Thought experiment
Imagine that money supply is doubled in the economy
It’s perfectly doubled in each place
Everybody knows this.
Information goes backwards.
Are there any real effects?
Quantity theory of money
Monetary effects, but no „real” effects
Changes in nominal magnitudes
Consumption and production should stay the same
Just as incomes of market participants
Interest rates should stay the same
Banking system vs. green fairy
New money is not ideally distributed
People have different knowledge
Money increases incomes at first in some places, and in others later on
Money goes into the economy through credit
markets (lower interest rate)
Cantillon effects
Not all prices are effected to the same extent
Redistribution effects follow
The consumption/investment ratio is changed
The amount of capital has different value in the eyes of participants
Conclusion: money is not neutral
Equation of exchange (I. Fisher)
MV = PT
Money spent equals money received
Money supply multiplied by „velocity of circulation”
Average price and number of transactions
Actually the Germans were first again (Karl Heinrich Rau)
u is mittlere Umlaufszahl des Geldes (velocity)
g is Geldmenge (money supply)
p is Preisniveau (price level)
w is umgesetze Menge von Gütern und
Leistungen (quantity of goods and services exchanged)
ug = wp
Monetarism and the business cycle
Cycles exists in the economy
Economy can fall below potential output
Economy can be stimulated into a boom (Phillips curve)
Solution: rules instead discretionary policies
Older monetarist program
Money supply should be constantly increased year by year
At the same pace as the economy grows
For example: 3-5% per year in order to
achieve „price stability”
Assumptions of the monetarist model
Predictable policy is a good policy
Rules are better than discretion
Velocity is stable
Money supply can easily be measured
Can be controlled by the central bank
MOST IMPORTANT: Stable prices mean
stability
Critique of the older monetarist program
Objective problems: velocity is not stable anymore
Money supply is not easily measured or controlled (financial innovation)
Stable prices might not mean stable
economy (Japan 1980s, 1920s, 1990s USA)
In other words – CPI does not explain
everything about economic activity
Quantity theory of money nowadays
The economic activity and prices are influenced by the money supply in the system
Hence monetary policy is the most important macroeconomic policy
Long run/Short run problem
Everybody and nobody is a monetarist
Fisher 1929
Fisher in the end of 1920s believed that the economy had strong fundamentals
Prices were fine and were not overvalued
He used empirical analysis (past prices)
After the collapse he became a huge debtor
until his death
Friedman in the 2004
„At the moment, the fundamentals are rather well orientated.
Inflation remains weak, and there is no sign of resumption in the increase of prices. Unemployment remains bearable. It
went back up around 6 %, but it is a rate which, in the past, has been often observed, including in periods of prosperity. Quarter after quarter, productivity advances at a steady pace. There is no financial crisis. Banks are not in trouble. Our situation is rather good and the only thing which, in the course of the last few months, slowed down the situation is to be found - once again – in the uncertainties created by terrorist threat and the war in Iraq.”
