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Lecture 4

Lecture 4. Money and inflation. Example: Zimbabwe hyperinflation. Example: Zimbabwe hyperinflation. Example: Zimbabwe hyperinflation. What happened?. A dramatic increase in government expenditure. For example, in 2006: Soldiers salary was raised by 300% Police’ salary was raised by 200%

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Lecture 4

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  1. Lecture 4 Money and inflation

  2. Example: Zimbabwe hyperinflation

  3. Example: Zimbabwe hyperinflation

  4. Example: Zimbabwe hyperinflation

  5. What happened? • A dramatic increase in government expenditure. • For example, in 2006: • Soldiers salary was raised by 300% • Police’ salary was raised by 200% • Government had no money to do that – they print money.

  6. Right now • Since April 2009, all transactions are done in foreign currencies, such as the US dollar or South Africa’s Rand.

  7. Price of a daily newspaper • Jan 1921: 0.30 mark • May 1922: 1 mark • Oct 1922: 8 marks • Feb 1923: 100 marks • Sep 1923: 1,000 marks • Oct 1, 1923: 2,000 marks • Oct 15, 1923: 1 million marks • Nov 17, 1923: 17 million marks

  8. This lecture • Quantity theory of money  how inflation is determined. • Demand for money  a link between output and money • Fisher equation

  9. Why could this happen? • What is money? • A store of value • A medium of exchange • A unit of account

  10. Money supply measure • C Currency $715.4 billion • M1 Currency + demand deposits + Checking accounts $1363.4 billion • M2 M1 + retail money market mutual fund + Saving deposits $6587.9 billion • M3 M2 + repurchase agreements $9976.2 billion • Note: US GDP is 14.256 trillion

  11. Money supply in US • Open market operations • Sell bond  decrease money supply • Buy bond  increase money supply • Reserve requirement • The discount rate

  12. Money supply in US

  13. Banks borrowing from Fed

  14. US money supply

  15. Velocity • Basic concept: the rate at which money circulates. • Example: In 2009, • US GDP: $14000 billion • Money supply = $700 billion (M1) • The average dollar is used 20 times. • So velocity = 20

  16. Quantity theory of money • V = velocity • T = value of all transactions (T = PY) • M = money supply. Money * Velocity = Price * Output M * V = P * Y

  17. Quantity theory of money • Take the log of previous equation: (1) • Since it works for time t, it also works for time t-1: (2) • Equations (1) – (2), we have: (3)

  18. Quantity theory of money • Equation (3) says: % change in M + % change in V = % change in P + % change in Y

  19. Inflation and money supply

  20. Inflation and money supply

  21. Demand for money • Consider the “trip to the bank” story: • People would have some of their income in their pocket, and the rest in a bank. • When the money in his pocket is lower than some number, he would take a trip to the bank to “refill” his pocket. • Therefore, factors that affect the number of the trips would affect his demand for money.

  22. Demand for money • Income effect: • When a person has a higher income, it is more costly for him to go to the bank (opportunity cost is high). • When a person has a higher income, he would typically consume more – therefore he needs more money in his pocket.

  23. Demand for money • Interest effect: • When the nominal interest rate is higher, putting money in the bank would earn more interests  less money in his pocket. • Price effect: • Higher price would require more money in the pocket.

  24. Demand for money • Money demand equation • α and β are two positive numbers: • α represents the relationship between money demand and the income • β represents the relationship between money demand and nominal interest rate.

  25. Discussion: • If, because of increasing popularity of credit use, people carry almost no cash in their pockets, regardless of their income. What would happen to the money demand equation? • The value of α would be reduced to almost zero -- people’s income levels would no longer have any effects on their demand for money in their pockets.

  26. Fisher equation • At the beginning of a year, Bill has 1 million dollars. Two options: • Option #1: Deposit into a bank to earn a preset nominal interest. At the end of the year, he would have: $ (1 + i) million

  27. Fisher equation • Option #2: Invest. • At the current price p, he would buy 1/p million units machines. • Each unit of machine would produce (1+r) units of output. At the end of the year, he would produce total output: 1/p x (1+r)

  28. Fisher equation: • Option #2 (continued): • At the end of the year, the new price is px(1+π ) • He would sell the output at the new price to get money: 1/p x (1 + r) x px(1+π) = (1+r) x(1+π)

  29. Fisher equation: • Two options should generate exact same amount of money: (1 + i) = (1+r) x(1+π) • 1 + i = 1 + r + π + r x π Since r x π is generally very small, we have the Fisher equation: i ≈ r + π

  30. Fisher equation • Since at the beginning of the year we do not know the inflation, so we use expected inflation:

  31. Discussions: • Since real interest rate does not vary much across time, nominal interest rate and the inflation should be highly correlated. See graphs next.

  32. The Fisher equation: time series evidence

  33. The Fisher equation: cross country evidence

  34. Cost of expected inflation • Cost of expected inflation • Menu cost: first may have to change their posted prices more often. • Tax laws: many provision of the tax code do not account for the inflation.

  35. Cost of unexpected inflation • Unexpected redistribution.

  36. Summary • Quantity theory suggests that inflation is almost entirely due to the money supply. • Demand for money depends on income, price level, and nominal interest rate. • Fisher equation suggests that nominal interest = real interest + expected inflation

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