CFA Level 1 (2009) - 2

Scud)' Session 6

Cross-Reference to CFA Institute Assigned Reading #24 - Money, the Price Level, and Inflation

LOS 24.i: Discuss the quantity theory of money and its relation to aggregate supply and aggregate demand.

If we break GOP imo the price level and its real output component (price x real output), we obtain an idemity known as the equation of exchange, which is:

money supply x velocity = GOP = price x real output

Velocity is the average number of times per year each dollar is used to buy goods and services (velocity = GOP / money). Therefore, the money supply multiplied by velocity must equal nominal GOP. The equation of exchange must hold with velocity defined in this way. Letting money supply = M, velocity = V, price = P, and real Output = Y, the equation of exchange may be symbolicaJJy expressed as:

IV!V = pl'

rhat \'elocit), and outpUt were dctermined by insrj[lltional fanors orher th~ln rhe mone\' supphand werc rhus nearlv COllstant. Therefore. if the moncy supply increases while

velocit), ;l1ld lluantities arc fixed. priccs must rise. Rearranging rhe equarioll of cxchange,

\\:T get:

price = Iv! V]

[Y

Since velocity (V) and rea) output (Y) change very slowly, an increase in the money supply (M) must result in a proportional increase in prices (inflation), If we increase !VI by 5%, nominal GOP (=PY) will increase 5% as well. Under the assumption that real GOP (Y) changes only very slowly in the short run, the emire increase must be refleered in the price level (P). Monetarists believe, based on this relation, that the money supply (J'vl) should bc increased only al the growrh rare of real OUtput (Y) so as [() main rain price stability.

In the long run the quantity theory of money will describe the results of money supply growth in excess of the growth rate of real output. If rcal GOP grows at 3(>;'i>over time and the money supply is increasing at 5%, we can expect long-run inflation of 2%

(5% - 3%). This result parallels the result we obtained using the aggregate supplyaggref!.ate demand model.

Study Session 6

Cross-Reference to CFA Institute Assigned Reading #24 - Money, the Price Level, and Inflation

KEy CONCEPTS

LOS 24.a

The functions of money are as a medium of exchange, a store of value, and a unit of account.

LOS 24.b

M 1 and M2 are measures of the U.S. money supply. M 1 includes currency, travelers' checks, and checking deposits of individuals and firms. M2 includes M 1, time deposits, savings deposits, and money market mutual funds.

Checks and credit cards are not part of the money supply. Checks are orders to transfer money (M 1) from one owner to another. Credit cards are a means of obtaining an immediate shorr-term loan and represent a promise to p'l\', not pa\'menr.

10\ 2'f,c

Commercial banb. thrift institutions. and mOlle\' market funds all act as inrCl"mcdi.tric·, in lenJing the funds of savers to borrowers of various types,

Financial innO\'ation involves the introduction of nC\\' products to better senT custom:::' needs and increase the proht of inrermediaries by decreasing borrowing COSts and increasing earnings from lending, These innovations are driven h,' changes in the economic environment. technolog;'. and regulation.

LOS 24.d

The C.S. Federal Reserve has a mandate to manage the money supply in such a way as to produce low inflation, fuJI employment, and economic growth.

The Fed can increase (decrease) the money supply by buying (selling) Treasury securities in the open market, decreasing (increasing) the discount rate, or decreasing (increasing) the required reserve ratio.

Assets on the Fed's balance sheet consist primarily of U.S. Treasury securities, but also include gold, IMF special drawing rights, and loans to banks. The Fed's liabilities arc primarily U.S. currency (Federal Reserve notes) but also include banks' reserve deposits.

LOS 24.e

In a fractional reserve banking system, banks must hold a percentage of their deposit, as required reserves and may lend out the rest (excess reserves), When new reserves ar'

added to the system, a system of fractional reserves alJows the banking system to increase the money supply by a multiple of new reserves, equal to [he reciprocal of the required reserve ra tlo.

Study Session 6

Cross-Reference to CFA Institute Assigned Reading #24 - Money, the Price Level, and Inflation

LOS 24.f

The monetary base consists of currency (Federal Reserve notes, coins) and banks' deposi ts at the Fed.

Changes in the monetary base change the quantity of money with a multiplier effect, which is a function of both the required reserve ratio and the currency drain (loan proceeds withdrawn from the banking system).

LOS 24.g

The demand to hold money is a decreasing function of the interest rate that can be earned on shaft-term securities.

The demand for money increases with real GOP and with the price level.

Innovations such as credit and debit cards and automated teller machines have tended [0 reduce the (!c'manc1 for mone\'.

[0.\ _.'Lh

The mane\' supply is controlled by the cenrral bank and equilibrium inrereSl rates arc derermined by the interseC[ion of the supply and demand for money.

All inncasl' (decrease) in the money supp'" will result in an excess supplv of (demand for) mane:', leading individuals and businesses to buy (selll securities, driving securities prices up (down) and decreasins (increasing) equilibrium interest rates.

In the shorr run, decreases (increases) in rhe equilibrium interesr tare from increases (decreases) in the money supply will increase (decrease) aggregate demand, which will increase (decrease) real GOP and the price level. In the long run, money supply growth has no effect on real GOP.

LOS 24.i

The quantiry theor)' of mane)' is based on rhe equation of exchange and an assumption that COP growth and mone)' velocity arc relatively constant, so that increases in the money supply, when rhe economy is operating at potencial (full-employment) GOP, will lead to a proportional increase in prices.

Study Session 6 .

Cross-Reference to CFA Institute Assigned Reading #24 - Money, the Price Level, and Inflation

1.Which of the following statements is least accurate? The existence and use of

money:

A.permits individuals to perform economic calculations.

B. requires the central bank to control the supply of currency.

C.increases the efficiency of transactions as against a barter system.

2.The M1 measure of the money supply is least likely to include:

A.savings account deposits.

B.checking account deposits.

C. currency held by the pu blic.

3.Depository institutions least lik{'~), include:

A.g;rowth funds.

H. credit unions.

C.commercial bank".

6.The policy tool the Federal Reserve uses most often is:

A.the discoun t rate.

B.reserve req Ulfemen ts.

C.open market operations.

The goals and targets of Federal Reserve policy least Ii/<ely include:

A.promoting economic growth and full employmenl.

B.maintaining stable exchange rates.

C. managing the mone~' sup pi v in such a way as to keep inAation Jow.

8.The money demand schedule slopes downward to the right showing that:

A.an expansion in the money supply increases interest rates.

B.as the opportunity cost of holding money rises, people want to hold less monev.

C.a reduction in the money supply reduces the interest rate.

Study Session 6

Cross-Reference to CFA Institute AssiJ!;ned Reading #24 - Money, the Price Level, and Inflation

9.The money supply schedule is vertical because the:

A.money supply is dependent upon interest rates.

B.demand schedule is downward sloping.

C. money supply is independent of interest rates.

] O. Which of the following statements is most like(J' accurale~ Money:

A.demand rises with nominal interest rates.

B.demand rises with nominal income.

C. supply rises with nominal interest rates.

] 1. If money supply and demand are in equilibrium and the central bank sells securities in the open market:

A.bank reserves will increase.

B.short-term interest rates will decrease.

C.firms and households will sell securities for cash.

12.The IIlIIi! lil:l'h !ong-rerIll effecl or ~ln increase in rhe lllonn supph' when thl"

CCOncHIl\" is al fuIJ-elllplo\'lncnt CDP is:

A.higher OUtpUl.

B.higher prices.

C.lower unelllpJo~·menl.

1.'1. If the monel' supphis rising and vclocin' is falling:

A.prices will fall.

B.real GDP will rise.

e. the impaer on prices and real CDP is uncertain.

] 4. According to the quantity theory of money:

A.real output and velocity are independent of the money supply.

B.real outpUt and velocitv increase with the money supply.

C. an increase in the money stock will decrease gross domestic producr.

Study Session 6

Cross-Reference to CPA Institute Assigned Reading #24 - Money, the Price Level, and Inflation

ANSWERS - CONCEPT CHECKERS

1.B Money functions as a unit of account. a medium of exchange, and a srore of value.

Money existed long before central banking was conceived of.

2.A Savings deposits arc a component of M2. M 1 includes currency not held at banks,

travelers' checks, and checking account deposits of individuals and businesses.

3. A The only kind of investment company that would be considered a depository institution is a money market mutual fund.

4.C By acting as financial intermediaries, depository institutions lower the cost of funds for

borrowers from what they would be if they had to seek out individuals willing to lend,

5.C The potentia) money supply expansion multiple is I / O. I 5 = 6.6 7 , so the open market

purchase can increase the nwney supply by a maximum of $6.(,- billion.

h, C l )pell market operation, Jre the fed'> most comnlOlll\" lIsed too!.

I3 The f'cd does not targ.el l'~changc rates ,mJ has no mandate III nLlintain st;lhk exchan~l rates.

f). B \\"ith interest ratcs on the vertical axis and the quantin' of real 1110nc\' (.n the horizonLlI axis. the downward slope of the monC\' demand ,chnJulc shows thai ;\> the opportunin cOSt of holding mone\' riscs. f1eople wall( to hold less mane\'. People would prefer to invest money in honds :ll1d CDs rather than hold cash when intCfe"t rates arc high.

9, C The money supply' schedule is vertical because the mone\" supphis independent of interest rates. The Fed comrols the money' suppl\'.

10.B Money demand rises with nominal income. As income increases, either because of inflation or increases in real output, more mane;' is needed in the economy to conduct transactions.

I I, C If the central bank sells securities, it is decreasing the money supply. This wilJ reduce bank reserves. Firms and households will have lower cash halances than thc\' wish to hold at cquilibrium, so they sell securitics, decreasing securities prices and incrcasing intcrest ratcs to their ncw equilibrium level.

12.B The long-term effect of an increase in the money supply when the economy is at full-employment GOP will be higher prices. Although output and employmcnt will

increase in the short run, they will return to potential real GOP levels in the long run,

13.C An increase in the mone;' supply is consistent with an incrcase In nominal GOP. Howevel', a decrease in velocity is consistent with a decrease in nominal GDP Unless we know the size of the changes in the two variables, there is no wav to tell what the net impact is on real GOP and prices.

14.A According to the quantity theory of money, real output and velocity are independent of the money supply. As a result, an increasc in the money supply increases prices.

Scudy Session 6

Cross-Reference to CFA Institute Assigned Reading #24 - Money, the Price Level. and Inflation

15. B The equation of exchange is: MV = PY Here, GDP = PY, so chac MY = GDP

Therefore, ($1.0 trillion)(V) = $7.0 trillion

v = $7.0 [[illion /$1.0 trillion

v = 7.0

The following is a review of the Economics principles designed to address the learning outcome ,~(a(emen(sset fonh by CFA Insti(U(e®, This topic is also covered in:

u.s. INFLATION, UNEMPLOYMENT, AND BUSINESS CYCLES

Study Session 6

EXAM Focus

Inflation is a [1erSiSrelH increase in the price level over time, InAation erodes the purchasing pOV,,'('I of a currenc\', If it accelerates unchecked, inf-lation ulrimate!l' Gin desrrova coul1tn':, monetar;' svsrem, forcing individuals and businesses to adopt foreig;l money or revert to oarreri ng physical goods.

The key word in our definition is "persistent." If the price level increases in a single jump but does nor cOIHinue rising, the economy is nOl experiencing inf-lation. An increase in the price of a single good or in reLative prices of some goods arc not inflation. If inflation is presenr, the prices of almost a11 goods and services are increasing.

UIsl- p[; :J;, n fb ~:io;~;I'T processc:"

The two rypes of inflation arc demand-pull and cost-push. Demand-pull inflation results from an increase in aggregate demand, whilc cost-push inflation results from a decrease in aggrcgare supply.

Demand-Pull Inflation

Demand-puIJ inflation can result from an increase in the money supply, increased governmenr spending, or any othcr cause that increases aggregate demand, hgure ] shows the effect on the price level when aggregate demand increases (shifts to the right). In Figure 1, the economy begins at equilibrium with output at GOP 1 and the price level

at PI'The aggregate demand and shorr-run aggregate SLlpply curves arc AD] and SRAS •

J

Real GOP is equal ro potenrial GOP, which is represented by the long-run aggregate supply curve LRAS.

Study Session 6 Cross-Reference to CFA Institute Assigned Reading #25 - U.S. Inflation, Unemployment, and Business Cycles

Figure I: Demand-Pull Inflation

AD,

' --------- ' --- ' ------ Real GDP

Now suppose the cen (fal bank increases the money su ppl~" wh ich increases aggregate demand to AD::" With no initial change in aggregate suppl)', output increases to GOP::, and the.: price Icvel increases to r::,'Prices rise, and real GDP is abovc potential (fullemplovment) CDP

\X'ith real GOP above its fulJ-emplo)'menr level, the increast in CDI' is not sustainable, Unemployment falls below its natural rate, which puts upward pressure on real wages, Rising real wages result in a decrease in shon-run aggregate supply (the curve shifts left from SRAS 1) until rcal GOP revens back (() full-employment GOP. The boom turns into a bust as output falls back to GOP" and the price level increases further to P~,

In the absence of other changes, the economy would reach a new equilibrium price level at P.o' But what would happen if the central bank tried to keep GOP above the full employment level with further increases in the money supply? The same results would occur repeatedly. Output could not remain above its potential ia the long run, but the induced increase in aggregate demand and the resulting pressure on wages would keep the price level rising ever higher. Demand-pull inflation would persist until the central bank reduced the growth rate of the money supply and allowed the economy to return to full employment equilibrium at a level of real GOP equal to potential GOP

Cost-Push Inflation

Inflation can also resulr from an initial decrease in aggregate supply caused by an increasc in the real price of an important facror of production, such as wages or energy,

Figure 2 illustrates the effeer on output and the price level of a decrease in aggregate supply. The reduction from SRAS 1 to SRAS::, increases the price level to P2 and with no initial change in aggregate demand, reduces outpUl to GOP2' The impact on output

is the key difference berween the demand-pull and cost-push effects: the demand-pull effect increases GOP above full-employment GOP, while cost-push inflation from a decrease in aggregate supply initially decreases GOP.

If the decline in GOP brings a policy response that stimulates aggregate demand so output returns to its long-run potential, the result would be a further increase in the price level to P3'

!y Session 6

s-Reference to CFA Institute Assigned Reading #25 - U.S. Inflation, Unemployment, and Business Cycles

The increase in the price ievel would only represent inflation if it persisted. For that to happen, the supply shock that caused SRAS (0 decrease would have to be repeated, and policy makers would have (0 keep responding by expanding the money supply. The oil crisis of the 1970s is an example of a cost-push inflation spiral.

Figure 2: Cost-Push Inflation

\

LOS 2,).c: Distinguish between anticipated and unanticipated inflation, and explain the costs of anticipated inflation.

P..:cal1 that in the aggregate demand - ::tggregate supply model, when workers' inflation expectations were different from actual inflation, equilibrium real GDP was not equal to potential (full-employment) real GDP. \Xfhen workers' expectations about inflation rates in the next period are correct, we say that inflation is anticipated. In Figure 3

we illustrate an increase in the price level from an initial level of 100 that is correctly anticipated. Aggregate demand is expected to increase from ADo (0 AD] and since workers (and owners of other important factors of production) anticipate inflation of 5%. money wage demands will increase by 5% and the shon-run aggregate supply curve shifts up (decreases) from SASo to SAS I'The new equilibrium at the end of the period is on the long-run aggregate supply curve, but at a price level of 105, that is 5% higher. As long as the rate of price inflation is anticipated correctly, this process can continue

and output will grow at the rale of growth of LRAS (full-cmployrnel1l or potel1lial GDP) without cyclical behavior.