Chapter 4: Money and Inflation

1. Chapter 4: Money and Inflation

2. Functions of Money • Medium of Exchange • Store of Value • Unit of Account • Standard of Deferred Payment

3. Types of Money • Commodity money: a commodity with some intrinsic value used as a medium of exchange (e.g., cigarettes in POW camps) • Fiat money: a commodity with no intrinsic value established by a government decree as money (e.g., coins & bills)

4. Characteristics of Money • Limited in supply • Widely accepted • Portable • Divisible • Uniform • Durable

5. Money Supply • M1 • Currency: coins & bills (25%) • Demand Deposits: checking account deposits (75%) • M2 • M1 • Time Deposits: savings account deposits less than $100,000

6. Money Supply • M3 • M2 • Time Deposits: savings account deposits more than $100,000 • L • M3 • Liquid assets (e.g., T-Bills)

7. The Measures of Money • C $434 billion in April 1998 • M1 $1,081 • M2 $4,165 • M3 $5,574 • L $6,826

8. Money Supply Line • The quantity of money in circulation is controlled by the central bank in real value = M/P Interest Rate (%) (M/P)s 10 5 80 Quantity of Money

9. Money Demand • The amount of money demanded for transaction and speculation purposes depends on personal income and interest rate • At any level of personal income, quantity demanded of money is a negative function of interest rate

10. Money Demand Line M/P = f(Y, r) Y = income r = real interest rate Interest Rate (%) 10 5 (M/P)d 100 80 Quantity of Money

11. Money Market Equilibrium Interest Rate (%) (M/P)s 5 (M/P)d 80 Quantity of Money

12. Federal Reserve System, FED • The central bank of the U.S. • Independent decision making unit with regional banks • In charge of money supply management and economic stabilization

13. Tools of Monetary Policy • Legal reserve ratio: ratio of cash reserves to deposits that banks are required to maintain • By lowering the ratio, banks will have more reserves to lend and invest, increasing the money supply

14. Tools of Monetary Policy • Discount rate: rate of interest the FED charges on loans to banks • By lowering the rate, banks encourage borrowing from the FED and lending to the public, increasing the money supply

15. Tools of Monetary Policy • Open Market Operations: FED’s purchases and sales of government bonds • By purchasing bonds and paying the sellers, the FED increases the money supply

16. Expansionary Monetary Policy • Increase the money supply by any one or combination of the above tools • Reduce the interest rate to encourage investment • Increase investment expenditures, thus creating employment & income

17. Expansionary Monetary Policy Interest Rate (%) (M1/P)s (M2/P)s 5 4 (M/P)d 85 80 Quantity of Money

18. Quantity Theory of Money • Equation of Exchange: MV = PY • M = money supply • V = income velocity of money: the rate of turn over of money • P = general price level • Y = output of goods & services

19. (M/P)d = kY where k is the percentage of money balances held for transactions Equilibrium (M/P)s = (M/P)d M/P = kY M/k = PY So, V = 1/k If k = 0.10, then V = 10: a $1 changes hands 10 time a year Income Velocity of Money

20. Money Supply Growth & Inflation • In 1960s, inflation was low and money supply growth constant at about 7% • In the 1970s, inflation rose as the money supply grew at an increasing rate to reach 10% • In the 1980s and 1990s, inflation fell as money supply grew at a declining rate to reach about 6%

21. Historical Data

22. International Data

23. Inflation • A continuous rise of the general price level • General price level is measured by the CPI or GDP Deflator • Percentage change of the general price level over the previous period

24. Inflationary Trend • Inflation stayed under 5% during the 1960s • It averaged 7.7% in the first half and 10.6% in the second half of the 1970s • Since the early 1980s, inflation rate has declined to as low as 3% in the late 1990s

25. Money and Inflation • Take percentage change from MV = PY %ΔM * %ΔV = %ΔP * %ΔY V = 1/k and Y at full employment are constant • %ΔM = %ΔP : a 1% increase in the money supply causes a 1% increase in the general price level

26. Sources of Gov’t Revenues • Taxes • Public Debt • Seigniorage or printing money: operates like an inflation tax on money holding as money loses real value

27. Fisher Effect • Define • i = nominal rate of interest • r = real rate of interest • π = inflation rate i = r + π r = i - π

28. Money, Inflation, Interest Rate • Quantity Theory of Money: a 1% increase in the money supply causes a 1% increase in inflation • Fisher Effect: a 1% increase in the inflation causes a 1% increase in the nominal interest rate

29. Historical Data

30. International Data

31. Real Interest Rate • Ex-ante: real interest rate when loan are made (known) • Ex-post: real interest rate when loans are paid (unknown, but measured by forecasting inflation rate)

32. Revised Fisher Effect • Define • i = nominal rate of interest • r = real rate of interest • π* = expected inflation rate i = r + π* r = i – π*

33. Revised Demand for Money • (M/P)d = L(i, Y) where L is for liquidity • (M/P)d = L(r + π*, Y) • Money demand depends on the • real rate of interest (-) • expected inflation rate (-) • personal income (+)

34. Linkage Among Money, Prices, and Interest Rates • Changes in money demand and supply determine the price level • Changes in the price level determine the inflation rate • The inflation rate affects the interest rate • The nominal interest rate affects the money demand

35. Linkage Among Money, Prices, and Interest Rates Money Supply Price Level Inflation Rate Nominal Interest Rate Money Demand

36. Cost of Expected Inflation • Inflation Tax • Menu Cost • Inefficiency due to inflation variability • Increase in tax liability • Consumer inconvenience

37. Cost of Unexpected Inflation • Loss of returns: • creditors lose if π* > π • borrowers lose if π* < π • Loss of real income when income is fixed

38. Hyperinflation • Whenπ > 50% per month • All unexpected costs get larger • Delay in tax collection • Inflation psychology • Caused by excessive printing press • Cure required fiscal reform

39. Hyperinflation in Germany