ECO 155 750 LECTURE 36 1 WELL, SO WHAT WE WANT TO DO TODAY, WE WANT TO PICK UP WHERE WE STOPPED LAST TIME. IF YOU'LL REMEMBER, WE WERE TALKING ABOUT THE MODERN QUANTITY THEORY OF MONEY. IF YOU'LL REMEMBER, THERE WAS THE OLDER -- THE CLASSICAL ECONOMISTS HAD THEIR QUANTITY THEORY OF MONEY. THAT WAS THE ORIGINAL VERSION OF IT. MV EQUALS PQ. AND THEY HAD CERTAIN ASSUMPTIONS THAT THEY MADE: THAT VELOCITY WAS CONSTANT AND THAT THE REAL GDP WAS CONSTANT, ALTHOUGH THEY DIDN'T HAVE THAT MEASURE OF GDP AT THE TIME. BUT THEY ASSUMED THAT REAL GDP WAS CONSTANT. AND SO ALL THEY REALLY HAD WAS -- THIS IS THE MONEY SUPPLY. THEY WERE SAYING IF THE MONEY SUPPLY WOULD DOUBLE, THEN, GOSH, THERE'S ONLY ONE OTHER THING IN THE EQUATION THAT CAN CHANGE. THE PRICE LEVEL WOULD HAVE TO DOUBLE, THE CONSUMER PRICE INDEX, THE GDP PRICE DEFLATOR AND SO FORTH. AND SO THAT WAS THE CLASSICAL ECONOMISTS' VERSION OF THIS. BUT -- AND I'VE WRITTEN IT DOWN HERE. THAT'S REALLY WHERE I'M GOING WITH THIS IS THAT IN THE MODERN QUANTITY THEORY OF MONEY, WHEN YOU SEE THE M IN THERE, IT DOESN'T STAND FOR MONEY SUPPLY. IT STANDS FOR MONEY DEMAND. AND SO LET ME COME BACK AND DO WHAT I DID THE OTHER DAY: MV EQUALS PQ. AND THIS IS THE MODERN VERSION OF THE QUANTITY THEORY OF MONEY. WHAT THEY DID IS THIS: THEY SWITCHED THE V OVER TO THE OTHER SIDE OF THE FORMULA, ONE OVER V TIMES. RATHER THAN PQ, LET'S PUT IN GDP. THAT'S NOMINAL
ECO 155 750 LECTURE 36 2 GDP. AND THEN RATHER THAN LEAVE IT AS ONE OVER V, THEY USED THE LETTER K TIMES GDP. AND THIS IS JUST A PROPORTION OR A FRACTION. PROPORTION. LIKE, FOR EXAMPLE, IT MIGHT BE POINT TWO -- AND THAT'S JUST AN EXAMPLE. BUT ANYWAY. AND THEN THIS M IS MONEY DEMAND. AND SO IN THE MODERN QUANTITY THEORY OF MONEY, THEY HAVE A FORMULA THAT BASICALLY SAYS THIS: MONEY DEMAND IS PROPORTIONAL TO ECONOMIC ACTIVITY OR INCOME. GDP IS BASICALLY INCOME FOR EVERYBODY IN THE UNITED STATES AS WELL AS WHAT GETS PRODUCED, SO THERE'S TWO DIFFERENT WAYS OF LOOKING AT IT. BASICALLY, WHAT THIS SAYS IS MONEY DEMAND IS PROPORTIONAL TO INCOME. AND SO IF YOUR INCOME WAS, UNDER THESE CIRCUMSTANCES, TEN THOUSAND DOLLARS AND THIS K WAS POINT TWO, THEN WHAT WE WOULD SAY IS MY MONEY DEMAND IS -- WHAT WOULD THIS BE -- TWO THOUSAND DOLLARS. IN MY CHECKING ACCOUNT AND IN CURRENCY IN MY POCKET, I LIKE TO HOLD TWO THOUSAND DOLLARS. THAT'S WHAT THIS APPROACH WOULD SAY. AND SO, BOY, THEY'VE REALLY COME A LONG WAYS FROM TALKING ABOUT MONEY SUPPLY OVER TO NOW MONEY DEMAND. COME A LONG WAYS, BUT IT TOOK SOME TIME TO DO IT. THIS IS LIKE 19 -- I DON'T KNOW -- '50S UNTIL THE PRESENT. AND THIS STUFF, THIS CLASSICAL VERSION OF THE QUANTITY THEORY OF MONEY, THIS IS GOING BACK A COUPLE HUNDRED YEARS OR EVEN FURTHER, REALLY, AND COMING FORWARD UNTIL ROUGHLY THE 1950S. THERE'S NO LIKE CERTAIN DATE HERE THAT I'VE GOT IN MIND,
ECO 155 750 LECTURE 36 3 BUT THIS IS THE MORE MODERN VERSION OF THIS. NOW, LET'S DRAW A CURVE TO GO ALONG WITH IT. 'CAUSE YOU KNOW ECONOMISTS CANNOT GO VERY FAR WITHOUT DRAWING A CURVE. AND WE'LL PUT DOLLARS UP HERE, MONEY, AND DOWN HERE GDP OR INCOME, IF YOU LIKE. AGAIN, THIS IS NOMINAL GDP, NOT REAL. OKAY. AND SO WHAT WE HAVE IS THIS MONEY DEMAND LINE. MONEY DEMAND IS PROPORTIONAL TO GDP. AND THE SLOPE OF THIS CURVE IS EQUAL TO K. AND SO IF K IS POINT TWO AS IT WAS A MOMENT AGO IN MY DISCUSSION, THEN THE SLOPE OF THE CURVE IS EQUAL TO POINT TWO. MEANING WHAT? MEANING IF YOU GO OVER BY ONE UNIT, YOU WOULD GO UP BY POINT TWO UNITS. OR OVER BY TEN UNITS, UP BY TWO. OKAY. SO THIS IS THE MONEY DEMAND EQUATION FROM THE MODERN QUANTITY THEORY OF MONEY. NOW, WE HAVE TO DO SOMETHING ELSE. WE HAVE TO PUT IN THE MONEY SUPPLY. SO LET ME DRAW A CURVE RIGHT HERE SHOWS MONEY SUPPLY. AND YOU RECALL WE'RE TALKING ABOUT THE M-1 MONEY SUPPLY WHICH IS CURRENCY PLUS CHECKING DEPOSITS. AND I'LL TAKE THAT DOWN HERE IN JUST A SECOND, BUT I JUST WANTED TO REMIND YOU WHAT KIND OF MONEY WE'RE TALKING ABOUT. NOT JUST THE CURRENCY IN YOUR POCKET BUT ALSO YOUR CHECKING ACCOUNT MONEY. OKAY. WELL, HERE'S BASICALLY WHERE WE'RE HEADED WITH ALL THIS. IF WE FIND THE POINT WHERE MONEY SUPPLY EQUALS MONEY DEMAND -- THIS IS GDP AND I'LL PUT AN E DOWN THERE FOR EQUILIBRIUM -- WE'VE
ECO 155 750 LECTURE 36 4 ESTABLISHED AN EQUILIBRIUM GDP FOR THE ECONOMY. SO WE'VE GOT THAT MONEY DEMAND EQUATION. LET ME WRITE AN EQUATION FOR THE MONEY SUPPLY. MONEY SUPPLY IS JUST WHATEVER THE FEDERAL RESERVE SETS IT AT -- AND I'LL PUT A LITTLE BAR OVER THAT TO SHOW A FIXED AMOUNT. SO WE'VE GOT AN EQUATION FOR MONEY SUPPLY AND MONEY DEMAND. HERE'S A THIRD EQUATION, AN EQUILIBRIUM CONDITION -- AND I'LL WRITE THAT OVER HERE. EQUILIBRIUM CONDITION. THIS HAS GOT TO BE SATISFIED FOR THE WORLD TO WORK OUT RIGHT. MONEY SUPPLY EQUALS MONEY DEMAND. YOU DON'T HAVE EQUILIBRIUM IN THE MONEY MARKET, IN THE QUANTITY OF MONEY, UNLESS MONEY SUPPLY EQUALS MONEY DEMAND. AND NOW WHAT I WANT TO DO IS WRITE A DIFFERENT VERSION -- I'LL CALL THIS THREE PRIME ON THIS EQUATION. MONEY SUPPLY EQUALS -- I'M GONNA SUBSTITUTE FOR MONEY DEMAND, THIS THING WE HAD UP HERE. KGDP. THAT'S THE EQUILIBRIUM CONDITION. AND THE EQUILIBRIUM CONDITION OF MONEY SUPPLY EQUALS MONEY DEMAND, OR MONEY SUPPLY EQUALS THAT PROPORTION K TIMES GDP. THAT IS WHAT WE SEE IN THIS DIAGRAM RIGHT HERE. THIS INTERSECTION OF THE TWO CURVES COMING TOGETHER, MONEY SUPPLY AND MONEY DEMAND. THAT'S WHERE WE GET EQUILIBRIUM IN THE ECONOMY. NOW, LET'S TAKE JUST A COUPLE OF MINUTES AND TALK ABOUT -- AND SEE WHAT HAPPENS IF THINGS DON'T WORK OUT THE WAY I'M SAYING. LET'S SUPPOSE THAT WE DO HAVE THIS MONEY DEMAND LINE WITH THE SLOPE OF
ECO 155 750 LECTURE 36 5 POINT TWO AND SUPPOSE WE DO HAVE THIS MONEY SUPPLY -- AND I MEAN THIS COULD BE LIKE ONE THOUSAND DOLLARS OR A HUNDRED DOLLARS, OR WHATEVER YOU LIKE. BUT LET'S SAY THIS IS THE SITUATION, BUT WE END UP WITH A DIFFERENT GDP. MAYBE IT'S GDP ONE. WHAT IF THAT HAPPENS? WOULD THAT BE OKAY? WELL, HERE'S WHAT WOULD HAPPEN. IF THE GDP IS GDP ONE, THEN WE COME UP TO THE BLUE LINE HERE, THE MONEY SUPPLY LINE, AND SAY, "WELL, WE'VE GOT A ONE THOUSAND DOLLAR MONEY SUPPLY." BUT WE SEE MONEY DEMAND -- AND THAT'S OFF OF THIS UPWARD SLOPING MONEY DEMAND LINE. WE SEE THAT MONEY DEMAND IS LESS THAN MONEY SUPPLY. AND IT MAKES NO DIFFERENCE HOW MUCH THESE ARE. I'LL PUT AN AMOUNT IN HERE, NINE HUNDRED DOLLARS, BUT THE DOLLAR AMOUNT DOESN'T MATTER. WHAT MATTERS IS THAT WE SEE THAT IF GDP -- AND THIS IS THE STARTING POINT FOR OUR DISCUSSION. IF GDP IS AT SOME AMOUNT THAT I SAY IS NOT EQUILIBRIUM BUT SOME OTHER AMOUNT, THEN WHAT I FIND IS THAT THE MONEY SUPPLY IS DIFFERENT THAN MONEY DEMAND. AND I SAY, "OH, LOOK. THERE IS EXCESS MONEY SUPPLY," OR SOMETIMES SAY EXCESS MONEY BALANCES, "IN THE ECONOMY." NOW, IF THERE'S EXCESS MONEY BALANCES, LET'S THINK ABOUT HOW THAT WOULD WORK OUT. NOT IN TERMS OF SOME EQUATION OR A GRAPH ON THE BOARD, BUT LET'S THINK HOW IT WOULD WORK OUT IN REAL LIFE WITH REAL PEOPLE. WHAT WOULD HAPPEN IS SOMETHING LIKE THIS. YOU MIGHT HAVE SOMETHING IN YOUR MIND, "I LIKE TO KEEP EIGHT HUNDRED DOLLARS IN MY
ECO 155 750 LECTURE 36 6 CHECKING ACCOUNT." YOU MIGHT JUST KIND OF FEEL THAT WAY. "I LIKE TO KEEP EIGHT HUNDRED DOLLARS IN MY CHECKING" -- NOT JUST A CHECKING ACCOUNT. MAYBE SEVEN HUNDRED IN YOUR CHECKING ACCOUNT AND ONE HUNDRED IN CASH IN YOUR POCKET OR BACK IN YOUR DORM ROOM OR YOUR HOUSE, OR WHATEVER. BUT YOU LIKE TO KEEP A MONEY SUPPLY OF EIGHT HUNDRED DOLLARS. AND SEVEN HUNDRED IN A CHECKING ACCOUNT AND ONE HUNDRED IN CASH. AND SUPPOSE YOUR BANK STATEMENT COMES TODAY IN THE MAIL AND YOU OPEN IT UP. AND YOU'RE NOT THINKING ANYTHING GOOD OR BAD OR ANYTHING. YOU JUST OPEN IT UP AND YOU SAY, "WOW, WOULD YOU LOOK AT THAT. I NORMALLY KEEP SEVEN HUNDRED BUCKS IN HERE AND I'VE GOT NINE HUNDRED DOLLARS IN MY CHECKING ACCOUNT. AND I'VE GOT THE HUNDRED BUCKS IN CASH HERE THAT I NORMALLY KEEP, SO I'VE GOT A MONEY SUPPLY, A PERSONAL MONEY SUPPLY, OF A THOUSAND DOLLARS." I USED THE WRONG NUMBER HERE. LET ME SAY EIGHT HUNDRED DOLLARS, JUST TO MAKE IT ALL GO ALONG WITH MY EXAMPLE I'M MAKING UP. YOU NORMALLY LIKE TO KEEP -- WHAT'D I SAY? DID I GET -- NO. YOU LIKE TO HAVE A MONEY SUPPLY OF EIGHT HUNDRED DOLLARS NORMALLY. THAT'S JUST YOU. BUT IN THIS PARTICULAR CASE YOU GOT A THOUSAND BUCKS MONEY SUPPLY. NINE HUNDRED DOLLARS IN YOUR CHECKING ACCOUNT AND ONE HUNDRED DOLLARS OF CASH. AND THEN YOU START THINKING, "BOY, THIS IS SUCH A NICE DAY." THAT'S WHAT I ALWAYS THINK. I THINK IT'S A NICE DAY WHEN THERE'S A LOT OF MONEY SORT OF SLOSHING AROUND IN MY CHECKING ACCOUNT AND I
ECO 155 750 LECTURE 36 7 ALSO THINK HOW SMART I MUST BE OR ELSE THAT MONEY WOULDN'T BE THERE. THAT MONEY DIDN'T SHOW UP ON ITS OWN. A SMART GUY PUT IT THERE. SO ANYWAY, YOU GET THIS STATEMENT AND YOU START GOING, "WOW, I'VE GOT A COUPLE HUNDRED BUCKS EXTRA." AND THEN YOU START THINKING THINGS LIKE, "YOU KNOW, MAYBE I'LL CALL SOME FRIENDS UP AND WE'LL GO OUT TO A MOVIE AND DINNER TONIGHT." OR "MAYBE I'LL BUY THAT NEW SHIRT I'VE BEEN WANTING." OR "MAYBE I'LL HAVE A NEW TIRE PUT ON MY CAR. I'VE NEEDED A NEW TIRE FOR AWHILE. I'VE BEEN DRIVING AROUND ON THAT SPARE. I THINK I'LL GET A NEW TIRE." BUT WHATEVER HAPPENS, WHEN THERE'S EXCESSIVE AMOUNTS OF MONEY IN THE ECONOMY, PEOPLE GET THIS LITTLE HAPPY SURPRISE WHEN THEY OPEN UP THEIR BANK BALANCE. AND THEN THEY START SAYING -- OR THEIR BANK STATEMENT. THEN THEY START SAYING, "I THINK I'M GONNA SPEND A LITTLE BIT OF THIS." SO EXCESS MONEY SUPPLY, SPEND MORE. I MEAN, THAT'S WHAT THAT MEANS. THERE'S NO LAW THAT SAYS THAT. THAT'S WHAT PEOPLE DO. THEY JUST SAY, "OH, I CAN AFFORD THAT" AND THEN THEY BUY SOMETHING THAT MAYBE A DAY BEFORE THEY WOULDN'T HAVE BOUGHT. SO WHEN YOU SPEND MORE, THEN THAT SHOWS UP AT THE STORES, GROCERY STORES, DEPARTMENT STORES AND SO FORTH, AS EXTRA SALES REVENUE. THAT'S AT THE STORES. AND THEN THE STORES DO THINGS LIKE THEY HIRE MORE WORKERS, HIRE WORKERS. WHY? "WELL, PEOPLE COMING IN AND BUYING STUFF AND WE NEED TO HAVE SOME MORE
ECO 155 750 LECTURE 36 8 WORKERS HERE." AND THEN THEY ALSO SAY -- THIS IS THE RETAIL STORES -- ORDER MORE MERCHANDISE. AND WHAT'S HAPPENING IS, THIS EXCESS MONEY SUPPLY IN THE ECONOMY, WHEN IT GETS SPENT, THEN THE STORES FEEL THAT COMING IN AND START TAKING APPROPRIATE ACTION BY HIRING WORKERS, ORDERING MERCHANDISE, AND THEN THE MANUFACTURERS START HIRING MORE WORKERS. THIS IS WHAT WE TALKED ABOUT IS, WHAT, GDP EXPANDS -- LET'S SAY GROWS, NOT EXPANDS. GDP GROWS. LET ME SAY INCREASES. THAT'S A BETTER WORD STILL. INCREASES. SO WHAT I'M SAYING TO YOU IS, WE STARTED OFF AT GDP ONE AND NOW WE JUST SAW THAT IF GDP IS GDP ONE AND WE DO HAVE THESE EXCESS MONEY SUPPLY OR EXCESS MONEY BALANCES, THEN FORCES ARE SET IN MOTION THAT CAUSE GDP TO RISE. AND SO THIS GDP ONE DOESN'T STAY THERE AT GDP ONE. IT'S GROWING NOW. WHY? 'CAUSE OF ALL THIS NEW SPENDING. HOW LONG WILL IT GROW? AND THE ANSWER IS: IT WILL GROW UNTIL THERE'S NO MORE EXCESS MONEY SUPPLY. THAT'S WHAT WE'RE TRYING TO GET RID OF HERE IS THE EXCESS MONEY SUPPLY. SO AS GDP STARTS TO GROW, THEN PEOPLE START SAYING, "I'D LIKE TO HOLD A LITTLE BIT MORE MONEY." AND AS THEY SAY "I'D LIKE TO HOLD A LITTLE BIT MORE MONEY," THEN THE EXCESS MONEY SUPPLY GETS A LITTLE SMALLER AND JUST FORCES A LITTLE BIT LESS. AND SO BASICALLY WHAT HAPPENS IS, GDP KEEPS GROWING UNTIL IT'S FINALLY UP TO THIS EQUILIBRIUM LEVEL AND THEN PEOPLE DON'T SAY, "I HAVE EXCESS MONEY BALANCES." NOW WHEN THEY GET THEIR BANK STATEMENT IN THE MAIL IT
ECO 155 750 LECTURE 36 9 SAYS SEVEN HUNDRED DOLLARS. YOU'VE GOT THE ONE HUNDRED DOLLARS IN CASH; YOU'VE GOT EIGHT HUNDRED DOLLARS. THAT'S WHAT YOU -- OH, I'M SORRY. IT'S THE OTHER WAY AROUND, ISN'T IT? BUT ANYWAY, THE MONEY DEMAND WOULD GROW. MY EXAMPLE DIDN'T GO ALONG WITH MY GRAPH. BUT MONEY DEMAND WOULD GROW AND FINALLY THERE'D BE NO MORE EXCESS MONEY BALANCES. AND THEN PEOPLE WOULD NOT BE SPENDING MORE; THEY WOULD BE SATISFIED WITH THE SITUATION AS IT IS AND WE'RE HERE AT EQUILIBRIUM. SUPPOSE WE STARTED OFF HERE AT GDP TWO. HOW WOULD THAT WORK OUT? AND THE ANSWER IS -- OH, AND THAT'S OUR NEW STARTING POINT, START HERE. IF WE HAVE GDP TWO, WE HAVE A VERY LEVEL OF NATIONAL PRODUCTION AND INCOME. OKAY. THEN HERE'S WHAT HAPPENS: PEOPLE DESIRE A LARGE AMOUNT OF MONEY BALANCES. AT THEIR HIGH INCOME, THEY'RE DOING A LOT OF SPENDING; THEY'RE BUYING A LOT OF THINGS. THERE'S A LOT OF ECONOMIC ACTIVITY. PEOPLE NEED TO HOLD A LOT OF MONEY. LET'S SAY I'LL PUT TWELVE HUNDRED DOLLARS HERE, JUST TO WORK WITH AN EASY NUMBER. SO IF WE STARTED WITH GDP AT TWO, GDP TWO, THEN WE HAVE A BIG MONEY DEMAND, QUANTITY OF MONEY PEOPLE WOULD LIKE TO HOLD. THE MONEY SUPPLY IS, IN THIS PARTICULAR CASE, A THOUSAND DOLLARS. AND SO WHAT WE'D SAY IS WE HAVE DEFICIENT MONEY BALANCES OR A DEFICIENT MONEY SUPPLY. AND IN THIS PARTICULAR CASE, SOMEBODY SAYS, "OH, I LIKE" -- OR THE AVERAGE PERSON, LET'S SAY. "OH, I LIKE TO KEEP TWELVE HUNDRED
ECO 155 750 LECTURE 36 10 DOLLARS IN MONEY, PERSONALLY, ON HAND, EITHER IN MY CHECKING ACCOUNT OR IN MY POCKET. I LIKE TO HOLD ON TO TWELVE HUNDRED DOLLARS WORTH OF MONEY." AND SO THEN HERE COMES THE BANK STATEMENT AND THEY OPEN IT UP, AND THEY GO, "OH, MAN. I'M A COUPLE HUNDRED BUCKS BELOW WHAT I NORMALLY LIKE TO KEEP." SO NOW PEOPLE -- THE AVERAGE PERSON'S OPENED UP THAT BANK STATEMENT AND IT'S SAYING DEFICIENT MONEY BALANCES -- AND COMPANIES ARE DOING THE SAME THING. AND THEN THEY SAY, "OH, BOY. I'M TWO HUNDRED BUCKS UNDER." AND IT'S KIND OF THIS LITTLE EMBARRASSING FEELING THAT YOU MIGHT HAVE. ONLY YOU KNOW, BUT YOU'RE STILL KIND OF SHOCKED INTO ACTION. AND YOU GO, "WHAT AM I GONNA DO? I'M TWO HUNDRED BUCKS LOW." I'LL TELL YOU WHAT I DO WHEN I'M TWO HUNDRED BUCKS LOW. I PUT ON A SKI MASK AND GO TO -- NO, I DON'T REALLY GO TO THE GIT 'N GO. WHEN MY BANK BALANCE IS A LITTLE BIT LOW, I THINK SOMETHING LIKE THIS: "GOSH, I WISH I HAD ANOTHER TWO HUNDRED BUCKS TO GET ME UP TO THE NORMAL AMOUNT. OH, IF I WOULD CUT MY SPENDING BY FIFTY DOLLARS A MONTH, CUT BACK A LITTLE BIT, FIFTY DOLLARS A MONTH, A LITTLE OVER A DOLLAR A DAY, THEN IN FOUR MONTHS MY BANK BALANCE WOULD'VE BUILT UP TO WHAT I NORMALLY LIKE TO KEEP. FIFTY DOLLARS A MONTH. I DON'T HAVE TO SOLVE THIS PROBLEM OVERNIGHT. JUST A LITTLE BIT AT A TIME." SO THE PERSON CUTS BACK ON SPENDING. DEFICIENT MONEY BALANCES, REDUCE SPENDING TO INCREASE MONEY BALANCES. HOW'D YOU LIKE THAT
ECO 155 750 LECTURE 36 11 SKI MASK APPROACH, THOUGH, IN THE GIT 'N GO? THAT'S REALLY ILLEGAL. I DON'T KNOW IF ANYBODY TOLD YOU THAT. ANYWAY, SO WHAT WE DO HERE IS IN ORDER TO BUILD UP OUR BANK ACCOUNT TO WHERE WE LIKE IT TO BE, WE JUST GET A LITTLE BIT FRUGAL. WE DON'T HAVE TO GO NUTS. THIS DOESN'T HAVE TO BE DONE IN ONE DAY, BUT WE'RE GONNA CUT BACK ON OUR SPENDING A LITTLE BIT. AND WHEN WE DO, THERE'LL BE REDUCED SALES REVENUES BY RETAILERS. AND WHEN RETAILERS SEE THESE REDUCED SALES REVENUES COMING IN, THEY WILL, LET'S SAY, LAY OFF SOME WORKERS. LAY OFF WORKERS. OR MAYBE ALL THEY DO IS THEY JUST SAY NO MORE OVERTIME. OR MAYBE WHAT THEY DO IS WHEN SOMEBODY RETIRES OR QUITS, THEY DON'T REPLACE 'EM. BUT SOMEHOW OR ANOTHER THEY SAY, "WE'RE NOT SELLING AS MUCH AND WE JUST DON'T NEED AS MANY EMPLOYEES TO HANDLE FEWER CUSTOMERS," AND THEN REDUCE MERCHANDISE ORDERS. AND THAT GOES ON BACK TO THE MANUFACTURER AND THEN ALL OF A SUDDEN GDP DECLINES. AND SO WE STARTED OFF AT GDP TWO, BUT ALL OF A SUDDEN NOW IT'S DECLINING. AND WHY IS THAT? BECAUSE PEOPLE ARE TRYING TO ACCUMULATE MONEY. YOU SEE, THERE'S A BIG PROBLEM WITH THAT ACCUMULATING MONEY. SUPPOSE THAT I'M TRYING TO GET AN EXTRA TWO HUNDRED DOLLARS INTO MY CHECKING ACCOUNT OR INTO MY POCKET AND YOU'RE TRYING TO GET AN EXTRA TWO HUNDRED DOLLARS INTO YOUR CHECKING ACCOUNT OR YOUR POCKET, AND THE NEXT PERSON AND THE NEXT PERSON AND THE NEXT PERSON. THE THING IS THAT WE CAN'T DO THAT. WELL, I MEAN, WE
ECO 155 750 LECTURE 36 12 CAN ALL WANT TO DO THAT. I CAN WANT TWO HUNDRED DOLLARS MORE BUT WHERE AM I GONNA GET IT? I CAN'T PRINT IT OUT. THE ONLY PLACE FOR ME TO GET AN EXTRA TWO HUNDRED DOLLARS IS FROM SOMEBODY ELSE. BUT THE THING IS IS OTHER PEOPLE ARE TRYING TO ACCUMULATE THEIR OWN TWO HUNDRED DOLLARS AND THE ONLY PLACE THEY CAN GET THAT IS FROM SOMEBODY ELSE LIKE ME. AND SO THERE'S REALLY NOT ANOTHER TWO HUNDRED DOLLARS TO GO AROUND FOR EVERYBODY AND WE'RE ALL JUST KIND OF CUTTING BACK ON OUR SPENDING. AND THAT'S GONNA CAUSE THE ECONOMY TO SLOW DOWN. AND WHEN IT DOES SLOW DOWN, WE'RE MOVING FROM GDP TWO BACK TO THE EQUILIBRIUM. AND AS WE SEE THIS HAPPEN, AS THE ECONOMY DOES SLOW DOWN, GDP STARTS TO DROP BACK, THEN PEOPLE DON'T WANT TO HOLD SO MUCH MONEY ANYMORE. A MOMENT AGO THEY WANTED TWELVE HUNDRED DOLLARS, THIS AVERAGE PERSON. BUT AS THEIR INCOMES GO DOWN AND WHAT THEY'RE SAYING HERE IS, "I WANT TWENTY PERCENT AS MUCH MONEY BALANCE AS WHATEVER MY ANNUAL INCOME IS." AS PEOPLE'S INCOME GOES DOWN, THEN THEIR DESIRED MONEY DEMAND GOES DOWN. AND SO FINALLY GDP HAS FALLEN ALL THE WAY BACK TO EQUILIBRIUM. THEIR MONEY DEMAND HAS FALLEN ALL THE WAY BACK DOWN TO ONE THOUSAND DOLLARS AND WE'VE ACHIEVED AN EQUILIBRIUM. SO ANYWAY, WHAT I AM SAYING TO YOU IS THIS: THE MODERN QUANTITY THEORY OF MONEY IS -- FIRST OF ALL, THEY USE THAT EQUATION OF EXCHANGE FOR MONEY DEMAND AND THEN THEY GO AHEAD AND SET UP
ECO 155 750 LECTURE 36 13 THIS SORT OF EQUILIBRIUM CONDITION OF MONEY DEMAND EQUALS MONEY SUPPLY, AND THEN BASICALLY WHAT THEY SAY IS, "ANY TIME THERE'S A DISAGREEMENT BETWEEN MONEY DEMAND AND MONEY SUPPLY, THIS THING DOWN HERE ON THE HORIZONTAL AXIS, NOMINAL GDP, THAT WILL ADJUST." AND SO REALLY WHAT THIS GROUP SAYS IS THAT THE QUANTITY OF MONEY IN THE ECONOMY WILL DETERMINE GDP, NOMINAL GDP. OKAY. ARE THERE QUESTIONS ABOUT THIS, WHAT WE'VE JUST COVERED. 'CAUSE WE'VE COVERED QUITE A BIT HERE? BUT, ON THE OTHER HAND, IT'S NOT ALL THAT COMPLICATED. THIS IS JUST ONE MORE SORT OF GRAPHICAL REPRESENTATION OF HOW THE ECONOMY OPERATES. LET'S SEE IF I CAN FIND OUT WHERE I AM HERE IN MY NOTES. YEAH, I SEE WHERE WE ARE. OKAY. ANY QUESTIONS ABOUT THIS? WHAT WE WANT TO DO NEXT IS WE WANT TO TALK ABOUT SHIFTING THESE CURVES. SHIFTING CURVES. HERE'S WHERE WE JUST WERE IN THIS DISCUSSION. WE SHOWED WHERE THE EQUILIBRIUM GDP IS. AND IF WE START OFF WITH A DIFFERENT LEVEL OF GDP, WE WILL MOVE TO THAT EQUILIBRIUM. SO THAT IS THE EQUILIBRIUM AND SO GDP WILL REMAIN AT THIS POINT FOR A LONG, LONG TIME UNLESS SOMETHING CHANGES. AND WHAT WOULD CHANGE IS THE MONEY DEMAND CURVE WOULD SHIFT, ROTATE, OR THE MONEY SUPPLY CURVE WOULD SHIFT. UNTIL THAT HAPPENS -- IF WE DON'T HAVE THESE CURVES SHIFTING, THEN WE JUST STAY AT THIS POINT. THIS IS OUR EQUILIBRIUM SITUATION; WE REMAIN IN THAT SPOT. OKAY.
ECO 155 750 LECTURE 36 14 SO LET'S SUPPOSE SOMETHING DOES COME ALONG AND CHANGE. HOW COULD THE MONEY SUPPLY CURVE SHIFT? WELL, THIS WOULD ONLY HAPPEN THROUGH FED POLICY, RIGHT? AND WE TALKED ABOUT THE FEDERAL RESERVE THE OTHER DAY AND HOW IT HAD THOSE THREE MAIN POLICIES. IF YOU REMEMBER, IT HAS OPEN MARKET OPERATIONS TO INFLUENCE THE MONEY SUPPLY. IT CAN CHANGE THE DISCOUNT RATE TO INFLUENCE THE MONEY SUPPLY OR IT COULD CHANGE RESERVE REQUIREMENTS TO AFFECT THE MONEY SUPPLY. THOSE -- THE FED POLICIES -- THERE ARE THREE FED POLICIES THAT COULD AFFECT THE MONEY SUPPLY. AND SO ANYWAY, ONE OF THOSE POLICIES COULD CHANGE. OKAY. SO LET'S DO LET ONE OF THESE POLICIES CHANGE. LET'S LET THE MONEY SUPPLY INCREASE MONEY SUPPLY FROM ONE THOUSAND DOLLARS TO FIFTEEN HUNDRED DOLLARS. LET'S JUST DO THAT IN THIS DIAGRAM HERE. LET ME PUT A ONE NEXT TO THAT AND THIS WILL BE WHEN OUR MONEY SUPPLY WAS A THOUSAND DOLLARS. IN A SECOND I'LL INCREASE THAT. WE'LL LET THIS EQUAL POINT TWO. LET ME ASK YOU A QUESTION HERE. HOW MUCH IS THIS GDP, THIS EQUILIBRIUM GDP? DOES ANYBODY KNOW? HOW COULD WE FIGURE THAT OUT? HERE'S WHAT WE KNOW IS THAT AT THIS POINT, AT THE EQUILIBRIUM GDP, MONEY SUPPLY EQUALS MONEY DEMAND. AND WE KNOW WHAT THE MONEY SUPPLY IS. IT'S EQUAL TO -- AND THIS IS OUR EQUILIBRIUM CONDITION. IT'S EQUAL TO ONE THOUSAND DOLLARS. SO ONE THOUSAND DOLLARS, MONEY SUPPLY,
ECO 155 750 LECTURE 36 15 EQUALS MONEY DEMAND WHICH IS POINT TWO TIMES GDP. NOW, HOW MUCH WOULD GDP HAVE TO BE? AND THIS IS JUST OUR EQUILIBRIUM CONDITION, MONEY SUPPLY EQUALS MONEY DEMAND. HOW MUCH WOULD GDP HAVE TO BE IN ORDER FOR THIS TO BE A TRUE STATEMENT? FIVE THOUSAND DOLLARS. AND, BY THE WAY, YOU COULD'VE DONE IT THIS WAY. IT'S ONE THOUSAND DOLLARS -- AND WHAT IT WOULD BE -- DIVIDED BY POINT TWO, RIGHT, EQUALS FIVE THOUSAND DOLLARS. ANYWAY, WHAT I'M SAYING TO YOU IS -- OH -- IS THAT GDP -- EQUILIBRIUM GDP IN THIS PARTICULAR CASE IS FIVE THOUSAND DOLLARS. OKAY. NOW WHAT WE WANT TO DO IS WE'VE GOT A FED POLICY. THE FED EITHER BUYS GOVERNMENT SECURITIES OR IT LOWERS THE DISCOUNT RATE OR IT LOWERS THE RESERVE RATIO. AND SO THE MONEY SUPPLY GOES UP. IN THIS PARTICULAR CASE WE'RE GONNA INCREASE THE MONEY SUPPLY TO FIFTEEN HUNDRED DOLLARS. MS-2 EQUALS FIFTEEN HUNDRED DOLLARS. OKAY. NOW -- AND I KNOW EVERYBODY CAN SEE THIS NEW POINT OF EQUILIBRIUM AND WE'LL GET THERE IN A SECOND, BUT DON'T JUMP THERE RIGHT AWAY. HERE'S WHAT I WANT YOU TO THINK ABOUT. YOU KNOW, YOU DON'T KEEP ALL THESE CURVES UP HERE. WHAT HAPPENED WAS THERE'S ONLY ONE MONEY SUPPLY AT ANY POINT IN TIME. IT USED TO BE A THOUSAND, BUT NOW THAT'S GONE AND NOW IT'S FIFTEEN HUNDRED DOLLARS. AND SO I'VE ALMOST ERASED THIS THING BECAUSE WE JUST DON'T WANT TO BE THINKING ABOUT IT, BUT I WANT TO REFER TO IT AGAIN SO I DON'T WANT IT
ECO 155 750 LECTURE 36 16 TO BE TOTALLY GONE. I JUST WANT IT TO BE KIND OF BEAT UP AND ALMOST FORGOTTEN. OKAY. SO HERE'S THE SITUATION. WE'VE ALREADY BEEN THROUGH ONE OF THESE POINTS. AT THE ORIGINAL GDP THAT WE'RE STARTING AT, WE HAVE A CERTAIN MONEY DEMAND. HERE'S OUR MONEY DEMAND LINE. HERE GDP IS FIVE THOUSAND DOLLARS. SO MONEY DEMAND IS EQUAL TO ONE THOUSAND DOLLARS IN THIS PARTICULAR CASE. AND IN THIS PARTICULAR CASE, MONEY SUPPLY IS EQUAL TO FIFTEEN HUNDRED DOLLARS. AND WE ALREADY WENT OVER THIS BEFORE IN OUR OLD DIAGRAM. WHEN I WAS SHOWING YOU HOW DO WE GET TO EQUILIBRIUM I WAS SAYING, "WELL, WHAT IF MONEY SUPPLY AND MONEY DEMAND ARE NOT EQUAL?" WE'RE IN ONE OF THOSE SITUATIONS. MONEY SUPPLY AND MONEY DEMAND ARE NOT EQUAL. ALL OF A SUDDEN MONEY SUPPLY WENT UP AND THERE'S INEQUALITY. AT THE ORIGINAL GDP WHERE WE STARTED -- START HERE -- AT THE ORIGINAL GDP MONEY DEMAND IS POINT TWO TIMES FIVE THOUSAND DOLLARS IS ONE THOUSAND, MONEY SUPPLY IS FIFTEEN HUNDRED DOLLARS SO WE HAVE EXCESS MONEY BALANCES. AND I WON'T GO THROUGH ALL THE DETAILS YET OR AT LEAST I WON'T WRITE 'EM DOWN, BUT I'LL SAY 'EM. EXCESS MONEY BALANCES, PEOPLE FEEL LIKE, "HEY, I CAN AFFORD TO TAKE A LITTLE VACATION" OR "I CAN AFFORD TO PUT THAT NEW TIRE ON MY CAR" OR WHATEVER. EXCESS MONEY BALANCES RESULT IN EXTRA SPENDING AND THEN GDP STARTS TO RISE. MORE PEOPLE GET JOBS AND SO FORTH. AND SO WE SEE THIS ORIGINAL EQUILIBRIUM GDP OF FIVE THOUSAND
ECO 155 750 LECTURE 36 17 DOLLARS STARTS TO INCREASE. INCREASE IN GDP. HOW FAR? WELL, OUT TO THIS POINT.. GDP -- I'LL PUT A TWO NEXT TO THAT. HOW MUCH IS THAT GDP? GDP-2. LET'S GO BACK TO THE FORMULA THAT WE WORKED WITH AWHILE AGO. WE HAVE MONEY SUPPLY EQUALS MONEY DEMAND. THAT HAS TO BE TRUE FOR US TO REACH AN EQUILIBRIUM AND THAT'S WHAT HAS HAPPENED HERE. WE'VE REACHED EQUILIBRIUM. THAT HAS TO BE TRUE. THIS IS FIFTEEN HUNDRED DOLLARS, MONEY SUPPLY, EQUALS POINT TWO TIMES GDP. THAT'S OUR EQUILIBRIUM. THIS IS THE MONEY DEMAND EQUATION, IS POINT TWO GDP. AND WE COULD, IF YOU LIKE, DIVIDE BY POINT TWO. THESE CANCEL SO IT SAYS GDP -- THIS IS THE EQUILIBRIUM GDP -- EQUALS -- REALLY, THIS IS LIKE MULTIPLYING BY FIVE -- SEVENTY-FIVE HUNDRED DOLLARS. QUESTIONS ABOUT THIS? IT'S REALLY PRETTY STRAIGHTFORWARD AND HERE'S THE MATH TO SORT OF FIGURE YOUR WAY OUT OF -- YOU KNOW, FIGURE YOUR WAY TO THE EQUILIBRIUM. WHERE IS EQUILIBRIUM? LET ME ERASE AND WE'LL DO ONE IN THE OTHER DIRECTION. SUPPOSE THE FEDERAL RESERVE CUTS THE MONEY SUPPLY OR REDUCES IT. THIS IS THAT K OR ONE OVER V. MONEY SUPPLY -- LET'S START OFF AGAIN A THOUSAND DOLLARS AND THEN WE'LL PUT IN EQUILIBRIUM, FIVE THOUSAND DOLLARS, GDP -- I'LL PUT IN A ONE THERE. NOW, LET'S SUPPOSE THE FEDERAL RESERVE CUTS THE MONEY SUPPLY FROM ONE THOUSAND DOLLARS TO, LET'S SAY, EIGHT HUNDRED DOLLARS. MS-2 EQUALS EIGHT HUNDRED DOLLARS. AGAIN, LET'S ERASE. THERE'S ONLY
ECO 155 750 LECTURE 36 18 ONE MONEY SUPPLY AND IT HAPPENS TO NOW BE EIGHT HUNDRED DOLLARS. IF THAT'S THE CASE, WE START OFF HERE -- START. THIS IS OUR BEGINNING POINT. GDP WAS FIVE THOUSAND DOLLARS TO BEGIN WITH. WHEN GDP IS FIVE THOUSAND DOLLARS, THEN PEOPLE WANT TO HOLD TWENTY PERCENT AS MUCH MONEY BALANCE AS THEIR INCOMES. THEN MONEY DEMAND IS POINT TWO TIMES FIVE THOUSAND DOLLARS EQUALS PEOPLE WOULD LIKE TO HOLD ONE THOUSAND DOLLARS MONEY DEMAND. THEY ACTUALLY DO HOLD MONEY SUPPLY EQUALS EIGHT HUNDRED DOLLARS. SO IF THERE'S MONEY DEMAND GREATER THAN MONEY SUPPLY, WE SAY THERE ARE DEFICIENT MONEY BALANCES. IF THERE ARE DEFICIENT MONEY BALANCES -- WE WENT THROUGH THIS BEFORE -- PEOPLE WILL REDUCE THEIR SPENDING, COMPANIES WILL HAVE LOWER RECEIPTS, THEY'LL LAY OFF EMPLOYEES, THEY'LL REDUCE THEIR PURCHASES OF NEW MERCHANDISE, AND SO FORTH, AND SO THERE'LL BE AN DECREASE IN GDP. AND THIS COULD EITHER BE A REDUCTION IN A PRICE LEVEL OR A REDUCTION IN THE QUANTITY OF PRODUCTION. IT COULD BE EITHER ONE AND IT COULD BE BOTH. IT'S JUST WE KNOW GDP GOES DOWN. WHETHER IT'S THE NOMINAL OR THE REAL PART, WE HAVEN'T REALLY GOT ANY ANSWER TO IT AT THIS POINT. THAT'S NOT WHAT WE'RE TRYING TO ACCOMPLISH RIGHT NOW. SO ANYWAY, GDP GOES DOWN. WELL, YEAH, IT GOES DOWN TO THIS POINT HERE WHERE MONEY SUPPLY AGAIN EQUALS MONEY DEMAND. OUR EQUILIBRIUM CONDITION: MONEY SUPPLY EQUALS MONEY DEMAND. THAT'S
ECO 155 750 LECTURE 36 19 THE EQUILIBRIUM CONDITION. MONEY SUPPLY, IN THIS PARTICULAR CASE, IS EIGHT HUNDRED DOLLARS EQUALS POINT TWO TIMES GDP. AGAIN DIVIDE BY POINT TWO. THESE CANCEL GDP. THIS IS THE NEW EQUILIBRIUM IS EQUAL TO -- THAT'S REALLY FIVE TIMES EIGHT HUNDRED -- FOUR THOUSAND DOLLARS. END. THAT'S OUR NEW DESTINATION POINT. ANY QUESTIONS ABOUT THIS? REALLY, THE GRAPH IS NOT THE IMPORTANT THING, ALTHOUGH IT'S NICE IF YOU CAN MANIPULATE THE GRAPH OR IF YOU UNDERSTAND IT. THE IMPORTANT THING IS THIS: THAT WE UNDERSTAND THIS CHAIN OF REASONING THAT RUNS FROM -- WELL, IF WE HAD DEFICIENT MONEY BALANCES, THAT'S WHEN YOU GO AND GET YOUR BANK STATEMENT AND YOU HAVE LESS IN YOUR ACCOUNT THAN YOU NORMALLY WOULD LIKE TO HAVE. AND THEN YOU SAY, "HOW COULD I ADJUST THAT?" AND THE ANSWER IS, "CUT BACK ON MY SPENDING JUST A LITTLE BIT." AND YOU THINK ABOUT THE GROCERY STORES AND THE DISCOUNT STORES, HOW THEY CUT BACK ON THEIR PURCHASES AND SO FORTH. THAT'S THE IMPORTANT THING FOR YOU TO UNDERSTAND: HOW WE'RE GONNA END UP AT THIS NEW LOWER LEVEL OF GDP. AND BEING ABLE TO DRAW THE GRAPH? I CAN DRAW THE GRAPH BUT, YOU KNOW, THERE'S NOT A PLACE ON THE TEST FOR YOU TO DO THAT. SO IT'S GREAT IF YOU CAN USE THE GRAPH TO REASON YOUR WAY TO THIS, BUT DRAWING THE GRAPH ISN'T REALLY THE POINT OF IT. IT'S THINKING ABOUT THE SORT OF LOGICAL STEP -- AND, BY THE WAY, THE TERM "ANALYSIS" JUST
ECO 155 750 LECTURE 36 20 REFERS TO BREAKING SOMETHING COMPLEX DOWN INTO SMALL PIECES AND UNDERSTANDING THOSE PIECES. AND THAT'S ALL WE'RE DOING HERE, IS WE'RE ANALYZING, WE'RE CONDUCTING AN ANALYSIS OF MONETARY POLICY AND SO WE SEE THE MONEY SUPPLY GO DOWN. AND THEN WHAT WE WANT TO KNOW IS WHAT ARE THOSE SMALL STEPS CONNECTING US FROM THE STARTING POINT TO THE ENDING POINT IN OUR ANALYSIS. AND THE STEPS ARE -- WELL, NUMBER ONE, NOW MONEY SUPPLY IS LESS THAN MONEY DEMAND. AND NEXT IS WE CUT BACK OUR SPENDING, AND THEN THE STORES RESPOND, AND SO WE GO THROUGH THIS WHOLE CHAIN OF LOGIC TO THEN COME TO THE FINAL POINT WHICH IS THE NEW GDP IS GONNA BE LESS. ANY QUESTIONS ABOUT THAT? THIS IS HOW WOULD FED POLICY AFFECT GDP. WE NEED TO TALK ABOUT SOMETHING ELSE. SHIFTS IN EITHER ONE OF THESE CURVES. WE JUST TOOK UP MONEY SUPPLY. SHIFTS IN EITHER ONE OF THESE CURVES WOULD CAUSE OUR EQUILIBRIUM GDP TO CHANGE, SO NOW WE WANT TO TALK ABOUT WHAT WOULD SHIFT THE MONEY DEMAND LINE OR THE MONEY DEMAND CURVE. OKAY. LET'S DO A LITTLE ERASING AND TALK ABOUT THAT A BIT. FIRST OF ALL OUR FORMULA: MONEY DEMAND EQUALS K TIMES GDP. THIS K RIGHT HERE IS KIND OF SPECIAL. IT'S REALLY THE THING THAT'S DRIVING THIS WHOLE MONEY DEMAND. LET'S PUT IT LIKE THIS. I'LL DIVIDE BOTH SIDES BY GDP SO IT'S MD OVER GDP EQUALS K. THIS K RIGHT HERE IS REALLY SHOWING US THE STRENGTH OF MONEY DEMAND. HOW MUCH
ECO 155 750 LECTURE 36 21 MONEY DO YOU WANT TO HOLD RELATIVE TO YOUR INCOME? LET ME GIVE YOU AN EXAMPLE. SUPPOSE YOUR INCOME IS TWENTY THOUSAND DOLLARS AND THE TYPICAL PERSON'S INCOME IS TWENTY THOUSAND DOLLARS. IF THAT WERE THE CASE, THEN MULTIPLY BY ALL THE PEOPLE AND THAT WOULD GIVE US GDP. SO ANYWAY. SUPPOSE THAT THE AVERAGE PER CAPITA PERSON'S INCOME IS TWENTY THOUSAND DOLLARS. AND THAT AVERAGE PERSON LIKES TO KEEP MONEY BALANCES OF, LET'S SAY TO MAKE IT EASY, TWO THOUSAND DOLLARS. THEN WHAT WE'RE SAYING IS THIS K WOULD EQUAL POINT ONE. IF THIS WERE FOUR THOUSAND DOLLARS, IT'D BE POINT TWO. AND YOU GET THE IDEA. SO ANYWAY, THE POINT IS THAT THIS K IS SHOWING US THE STRENGTH OF MONEY DEMAND. OKAY. THE K SAYS THAT MONEY DEMAND IS PROPORTIONAL TO INCOMES OR ECONOMIC ACTIVITY. BUT THE BIGGER THAT NUMBER, THEN THE BIGGER THE PROPORTION. IF THIS NUMBER IS POINT THREE, I REALLY WANT TO HOLD A LOT OF MONEY. POINT THREE TIMES TWENTY THOUSAND, I WANT TO HOLD SIX THOUSAND DOLLARS WORTH OF MONEY. POINT ONE, I ONLY WANT TWO THOUSAND. SO ANYWAY, THAT K IS SHOWING US THE STRENGTH OF OUR MONEY DEMAND, AND I'M JUST SORT OF MENTIONING THAT. BECAUSE IT'S K THAT WILL CHANGE -- LET ME DRAW THIS CURVE AGAIN. GDP AND MONEY -- LET'S DRAW TWO OF THESE. MD EQUALS POINT ONE TIMES GDP AND MD EQUALS POINT TWO TIMES GDP. WHAT YOU CAN SEE IS THIS: THE STRONGER THE MONEY DEMAND IS, THE HIGHER THAT CURVE GOES. STRONG MONEY
ECO 155 750 LECTURE 36 22 DEMAND? I REALLY WANT TO HOLD A LOT OF MONEY. AND LET'S DO IT THIS WAY -- AND I JUST DID THIS A MOMENT AGO. BUT LET'S SAY THAT INCOME IS TEN THOUSAND DOLLARS. I'M SAYING IN THIS ONE CASE YOU WANT TO HOLD WHAT THE FIRST LINE -- LET ME GIVE THESE NUMBERS ONE AND TWO. WITH THE FIRST MONEY DEMAND LINE BEFORE IT ROTATED UPWARD, WE WANTED TO HOLD TEN PERCENT OF TEN THOUSAND DOLLARS. I WANTED ONE THOUSAND DOLLARS IN MONEY BALANCES. OKAY. AND NOW IN THIS NEW CASE I WANT TWO THOUSAND DOLLARS WORTH OF MONEY BALANCES. SO WHEN THE CURVE ROTATES UPWARDS, THAT REFLECTS A HIGHER K VALUE. THIS IS K ONE, K TWO. AND ALL WE'RE TALKING ABOUT WITH THE K IS THE STRENGTH OF MONEY DEMAND. OKAY. SO HERE'S THE QUESTION: WHAT WOULD INCREASE MONEY DEMAND? WHY DOES MONEY DEMAND INCREASE? ONE THING WHICH I DO NOT WANT TO SAY WILL SHIFT THE CURVE BUT WHICH MOVES US ALONG THE CURVE IS THAT THERE'S A CHANGE -- LET'S SAY AN INCREASE IN GDP AND INCOME, THEN WE MOVE ALONG THE CURVE FROM ONE POINT TO ANOTHER. AND THAT IS NOT WHAT WE'RE LOOKING FOR HERE. IF OUR GDP ROSE AND OUR AVERAGE INCOME ROSE, WE WOULD MOVE ALONG THIS CURVE. AND WE WOULD WANT MORE MONEY, BUT THAT IS NOT A SHIFT IN THE CURVE; THAT'S A MOVEMENT ALONG THE CURVE. SO THAT IS DEFINITELY NOT WHAT WE'RE TALKING ABOUT HERE. WHAT WOULD CAUSE PEOPLE TO DESIRE MONEY BALANCES? LET ME GIVE YOU THREE THINGS. AND YOU CAN THINK OF MORE, BUT THREE ARE, I
ECO 155 750 LECTURE 36 23 THINK, ENOUGH TO ILLUSTRATE THE IDEA. FIRST OF ALL, REDUCED INTEREST RATE ON, LET'S SAY, BONDS AND SAVINGS ACCOUNTS. HERE'S WHAT'S GOING ON. YOU'VE GOT A PORTFOLIO OF FINANCIAL WEALTH. YOU HAVE, I HAVE, EVERYBODY HAS. WE'VE GOT A PORTFOLIO OF FINANCIAL WEALTH. ONE OF THE THINGS IN OUR PORTFOLIO IS MONEY BUT SOMETHING ELSE MIGHT BE BONDS AND SOMETHING ELSE MIGHT BE SAVINGS ACCOUNTS. THAT'S JUST AN EXAMPLE. YOU CAN IMAGINE -- WELL, LET ME JUST PUT PERCENTS OUT HERE. LET'S SAY THAT IN THE FIRST INSTANCE THIS IS FORTY PERCENT OF MY PORTFOLIO, THE BONDS ARE THIRTY PERCENT, AND THEN THE SAVINGS ACCOUNT IS THIRTY PERCENT. THAT'S OUT OF A HUNDRED PERCENT. OKAY. NOW, WHAT I'M SAYING IS THIS: IF INTEREST RATES ON BONDS AND SAVINGS ACCOUNTS COME DOWN, BONDS AND SAVINGS ACCOUNTS AREN'T QUITE AS LUCRATIVE AS THEY USED TO BE. AND IF THEY'RE NOT QUITE AS LUCRATIVE AS THEY USED TO BE, THEN WHAT I'M LIKELY TO SAY IS SOMETHING LIKE, "MAN, BONDS AND SAVINGS ACCOUNTS. YOU KNOW, I'M NOT TOO WILD ABOUT THOSE. I THINK I'M GONNA LOWER MY HOLDINGS OF THOSE THINGS NOW THAT THEY ARE A LITTLE BIT LESS REWARDING. AND I'LL HOLD MORE OF OTHER ASSETS. OH, LOOK. MONEY." AND SO THE IDEA IS, IF INTEREST RATES COME DOWN, THEN WHAT WE TEND TO SEE IS LARGER MONEY BALANCES AND SMALLER BALANCES IN SOME OF THESE OTHER FINANCIAL ASSETS. AND SO WHAT WE'RE TRYING TO UNDERSTAND IS, WHAT WOULD INCREASE MONEY DEMAND? AND THE ANSWER IS: WELL,
ECO 155 750 LECTURE 36 24 IF INTEREST RATES ON BONDS AND SAVINGS ACCOUNTS, ALTERNATIVE INVESTMENTS, IF THE YIELDS ON THOSE CAME DOWN, WE'D HOLD MORE MONEY. HOW ABOUT THIS: IF THE STOCK MARKET CRASHED AND PEOPLE JUST SAID, "MAN, IT'S GONNA CRASH TOMORROW AND THE NEXT DAY, AND YOU JUST CANNOT MAKE MONEY IN THE STOCK MARKET." IF THAT WAS THE CASE, PEOPLE WOULD SELL THEIR STOCKS AND HOLD SOME MONEY. MONEY IS A STORE VALUE. YOU REMEMBER THOSE THREE FUNCTIONS PERFORMED BY MONEY. THE THIRD IS MONEY IS A STORE VALUE. AND THAT'S ALL WE'RE SAYING HERE IS PEOPLE WILL HOLD MORE MONEY IF INTEREST RATES ARE LOWER. OKAY. HOW ABOUT A SECOND THING THAT WOULD CAUSE PEOPLE TO HOLD MORE MONEY BALANCES WOULD BE A REDUCTION IN THE INFLATION RATE. A REDUCED INFLATION RATE. NOW, IN ORDER TO EXPLAIN THIS ONE, LET ME GO AT IT SORT OF IN A BACKWARD DIRECTION -- AS I DO SO MANY THINGS. LET ME GO AT THAT IN SORT OF A BACKWARD DIRECTION 'CAUSE WE'VE TALKED ABOUT THIS BEFORE. WHAT I TOLD YOU EARLIER WAS THIS. IF THERE IS INFLATION, IF PRICES ARE GOING UP, THEN THE INFLATION TAXES BASICALLY YOUR MONEY BALANCES. I GAVE THE EXAMPLE OF SUPPOSE I'VE GOT TEN DOLLARS IN MY POCKET AND I GO TO, YOU KNOW, HARDEE'S OR SOMEPLACE LIKE THAT, AND HAMBURGERS ARE A DOLLAR APIECE. THE TEN DOLLARS IN MY POCKET WILL BUY ME TEN HAMBURGERS. SUPPOSE THEN THERE'S INFLATION AND PRICES
ECO 155 750 LECTURE 36 25 GO UP AND THEY DOUBLE. I'VE STILL GOT TEN DOLLARS IN MY POCKET, BUT NOW HAMBURGERS ARE NOT ONE DOLLAR APIECE; THEY'RE TWO DOLLARS APIECE NOW THAT PRICES HAVE DOUBLED. AND SO NOW MY TEN DOLLARS WHICH USED TO BUY TEN HAMBURGERS, NOW IT WILL ONLY BUY FIVE HAMBURGERS. AND SO WHEN I WAS HOLDING MONEY, IF PRICES GO UP, MY MONEY WILL BUY LESS AND MY MONEY BALANCES ARE BEING TAXED. I'M BEING PUNISHED FOR HOLDING MONEY. WELL, NOW I WANT TO TURN THAT AROUND AND IT GOES IN THE OPPOSITE DIRECTION. IF THE INFLATION RATE COMES DOWN OR PRICES WERE TO GO DOWN, THEN WHAT WOULD HAPPEN IS I WOULD BE REWARDED FOR HOLDING MONEY. AND WE TALKED EARLIER ON, WHEN WE WERE TALKING ABOUT THE AGGREGATE DEMAND CURVE, THE REAL BALANCE EFFECT. SUPPOSE PRICES COME DOWN. I'VE GOT TEN DOLLARS IN MY POCKET. IT WILL BUY -- ORIGINALLY WILL BUY TEN HAMBURGERS. AND SUPPOSE THE PRICE OF HAMBURGERS ACTUALLY WENT DOWN TO -- FROM A DOLLAR APIECE AND I'LL JUST SAY TO FIFTY CENTS APIECE. NOW THIS TEN DOLLARS IN MY POCKET WILL BUY TWENTY HAMBURGERS. I'VE BEEN REWARDED FOR HOLDING MONEY IN MY POCKET. SO ANYWAY, IF THERE'S A REDUCED INFLATION RATE, THEN PEOPLE ARE MORE WILLING TO HOLD MONEY. THEY ARE LESS SUBJECT TO THAT INFLATION TAX ON THEIR MONEY BALANCES. OKAY. AND, BY THE WAY, LATER ON WE'LL COME BACK AND SAY WHY DID MONEY DEMAND DECREASE. IT WOULD DECREASE BECAUSE, "OH, I DON'T WANT TO HOLD MONEY
ECO 155 750 LECTURE 36 26 BALANCES IF THERE'S MORE INFLATION." NOW WE'RE TALKING ABOUT THE OPPOSITE, THERE'S LESS INFLATION. HOW ABOUT THIS POSSIBILITY WHY YOU'D HOLD MORE MONEY BALANCES. IF PEOPLE ARE PAID ONCE A MONTH RATHER THAN ONCE A WEEK AS PREVIOUSLY. THAT IS TO SAY, SUPPOSE THAT YOUR EMPLOYER INCREASES THE PERIOD OF TIME BETWEEN PAYCHECKS. YOU KNOW, IF YOU'RE GETTING PAID ONCE A WEEK -- MAYBE YOU GET PAID, LET'S SAY, TWO HUNDRED DOLLARS A WEEK. OKAY. AND MAYBE YOU'D TAKE THIS TWO HUNDRED DOLLARS OUT AND KIND OF SPEND IT OVER THE COURSE OF THE WEEK, AND YOUR AVERAGE HOLDINGS OF MONEY IS -- WELL, LIKE, IF YOU START OFF WITH TWO HUNDRED DOLLARS AT THE START OF THE WEEK AND YOU SPEND THAT ALL DOWN BY THE END OF THE WEEK, YOU WENT FROM TWO HUNDRED TO ZERO, AND ON AVERAGE YOU WERE HOLDING ABOUT A HUNDRED DOLLARS. SUPPOSE INSTEAD THAT YOUR EMPLOYER PAYS YOU ONCE A MONTH AND PAYS YOU EIGHT HUNDRED DOLLARS AT THE START OF THE MONTH. FOUR WEEKS, TWO HUNDRED DOLLARS PER WEEK. SO YOU GET EIGHT HUNDRED DOLLARS AND THEN YOU SPEND THAT DOWN FROM EIGHT HUNDRED DOLLARS DOWN TO ZERO. FIRST OF THE MONTH TO THE END OF THE MONTH, YOU GO FROM EIGHT HUNDRED TO ZERO. BUT ON AVERAGE, YOU'RE HOLDING FOUR HUNDRED DOLLARS IN CURRENCY -- WELL, NOT CURRENCY BUT MONEY. COULD BE CURRENCY, COULD BE CHECKING ACCOUNT MONEY. BUT THE LESS OFTEN YOU GET PAID, THE MORE YOU'RE GONNA HOLD IN THAT BANK ACCOUNT ON AVERAGE.
ECO 155 750 LECTURE 36 27 SO THESE ARE THREE DIFFERENT EXAMPLES OF WHAT WOULD CAUSE PEOPLE TO HOLD MORE MONEY. LET'S DRAW THE GRAPH TO GO ALONG WITH THAT. OH, I BETTER LEAVE THAT UP THERE. NO, I DON'T NEED THAT THERE. LET'S DRAW THE GRAPH TO GO ALONG WITH AN INCREASE IN MONEY DEMAND. THIS WILL PRODUCE MAYBE SURPRISING RESULTS. MAYBE YOU WON'T BE SURPRISED BUT I ALWAYS KIND OF FIND IT SURPRISING. HERE'S OUR MD ONE EQUALS K ONE TIMES GDP, AND WE'LL LET THIS EQUAL POINT ONE, AND WE'LL INCREASE MONEY DEMAND, MD TWO EQUALS K TWO TIMES GDP -- WE'LL LET THAT EQUAL POINT TWO. PUT IN OUR MONEY SUPPLY LINE, MS -- AND I'LL PUT A BAR OVER THAT. WE'RE NOT GONNA CHANGE THAT HERE IN THIS EXAMPLE. HERE'S WHAT WE HAVE. WE START OFF WITH GDP EQUILIBRIUM, GDP ONE. HOW MUCH IS THAT? OH, I DIDN'T TELL YOU THIS, DID I? LET'S SAY A THOUSAND DOLLARS. POINT ONE TIMES TEN THOUSAND DOLLARS WOULD EQUAL -- YEAH, THAT WORKS OUT. TEN THOUSAND DOLLARS. IF MONEY DEMAND GOES UP, WHAT WE'RE SAYING IS GDP WOULD GO DOWN IN THIS PARTICULAR CASE TO FIVE THOUSAND DOLLARS. LET ME SAY IT IN WORDS. WELL, I MEAN, I'VE BEEN SAYING WORDS, BUT LET ME SAY IT IN SLIGHTLY DIFFERENT WORDS. HERE'S WHAT I'M SAYING TO YOU: IF WE START OFF AT THE ORIGINAL EQUILIBRIUM POINT, MONEY SUPPLY EQUALS MONEY DEMAND, AND THEN SOMETHING HAPPENS. I DON'T KNOW WHAT, BUT SOMETHING HAPPENS AND CAUSES PEOPLE TO DESIRE MORE MONEY. THEN WE START DOING THIS. WE SAY, "OH, I LIKE TO HAVE A LITTLE BIT
ECO 155 750 LECTURE 36 28 MORE MONEY IN MY BANK ACCOUNT. I'M GONNA CUT BACK ON MY SPENDING A LITTLE BIT." AND SO WHEN PEOPLE START CUTTING BACK ON SPENDING, THAT'S WHEN GDP WILL START TO FALL. AND NOT UNTIL I AM HOLDING THE AMOUNT OF MONEY -- HERE'S THE MONEY SUPPLY. NOT UNTIL I'M HOLDING THE AMOUNT I'D LIKE TO HOLD, NOT UNTIL WE GET BACK TO HERE WILL I BE SATISFIED WITH MY MONEY BALANCES. SO AN INCREASE IN MONEY DEMAND -- INCREASE IN MONEY DEMAND WILL CAUSE A DECREASE IN GDP. WE ALREADY SAW THIS. A DECREASE IN THE MONEY SUPPLY WOULD'VE CAUSED A DECREASE IN GDP. SO IN TERMS OF HOW IS GDP AFFECTED, IT'S AFFECTED THE SAME EITHER BY A TIGHT MONETARY POLICY, A CONTRACTIONARY POLICY, ONE THAT REDUCES MONEY SUPPLY, THAT HAS THE SAME EFFECT ON GDP AS IF PEOPLE WANTED TO HOLD MORE MONEY. THEIR MONEY DEMAND WENT UP. I THINK THAT WOULD BE A GOOD PLACE TO STOP FOR THIS DAY AND WE'LL PICK UP WITH THIS NEXT TIME. SO LONG.