How are the money supply and inflation related? And what does the Federal Reserve have to do with this relationship? Episode 1 of the Feducation video series reviews the functions of money, features an interactive auction that demonstrates the relationship between the money supply and inflation, then utilizes a simple equation to show how changes in the money supply affect the economy. The video also describes how the Fed uses monetary policy to achieve its dual mandate of maximum employment and price stability.
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I’d like to welcome you to Feducation. This is our first go at Feducation, and, if it’s a success, our plan is to make it a regular program. Today, our topic is money and inflation.
My name is Scott Wolla. I’m an economic education specialist at the Federal Reserve Bank of St. Louis. Feducation was developed to provide economic content and equip people with a better understanding of the Federal Reserve and its policy actions. Our first topic was “Money and Inflation,” and we began by comparing three separate, yet similar, items—the front page of the Wall Street Journal, a subscription card to The Economist magazine and a $20 bill.
I asked the audience to compare these three types of paper, and then I crumpled everything together into a ball and asked for a volunteer to throw it away. As expected, the volunteer wanted to keep the $20 and she promised to throw the rest away later. But why, what makes that type of paper money so special?
We’re going to talk a little bit about functions of money to get things started, and the characteristics that forms of money have. Money is a medium of exchange. The medium of exchange means that it makes transactions easier to conduct. So, in the absence of money, we might have to barter for goods and services. This would be a problem for me as an economic educator. If I wanted my transmission fixed on my car, I would have to find a mechanic who would exchange his transmission repair services for a lesson on aggregate supply and aggregate demand.
In the absence of a barter economy, we use money as our medium of exchange. So, I come to work, they pay me in cash, and it’s easier to find someone who will fix my transmission for money, than it is for economics lessons. So, the first function of money is that money is a medium of exchange.
It’s a store of value. You can take the cash out of your wallet, put it in your sock drawer and leave it there for three or four years. When you pull it out again, it has the same value, minus inflation, as when you put it in—unlike bushels of corn. In a commodity- or barter-based economy, you might take a few bushels of corn and stick them in the corner of your shed, and the chickens might eat it, or it might rot. But money actually is a very good store of value.
It’s a measure of value. So I was talking to one of my friends on the phone this weekend, and I was saying how happy I was that gas prices were down. I quoted the price, it was $3.29 on Friday, and he said, “well here, it’s $3.04,” and I was not quite as excited as I once was about cheap gas prices. But, we were both quoting gas prices as a measure of value. I didn’t quote the price of gas in terms of corn and then he price it in terms of chickens, we both quoted the price in terms of money—and that makes those transactions easier as well.
To further our discussion of money, I introduced a guest auctioneer and we conducted an auction. Each audience member was given a certain amount of plastic chips, and each chip was worth $1. Our first round consisted of three separate lots or auction items, which represented the total output of our auction economy. These items included a voodoo doll keychain, two chocolate bars and a gift card, and a FRED hoodie from the St. Louis Fed.
The bidding was fast and furious, and at the end of the first round, we tallied the winning bids. Then, we handed out more chips and held a second auction for an identical group of items. Once again, bidding was fast paced, and again, we tallied the winning bids at the end of the auction.
So, this is how things turned out: in our first round, the total price paid for all three goods was $30; in round two it was $103. Now, were there any differences in the goods that were sold between the two rounds? No, they were identical, weren’t they? So, how would you explain the difference in the price? In round two, more than three times the total price was paid for the three goods. It was the quantity of chips, right? And the chips in this auction represented money, so would it be safe to make an early conclusion that the amount of money had something to do with the price of goods in the two markets? So, our prices were higher, presumably because there was more money in the second round than the first round.
All right, we’re going to talk about inflation today, which we’ll define as a sustained increase in the average price level of all goods and services produced in the economy. There are a couple of key terms there. One of them is “average price level.” So, for instance, when the price of gas goes up and down, or the price of milk goes up and down, it doesn’t necessarily mean there’s inflation, because inflation is a basket—it’s the average price level. So, instead of looking at the prices of individual goods, when we look at inflation, we look at the price level of that entire basket of goods that are in the measure. So what causes inflation?
Inflation is caused when the money supply in an economy grows at faster rate than the economy’s ability to produce goods and services. In our auction economy the production of goods and services was unchanged, but the money supply grew from round one to round two. Because the money supply grew, and the output of goods and services did not grow, our economy experienced inflation.
I needed volunteers for the next part of the program and recruited five willing audience members. The volunteers were each given a sign displaying one of five symbols, which form the equation of exchange.
So let’s define our variables: M we’re going to define as the supply of money in the economy, we’re going to think about coins, we’re going to think about currency, we’re going to think about deposits, and checking accounts, traveler’s checks—anything you spend as money. V is velocity. When you think velocity you think speed. In this case, velocity is the number of times per year that the average dollar is spent on goods and services. So you have the amount of money and the number of times it’s spent in a time period, in this case one year. Our equal sign is just kind of our placeholder there. P is the overall price level. It’s not the prices of individual goods, this is the price level of that basket of goods—all of the output sold in the economy. And Q is the quantity of goods and services produced, also known as output.
The equation of exchange is a simple model of a macroeconomy during a time period. MV represents the total amount spent by buyers, and PQ represents the total amount received by sellers. Because this is an equation, one side must equal the other. If there’s a change of the variables in one side of the equation, then this must be reflected by a change on the other side of the equation in order to keep MV equal to PQ.
I asked M to raise her letter, and Q and V to remain steady. In this example, what happens to P? P must increase in order to keep both sides of the equation equal. In other words, when the money supply increases, and neither velocity nor quantity changes, the price level must also increase—we call this inflation.
This equation helps us understand the relationship between money supply and price level. The opposite holds true as well, if M decreases and we hold V and Q constant then P must decrease.
Think about a recession. During a recessionary period, V might decrease as people cut spending. Remember, V is the velocity of money, or the number of times a year that the average dollar is spent on final goods and services. So, if we see a decrease in V while M and Q remain constant, we can expect to see a decrease in P as well.
On the other hand, during an inflationary period, V might increase as people rush to make purchases before prices rise too much—so the money supply might turn over faster—and keeping M and Q constant, P might increase as well, leading to even higher prices and further inflation.
The equation of exchange is most often used to describe what would happen over the long run, but it has both long- and short-run considerations, and this is where it may be more applicable to Fed policy. Assuming that resources are underutilized in a recession—this means there is high unemployment, and that factories and equipment are sitting idle—we would expect to see a decrease in Q, the quantity of all goods and services produced in the economy. Under these conditions, how would the variables respond to an increase in M, the money supply?
In an economy where resources are underutilized, Q might start to rise in response to an increase in M. Seems simple, right? But what if M stayed high for an extended period? How would these other variables respond? Eventually, P would start to rise as well, and that’s where we get the short-run and long-run story of inflation. During periods of underutilization, when the money supply is increased, there will be an increase in output; however, as those idle resources are utilized—as idle factories return to production and the labor market begins to tighten up—an increase in the money supply will be reflected in the price level. This is inflation caused by too much money chasing too few goods.
The equation of exchange can be useful in terms of macroeconomic application. It provides a framework for understanding the economy, and it tells about the importance of the money supply. M can be used to influence P and Q—in the short run, it can have some effect on Q, but in the long run, it’s all about P. It’s all about the price level.
The Federal Reserve is the central banking system of the United States, and among other things, the Fed has the job of conducting monetary policy to influence the growth of the money supply. Monetary policy is when a nation’s central bank uses its monetary policy tools to achieve such goals as maximum employment, stable prices and moderate long-term interest rates. The Federal Reserve’s dual mandate is to promote the two coequal objectives of maximum employment and price stability.
When people think about the Federal Reserve, they often think about the monetary policy piece. They see Chairman Bernanke testifying in front of Congress, or hear about what the FOMC did, but the link between the money supply and the other variables is not always well understood.
To summarize, the money supply is important because if the money supply grows at a faster rate than the economy’s ability to produce goods and services, then inflation will result. Also, a money supply that does not grow fast enough can lead to decreases in production, leading to increases in unemployment.
This video was produced by the Federal Reserve Bank of St. Louis. For more information, visit us online at stlouisfed.org.