Why Study Money and Monetary Policy

Money, also referred to as the money supply, is defined as anything that is generally accepted in payment for goods or services or in the repayment of debts. Money is linked

Money and Business CycIes

www.federalreserve.gov

General information, monetary policy, banking system, research, and economic data of the Federal Reserve.

to changes in economic variables that affect all of us and are important to the health of the economy. The final two parts of the book examine the role of money in the economy.

In 1981-1982, total production of goods and services (called aggregate output) in the U.S. economy fell and the unemployment rate (the percentage of the available labor force unemployed) rose to over 10%. After 1982, the economy began to expand rapidly, and by 1989 the unemployment rate had declined to 5%. In 1990, the eight-year expansion came to an end, with the unemployment rate rising above 7%. The economy bottomed out in 1991, and the subsequent recovery was the longest in U.S. history, with the unemployment rate falling to around 4%. A mild economic downturn then began in March 2001, with unemployment rising to 6%.

Why did the economy expand from 1982 to 1990, contract in 1990 to 1991, boom again from 1991 to 2001, and then contract again in 2001? Evidence suggests that money plays an important role in generating business cycles, the upward and downward movement of aggregate output produced in the economy. Business cycles affect all of us in immediate and important ways. When output is rising, for example, it is easier to find a good job; when output is falling, finding a good job might be difficult. Figure 4 shows the movements of the rate of money growth over the 1950-2002 period, with the shaded areas representing recessions, periods of declining aggregate output. What we see is that the rate of money growth has declined before every recession. Indeed, every recession since the beginning of the twentieth century has been preceded by a decline in the rate of money growth, indicating that

Money

Growth Rate

Business Cycles Since 1950 Images

FIGURE 4 Money Growth (M2 Annual Rate) and the Business Cycle In the United States, 1950-2002

Note: Shaded areas represent recessions.

Source: Federal Reserve Bulletin, p. A4, Table 1.10; www.federalreserve.gov/releases/h6/hist/h6hist1.txt.

FIGURE 4 Money Growth (M2 Annual Rate) and the Business Cycle In the United States, 1950-2002

Note: Shaded areas represent recessions.

Source: Federal Reserve Bulletin, p. A4, Table 1.10; www.federalreserve.gov/releases/h6/hist/h6hist1.txt.

changes in money might also be a driving force behind business cycle fluctuations. However, not every decline in the rate of money growth is followed by a recession.

We explore how money might affect aggregate output in Chapters 22 through 28, where we study monetary theory, the theory that relates changes in the quantity of money to changes in aggregate economic activity and the price level.

Thirty years ago, the movie you might have paid $9 to see last week would have set you back only a dollar or two. In fact, for $9 you could probably have had dinner, seen the movie, and bought yourself a big bucket of hot buttered popcorn. As shown in Figure 5, which illustrates the movement of average prices in the U.S. economy from 1950 to 2002, the prices of most items are quite a bit higher now than they were then. The average price of goods and services in an economy is called the aggregate price level, or, more simply, the price level (a more precise definition is found in the appendix to this chapter). From 1950 to 2002, the price level has increased more than sixfold. Inflation, a continual increase in the price level, affects individuals, businesses, and the government. Inflation is generally regarded as an important problem to be solved and has often been a primary concern of politicians and policymakers. To solve the inflation problem, we need to know something about its causes.

Index (1987= 100)

Money Supply

FIGURE 5 Aggregate Price Level and the Money Supply In the United States, 1950-2002

Sources: www.stls.frb.org/fred/data/gdp/gdpdef;www.federalreserve.gov/releases/h6/hist/h6hist10.txt.

The average price of goods and services in an economy.

www.newsengin.com /neFreeTools.nsf/CPIcalc ?OpenView

Calculator lets you compute how buying power has changed since 1913.

FIGURE 5 Aggregate Price Level and the Money Supply In the United States, 1950-2002

Sources: www.stls.frb.org/fred/data/gdp/gdpdef;www.federalreserve.gov/releases/h6/hist/h6hist10.txt.

What explains inflation? One clue to answering this question is found in Figure 5, which plots the money supply and the price level. As we can see, the price level and the money supply generally move closely together. These data seem to indicate that a continuing increase in the money supply might be an important factor in causing the continuing increase in the price level that we call inflation.

Further evidence that inflation may be tied to continuing increases in the money supply is found in Figure 6. For a number of countries, it plots the average inflation rate (the rate of change of the price level, usually measured as a percentage change per year) over the ten-year period 1992-2002 against the average rate of money growth over the same period. As you can see, there is a positive association between inflation and the growth rate of the money supply: The countries with the highest inflation rates are also the ones with the highest money growth rates. Belarus, Brazil, Romania, and Russia, for example, experienced very high inflation during this period, and their rates of money growth were high. By contrast, the United Kingdom and the United States had very low inflation rates over the same period, and their rates of money growth have been low. Such evidence led Milton Friedman, a Nobel laureate in economics, to make the famous statement, "Inflation is always and everywhere a monetary phenomenon."2 We look at moneys role in creating inflation by studying in detail the relationship between changes in the quantity of money and changes in the price level in Chapter 27.

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Responses

  • struan
    Why study money and monetary policy?
    8 years ago
  • cooper macleod
    Why study banking and monetary policy?
    6 years ago
  • tyyne
    Why study money and monetary plicy?
    3 months ago

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