Economics: The Quantity Theory of Money (review)

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So I just bought some groceries and I got this dollar in change and it says Lucy on it. Now I have no idea who Lucy is, but Lucy, wherever she may be, has made me think about the fact that any given dollar bill gets spent and re-spent and spent again in the economy in the process of our goods and services changing hands. It makes me think about the relationship between money and real goods and services. What's the connection and this is really an important question because it's at the heart of the question of whether the Fed can really influence the economy or not. Here's the question. What's the relationship between paper money, which is nominal, that is, imaginary, and real goods and services, that is, stuff that we actually buy at the store that satisfies our wants and needs. Is there a connection between the nominal economy, the money economy and the real economy, and if so, what is it?
Well, we're going to start right now with a very pessimistic look at this relationship and this comes from the classical economists, the heirs of Adam Smith. The classical economists are the people who gave us supply and demand diagrams and prices that adjust instantly to clear markets. In the view of the classical economists, there is no relationship between the nominal economy and the real economy. Money is neutral. If you increase the money supply, all you do is increase the price level; you don't change the real quantity of goods and services. You don't change the standard of living. You don't change employment or output or investment or any of the real variables in the economy. All you do is increase prices proportionally. Let's see where the classical economists got that conclusion.
We go back to this equation that explains the relationship between money, prices and real output in the economy. This is called the quantity equation. And the quantity equation is quite intuitive. It says that all the shopping that's done in our economy, the gross domestic product has got to be paid for somehow with the money supply. Whenever you go shopping, you pay for whatever you get with cash or checks and that's the money supply. Now the money supply in our economy is about a trillion dollars and the gross domestic product is about eight trillion dollars. That means that every dollar bill circulating in our economy on average is being spent and re-spent eight times during the year to make this equation balance. All the shopping has to be paid for and since the money supply is less than the gross domestic product, that means dollars are spent and re-spent, and the rate of re-spending is called velocity. Well, the classical economists said, "Look, consider this reasoning. If the velocity of money is constant, then any increase in the money supply shows up as either an increase in the price level or an increase in real output."
However, real output is governed by the speed limit of the economy, that is, there's full employment output and if you try to have more output than full employment, prices go right up and if you try to have less employment than full output, then you've got slack in the economy and wages and prices fall. So if you believe that wages and prices adjust instantly to keep supply and demand in balance, if you're a classical Adam Smith schooled economist who believes that prices do all the work in the economy adjusting up and down to make supply and demand balance, then you believe that any change in the money supply is going to immediately feed in to a change in prices with no change in the real economy. This is what's meant by the statement "money is neutral." If we say that money is neutral, we're speaking from a classical point of view. Increasing the money supply by 10 percent only increases the price level by 10 percent with no change in real output. Nothing changes. Output, investment, employment, all that stuff that we really care about, the whole real economy, the economy of goods and services remains unchanged. The change in the money supply influences only nominal variables. This is what's called the classical dichotomy. The world of money is completely separate from the world of goods and services, that is, the real economy is disconnected from the monetary economy. Now that's a very extreme position and most economists nowadays believe that changes in the money supply, at least in the short run, can influence output, as well as prices. But in the long run, the classical position holds, that is, even the models that we use nowadays that allow some latitude for money to affect output, in the long run all of the affect goes into a change in prices and we'll see that shortly.
But first, let me give you an example of what a timed series would look like following a change in the money supply. Suppose we're in a world where the money supply can have an influence on output in the short run. And this is certainly the case, I mean, in 1992 when the Federal Reserve had encouraged banks to lend more money to businesses and end the credit crunch that followed the banking crisis of the 80's. What happened was interest rates fell and businesses began borrowing and beefing up their capital stock, building more factories and buying more equipment. So in the short run with the increase in money supply, there was an increase in output. Here's what it looked like. The Fed was clipping along here with the money supply at a fixed rate and notice here I'm using movement along the horizontal axis to indicate the passage of time. So time passes as this line flows to the right. And here we are with the Fed making the decision to increase the money supply, let's say by 40 percent. So the Fed increases the money supply and this new money supply just clips along for the rest of time. Well, what's going to happen in the economy? What would really happen is that output would begin to increase because of the availability of credit. Businesses can borrow easier, interest rates are lower and output increases, but then at some point prices begin to increase and when they do, the demand for money increases and with the increase in demand for money, interest rates rise, people stop spending as much, consumers don't like the higher prices because it shrinks the real value of their wealth and foreigners stop buying our stuff because other goods from other countries are less expensive. So the rise in prices then choke output back to its full employment level and output goes along. There's been a temporary blip here, a little stimulus to the economy from the monetary policy, but nothing enduring. In fact, what happens is prices clip along at their regular rate and then with the increase in money supply, prices begin rising and they rise until they get to their new level which is going to be proportionally equal to the increase in the money supply. So if the money supply goes up by 40 percent, then in the long run prices are also going to rise by exactly the same amount, 40 percent, and output is going to be unchanged. That's because output in the long run has to respect the speed limit and then if we're above the speed limit, prices are going to rise until we've dropped back to the speed limit as we've seen in our other models.
So how long does this process take? How much of an increase in output are we going to get? Listen, even if it doesn't last forever, it's better than nothing, right? Can monetary policy have an affect in the short run even if it can't have an affect in the long run? Well, that depends. It depends on quickly people digest the future. If people are forward looking, forming rational expectations of what's to come, they're not going to be fooled at all. This increase in the money supply, they know, if going to very quickly create inflation, in fact, they may even act in anticipation by raising their prices now. They say, "Oh-oh, money supply up 40 percent, that means prices are going up 40 percent. I better raise my prices now." Labor unions negotiate for higher wages, people try to raise their prices so they're not caught behind with their rivals raising the prices before them and what we might get is an instantaneous adjustment of prices with no period of higher income at all. This is the extreme view in which monetary policy can have no effect, not even in the short run. If expectations are rational, we're more likely to have the case here represented by the dotted lines where all the adjustment is instantly on the side of prices with no change in real output at all.
So back to our original question. Can money make a difference in the real economy? Can a change in the money supply influence output, employment and investment? And the answer is it depends. In the long run clearly not. The nominal economy in the long run influences only the nominal economy. In the short run, however, it's possible that only to the extent that people do not perfectly digest the future, don't perfectly change their behavior in response to what they see coming to the extent that they do, money has no affect at all. It's perfectly neutral. But to the extent that people are fooled, they're slow to change their expectations, money can in the short run have an effect on the real economy.
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The Quantity Theory of Money (review) Page [2 of 2]