Monetary Policy and the Fed
Read this chapter to understand in more detail the monetary policy tools, process, and impacts on the U.S. economy. Review specific monetary policies and their effects from our recent history.
Monetary Policy and the Equation of Exchange
Why the Quantity Theory of Money Is Less Useful in Analyzing the Short Run
The
stability of velocity in the long run underlies the close relationship
we have seen between changes in the money supply and changes in the
price level. But velocity is not stable in the short run; it varies
significantly from one period to the next. Figure 11.7 "The Velocity of
M2, 1970–2011" shows annual values of the velocity of M2 from 1960 to
2011. Velocity is quite variable, so other factors must affect economic
activity. Any change in velocity implies a change in the demand for
money. For analyzing the effects of monetary policy from one period to
the next, we apply the framework that emphasizes the impact of changes
in the money market on aggregate demand.
Figure 11.7 The Velocity of M2, 1970–2011
The annual velocity of M2 varied about an average of 1.78 between 1970 and 2011.
The
factors that cause velocity to fluctuate are those that influence the
demand for money, such as the interest rate and expectations about bond
prices and future price levels. We can gain some insight about the
demand for money and its significance by rearranging terms in the
equation of exchange so that we turn the equation of exchange into an
equation for the demand for money. If we multiply both sides of Equation
11.1 by the reciprocal of velocity, 1/V, we have this equation for
money demand:
Equation 11.10
The equation of
exchange can thus be rewritten as an equation that expresses the demand
for money as a percentage, given by 1/V, of nominal GDP. With a
velocity of 1.87, for example, people wish to hold a quantity of money
equal to 53.4% (1/1.87) of nominal GDP. Other things unchanged, an
increase in money demand reduces velocity, and a decrease in money
demand increases velocity.
If people wanted to hold a quantity of
money equal to a larger percentage of nominal GDP, perhaps because
interest rates were low, velocity would be a smaller number. Suppose,
for example, that people held a quantity of money equal to 80% of
nominal GDP. That would imply a velocity of 1.25. If people held a
quantity of money equal to a smaller fraction of nominal GDP, perhaps
owing to high interest rates, velocity would be a larger number. If
people held a quantity of money equal to 25% of nominal GDP, for
example, the velocity would be 4.
As another example, in the
chapter on financial markets and the economy, we learned that money
demand falls when people expect inflation to increase. In essence, they
do not want to hold money that they believe will only lose value, so
they turn it over faster, that is, velocity rises. Expectations of
deflation lower the velocity of money, as people hold onto money because
they expect it will rise in value.
In our first look at the
equation of exchange, we noted some remarkable conclusions that would
hold if velocity were constant: a given percentage change in the money
supply M would produce an equal percentage change in nominal GDP, and no
change in nominal GDP could occur without an equal percentage change in
M. We have learned, however, that velocity varies in the short run.
Thus, the conclusions that would apply if velocity were constant must be
changed.
First, we do not expect a given percentage change in
the money supply to produce an equal percentage change in nominal GDP.
Suppose, for example, that the money supply increases by 10%. Interest
rates drop, and the quantity of money demanded goes up. Velocity is
likely to decline, though not by as large a percentage as the money
supply increases. The result will be a reduction in the degree to which a
given percentage increase in the money supply boosts nominal GDP.
Second,
nominal GDP could change even when there is no change in the money
supply. Suppose government purchases increase. Such an increase shifts
the aggregate demand curve to the right, increasing real GDP and the
price level. That effect would be impossible if velocity were constant.
The fact that velocity varies, and varies positively with the interest
rate, suggests that an increase in government purchases could boost
aggregate demand and nominal GDP. To finance increased spending, the
government borrows money by selling bonds. An increased supply of bonds
lowers their price, and that means higher interest rates. The higher
interest rates produce the increase in velocity that must occur if
increased government purchases are to boost the price level and real
GDP.
Just as we cannot assume that velocity is constant when we
look at macroeconomic behavior period to period, neither can we assume
that output is at potential. With both V and Y in the equation of
exchange variable, in the short run, the impact of a change in the money
supply on the price level depends on the degree to which velocity and
real GDP change.
In the short run, it is not reasonable to assume
that velocity and output are constants. Using the model in which
interest rates and other factors affect the quantity of money demanded
seems more fruitful for understanding the impact of monetary policy on
economic activity in that period. However, the empirical evidence on the
long-run relationship between changes in money supply and changes in
the price level that we presented earlier gives us reason to pause. As
Federal Reserve Governor from 1996 to 2002 Laurence H. Meyer put it: "I
believe monitoring money growth has value, even for central banks that
follow a disciplined strategy of adjusting their policy rate to ongoing
economic developments. The value may be particularly important at the
extremes: during periods of very high inflation, as in the late 1970s
and early 1980s in the United States … and in deflationary
episodes".
It
would be a mistake to allow short-term fluctuations in velocity and
output to lead policy makers to completely ignore the relationship
between money and price level changes in the long run.