Money Supply and GDP

A decrease in the money supply will have the effect of raising interest rates. Once the interest rates are increased, then business investment will decrease. The decrease in business investment, all things else being equal, will decrease the GDP, as the investment component will decrease. The multi-step process is illustrated graphically below.

Figure 2 adapted from Krugman & Wells p. 473

            Figure 2 represents the money market. The X-axis shows the quantity of money, or “real money”. The Y-axis shows the real interest rate, designated with a lower case “I”. The vertical lines represent the money supply, as determined by the Federal Reserve through open market operations. This graph shows the decrease in the money supply (M-bar one to M-bar two). The equilibrium interest rate at the meeting of the money supply and the line representing the demand for money is higher on the y-axis than it was previous. This represents an increase in the interest rate.

            The next step in related processes between a decrease in the money supply and the lowering of the GDP is looking at the relationship between the interest rate and overall investment. These are inversely correlated so that when the interest rate increases, as in the first graph, investment is lowered. The best way to illustrate the relationship is through side-by side graphs that directly trace the rise in interest rates with a concurrent drop in investment, but technologic limitations prevent that from being shown clearly here.          

 

Figure 3 adapted from Krugman & Wells p. 281

            In Figure 3, the y-axis is the same as in Figure 2, with the interest rate change from Figure 2 carried over from the previous graph. The x-axis represents the total investment expenditure, or” I”. The pink line shows the inverse relationship between the interest rate and the investment. As the money supply decreased, the interest rate increased. As the interest rate increased, the point on the pink line moved from E₁ to E₂. The total investment thus decreased in value as the interest rate increased in consequence of the decreasing money supply.

            Figure 4 will show the ultimate result of the decrease in the money supply: lowered GDP.

Figure 4 adapted from Krugman & Wells. p. 344

Figure 4 is the graph of GDP against aggregate expenditure. The graph is only at equilibrium where the `colored lines meet the 45-degree line in black. This graph shows that equilibrium GDP will be lower wen changed by a decrease in the investment component. All things being equal, the sum of consumer expenditures, government expenditures, business investment, and net exports will decrease if one of those components is lowered. The previous figures have shown graphically how decreasing the money supply increases interest rates, which decreased investment spending. Here is the culmination of those processes. GDP at equilibrium is lower (y₂, representing the level of GDP at E₂ where the green line intersects the 45-degree line).  Thus, decreasing the money supply decreases the GDP.


Krugman, P. & Wells, R. (2013). Macroeconomics. New York, NY : Worth Publishers

Three Roles of Money

Money has three roles.

The first role of money is to be a medium of exchange. People have needs and wants that they cannot produce themselves. They also have skills so that they can provide services and create goods in excess of what they need. This surplus is what they create to trade on the open market. Without money, a chicken farmer who wants a massage has to carry around his chickens to the massage place to trade for a massage. The problem is that the farmer also had to find a masseuse that wanted a chicken in exchange for his services. Money as a medium of exchange got rid of this so that there is something standing in as chickens and massages that are more universally accepted in trade. Ideally, this chit is portable, durable, and not easily copied. It mediates trade and makes markets more efficient (Krugman & Wells p. 413).

The second role of money is as a store of value. In the previous example, the chickens have value for a time, but they will eventually die or be consumed for dinner. Money as a store of value is something unlike the chickens in that it will not perish and instead will maintain purchasing power in the future. It is just as tradable now as it is the future.  Krugman (2013) notes that this is not a unique feature of money, as many things can hold their value over time and not perish (p. 414). Land, is a good example of such a good

The final role of money is as a unit of account. The unit of account role of money allows for easier comparisons and allows people in the marketplace to quantify the value of goods and services in trade. As in the masseuse and the farmer example, instead of one chicken in exchange for one massage, it allows for more specifics (Krugman & Wells p. 414). How big is the bird? How old is it? How long is the massage expected to be. All of these are points of negotiation that do not need to happen when there is quantification. Units give clarity in conversation and negotiation so that all parties are speaking of similar things.

Krugman, P. & Wells, R. (2013). Macroeconomics. New York, NY : Worth Publishers

 

Growth of On-Line Commerce

In a situation where more transactions take place online there will be fewer uses for having cash on hand. As more commerce and banking goes online, then the demand will rise for alternate payment systems like PayPal and Amazon Payments. There is also the rise of the crypto currencies that operate outside of the state-sponsored monetary system, such as bitcoin.

            That said, electronic commerce is growing, but from a relatively low base. The Department of Commerce has been tracking the rise in e-commerce over the past twenty years. In the most recent quarter, online sales only accounted for 6.1% of total sales. The trend is clear though, more and more sales are happening on line, as illustrated in figure one.

Figure 1 from http://www.census.gov/retail/mrts/www/data/pdf/ec_current.pdf

The linear trend show that if it holds, it will still take over thirty-five years for all commerce to happen on line. Of course, that is if the linear trend holds. It has doubled in the last five years, so if it follows the trend where it doubles every five year, then it will be much faster.

            If banking takes off as quickly as commerce did, there will soon be a reduced demand for holding cash – though there are still cultural biases to holding physical cash. What it will not do is decrease the supply money much. Currency in circulation is just a small part of the money supply (Krugman & Wells p. 425). Banked dollars that are accessible through checking are just as good as those that are folded in the wallet. 

References

Krugman, P. & Wells, R. (2013). Macroeconomics. New York, NY : Worth Publishers

Thomas, I.,  Liu, X., & Weidenhamer, D. (2014, November 18) Quarterly Retail E-Commerce Sales: 3^rd Quarter 2014. U. S. Census Bureau News. Washington, D. C.  Retrieved at http://www.census.gov/retail/mrts/www/data/pdf/ec_current.pdf