MONEY AND AGGREGATE DEMAND - THE MONETARIST MODEL : PART TWO

Using the quantity theory, how will the following events affect the money supply, V, and nominal income (or $GNP)?

Event A: Because of widespread bank failures, the public increases its cash holdings.
Event B: Credit cards become widely used.
Event C: The money supply is reduced.
Event D: The nominal interest rate rises.

Event A: MS down, V down, $GNP down. (This happened in the Great Depression). Note that the change in $GNP is also the change in aggregate demand.
Event B: MS unchanged, V up, $GNP up.
Event C: MS down, V unchanged, $GNP down.
Event D: MS unchanged, V up, $GNP up.

If the money demand equals 5% of income, the money supply is $60, and real GNP is 1,000 units of output, what will the price level be? What will the price level be if the money supply is $120? What happens to nominal income? To real money holdings?

• P = MS/kQ. K is 0.05 and V= 20. In the first case, P equals $1.20. In the second case, $2.40. $GNP equals V times MS, increasing from $1,200 to $2,400. Note that P also equals $GNP/Q. The real money supply (MS/P) equals 5% of real income or $50 (in real dollars). In the first case, it’s $60/1.20, in the second, $120/2.40.

An economic forecaster predicts that output will grow by 4% next year, the money supply will grow at 10%, and V will follow its historical pattern of growing at 3% per year. What will be the predicted rate of inflation?

• 9% (10% + 3% - 4%).

A small country produces 5,000 units of output and has a money supply of $2,000. Its citizens want to hold 10% of their income in money (k = 0.10).
a. What are V, $GNP, P, and the real money supply (MS/P).
b. If the money supply doubles to $4,000 but real output and V stay the same, what will $GNP, P, and the real money supply be?

a. V= 10. $GNP = $20,000. P=$4.00 MS/P =500.
b. $GNP = $40,000. P= $ 8.00. MS/P = 500.

Suppose you believe that over the next thirty years V will increase by 2% annually, output will grow at 3% per year, and the money supply will grow at 9% per year. Would you invest in a thirty-year bond paying 10% if you want a real return of 6%?

• You should believe that inflation will be 8%. The real rate of interest on the bond will only be 2%. You should not buy the bond.

Show with and AD and AS diagram how a decrease in the money supply can cause a recession and how the economy can recover on its own.

• A fall in the money supply reduces $GNP and shifts the AD curve left. In the short run, the short-run AS curve remains unchanged, so prices and output will fall as the economy sinks into a recession. In the long run, the AS curve will shift down as wages fall. This will reduce prices further and shift the economy to the right along the new AD curve to full employment.

Assume that V is constant. Assume the money supply is growing at 10% and output at 3%. The real rate of interest is 5%. What is the nominal rate of interest?
What will happen to interest rates, real and nominal, if the money-supply growth rate drops to 4% and the public has fully anticipated this event?

• Inflation will be 7%. The nominal interest rate will be 12% (5%+7%). If money supply growth falls to 4%, inflation will fall to 1%. The nominal interest rates will fall to 6% (5%+1%). The real interest rate will still be 5%.

In a small country, MS = $300, V= 10, and Q= 1,500.
a. What is P?
b. If MS falls to $250 and the price level does not change, what will happen to Q?
c. If 1,500 is the full-employment level of output, what will P be in the long run?

a. P= $2.00
b. Q= $1,250 (i.e., the economy is in recession).
c. P=$1.67 (when prices fall, the economy returns to full employment).

In terms of the quantity theory, how could unions raise the rate of inflation? Could a 10% inflation rate be explained by union activity?

• Unions do not affect the money supply or V. So they can affect inflation only by reducing output growth. To increase inflation by 1%, they must reduce output growth by 1%. To cause a 10% rate of inflation, they would have to reduce national output by 10%. Unions have never been observed causing output to fall this drastically; They cannot be a major cause of inflation.

Can higher oil prices cause inflation?

• Higher oil prices will not affect the money supply or V. So they affect inflation only by reducing output growth. Some economists estimated that output grew about 1% to 2% slower for several years because of the oil price increases in the ‘70s. Thus, higher oil prices added only 1% to 2% to the inflation rate. So why did our economy have such a high inflation rate (12%) when oil prices went up? Because the Fed dramatically increased the growth rate of the money supply. In Germany and Japan, the inflation rates were low and almost unaffected by the higher oil prices, because the money growth rate was kept low.

Copyright 2008 by Sujanto Rusli
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