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Chapter – 20 – Money Growth, Money Demand, and Modern Monetary Policy

Chapter 20

Money Growth, Money Demand, and

Modern Monetary Policy

Chapter Overview

In contrast with the United States, money plays a central role in the formulation of

European monetary policy. What accounts for the difference? In this chapter we will

examine the link between money growth and inflation (to clarify the role of money in

monetary policy) and explain the logic underlying central bankers’ focus on interest rates.

Learning Objectives: Establish an understanding of:

1. Monetary aggregates

2. The quantity theory of money

3. The velocity of, and demand for, money

4. Monetary targeting

Important Points of the Chapter

Even though most of the discussion about monetary policy these days seems to focus on

interest rates and exchange rates, central bankers do care about money. Most economists

agree with Milton Friedman that, “inflation is always and everywhere a monetary

phenomenon.” In contrast with the United States, money plays a central role in the

formulation of European monetary policy. The ECB’s monthly announcements of its

target interest rate have always mentioned money growth, whereas since July 2000 the

FOMC stopped publishing target ranges for the monetary aggregates, saying that they no

longer provided “useful benchmarks for monetary policy.”

Application of Core Principles

Principle #5: Stability. The higher the rate of money growth, the higher inflation is

likely to be. Thus, to avoid sustained episodes of high inflation, a central bank must be

concerned with money growth.

Principle #4: Markets. Changes in velocity can be linked to interest rates and to

innovations in financial markets, such as the introduction of stock and bond mutual funds

that allowed checking privileges in the late 1970s and early 1980s.

Principle #1: Time. The higher the nominal interest rate, the less money individuals will

hold.

Principle #2: Risk. Changes in the riskiness of other assets will affect the demand for

money.

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Chapter – 20 – Money Growth, Money Demand, and Modern Monetary Policy

Principle #5: Stability. By keeping interest rates stable, policymakers can insulate the

real economy from disturbances that arise in the financial system.

Teaching Tips/Student Stumbling Blocks

The material in this chapter lays the groundwork for the presentation of the new

approach to macroeconomics that is explored in Chapters 21 and 22. The purpose

of this chapter is to get the student to the point where he or she realizes why

modern central banks focus on interest rate control.

The primary focus in chapter 20 is on Core Principle 5, which states that stability

enhances economic welfare. The specific application is with regard to the “money

market” and whether, given the long-run relationship between the money supply

and the price level (or, in rate of change form, between money growth and

inflation) control of the money supply as a short-term policy procedure can

stabilize the economy. As you may have anticipated from the title of chapter 18

(Monetary Policy: Using Interest Rates to Stabilize the Domestic Economy), the

answer is “no.”

The fundamental framework used is the Quantity Theory of Money, presented in

section II. The easiest way to explain the fundamentals of the theory is in terms of

supply and demand. Specifically, the demand for money can be written as:



Using Ms for the money supply (which, in additional detail from Chapter 17 is (m

x MB), the money multiplier times the monetary base). Setting the money supply

equal to money demand then gives equilibrium in the money market:



You can then explain that instability in velocity, V, shows up as instability in

money demand (1/V). Setting the money supply at some level (fixing the left hand

side of this expression) then means that variability in V must be offset by

fluctuations in P and/or Y in order for the equation to hold. That is, if V is volatile

and unpredictable, using the money supply as the policy instrument and setting it

at a specific value implies unwanted volatility in prices or output.

Multiplying both sides by V and expressing in terms of rates of change, we

obtain, as in text equation (4),

Y%P%V%M% 

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Chapter – 20 – Money Growth, Money Demand, and Modern Monetary Policy

In terms of rates of change, for a given rate of money growth (setting %∆M to a

constant value), variability in velocity (fluctuations in %∆V) implies unwanted

variability in inflation (%∆)) and/or economic growth (%∆Y). By Core Principle

5, such instability lowers economic welfare.

So, the question to pose for students is: is velocity volatile and unpredictable? The

quick answer for the U.S. is “yes” and they should be watching for support of this

result. You’ll find it in Figures 20.8 and 20.9 and the discussions of them in the

text. As a result, policymakers use the interest rate as their operating instrument

for short-term policy.

Features in this Chapter

Applying the Concept: Inflation and the Collapse of the Soviet Union

Rapid money growth was the source of the extraordinary levels of inflation that occurred

in the “former Soviet Republics” after the collapse of the Soviet Union. Committed to

high levels of expenditure, these new countries had no source of revenue beyond the

printing of money. Officials in these countries eventually put the money-printing

authority into the hands of independent central banks, and an amazing transformation

resulted.

Your Financial World: Understanding Inflation Statistics

When people think about inflation they think about the Consumer Price Index (CPI). It is

the most commonly used and closely watched measure of inflation in the United States.

To construct the CPI, government statisticians construct a representative market basket of

goods and services and track how much it costs from month to month. Inflation, as

measured by the CPI, is the percentage change in the price of this basket. The CPI tends

to overstate inflation by an estimated one percentage point a year because it does not

account for changes in consumer buying patterns or improvements in the quality of goods

and services.

Applying the Concept: The ECB’s Reference Value for Money Growth

The monetary policy strategy of the ECB assigns a prominent role to money. It came

under criticism for this, as observers claimed that the relationship between money growth

and inflation was too unpredictable to be useful in the short run. In response, the ECB

decided to downgrade the role of money, and as of May 2003, money growth would be

used as “a crosscheck” and not as a major part of their strategy.

Your Financial World: Free Checking Accounts Are Rarely Free

Checking accounts may not have a monthly service charge but that doesn’t mean that

they are free; there may be significant fees associated with the account.

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Chapter – 20 – Money Growth, Money Demand, and Modern Monetary Policy

Tools of the Trade: Using Statistical Models in Policy Evaluation

The use of statistical models in policy evaluation has pitfalls. For an economic prediction

to be valid, it must be based on data drawn from a historical period in which the same set

of policies was in place; if it isn’t the results can be seriously misleading. As observed by

economist Robert Lucas, altering economic policy will change people’s economic

decisions. This is because people take policymakers’ actions into account when they

form their expectations. This is known as the Lucas Critique and has taught

policymakers that people’s responses must be taken into account in formulating policy.

Applying the Concept: Financial Innovation and the Shifting Velocity of Money

Financial innovations influence the velocity of money and create serious difficulties for

statisticians who are trying to construct useful definitions of the monetary aggregates.

The aggregates can always be adjusted after the fact to account for changes in the

financial system, and for the purpose of monitoring long-run economic conditions that is

sufficient. The real difficulty is calculating the impact of such changes as they are

occurring, so that the information can be used for short-run policymaking.

In the News: Will Fed’s ‘Easy Money’ Push Up Prices?

The Fed has held short-term interest rates near zero for four years and expects to keep

them there for another few years. It has printed money and pumped it into the economy.

Will that be inflationary? David Wessel argues “no.” That more money would spark

inflation is difficult to predict in the short run, especially given higher unemployment and

unused capital. Further, loans by banks holding excess reserves are less likely with the

Fed’s ability to increase the interest rate paid on those excess reserves. Some argue that

the Fed wants inflation, which is contrary to the Fed’s history. The Fed has said that it

will tolerate inflation higher than target if unemployment remains high, thus causing

consumers, businesses and markets to expect higher inflation, often causing that higher

inflation.

Lessons of the Article: Both theory and experience confirm that money growth drives

inflation in the long run. In the short run, however, the link is loose. Beginning in

2008, the volume of base money in the United States (and in other advanced

economies) soared, but inflation didn’t follow. The Fed is committed to keeping

inflation low and argues that it has the tools to do so. As the U.S. economy recovers,

the Fed’s claims will be tested.

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Chapter – 20 – Money Growth, Money Demand, and Modern Monetary Policy

Additional Teaching Tools

An October 9, 2013 article in the Wall Street Journal entitled “Yellen Can Do It All,

Unfortunately, She Has To”

(http://blogs.wsj.com/moneybeat/2013/10/09/yellen-can-do-it-all-unfortunately-she-has-t

o/?KEYWORDS=MOnetary+aggregates) discusses the many responsibilities Janet

Yellen will need to assume when she takes on the role of “the world’s most powerful

economic policy maker.”

Virtual Tools

Learn more about Milton Friedman on this site from the Nobel e-Museum, which also

includes links to articles and other resources.

http://www.nobel.se/economics/laureates/1976/index.html

Learn more about Robert Lucas on this site from the Nobel e-Museum, which also

includes links to articles and other resources.

http://www.nobel.se/economics/laureates/1995/index.html

For More Discussion

Try an experiment: have students play a board game like Monopoly or Life and keep

track of all the transactions. They can measure the supply of money that comes with the

game, and then calculate the velocity. Do different groups of players come up with

different results?

Debate the Fed’s decision to stop publishing the data on M3. Students can find sources

on the web that attempt to replicate the M3 data and its growth rate and critically evaluate

the findings.

Chapter Outline

I. Why We Care About Monetary Aggregates

1. Every country with high inflation has high money growth; thus to avoid

sustained episodes of high rates of inflation, a central bank must be concerned

with money growth.

2. It is impossible to have high, sustained inflation without monetary

accommodation.

II. The Quantity Theory and the Velocity of Money

A. Velocity and the Equation of Exchange

1. To understand the relationship between inflation and money growth we need

to focus on money as a means of payment.

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2. The number of times each dollar is used (per unit of time) in making payments

is called the velocity of money; the more frequently each dollar is used, the

higher the velocity of money.

3. Using data on the quantity of money and nominal GDP we can compute the

velocity of money; each monetary aggregate has its own velocity.

4. The equation of exchange, MV=PY provides the link between money and

prices if we rewrite it in terms of percentage changes.

B. The Quantity Theory of Money

1. In the early 20th century, Irving Fisher wrote down the equation of exchange

and derived the implication that money growth plus velocity growth equals

inflation plus real growth.

2. Assuming that no important changes occur in payment methods or the cost of

holding money, and that 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.

3. 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).

C. The Facts about Velocity

1. Fisher’s logic led Milton Friedman to conclude that central banks should

simply set money growth at a constant rate.

2. 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.

3. Knowing that the multiplier is a variable, Friedman suggested changes in

regulations that would limit banks’ discretion in creating money and tighten

the relationship between the monetary aggregates and the monetary base.

4. However, even with Friedman’s recommendations, the central bank would

stabilize inflation by keeping money growth constant only if velocity were

constant.

5. In the long run, the velocity of money is stable, though there can be significant

short-run variations.

6. Changes in velocity occurred in the late 1970s and early 1980s both as a result

of high interest rates (which made holding money costly) and the introduction

of new stock and bond mutual funds against which checks could be written

(allowing people to economize on the amount of money they held).

7. Fluctuations in velocity are tied to changes in people’s desire to hold money

and so in order to understand and predict changes in velocity policymakers

must understand the demand for money.

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Chapter – 20 – Money Growth, Money Demand, and Modern Monetary Policy

III.The Demand for Money

A. The Transactions Demand for Money

1. The quantity of money people hold for transactions purposes depends on their

nominal income, the cost of holding money, and the availability of substitutes.

2. Nominal money demand rises with nominal income, as more income means

more spending, which requires more money.

3. Holding money allows people to make payments, but has a cost: the interest

foregone. There may also be costs in switching between interest-bearing

assets and money.

4. As the nominal interest rate rises, people reduce their checking account

balances; that allows us to predict that velocity will change with the interest

rate.

5. The higher the nominal interest rate, the less money individuals will hold for a

given level of transactions, and the higher the velocity of money.

6. The transactions demand for money is also affected by technology, as

financial innovation allows people to limit the amount of money they hold.

7. The lower the cost of shifting money between accounts, the lower the money

holdings and the higher the velocity.

8. An increase in the liquidity of stocks, bonds, or any other asset reduces the

transactions demand for money.

9. People also hold money to ensure against unexpected expenses; this is called

the precautionary demand for money and can be included with the

transactions demand.

10. The higher the level of uncertainty about the future, the higher the demand for

money and the lower the velocity of money.

B. The Portfolio Demand for Money

1. Money is just one of many financial instruments that we can hold in our

investment portfolios.

2. Expectations that interest rates will change in the future are related to the

expected return on a bond and also affect the demand for money.

3. When interest rates are expected to rise, money demand goes up as people

switch from holding bonds into holding money.

4. The demand for money will also be affected by changes in the riskiness of

other assets; as their risk increases so does the demand for money.

5. Money demand will increase if other assets become less liquid.

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Chapter – 20 – Money Growth, Money Demand, and Modern Monetary Policy

IV. Targeting Money Growth in a Low-Inflation Environment

1. Controlling inflation in a high-inflation environment means reducing money

growth; in a low-inflation environment it is not so simple.

2. To use money growth as a direct monetary policy target there must be a stable

link between the monetary base and the quantity of money and there must be a

predictable relationship between the quantity of money and inflation.

B. The Instability of U.S. Money Demand

1. An increase in the opportunity cost of holding money can be used to forecast

an increase in velocity, but the data show that the relationship can shift over

time.

2. There are several reasons for the instability of U.S. money demand over the

last quarter of the 20th century; the primary one has to do with the introduction

of financial instruments that paid higher returns than money, but could still be

used as a means of payment.

3. A second explanation for the breakdown in the relationship between the

velocity of M2 and its opportunity cost has to do with changes in mortgage

refinancing rates.

4. Refinancing creates demand for money; people take equity from their homes

and deposit the funds in liquid deposit accounts until they are spent. Also, the

process of refinancing moves funds through accounts that are part of M2.

C. Targeting Money Growth: The Fed and the ECB

1. The difference of opinion between the Fed and the ECB regarding the focus

on money in monetary policy can be traced to their divergent views on the

stability of money demand.

2. The justification for the ECB’s emphasis on money in its monetary policy

framework comes from studies that have indicated that the demand for money

in the euro area is stable (which means that changes in velocity are

predictable).

3. Even given the difference in emphasis on money growth, the ECB and the Fed

have both chosen interest rates as their operating targets because those rates

are the link between the financial system and the real economy.

4. By keeping interest rates stable, policymakers can insulate the real economy

from disturbances that arise in the financial system.

5. Targeting money growth destabilizes interest rates.

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Chapter – 20 – Money Growth, Money Demand, and Modern Monetary Policy

Terms Introduced in Chapter 20

equation of exchange

Lucas critique

nominal gross domestic product

portfolio demand for money

precautionary demand for money

quantity theory of money

transactions demand for money

velocity of money

Using FRED: Codes for Data in This Chapter

Data Series FRED Data Code

M1 M1SL

M2 M2SL

Consumer prices: US CPIAUCSL

Consumer prices: Brazil BRACPIALLMINMEI

Nominal GDP GDP

M2 velocity M2V

M1 velocity M1V

Chained CPI US SUUR0000SA0

GDP Deflator GDPDEF

M2 own rate of return M2OWN

U.S. 3‐month T‐bill rate TB3MS

Federal funds rate FEDFUNDS

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Chapter – 20 – Money Growth, Money Demand, and Modern Monetary Policy

Lessons of Chapter 20

1. There is a strong positive correlation between money growth and inflation.

a. Every country that has had high rates of sustained money growth has experienced

high rates of inflation.

b. At very high levels of inflation, inflation exceeds money growth.

c. At moderate to low inflation, money growth exceeds inflation.

d. Ultimately, the central bank controls the rate of money growth.

2. The quantity theory of money explains the link between inflation and money growth.

a. The equation of exchange tells us that

i. The quantity of money times the velocity of money equals nominal GDP.

ii. Money growth plus velocity growth equals inflation plus real growth.

b. If velocity and real growth were constant, the central bank could control inflation

by keeping money growth constant.

c. In the long run, velocity is stable, so controlling inflation means controlling

money growth.

d. In the short run, velocity is volatile.

3. Shifts in velocity are caused by changes in the demand for money.

a. The transactions demand for money depends on income, interest rates, and the

availability of alternative means of payment.

b. The portfolio demand for money depends on the same factors that determine the

demand for bonds: wealth, expected future interest rates, and the return, risk, and

liquidity associated with money relative to alternative investments.

4. The quantity theory of money and theories of money demand have a number of

implications for monetary policy.

a. Countries with high inflation can reduce inflation by controlling money growth.

b. Countries with low inflation can control inflation by targeting money growth only

if the demand for money is stable in the short run.

c. In the United States, the relationship between the velocity of M2 and its

opportunity cost (the yield on an alternative investment) has proven unstable over

time.

d. The instability of money demand in the United States has caused Federal Reserve

policymakers to pay less attention to money growth than to interest rates.

e. In the Euro area, money demand is stable, which has caused the ECB’s

policymakers to pay more attention to money growth than the Fed does.

f. Regardless of the stability of money demand, central banks target interest rates to

insulate the real economy from disturbances in the financial sector.

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