public expects the central bank to do. If “inflation is always and everywhere a monetary phenomenon,” why did the huge expansions of central bank money by the Federal Reserve, the ECB, and the Bank of Japan between 2007 and 2015 not result in high inflation in those economies? Answer: The massive expansion of central bank money (currency plus reserves) did not translate into high growth rates in the broad monetary aggregates that are most tightly linked to inflation. The financial crisis altered the behavior of banks, whose role in lending and deposit creation is critical for transmitting changes in the monetary base to broad money. To a large extent, banks responded to the increase in the monetary base by hoarding excess reserves rather than increasing lending. As a result, broad money growth was muted. Put differently, the money multiplier fell drastically in these economies as banks became unwilling or unable to convert reserves into credit. Why might the ECB place somewhat greater emphasis than the Federal Reserve on money growth rates in discussing monetary policy? Answer: The usefulness of money growth as a policy guide depends on the stability of money demand (or velocity). In its early years, the ECB was more confident than the Fed regarding the stability of money demand. Since 2005, however, the ECB also has downplayed the importance of money growth in policy setting. Analysis of euro-area M3 growth now serves as a “cross check” for a broad assessment of financial and economic conditions affecting inflation and economic growth. Data Exploration A scatter plot can reveal a relationship between two indicators. Construct a scatter plot of annual data beginning in 1959 for inflation and money growth. Measure these as the percent change from a year ago of consumer prices (FRED code: CPIAUCSL) and M2 (FRED code: M2SL), respectively. Then, display a second scatter plot of annual data beginning in 1959 for inflation (measured as before) and the federal funds rate (FRED code: FEDFUNDS). Which indicator is more closely linked to inflation: money growth or the interest rate? Does that tell us which policy instrument is the better? Answer: The scatter plots are below. The federal funds rate appears more closely linked to inflation. However, this information is insufficient to determine the correct monetary policy tool. Correlation is not necessarily causation, so while the interest rate may be more highly correlated with inflation than M2 growth, the reason may be that inflation changes cause interest rate movements, rather than vice versa. Moreover, if the interest rate were not the current policy tool, then switching to a new policy regime of using the interest rate as a tool may result in the observed correlation breaking down. Consequently, the relatively close link in the interest rate-inflation scatter plot is just a starting point for evaluating the interest rate as a policy tool, but it does not prove that the interest rate is the superior policy instrument. Plot the percent change from a year ago of the velocity of money (FRED code: A14187USA163NNBR) between 1922 and 1939. Compare the typical scales of the velocity declines during the recessions of this “interwar” period and the velocity declines during the recessions shown in Panel B of Figure 20.4. Were the 1929-33 and 2007-2009 periods special? What role might wealth have played in these two episodes? Answer: The data plot for the interwar period is below. Aside from the Great Depression and the 2007-2009 financial crisis, the declines in velocity during recessions averaged about 5 percent in both the interwar period and in the period shown in Panel B of Figure 20.4. In the 1929-1933 and 2007-2009 episodes, the velocity declines exceeded 10 percent. In the 1929-1933 period, the plunge in stock market wealth preceded the banking crisis, while the drop in housing wealth preceded the 2007-09 financial crisis. In both cases, loss of wealth and financial turmoil led to falling nominal (and real) GDP. Heightened risks and risk aversion encouraged additional demand for money, depressing velocity. Plot annually since 1950 the reciprocal of the consumer price index (FRED code: CPIAUCSL) to see how inflation erodes the purchasing power of money. To start with an initial value of 1.0, in the Units dropdown box in FRED, select the option “Index (Scale to value to 100 for the chosen date)” and then apply the formula “(1/a)*100”. If a dollar bought one unit of goods and serves in 1950, as of which year did the dollar buy only one-half unit? As of 2015, how many units of goods and services did a dollar buy?
Answer: The data is plotted below. The dollar purchased about one-half unit of goods around 1974. As of 2015, it purchased only about 10 percent of the goods that it would have purchased in 1950. In Figure 20.1, which compares money growth and inflation over an extended time period, would Mexico be above or below the 45o line? Plot since 1987 on a quarterly basis the percent change from a year ago of the consumer price index (FRED code: MEXCPIALLQINMEI) and M1 (FRED code: MYAGM1MXM189N) in Mexico. Then download the data and calculate the averages of these inflation and money growth measures. Where would Mexico appear on Figure 20.1? Were there episodes since 1987 when Mexico was on the other side of the 45-degree line? If so, why? Answer: The plot appears below. The average of the annual inflation rate was 20 percent, while the average rate of annual money growth was 29 percent. So, Mexico would appear below the 45-degree line on Figure 20.1. Inspecting the plot below, money growth persistently exceeded inflation since the late 1990s. In the 1980s and briefly in the mid-1990s, however, Mexico experienced periods of very high inflation when its money lost value so rapidly that people rushed to spend it quickly (as in the children’s game of “hot potato”). This spending behavior raised velocity and (as the quantity theory implies) temporarily pushed inflation above the rate of growth of money. Organization for Economic Co-operation and Development, M1 for Mexico© [MANMM101MXQ189S], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/MANMM101MXQ189S. In theory, the velocity of money should rise with the cost of holding it. To assess the theory, plot the opportunity cost of holding M2 – defined as the difference between the three-month Treasury bill rate (FRED code: TB3MS) and the interest rate on M2 components (FRED code: M2OWN) – and (on the right scale) the percent change from a year ago of M2 velocity (FRED code: M2V). What do you conclude?
The plot appears below. The opportunity cost of holding M2 appears to rise in advance of recessions and fall during recessions, consistent with the cycles of M2 velocity. After the early 1980s, and especially after the mid-1990s, M2 velocity appears more closely linked than earlier to the opportunity cost of holding it. That change in sensitivity also is evident in Figure 20.5. However, with the Treasury bill rate close to zero after 2010, the relationship weakened. Perhaps the Treasury bill rate in this period is not a good proxy for the opportunity cost of holding M2. indicates more difficult problems. Solution Manual for Money, Banking and Financial Markets Stephen G. Cecchetti, Kermit L. Schoenholtz 9781259746741, 9780078021749, 9780077473075
