Prof. Bryan Caplan

Econ 311

Fall, 1999

Week 6: Money Supply and Money Demand

  1. Back to Aggregate Demand
    1. In the initial discussion of AD, I stated that its main determinants of are money supply and money demand. Changes in these factors are what make it possible for some spending to increase without reducing other spending. Now this topic can be explored in greater depth.
    2. First point: there are many different definitions of "money." For purposes of this class, I will use the narrowest possible definition: by "money" I mean the monetary base, which is comprised of cash, coins, and deposits with the Federal reserve.
    3. All other assets, including checks, savings, CDs, MMMFs, etc., will be referred to as money substitutes.
    4. One key difference between monetary base and money substitutes: government has total control over monetary base, counterfeiting aside. It does not have this control over money substitutes.
  2. Why Money?
    1. Barter and the problem of double coincidence of wants.
    2. People try to find and hold commodities that are:
      1. Identifiable
      2. Divisible
      3. Portable - high value per unit
      4. Stable in value
    3. Virtuous spiral of money: once you know other people want a commodity, you want it too, which makes others want it still more...
    4. Money always begins as a real commodity with independent value, but can remain valuable later after the commodity loses all independent value. Gold and silver most common versions.
    5. Money substitutes - including paper money - develop to increase transactional convenience.
    6. National governments gradually monopolized supply of paper money, but at first kept the tie to gold.
    7. Eventually, though, basically all governments "cut the tie to gold." Since then, national governments have been able to print (base) money at whatever rate they desire.
  3. Money Supply and Money Demand
    1. People use money to buy goods. But we can flip perspectives and say that people are using goods to buy money. We can then put the quantity of money on the x-axis, and the price of money in terms of goods on the y-axis.
    2. If P is the price level - the amount of money needed to buy a given quantity of goods - what is the price of money - the amount of goods needed to buy a dollar of money? The price of money is just the reciprocal of the price of goods: (1/P).
    3. The government (institutionally, the Federal Reserve) just picks the level of the monetary base, we can draw the supply of money as vertical.
    4. How much money do people want to hold at different price levels? The higher the price level P is, the MORE they want. In other words, the higher the price of money (1/P) is, the LESS they want.
    5. People often assume that the quantity of money people want is exactly proportional to the price level. Why? People actually want a given amount of REAL purchasing power.
    6. Interest and money: People often speak as if "interest is the price of money." But it is better to say that interest rate changes shift the money demand schedule. If interest rates increase, people lose more interest by holding money instead of interest-bearing assets. (Base money's nominal interest return is fixed at 0). Therefore:
      1. Interest rate increases make money demand decrease.
      2. Interest rate decreases make money demand increase.
  4. Money Substitutes; Banking and Financial Market Regulation
    1. There are many substitutes for base money. When they are particularly close substitutes, people often start calling them "money" too.
      1. Checks
      2. Savings
      3. CDs
    2. There are official statistics on the quantity of money for many different definitions: M1, M2, M3, etc. The monetary base is special, since it is under the full control of the government.
    3. The important thing to realize is that there is a whole universe of "money substitutes," whether official definitions recognize them or not:
      1. Checks, savings, CDs
      2. Credit cards; ATM cards
      3. MMMFs
      4. Bonds
      5. Stocks
      6. ???
    4. Whenever the variety of money substitutes increases or the quality of existing substitutes improves, the demand for the monetary base tends to decrease.
    5. There is an enormous and diverse body of regulations related to money substitutes.
    6. Many specifically apply to "banking," though some of these have been gradually repealed, partly in response to competition by "non-bank banks":
      1. Interest rate ceilings
      2. Branch banking laws
      3. Asset restrictions
      4. Reserve requirements
      5. Bank insurance
    7. Others apply to "securities," which includes stocks, bonds, and more.
      1. Information and filing requirements
      2. Placement restrictions
  5. Inflation, Nominal Interest Rates, the Market for Loanable Funds, and Seigniorage
    1. The market for loanable funds has real rates on the y-axis.
    2. What if we show it with nominal rates instead? Then supply and demand for loanable funds depend on expected inflation.
    3. Higher inflation increases demand for nominal loans and decreases supply until the nominal rate rises by the same amount as inflation has increased.
    4. Is inflation good for debtors? Only if it's unanticipated.
    5. What happens if there is high inflation? Nominal interest rates rise a lot, so the money demand schedule decreases a lot. (Remember that the nominal interest rate earned by base money is 0!)
    6. So the quantity of money demanded increases as P increases but decreases as expected inflation increases! When people expect high inflation, value of money drops immediately.
    7. Why would people expect high inflation? Almost invariably because the government's rate of money supply creation is high.
    8. Why do governments choose high rates of money growth? They can buy real goods using the printing press. It's an easy alternative to direct taxation.
    9. Printing money for revenue is called "seigniorage." It is only a minor factor in modern Western countries, but in other countries and throughout history it has been the driving force behind monetary policy.
    10. When inflation gets high enough, people call it "hyper-inflation." Many switch to other currencies; others move into barter.
  6. Inflationist Fallacies
    1. Numerous variants on one theme: "If one person gets more money, that person is richer. Therefore, if everyone had more money, everyone would be richer."
    2. Normally, though, printing money just reduces the nominal value of money, and transfers real resources to the government. AD increases, AS stays the same.
    3. Particularly bad version of the fallacy: "Since prices are rising, the money supply must grow fast enough to 'keep up.'" The consequence of money creation becomes a justification for more money creation.
  7. Application: Post-Socialist Hyperinflations
    1. After the collapse of Communism in Eastern Europe and Russia, their governments mostly turned to the printing press for finance rather than drastically cut government spending.
    2. The result was massive inflation, with the rate closely linked to the rate of money creation.
    3. Inflation was then often blamed on the budding free market, even though it was the fault of the governments involved.