Demand
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- Money Finance And The Real Economy
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Capital Flows, Asset Prices, and the Real Economy: A 'China Shock' in the U.S. Real Estate Market. Zhimin Li, Leslie Sheng Shen, Calvin Zhang. Abstract: We study the effects of foreign real estate capital flows on local asset prices and employment using detailed housing transactions data.
A money demand function intends to display the influence that some economic aggregate variables will have upon the aggregate demand for money. The above discussion indicates that money demand will depend positively on the level of real GDP and the price level due to the demand for transactions. Money demand will depend negatively on average interest rates due to speculative concerns. We can depict these relationships simply using the following functional representation.
Here MD is the aggregate, economy-wide money demand, P$ is the current US price level, Y$ is US real GDP, and i$ is the average US interest rate. The f stands for 'function.' f is not a variable or parameter value, it simply means that some function exists that would map values for the right-hand-side variables, contained within the brackets, into the left-hand-side variable. The '+' symbols above the price level and GDP levels mean that there is a positive relationship between changes in that variable and changes in money demand. For example, an increase (decrease) in P$ would cause an increase (decrease) in MD. A '-' symbol above the interest rate indicates that changes in i$ in one direction will cause money demand to change in the opposite direction.
For historical reasons, the money demand function is often transformed into a real money demand function as follows. First, rewrite the function on the right-hand side to get,
In this version, the price level, P$, is brought outside the function f( ) and multiplied to a new function labeled L( ), called the liquidity function. Note that L( ) is different from f( ) since it contains only Y and i$ as variables. Since P$ is multiplied to L( ) it will maintain the positive relationship to MD and thus is perfectly consistent with the previous specification. Finally, by moving the price level variable to the left-hand-side we can write out the general form of the real money demand function as,
This states that real money demand, MD/P$, is positively related to changes in real GDP (Y$) and the average interest rate (i$) according to the liquidity function. We can also say that the liquidity function represents the real demand for money in the economy. That is, the liquidity function is equivalent to real money demand.
Finally, simply for intuition's sake, any real variable represents the purchasing power of the variable in terms of prices that prevailed in the base year of the price index. Thus, real money demand can be thought of as the purchasing power of money demanded in terms of base year prices.
Supply
Money supply is much easier to describe because we imagine that the level of money balances available in an economy is simply set by the actions of the central bank. For this reason it will not depend upon other aggregate variables and thus we need no function to describe it.
We will use the parameter MS$ to represent the nominal US money supply and assume that the FED, using its three levers, can set this variable wherever it chooses. To represent real money supply, however, we will need to convert by dividing by the price level. Hence let, represent the real money supply in terms of prices that prevailed in the base year.
Equilibrium
The equilibrium interest rate is determined at the level that will equalize real money supply with real money demand. We can depict the equilibrium by graphing the money supply and demand functions on the following diagram
The functions are drawn on the adjoining diagram with real money, both supply and demand, plotted along the horizontal axis and the interest rate plotted along the vertical axis.
Real money supply, , is drawn as a vertical line at the level of money balances, measured best by M1. It is vertical because changes in the interest rate will not affect the money supply in the economy.
Real money demand, i.e., the liquidity function L(Y$, i$) is a downward sloping line in i$ reflecting the speculative demand for money. In other words, there is a negative relationship presumed to prevail between the interest rate and real money demand.
Where the two lines cross determines the equilibrium interest rate in the economy, i$ since this is the only interest rate that will equalize real money supply with real money demand.
International Finance Theory and Policy - Chapter 40-7: Last Updated on 1/11/05
During the dark ages of economics, the quantity theory of money held forth that the amount of money swooshing through the economy determined everything from inflation to economic growth. An excess supply of money available to the public would chase a limited supply of goods, inducing higher inflation and thereby limiting growth.
Broad changes to society have all but ended the idea that inflation is always and everywhere a monetary phenomenon.
The changing structure of the economy, the integration of advanced technology into the production of goods and provision of services, and broad demographic changes have all contributed to the conditions that have all but ended the idea that inflation is always and everywhere a monetary phenomenon.
As monetarism faded into the background, modern monetary policy became centered on inflation-targeting via central bank manipulation of short-term interest rates.
In the United States, the Federal Reserve settled on a dual mandate of maintaining price stability while minimizing unemployment. After all, an hour of unemployment can never be recovered, forever subtracting from an economy’s potential growth.
More recently, the Fed changed its long-term strategy and will no longer engage in preemptive rate hikes to quash the first signs of inflation. Rather, it will engage in average inflation targeting, which will focus on full employment and seek to target a 2% inflation rate over a period of years.
Velocity of money’s decline
Not surprisingly, the cousin of monetarism and a focus on the money supply, the velocity of money, has experienced a historic decline implying slower growth due to the broad and deep shock caused by the pandemic.
Although the money supply no longer has the attention of the financial markets or the monetary authorities — think of the emergence of credit cards and how little cash you carry around in your wallet these days, and think of how often you pay for something with a check — we still keep track of what are referred to as money aggregates.
There are several measures, beginning with M1, the amount of money readily available to the public, defined as the amount of cash plus demand deposits (checking account balances).
Next up is the M2 money supply, which equals cash plus checking account balances plus savings deposits. M2 is the benchmark we will discuss because of the unique importance of savings deposits during the pandemic or any other economic downturn.
M2 is growing at a rate of 23% per year. Was the economy suddenly awash in the cash that had been stashed in mattresses?
In the first figure below, we show the growth rate of M2 money supply during recessions and recoveries, with sharp increases in M2 occurring at or near the outset of the 1990, 2001 and 2008 recessions and again at the end of 2019 as the global manufacturing recession took hold. That threat to the global economy was quickly followed by the global economic shutdown at the onset of the coronavirus pandemic.
M2 is growing at a rate of 23% per year. Was the economy suddenly awash in the cash that had been stashed in mattresses from Hoboken to Hollywood? Has the public been waiting for the bottom to fall out the economy all this time?
Probably not! In fact, the amount of currency put into the economy is mostly irrelevant these days. Again, think of credit cards and buying things with your smartphone.
Instead, the second chart shows that the growth of M2 in the modern era of digital spending (probably beginning around 2005 and becoming full-blown in the 2010s) is determined by the growth of savings deposits. In the current episode since 2012, the growth of savings has been nearly identical to the growth of M2 money supply.
The paradox of thrift
So why do you think that savings deposits would grow during times of distress? We’d argue that the propensity to save (and not to spend) grows when economic uncertainty increases.
Money Finance And The Real Economy Class
A household is more likely to restrict spending to essential items (food, rent, utilities, car payments and health care), saving whatever might be left over just in case things get worse. In other words, it’s the same challenge that faced the economy during the Great Depression, or what is known as the “paradox of thrift.”
As soon as a recession is over, overdue bills are paid and spending on non-essentials becomes possible again.
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That seems to be confirmed by the decrease in savings deposits after each of the recessions. As soon as a recession is over and a household income stream becomes secure, overdue bills are paid and spending on non-essentials becomes possible again, with the depletion of savings adding to the economic boom.
The propensity to save and spend have ramifications for public policy during a pandemic. We’ve talked before about the spending attributes of lower and upper-income cohorts. Those at the bottom of the earnings ladder typically spend more than their salaries, with the difference made up by social safety-net benefits.
Each dollar of income made available to the lowest-earning cohorts is spent on putting food on the table and other essentials of life, with each dollar spent generating additional income and spending along a stream of commerce. Members of the lowest income group would be expected to have little or no savings to get them through an economic shutdown, and it is that group that needs the most assistance during a pandemic.
Moving up the income ladder, the ability to spend increases with the amount of income. During a pandemic, however, those high-income groups would have less to spend on. (How many new couches can you buy?) Therefore, providing benefits to high-income groups through tax breaks would not be expected to generate increases in overall spending, with the excess funds merely salted away in a savings account.
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At a time of distress, it is in everyone’s best interest to target policy for those cohorts that are most likely to spend any and all income received.
Finally, the recent spike in M2 growth has induced a discussion round the threat of runaway inflation due to monetary action taken by the central bank to stimulate accommodation as legislators have been unwilling to provide fresh fiscal stimulus.
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The takeaway
But as the last figure illustrates, recessions are more likely to threaten the economy with deflation than inflation. The Fed knows how to squeeze inflation out of an economy. Deflation, on the other hand, has no easy or straightforward solution – think of the Depression.
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