Money Supply, Central Bank, Inflation and Monetary Policy

1
Money Supply, Central Bank, Inflation and
Monetary Policy
Money, get awayGet a good job with more pay and
your O.K.Money it's a gasGrab that cash with
both hands and make a stashNew car, caviar, four
star daydream,Think I'll buy me a football
teamMoney get backI'm all right Jack keep your
hands off my stack ------- Money, Pink Floyd
(The Dark Side of the Moon)

• Dr. Fidel Gonzalez
• Department of Economics and Intl. Business
• Sam Houston State University

2
Money Supply and The Central Bank
Now, we are going to analyze the role of money in
the economy and how that affects the overall
economy.
First, we need to define money, its functions and
different types.
Money set of assets in the economy that people
regularly use to buy goods and services from
other people.
In other words, anything that you use to buy and
sell things is consider a money. For example, a
friend of mine in college use to exchange beer
for services in our dorm. He would exchange a six
pack of shiner bock beer to have a roommate
washing his clothes. You can see how the beers
in this example are considered money.
3
Money Supply and The Central Bank functions of
money
Money has three main functions

• Medium of exchange use to purchase good and
  services.
• Money as a medium of exchange is very useful
  because it avoids the double coincidence of
  wants.
• If there is no money, if you want to buy a car
  you need to find a car salesman that wants the
  good that you have to offer. For example, I would
  have to find a salesman that is willing to give a
  car in exchange for a set of lectures in
  economics.
• That will be very difficult because it requires
  the double coincidence of wants. I need to want
  what the salesman has and the salesman needs to
  want what I have.
• Money as a medium of exchange makes trade so much
  easier and faster. If there is money, all I need
  to do is find someone that is willing to pay for
  my economics lectures and later use the money to
  buy a car.

4
Money Supply and The Central Bank functions of
money
2) Unit of account money is hoe prices are
posted. All goods and services are measured in
money terms. This makes comparisons between goods
very easy.
3) Store of value transfer purchasing power from
today to the future. Money as a store of value
allows you to store value so that in the future
you can buy goods and services. For example, if
you get paid 100 dollars today you will spend 60
with your friends but you may want to hold on to
the remaining 40 so that you can buy food next
week. Money allows to store value so that in the
future you can buy goods and services. When there
is inflation money is not a very good store of
value because you can less things in the future.
5
Money Supply and The Central Bank types of money
We are going to consider two types of money

• Commodity money this money that has intrinsic
  value. What that means is that it is money that
  is valuable by itself. For example
• Gold it was used as a currency for many
  centuries, but gold it is also valuable for its
  properties as a metal. It has an intrinsic value.
• Silver it was also used as currency in the US,
  Mexico and other countries.
• Cocoa beans in ancient Mexico, Aztecs and Mayans
  used cocoa beans as their currency. Cocoa was
  very valuable because it was consider a delicacy.
  

2) Fiat money fiat money is money because the
government says so. Fiat means by government
decree. So, the fiat money literally means money
by government order. Present day currency (bills
and coins) are fiat money. They do not have an
intrinsic value. A dollar is just a piece of
paper. Q Why do people accept dollar bills in
exchange for goods or services? A Because the
know they can use it later on to buy goods and
services themselves.
6
Money Supply and The Central Bank types of money
For example Imagine you go to the Mac Store and
get a hundred-dollar bill from your wallet and as
a result the store salesman gives you a Ipod. If
you think about this is a weird thing. You just
exchange a piece of paper that has no intrinsic
value for a cool Ipod where you can watch video
and listen to music. The reason why the salesman
accepts the one hundred-dollar bill in exchange
for the Ipod is because he knows that later he
can use it to buy other stuff. Moreover, the
salesman is required to accept the money as a
method of payment for the Ipod. It is required by
the government to do it. If you look at a dollar
bill of any denomination you will see that in the
front of the bill says This note is legal
tender for all debts, public and private In
other words, the government is saying, this is
money because I said so and you have to accept it
as a payment for goods and services. In order for
this system of fiat money to work people have to
trust the government. If they believe that the
government can not enforce the law at all then
people is not going to accept money. Would you
accept a bill that you do not know whether you
can exchange it later on for goods and services?
A NO.
7
Money Supply and The Central Bank types of money
In order for this system of fiat money to work
people have to trust the government. If they
believe that the government can not enforce the
law at all then people is not going to accept
money. Would you accept a bill that you do not
know whether you can exchange it later on for
goods and services? A NO. Clearly the type of
money we use today is the Fiat money. However, it
was not like that. Money evolve from commodity
money to money backed up by silver or gold to
fiat money. The next slide shows a very brief
history of money.
8
Money Supply and The Central Bank brief history
of fiat money
(2)
(2)
(4)
(4)
(1)
(3)

• British guard has gold that weights 3 pounds.
• The guard does not like to have the gold laying
  around because you never know if it can get
  stolen. So, he takes his gold to this person who
  promises him that he will put his gold in a safe
  box and it will be safe.
• The British guard asks the safe keeper to give
  him a receipt that he can use later on to claim
  his three pounds of gold. The receipt says that
  the British guard has 3 pounds of gold in the
  safe.
• The British guard now wants to buy a horse. He
  can go to the place where the gold is stored, get
  the gold and pay the horse owner or he can give
  the horse owner the receipt of the gold so that
  when the horse owners wants the gold he can claim
  it. The horse owner is going to prefer the
  receipt because that way he does not have to walk
  around with three pounds of gold in his pocket.
• This receipt was called a pound, because it
  represented the amount of gold or silver a person
  could claim in the bank.

9
Money Supply and The Central Bank brief history
of fiat money
This is why all major currencies have names that
represent a measurement of weight. For example,
the British pound represented one pound of
silver. the American dollar represented 24 grams
of silver or 1.6 grams of gold the Mexican Peso
represented also represented a weight of gold and
silver. So how did we go from having currency
backed up by silver to fiat money? As you can
tell, people with dollar note never went to the
bank and claim the amount of silver they were
entitled to because they had no use for the
silver. It was too much work to go the bank and
get a bill. Moreover, the government realized
that in order to increase the amount of money,
they needed to have more silver. Thus, the amount
of currency in circulation was limited by the
amount of silver. This became a problem because
the economy was growing and more money was
needed. Thus, finally governments started to
break away from the currency backed up by silver
or gold. In the seventies almost all countries
did not have currency backed by gold or silver.
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Money Supply and The Central Bank measurements
of money
How much money is there in the economy? Since
money can be any asset used to buy and sell goods
there are many things that can be considered
money we need to find a way to measure them. We
are going to consider three measures according to
their liquidity. Liquidity refers to the easiness
that an assets can be exchange for another asset.
We are going to start with the most liquid term
of money

• M1 currency (bills and coins) balance in
  checking accounts deposits travelers checks.
• In this case currency refers to the amount of
  bills and coins in the hands of the public. For
  example, currency in the bank is not considered
  part of M1.
• In 2004, the total amount of M1 was equal to 1.4
  trillion.
• M1 is liquid money because we can very easily use
  it to buy goods and services.

11
Money Supply and The Central Bank measurements
of money
B) M2 M1 savings deposits small time
deposits money market accounts. Savings
deposits the balance of people on their savings
accounts. These accounts are less liquid because
usually you have to pay a penalty (fee) if you
suddenly want to use your savings account. Small
time deposits deposits that you have in your
bank account that you can not use during a period
of time that is less than 100,000 dollars. For
example, a certificate of deposit (CD) of 10,000
dollars is consider a small time deposit. Money
market accounts this refers to short-term
borrowing and lending. For example, when the US
government needs money from people sometimes it
issues what is called a Treasury Bill (T-Bill).
The T-Bill is an IOU from the government and it
is consider a money market account. Short-term
borrowing and lending usually refers to less than
a year. Also when a firm (say Coca-Cola company)
borrows money for less than a year from someone
else that is also consider a money market
account. Finally, note that M2 INCLUDES M1.
However, it also has other things that are less
liquid. For example, if you want to use your
savings to buy a car you have to pay a fee to
used your savings and that makes it less liquid
than cash. In 2004, M26.6 trillion.
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Money Supply and The Central Bank measurements
of money
C) M3 M2 large time deposit account (over
100,000) banks repurchase agreements
Eurodollars. Large time deposit account deposits
that you have in your bank account that you can
not use during a period of time that is over
100,000. Banks repurchase agreements when a
bank (say Bank of America) lends money to another
bank (say Chase), Bank of America gets an IOU
from Chase saying that it will pay back. That IOU
is a Banks repurchase agreement, it is usually
very short term lending. Eurodollars dollar
denominated accounts in countries other than the
US. For example if you have a 20,000 dollar
account in France that is consider a Eurodollar.
It does not have to be in Europe as long as the
account is located outside of the US it is
considered a Eurodollar. In 2004, M310
trillion. M3 is the less liquid of the all three
Ms. The most common measurements of money are
M1 and M2.
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Money Supply and The Central Bank Money creation
by Banks
If we look at M1 we see that is composed by
currency, balances in checking accounts and
travelers checks. Now, we are going to see that
Banks by lending money can create more checking
account deposits and therefore M1 increases
(increasing also M2 and M3). To see how banks
create more checking account deposits we need to
consider the banks T-account
For the bank a 1,000 deposit represents a
liability to the bank because the banks owes the
money to the depositors. However, once someone
deposits 1,000 the Banks keeps some money as a
reserve just in case the depositor would want
some of the money. In the example above the Bank
kept a 10 of the deposit as reserves (100). The
remaining 900 dollars are lent to somebody else.
That represent an asset to the bank because the
borrower owes the money to the bank.
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Money Supply and The Central Bank Money creation
by Banks
Now, lets see what happens when someone deposits
1,000 in the Bank and the bank has a reserve
ratio of 10. Reserve Ratio (RR) percentage of
each deposit that is kept as reserve in the bank.
Round 1 Initial deposit of 1,000. From this
100 are reserves and the other 900 are lent.
Round 2 the borrower of the 900 receives the
money on this checking account . As a result the
900 becomes a deposit. From the 900 ten percent
is kept as reserve (90) and the remaining 810
are lent again.
Round 3 again the borrower of the 810 deposits
the loan on this checking account . The 810
becomes a deposit. From the 810 ten percent is
kept as reserve (81) and the remaining 729 are
lent again.
This process continues until there is no more
money left to be lent.
You can see that the initial deposit of 1000
more deposits. Remember that each deposit (1000,
900, 810, and all the others) is part of the
balance in checking account and therefore M1 has
increased. That is, M1 increased because the
initial deposit of 1000 dollars increases the
total amount deposited in the bank and therefore
M1 is bigger.
15
Money Supply and The Central Bank Money creation
by Banks
Q What was the total increase in the amount of
deposits? A Round 1 1,000 Round 2 1,000 x
(1-0.1) 900 Round 3 900 x
(1-0.1)810 Increase in deposits 1000 900
810 all the other deposits. Fortunately, we do
not have to go round by round to obtain the total
amount of deposits. Using mathematics we obtain
that the increase in deposits are the following
An initial deposit of 1,000 increases the amount
of checking deposits in 10,000. Q What happened
to M1? M1 also increased by 9,000. Why 9,000
and not 10,000? Because the initial deposit of
1,000 was currency turn into deposit which both
of them are part of M1 but the remaining 9,000
created in form of deposits in an increase in M1.
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Money Supply and The Central Bank Money
multiplier
The change in deposits can be generalized as
follows
We can divide the change in deposits as follows
That is, the MM tells us by what factor deposits
change. In our previous example,
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Money Supply and The Central Bank Money
multiplier
This means, that when RR0.1 a deposit of 1,000
will produce a change of 10,000 dollars in
deposits.
Let consider another example Initial Deposit
5,000 RR0.25 Question What is MM? What is the
change in deposits? Answer
Imagine that RR goes down and now
RR0.20 Question What is MM? What is the change
in deposits? Answer
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Money Supply and The Central Bank Money
multiplier
As you can see when RR decrease the MM increases
from 4 to 5. When RR goes down MM increases and
also the change in deposits increases. When RR
goes up MM decreases and also the change in
deposits decreases.
The previous two statements make sense. When RR
goes down the bank keeps a higher percentage of
deposits as reserves. Therefore, less money is
lent and the corresponding deposit also goes
down. This decreases the total amount of new
deposits. When RR goes up the bank keeps a lower
percentage of deposits as reserves. Therefore,
more money is lent and the corresponding deposit
also goes up. This increases the total amount of
new deposits. What if the RR1. This means that
every deposit is backed up 100 by reserves in
the Bank. In that case, the initial deposit does
not create any more deposits.
That is, an initial deposit of 5,000 creates a
change in deposits of just 5,000.
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Money Supply and The Central Bank Money
multiplier
What if the RR0. This means that every deposit
is lent completely. In that case, there an
infinite increase in the total level of deposits.
That is, an initial deposit of 5,000 creates an
infinite change in deposits.

• One last thing we have to say about MM. In the
  real world, the MM is less than the value we
  obtained in our formula.
• There are two reasons for this
• Banks sometimes like to have more reserves than
  what the reserve ratio says. They do this when
  the believe something bad is going to happen to
  the economy.
• Not all money lent by the banks is deposited back
  in the bank, some of it is kept as cash. This
  reduces the amount of new deposits and the MM.

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Money Supply and The Central Bank The Federal
Reserve Bank System
The federal reserve bank system is very important
because it has an important control (although is
not perfect) over the money supply. Money supply
is the amount of money available to purchase
goods and services. We actually have covered
money supply before. M1, M2 and M3 are different
measures of the money supply. As we just covered,
Banks can change M1 when the RR changes and
therefore affect the money supply. On the other
hand, also the Federal Reserve Bank can affect
the money supply. Before we cover how it can do
that, lets see what is the Federal Reserve Bank
System. The Federal Reserve Bank System (The Fed)
was created in 1914 and is made up by a Board of
Governors and has 12 regional branches across the
US. The regional branches are located in Dallas,
San Francisco, Atlanta, New York, Richmond,
Kansas City, Minneapolis, Chicago, Cleveland,
Boston, Philadelphia and St. Louis.
21
Money Supply and The Central Bank The Federal
Reserve Bank System
The independence of the Fed is essential for the
well being of the economy. Example
(1)
(4)

• President needs 50 billion to buy warship.
• Calls the Fed to print money and give him the
  cash to buy the warship.
• If the Fed is not independent they will do what
  the president asks and print the 50 billion.
• President gets the money and buys ship.
• Warship goes to the president

(5)
50 billion
(2)
(3)
This creates a big problem, when the government
prints more money that creates inflation. Higher
inflation means that prices have increase and
therefore money is worth less than before.
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Money Supply and The Central Bank The Federal
Reserve Bank System
The reduction is the value of money acts as a tax
on the money held by the public. You can think
about it this way. You have 20 dollars and can
buy 4 beers at 5 dollars each. 1) The
government wants 10 of the 20 you have to help
pay for the warship. The government can
physically force you and take 10 from your
wallet. In that case you will be left with 10
which is worth 2 beers. 2) Another option is
print money (like in the previous slide). When
the government does this prices increase. Lets
say that now beer costs 10 dollars. With the 20
dollars in your wallet you can now only afford 2
beers. As you can see in both options you are
left with money that can only buy 2 beers. The
second option is the inflation option and as you
can see inflation acts like a tax because by
reducing the value of money you can only afford 2
beers now, same as the government taking 10
from your wallet.
23
Money Supply and The Central Bank The Federal
Reserve Bank System

• Inflation tax is a really bad tax because
• Hurts the poor more poor people tend to have
  more of their assets in form of money so they
  suffer bigger losses when there is inflation.
• Invisible tax most people see inflation but they
  do not know what is going on.
• Easy to implement in contrast with income or
  sales taxes. The government does not need to go
  to congress to set taxes. The only thing you have
  to do is to print money.
• The fact that is an invisible tax and that it is
  easy to implement makes inflation very tempting
  for a government that needs to buy goods and
  services.

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Money Supply and The Central Bank The Federal
Reserve Bank System

• Q What are the functions of the Fed?
• The Feds main goal is to observe and regulate
  the financial sector. In particular the Banking
  system.
• This is very important because it ensures that
  lenders and borrowers follow the law. Banks are
  specially important because Banks are the most
  important part of the financial system. Just
  imagine what would happen if all Banks were
  bankrupt. Moreover, Banks take money from the
  public (when you deposit money) and the Fed
  ensures that Banks do not take unnecessary risks
  with your money.
• 2) Lender lends money to the banks. In many
  cases the Fed acts as a lender of last resort.
  This is an essential feature of the Fed because
  it reduces Banks panics.
• For example imagine that for some reason a lot of
  people (more than the usual) go to the bank today
  to withdraw all the money they have in the Bank.
  The Bank is not going to be able to give everyone
  their money immediately because most of it has
  been lent to somebody else. When people realize
  that they can not get their money they will panic
  and even more people will go to the bank.

25
Money Supply and The Central Bank The Federal
Reserve Bank System
So, who are you gonna call? The Fed. The Fed
will be the lender of last resort and lend money
to the bank so that when the initial group of
people go to the Bank there is enough money to
pay them back and nobody panics. 3) Affect the
Money Supply the Fed has the monopoly in the
creation of currency. That is the Fed can print
more dollars bills increasing M1 and the money
supply. Nobody else can create currency and if
they do they go to jail. The Fed is the most
important monopoly in the world.
26
Money Supply and The Central Bank The Federal
Reserve Bank System

• But how does the Fed actually affects the money
  supply?
• The Fed uses three different instruments
• Open Market Operations (OMO) these are places
  when the Fed buys or sells bonds in the open
  market.
• Reduce money supply when the Fed wants to
  reduce the money supply all the have to do is to
  SELL bonds in the open market. By selling bonds
  the public gives the Fed money in exchange for a
  Treasury Bill and the total amount of money in
  the hands of the public goes down (now they have
  a bond instead of cash).
• For example, imagine that you have 1 million
  dollars in cash. This will be part of M1 and M2
  and therefore part of the money supply.
• Now assume that the Fed SELLS you a bond for 1
  million dollars. This transaction implies that
  you give the Fed your 1 million dollars in cash
  and in return you get an IOU that says that the
  Fed owes you 1 million dollars. Now the 1
  million dollars is in a vault at the Fed and
  therefore is not part of M1 anymore. (Remember
  that only currency in the hands of the public is
  part of M1). The money supply decreased by 1
  million dollars.

27
Money Supply and The Central Bank The Federal
Reserve Bank System
Increase money supply when the Fed wants to
increase the money supply all the have to do is
to BUY bonds in the open market. By buying bonds
the public gives the Fed a paper (a bond) in
exchange for cash and the total amount of money
in the hands of the public goes up (now they have
a cash instead of a bond). For example, imagine
that you now have a bond worth 1 million
dollars. This will NOT be part of M1 or M2 and
therefore is NOT part of the money supply. Now
assume that the Fed BUYS the bond form you and
pays you 1 million dollars in cash. This
transaction implies that you give the Fed your
bond and you get 1 million dollars in cash. Now
the 1 million dollars in cash is in the public
hands and it is part of M1. The money supply
increased by 1 million dollars. Therefore using
OMOs the Fed buy or sells bonds which increases
or decreases the money supply. Remember Buy
Bonds means money supply increases Sell Bonds
means money supply decreases
28
Money Supply and The Central Bank The Federal
Reserve Bank System
2) Discount Policy the Fed lends money to the
banks. These loans are called discount loans and
the interest rate charged to the Bank is called
the discount interest rate. When the Fed lowers
the discount rate Banks borrow more from the Fed
because it is cheaper to borrow money. Higher
borrowing from the Fed increases the amount of
reserves the Banks have and therefore it
increases the amount of loans made to firms and
households. Higher lending increases the number
of checking deposits and therefore the money
supply increases.
When the Fed increases the discount rate then the
money supply increases
As of today the Federal Discount Rate is 5
29
Money Supply and The Central Bank The Federal
Reserve Bank System
3) Reserve Requirement the Fed as the agent in
charge of regulating Banks usually sets a reserve
requirement that all Banks need to follow. The
reserve requirement is the minimum of reserve
ratio that Banks need to have. Banks do not like
having reserves because that is money that is not
lent and therefore they are not making money out
of it. It is money just sitting in their vault.
In most cases the Banks reserve ratio is just
equal to the reserve requirement. That is, Banks
have the minimum reserve requirement that the Fed
tells them they must have. In some circumstances,
when there is a lot of uncertainty, Banks have
more reserves than the reserve requirement set by
the Fed, this extra reserves are called excess
reserves. Reserve Ratio Reserve Requirement
Ratio Excess Reserves Ratio From before, it
follows that in general Excess Reserve Ratio 0
but not always. Thus, when the Fed increases the
reserve requirement the reserve ratio increases,
the money multiplier decreases and the money
supply goes down. When the Fed increases the
reserve requirement the reserve ratio decreases,
the money multiplier increases and the money
supply goes down. Currently, the Reserve
Requirement is 10
30
Money Supply and The Central Bank The Federal
Reserve Bank System
That is,
31
Money Supply and The Central Bank Quantity
Theory of Money
During the 70s a new Theory of Money was
introduced in Macroeconomics. This school of
thought was called The Monetarist. They
introduced the Quantity Money Equation shown
below
M V P Y
M amount of money in the economy (M1 or M2) V
velocity of money (this is the average number of
purchases that one dollar makes during a year).
For example, if V4 that means that a dollar in
average is used four times during a year to buy
good and services. P price level (remember
this is the average price level in the economy) Y
real GDP Therefore, MV amount of money x
velocity total amount of purchases in the
economy PY price x real GDP nominal GDP
32
Money Supply and The Central Bank Quantity
Theory of Money
The quantity of money Equation is an identity, it
is always true. Monetarists transformed the
quantity money equation in percentage change and
they obtained that
In addition, they said the V (velocity) is
usually constant. That is, V does not change much
because it depends on peoples customs and people
do not change their behavior that much. For
example, in 2004 V8.6, Monetarists would say
that V will not change in 2005 (still will be
8.6). Therefore if V does not change then
change in V 0 The percentage change equation is
modified to the following
This is one of the most important concepts in
Macroeconomics when the amount of money
increases either P increases or Y increases or
both.
33
Money Supply and The Central Bank Quantity
Theory of Money
For example, imagine that the Fed decides to
increase M by 8
This is one of the most bitter and contentious
issues in Macroeconomics. Why? Remember that Y
(Real GDP) Yf(K,L, NR). That is, real GDP
depends on capital, labor and natural resources.
It does NOT depend on M. Therefore, some
economist say that when M increases there is no
reason for Y to change, therefore change in Y
0 The percentage change equation is now
This means that an increase in the money stock
produces an equal percentage change in the price
level. In other words, the inflation rate ( which
is the change in P) is equal to percentage
change in the quantity of money.
34
Money Supply and The Central Bank Quantity
Theory of Money

• In the previous example an increase of 8 in M
  only produces a 8 increase in prices and real
  GDP does not change.
• Q Why is this result so important?
• A Because it gives one possible explanation of
  inflation.
• Remember that in the AD and AS model we
  established that prices can increase because AD
  shits right (positive demand shock) or AS shifts
  left (negative supply shock). Now, we have
  another reason for the existence of inflation.
• Summarizing inflation takes place because
• AD shifts right (positive demand shock)
• AS shifts left (negative supply shock)
• The Fed increases the money supply M

35
Money Supply and The Central Bank Quantity
Theory of Money
However, some economist do not agree with the
fact that Y is completely independent of M. They
say that when M increases P goes up BUT when
firms see P increases they work more. This in
turn will increase Y. Q Why people will work
more if P increases? Imagine that the Fed
increases M which in turn increase P. Some
economists think that when P goes up the firms
believe that higher prices are a result of an
increase in the AD (positive demand shock). Well,
if the AD increases that means that consumers are
buying more things so it makes sense for firms to
produce more. However, firms eventually realized
that they have been fooled the increase in P was
not due to higher AD but to higher M. If the
increase in P is due to higher M then firms have
no reason to produce more, the demand for their
has not increase, it was just an illusion. So
where does these leaves us? What is the
relationship between M and Y? The general
consensus is that in the short-run there is small
but positive relationship between M and
Y. However, in the long run there is NO
relationship between M and Y.
36
Money Supply and The Central Bank Quantity
Theory of Money
For example, change M 8 In the short-run
change Y2 and change in P 6 In the
long-run change Y 0 and change in P
8 That is, in the short-run an increase in M
produces some inflation but also a small increase
in real GDP. However, in the lung-run the
increase in M produces only inflation in the
equal proportion as the change in M.
37
Money Supply and The Central Bank Phillips Curve
In 1958 a British economist called Alban W.
Phillips graphed the relationship between
inflation and unemployment in England from 1861
to 1957. He found that the relationship is
negative. In the following graph I did the same
thing as Phillips but for the US from 1950 to
1969.
38
Money Supply and The Central Bank Phillips Curve
As you can tell the graphs shows a negative
relationship between inflation and unemployment.
The relationship between unemployment and
inflation is known as the Phillips curve. In this
case the Phillips curve shows a negative
relationship between them. Q What creates this
Phillips curve with a negative relationship
between unemployment and inflation? A
QBut didnt we just said that higher M produces
slightly higher Y only in the short-run? A Yes,
and that is exactly what happened. American
learned that from 1950 to 1969 the Fed was
increasing M and therefore the increase in P was
due to higher M and not to a higher AD. So
following graph shows you what happened after
1969.
39
Money Supply and The Central Bank Phillips Curve
After 1969, once people learned about the Fed
trying to fool them the negative relationship
between unemployment and inflation became
actually a little positive.
40
Money Supply and The Central Bank Phillips Curve
As someone once said fool me once shame on you
fool me twice shame on me. Thus, the Phillips
curve is going to look differently in the
long-run than in the short-run.
Inflation
Inflation
Short-Run Phillips Curve
Long-Run Phillips Curve
Unemployment
Unemployment
In the short-run the Phillips curve shows a
negative relationship between inflation and
unemployment. In the long-run the Phillips curve
shows no relationship or small positive
relationship between inflation and unemployment
41
Money Supply and The Central Bank Monetary Policy
Monetary policy actions by the Fed to manage
the money supply and interest rate to pursue
economic objectives
The money supply (MS) affects the interest rate
because the price of money is the interest rate.
Money Market
The demand for money has a negative slope because
the higher the interest rate the less money you
want to have and the more savings that pay r you
want. Similarly when r is low you do not want to
save much and instead you use it to buy things so
the demand for money increases The MS does not
depend by the interest rate because is set by the
Fed and the money multiplier (MM).
MS
Price of money (r)
r
MD
M
Amount of money (M)
The purpose of the monetary policy is to affect
MS to 1) price stability (low inflation), 2)
high employment, 3) economic growth and 4) stable
financial markets.
42
Money Supply and The Central Bank Monetary Policy
Monetary Policy affects the equilibrium in the AD
and AS model
1) Monetary Policy the Fed can increase or
decrease the money supply.
The money supply will affect the aggregate demand
in three different ways
A) Wealth an increase in money supply lowers
prices increase the real wealth of households,
stimulating consumption.
B) Interest Rate an increase in money supply
lowers interest rates stimulating investment and
consumption of durable goods.
C) Exchange Rate an increase in money supply
lowers interest rates reducing the demand for
dollars, the value of the dollar depreciates and
that stimulates exports and reduces imports.
43
Monetary Policy
Next, the Fed sells bonds in the open market

• Assume the economy is at long-run equilibrium

Money Market
Total Economy
AS-LR
P
AS-SR1
MS
MS1
r
AS-SR
P1
P-SR
r
P
r1
AD1
MD
AD
Q
Q-SR
Q
M
M1
M
1) Money supply increases producing a decrease in
the interest rate and an increase in prices.
2) A drop in the interest rates, increases
consumption (in particular durable goods) and
investment. Hence, AD goes up.
When the AD increases, the production increases
in the short-run to Q-SR and P-SR.
3) Since the economy is producing above the full
employment level, firms need to pay higher prices
for their inputs. Higher input prices, increases
the cost of the firms, reduces profits and the
supply goes down.
At the new equilibrium point, we have the
long-run output but higher prices
44
Monetary Policy

• Q Why the Fed will increase the money supply?

A If the economy is below full employment
Money Market
Total Economy
AS-SR
AS-LR
P
MS
MS1
r
P1
P
r
r1
AD1
MD
AD
Q-SR
Q
Q
M
M1
M
Increasing money supply shifts the AD so that the
economy reaches the long-run equilibrium
Prices increase but real GDP also goes up.