Nominal money supply growth

Nominal money supply growth is a term from macroeconomics , under which a numerical growth of the money supply of an economy is understood without taking the price level into account . Nominal money supply growth can be positive or negative. By dividing the nominal money supply by the price level, the real money supply can be derived, which is influenced on the one hand by a change in the price level and on the other hand by a change in the nominal money supply.

Alternative definition

A concrete definition cannot be found in the specialist literature, since the money supply growth is described in connection with the interactions with production , price level and unemployment in an economy .

Monetary Policy Actors

The central banks as actors in monetary policy control the nominal money supply through the interest rate and their open market operations .

The main objective of the monetary policy of the European Central Bank is price stability in the European currency area . The ECB "uses its instruments in such a way that, if possible, [...] a certain nominal amount of money is realized", which is supposed to counteract the price increase and keep the inflation rate low. The nominal money supply is controlled by the ECB's expansionary monetary policy (increasing the money supply) or contractive monetary policy (reducing the money supply).

Effects based on the IS-LM model

The macroeconomic effects of a money supply growth can be represented with the help of models. In the short term, reference is made to the IS-LM model and in the medium term, the aggregated demand relationship from the AS-AD model is used for explanation.

With the help of the IS-LM model it can be examined how the income and the interest rate on the goods, money and financial markets of a closed economy are influenced by a change in nominal money supply. The model assumes that the price level is a constant, so that the real money supply changes in the same proportion to the nominal money supply. The nominal money supply is an exogenous variable in the model. The change in the nominal money supply always leads to a shift in the LM curve. If the nominal money supply changes, the IS function does not change, since neither the supply of goods nor the demand for goods are directly influenced. The IS function equation does not include a nominal money supply variable. It is different with the LM function. The nominal money supply variable is included in the LM function, so that a shift in the LM curve is triggered.

Monetary expansion

In the case of an expansionary monetary policy, the LM curve shifts downwards in the model, so that the simultaneous equilibrium on the goods, money and financial markets also shifts. The increase in the amount of money leads to a lower interest rate, which in turn has a positive effect on investments. With a lower interest rate, companies are ready to invest more quickly. For example, if there is a lack of liquidity, companies can take out lower-interest loans to finance their investments. Companies are able to produce more. The excess production leads to an increase in income, so that the individuals increase their consumption.

Money supply reduction

In the case of a restrictive monetary policy, the LM curve shifts upwards in the model. A new simultaneous equilibrium arises on the goods, money and financial markets. The reduction in the amount of money increases the interest rate, which prompts companies to invest less and to invest their money in securities, for example. Production decreases and income decreases until the new equilibrium is reached.

Model consideration with variable price level

If one looks at the IS-LM model with the assumption that the price level is variable, another effect results. As described above, an increase in the nominal money supply leads to an increase in output in the short term. More employees are needed to increase production, so that the unemployment rate falls. Wages and prices are rising. With a nominal money supply increase and a simultaneous price increase, the real money supply no longer changes in the same proportion to the nominal money supply. An increase in the price level weakens the effect of a nominal increase in the money supply.

As shown here, one might think that expansionary monetary policy would affect production. This is the case in the short term. But in the medium term, the change in the money supply has no effect either on production or on the interest rate, but only influences the price level.

Nominal money supply growth in the medium term based on the aggregated demand relationship

The aggregated demand relationship shows what effect money supply growth has on inflation and production in the medium term. The starting point is the aggregated demand function from the AS-AD model, with government spending and taxes left out for simplicity.

The following functional equation is obtained: ${\displaystyle Y=\gamma {\frac {M}{P}}}$

Y =	production
M =	Nominal amount of money
P =	Price level
${\displaystyle \gamma =}$	Constant; Indicator of the reaction of production to changes in the real money supply

In order to capture growth rates from the equation, the equation must be converted.

It results: ${\displaystyle g_{\mathrm {yt} }=g_{\mathrm {mt} }-\pi _{\mathrm {t} }}$

${\displaystyle g_{\mathrm {yt} }=}$	Production growth rate
${\displaystyle g_{\mathrm {mt} }=}$	Nominal money supply growth rate
${\displaystyle \pi _{\mathrm {t} }=}$	Growth rate of the price level (inflation rate)

According to Okun's law, there is normal output growth that must be achieved in order to keep the unemployment rate constant. This fact is caused by the technical progress and increasing productivity of the employees. Only when normal output growth is exceeded does the unemployment rate fall. A change in the unemployment rate is not expected in the medium term. In the medium term, production growth corresponds to the normal growth rate. ${\displaystyle g_{\mathrm {yt} }}$

The following applies: ${\displaystyle g_{\mathrm {yt} }={\overline {g}}_{\mathrm {y} }}$

The central bank monitors the development of inflation. It then determines the amount of money required to achieve the target inflation rate. The above equation assumes that the central bank keeps the growth rate of the nominal money supply constant in each period.

The following applies: ${\displaystyle g_{\mathrm {mt} }={\overline {g}}_{\mathrm {m} }}$

The assumptions of the constant growth rate of production and nominal money supply show that the growth rate of inflation is also constant in the medium term.

After rearranging the above equation and taking into account the above assumptions of constant growth rates, the result is: ${\displaystyle \pi }$ ${\displaystyle \pi ={\overline {g}}_{\mathrm {m} }-{\overline {g}}_{\mathrm {y} }}$

In the medium term, the inflation rate must correspond to the difference between nominal money supply growth and normal production growth.

If a certain inflation rate is to be achieved in the medium term, the money supply must increase by the targeted inflation rate and the normal growth rate of production.

An excessive increase in the nominal money supply above normal output growth leads to a high rate of inflation.

Summary

Based on the above results, the following relationships emerge:

A change in the growth rate of the nominal money supply has a short-term effect on production. This requires a change in the unemployment rate, so that if the money supply is reduced, an increase in the unemployment rate must be expected.

In the medium term, a nominal change in the money supply is neutral in terms of production and the unemployment rate. In the medium term, production corresponds to the normal growth rate. Only a change in the price level can be seen. Associated with this are corresponding changes in the inflation rate.

Application example

What monetary growth does the central bank have to aim for if its goal is to reduce inflation from 14% to 4%?

From the above explanations, it is known that the central bank must reduce nominal money growth in order to reduce the rate of inflation.

The reduction in monetary growth has an impact on the unemployment rate and output growth. The effects can be determined using three equations:

• 1. Phillips curve : ${\displaystyle \pi _{\mathrm {t} }-\pi _{\mathrm {t-1} }=-\alpha (\mu _{\mathrm {t} }-\mu _{\mathrm {n} })}$

• 2. Okun's law : ${\displaystyle \mu _{\mathrm {t} }-\mu _{\mathrm {t-1} }=-\beta (g_{\mathrm {yt} }-g_{\mathrm {yn} })}$

• 3. modified aggregated demand relationship: ${\displaystyle g_{\mathrm {yt} }=g_{\mathrm {mt} }-\pi _{\mathrm {t} }}$

The following assumptions exist:

${\displaystyle \alpha =1}$

${\displaystyle \mu _{\mathrm {n} }=6}$ (natural unemployment rate)

${\displaystyle \beta =0{,}4}$

${\displaystyle g_{\mathrm {yn} }=3}$ (natural growth in production)

The central bank has decided to distribute the reduction in the inflation rate evenly over five years, so that it is reduced by 2 percentage points annually.

The following values ​​result for the unemployment rate, output growth and nominal money supply growth in the respective years:

year	0	1	2	3	4th	5	6th	7th	8th
inflation rate ${\displaystyle \pi _{\mathrm {t} }}$	14th	12	10	8th	6th	4th	4th	4th	4th
Unemployment rate ${\displaystyle \mu _{\mathrm {t} }}$	6th	8th	8th	8th	8th	8th	6th	6th	6th
Production growth ${\displaystyle g_{\mathrm {yt} }}$	3	-2	3	3	3	3	8th	3	3
Nominal money supply growth ${\displaystyle g_{\mathrm {mt} }}$	17th	10	13	11	9	7th	12	7th	7th

• First, the change in the unemployment rate is determined by plugging the values ​​into the equation of the Phillips curve.

• In the second step, production growth is determined by inserting the determined unemployment rate into the equation of Okunschen's law.

• The final step is to use the aggregated demand relationship to determine the growth of the nominal money supply.

Year 0:

The original inflation rate is 14%. The natural unemployment rate is 6%, the normal growth rate of production is 3% and the central bank is increasing the nominal money supply at a growth rate of 17%.

Year 1:

• 1. With the aim of lowering inflation, an increase in unemployment must be accepted in the short term.

Inserting the given values ​​into the equation of the Phillips curve:

${\displaystyle \pi _{\mathrm {t} }=12}$

${\displaystyle \pi _{\mathrm {t-1} }=14}$

${\displaystyle \alpha =1}$

${\displaystyle \mu _{\mathrm {n} }=6}$

${\displaystyle 12-14=-1(\mu _{\mathrm {t} }-6)}$

${\displaystyle \mu _{\mathrm {t} }=8}$

The unemployment rate rises 2 percentage points above its natural level in years 1-5. This corresponds to 10 annual percentage points of excess unemployment.

• 2. An increase in unemployment leads to a decrease in production below its normal level.

Inserting the given values ​​into the equation of Okun's law:

${\displaystyle \mu _{\mathrm {t} }=8}$

${\displaystyle \mu _{\mathrm {t-1} }=6}$

${\displaystyle g_{\mathrm {yn} }=3}$

${\displaystyle 8-6=-0{,}4(g_{\mathrm {yt} }-3)}$

${\displaystyle g_{\mathrm {yt} }=-2}$

The rate of growth in production falls 5 percentage points below its normal level.

• 3. In the first year the central bank has to reduce the nominal money supply so much that the increase in unemployment is actually achieved. The central bank does this by trying "to reduce the real money supply in such a way that it restricts production activity".

Substituting the given values ​​into the equation of the aggregated demand relationship:

${\displaystyle g_{\mathrm {yt} }=-2}$

${\displaystyle \pi _{\mathrm {t} }=12}$

${\displaystyle -2=g_{\mathrm {mt} }-12}$

${\displaystyle g_{\mathrm {mt} }=10}$

Nominal money supply growth falls by 7 percentage points.

Year 2

• 1. The unemployment rate remains constant compared to the previous year.

${\displaystyle \pi _{\mathrm {t} }=10}$

${\displaystyle \pi _{\mathrm {t-1} }=12}$

${\displaystyle 10-12=-1(\mu _{\mathrm {t} }-6)}$

${\displaystyle \mu _{\mathrm {t} }=8}$

• 2. In the second year the unemployment rate remains the same as in the previous year, so that production returns to normal growth of 3%.

${\displaystyle \mu _{\mathrm {t} }=8}$

${\displaystyle \mu _{\mathrm {t-1} }=8}$

${\displaystyle 8-8=-0{,}4(g_{\mathrm {yt} }-3)}$

${\displaystyle g_{\mathrm {yt} }=3}$

• 3. The central bank must ensure that the unemployment rate remains at 8% in years 2-5. "This requires real money supply growth that corresponds exactly to the normal growth rate."

${\displaystyle g_{\mathrm {yt} }=3}$

${\displaystyle \pi _{\mathrm {t} }=10}$

${\displaystyle 3=g_{\mathrm {mt} }-10}$

${\displaystyle g_{\mathrm {mt} }=13}$

Years 3 and 4

The unemployment rate remains at 8%. Therefore, the rate of production growth does not deviate from its normal level. It remains at 3%.

The inflation rate continues to decrease by 2 percentage points annually, so that nominal money supply growth must also decrease by 2 percentage points. Only in this way can the normal growth rate of production be realized. This in turn leads to an unemployment rate of 8%, which remains the same as in the previous year.

Year 5

The central bank has achieved its goal. The inflation rate is 4%. Now it has to ensure in the following years that all sizes assume their original values ​​in the medium term.

Year 6

• 1. The unemployment rate is returning to its natural level.

${\displaystyle \pi _{\mathrm {t} }=4}$

${\displaystyle \pi _{\mathrm {t-1} }=4}$

${\displaystyle 4-4=-1(\mu _{\mathrm {t} }-6)}$

${\displaystyle \mu _{\mathrm {t} }=6}$

• 2. The return to the natural unemployment rate requires strong output growth.

${\displaystyle \mu _{\mathrm {t} }=6}$

${\displaystyle \mu _{\mathrm {t-1} }=8}$

${\displaystyle 6-8=-0{,}4(g_{\mathrm {yt} }-3)}$

${\displaystyle g_{\mathrm {yt} }=8}$

• 3. The central bank must accelerate the growth rate of the nominal money supply so that target inflation can be maintained.

${\displaystyle 8=g_{\mathrm {mt} }-4}$

${\displaystyle g_{\mathrm {yt} }=12}$

Years 7-8

The unemployment rate and production growth have returned to their original levels. The inflation rate is at the targeted 4%. The central bank has cut money supply growth to 7% and will keep this growth in nominal money supply constant for the next few years.

References

literature

• Blanchard, Illing: Macroeconomics , 4th edition, Pearson Studium, Munich, 2006, ISBN 978-3-8273-7209-3
• Blümle / Patzig: Basic features of macroeconomics , 3rd edition, Haufe Verlag, ISBN 3-448-02855-X
• Felderer, Homburg: Macroeconomics and New Macroeconomics , 9th Edition, Springer, ISBN 3-540-25020-4

Footnotes

1. ↑ Blümle / Patzig: Grundzüge der Makroökonomie, 3rd edition, Haufe Verlag, p. 236
2. ↑ Felderer, Homburg: Macroeconomics and new macroeconomics, 9th edition, Springer, p. 152 ff
3. ↑ ^{a b c} Blanchard, Illing: Makroökonomie, 4th edition, Pearson Studium, Munich, 2006, pp. 153 ff
4. ^ Blanchard, Illing: Macroeconomics, 4th edition, Pearson Studium, Munich, 2006, p. 219 ff
5. ↑ ^{a b c d e f} Blanchard, Illing: Makroökonomie, 4th edition, Pearson Studium, Munich, 2006, pp. 270 ff
6. ↑ Blanchard, Illing: Makroökonomie, 4th edition, Pearson Studium, Munich, 2006, p. 275
7. ↑ ^{a b} Blanchard, Illing: Makroökonomie, 4th edition, Pearson Studium, Munich, 2006, p. 276