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Economics

Economics. Chapter 5 Inflation, Deflation and the Money Market. Inflation and deflation. Inflation A persistent increase in the general price level Deflation A persistent decrease in the general price level. Main features of inflation and deflation. Persistent Not once-and-for-all

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Economics

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  1. Economics Chapter 5 Inflation, Deflation and the Money Market

  2. Inflation and deflation • Inflation • A persistent increase in the general price level • Deflation • A persistent decrease in the general price level

  3. Main features of inflation and deflation • Persistent • Not once-and-for-all • E.g. Tobacco tax  Price of cigarette  • (price increases once only, not inflation) • General price level • Overall increase/decrease in the prices of goods & services • Overall adjustment of the money price of goods • During inflation • Value of the money falls • Purchasing power of money falls • Monetary phenomenon • Too much money, but too few goods

  4. Main features of inflation and deflation Relationship between money and inflation • Inflation • Persistence increase in general money prices • If there is no money • No money prices • No inflation

  5. The Quantity Theory of Money (QTM) (貨幣數量論) Basic concepts • Nominal income and real income • The velocity of circulation of money • The equation of exchange

  6. The Quantity Theory of Money (貨幣數量論) 1. Nominal income and real income • Real income (Y) • Total output • Quantity of production • GDP at constant price • Nominal income (PY) • Monetary value of total output • General price level (P) x Quantity (Y) • GDP at market price

  7. The Quantity Theory of Money (貨幣數量論) 2. The velocity of circulation of money • Denoted as “ V ” • Average number of times a unit of money is circulated (or changes hands) in a period to buy national output

  8. The Quantity Theory of Money (貨幣數量論) Illustration • A pays $100 for B’s product B’s income = $100 • B pays $100 (income he gain from A) for C’s product C’s income = $100 • The $100 circulated for the purchases = 2 times • Velocity of circulation of money in this year = 2 $100 $100 Output Value = $100 Output Value = $100 A C B

  9. The Quantity Theory of Money (貨幣數量論) Try this • Assume the Ms = $100 • What is the velocity of circulation of this $100? • The $100 circulated for the purchases = 5 times • Velocity of circulation of money in this year = 5 $100 $100 $100 $100 $100 A C B F D E

  10. The Quantity Theory of Money (貨幣數量論) Try this • Assume the Ms = $100 • What is the velocity of circulation of this $100? • The $100 circulated for the purchases = 6 times • Velocity of circulation of money in this year = 6 • The $100 finally goes to Mr. A  $100   $100  $100   $100  $100   $100 A B

  11. The Quantity Theory of Money (貨幣數量論) Try this • In a one-man economy, assume the Ms = $100 • What is the velocity of circulation of this $100? • The $100 circulated for the purchases = 0 times • Velocity of circulation of money in this year = 0 • The QTM cannot be used to explain anything.  $100  A

  12. The Quantity Theory of Money (貨幣數量論) Try this • In a barter system, with no Ms • What is the velocity of money? • Since there is no money supply, • Velocity of circulation of money cannot be measured • The QTM cannot be used to explain anything. A B

  13. The Quantity Theory of Money (貨幣數量論) In another point of view • There is only $100 cash circulated in the market •  Money supply (M) = $100 • Total market value = P x Y = $100 x 2 = $200 • Then, Velocity (V) = = 2 [meaning that each unit of money is necessary to circulate twice (velocity) to finance the purchase of national output] • Formula: V =

  14. The Quantity Theory of Money (貨幣數量論) 3. The equation of exchange • From the formula: V = • Rewrite as: MV=PY • MV = Ms x No. of times in circulation = Total expenditure on goods & services • PY = Price x Output = Total nominal income • Since Total expenditure = Total nominal income(GDP by expenditure approach) (GDP by income approach) • Then, Equation of exchange : MV=PY

  15. Explanation of inflation by the QTM • Long-term effects (Classical QTM) Assumptions • The velocity of circulation of money is stable. • Statistics show that velocity of M2 is quite stable. • V is constant. • Real nation income is constant. • Price mechanism leads to full employment • Full employment: resources and technology are fully utilized. •  Production is maximized already. • Y is constant.

  16. Explanation of inflation by the QTM • Long-term effects (Classical QTM) According to the equation • If V and Y are constant, • When MS 5%  Price level  5% • Conclusion: MV=PY  M V= P Y %M =% P

  17. Explanation of inflation by the QTM M V=P Y The Classical QTM in long run • Given the equation with • constant velocity of money • constant real output • When • Ms  P  • Ms  P  • In order words, • Expansionary monetary policy ( Ms  , r  )  Inflation (P ) • Contractionarymonetary policy ( Ms , r )  Deflation (P ) • If V and Y are constant, • When MS 5%  Price level  5% • Conclusion:

  18. Explanation of inflation by the QTM • Short–term effects (Modern QTM) Assumptions • Modern economic explanation: • If Ms Real income  (in short run) • Expansion of firms • Illustration • Ms  P  • More profit  Firm expands production (i.e. Y) • Market is finally back to equilibrium level (in long run)

  19. Explanation of inflation by the QTM • Short–term effects (Modern QTM) Explanation: • Given MV = PY • where M = Money supply, V = Velocity of circulation of money, P = Price level, Y= Real income • Velocity of money is constant • In short run, Ms  PY (nominal income)  • That is, when Ms  Both P & Y   M V= (P Y)

  20. Explanation of inflation by the QTM • Short-term effects (Modern QTM) According to the equation • If V is constant, • When MS 5%  Nominal income (PY)  5% • Conclusion: MV=PY  M V= P Y %M =% PY

  21. Explanation of inflation by the QTM Conclusion • Long-term effects (Classical QTM) • V and Y are constant • Increase in Ms Increase in P • %  Ms= % P • Inflation rate = Growth rate of Ms • Inflation occurs because of the increase in money supply  M V= P Y

  22. Explanation of inflation by the QTM For calculation Long-term effects (Classical QTM) • %  Ms= % P • Question: Given that the money supply grows at a rate 5% p.a.. Base of the classical QTM, what will be the yearly inflation rate? • Answer: % Ms= % P 5% = % P  % P = 5%  Yearly inflation rate = 5%

  23. Explanation of inflation by the QTM Conclusion • Short–term effects (Modern QTM) • V is constant • Increase in Ms Increase in nominal income (PY)  Increase in P & Y • %  Ms= % P + % Y • Inflation rate < Growth rate of Ms • Inflation occurs partly because of the increase in money supply  M V= P Y

  24. Explanation of inflation by the QTM For calculation Short-term effects (Modern QTM) • %  Ms= % P + % Y • Question: Given that the money supply increase by 10% and the real income increases by 3% in the mean time. Base on the modern QTM, what will be the inflation rate? • Answer: %  Ms= % P + % Y 10% = % P + 3%  % P = 10% - 3% = 7%  Inflation rate = 7%

  25. Explanation of inflation by the QTM Points to remember: •  Ms = P • Increase in money supply leads to increase in price level • There is inflation, but • Not increase in inflation rate Question (textbook p.142): In the long run, if there is a persistent increase in money supply, the inflation rate will rise. True or false? Answer: It’s incorrect. The inflation rate will rise only when there is a persistent growth rate of the money supply. (i.e. Inflation rate = %P = %Ms)

  26. Explanation of inflation by the QTM Points to remember: • % Ms =% P = inflation • Decrease in the growth rate of money supply leads to decrease in inflation • Since there is still inflation, price level increases Question (textbook p.142): In the long run, if the growth rate of the money supply falls, the price level will fall. True or false? Answer: It’s incorrect. The price level will fall only when there is negative growth in the money supply. (i.e. Ms=P) (Growth rate of Ms ≠ Ms)

  27. Explanation of inflation by the QTM 3. Inflation is a monetary phenomenon • Classical QTM:A persistent increase in money supply causes inflation. • Explanation (Milton Friedman) • Money is a medium of exchange (for transactions purposes) • More money on hand, people will like to buy more goods,i.e. demand for goods increases • Without increase in output, price level will rise. • ConclusionThere is too much money chasing too few goods. P ($) S P1 E1 E0 P ($) P0 D1 S D0 Q (units) 0 Q0 Q1 E0 P0 D0 Q (units) 0 Q0

  28. Hyperinflation

  29. Inflation and interest rates Interest • The price of an earlier availability of goods. Nominal interest • Interest calculated in terms of money • E.g. • Mr. A borrows $100 from a bank. • He pays back $110 after a year. (Principle=$100, interest=$10) • Nominal interest = $10 • Nominal interest rate =

  30. Inflation and interest rates Real interest • Interest calculated in terms of goods (or purchasing power of money) • E.g. • Suppose a cup costs $10. • $100 (principle) can exchange for 10 cups. • If the price of a cup remains unchanged (no inflation), i.e. $10 per cup • $110 (principle + interest) can exchange for 11 cups. • Real interest = 1 cup • Real interest rate =

  31. Inflation and interest rates In reality • Loan agreement: in terms of nominal interest rates • However, real interest rates affects our purchasing power Measure in nominal interest rate • In terms of money: • Borrow = $100 • Interest = $10 • Nominal interest rate = 10% If price of cup remains unchanged, i.e. $10 per cup, • In terms of goods • Borrow = 10 cups ($100) • Interest = 1 cups • Real interest rate = 10% • Without inflation: Nominal interest rate = Real interest rate

  32. Inflation and interest rates Measure in nominal interest rate • In terms of money: • Borrow = $100 • Interest = $10 • Nominal interest rate = 10% If price of cup increases, i.e. $11 per cup, • In terms of goods • Borrow = 10 cups ($100) • Pay back = 10 cups ($110) • Interest = 0 cups • Real interest rate = 0% • With inflation, • The purchasing power of money reduces by 10% • Nominal interest rate offsets the adverse effect of inflation on purchasing power • In this case, realized real interest rate = 0%

  33. Inflation and interest rates Mr. A has $100 • Nominal interest rate = 10% • Because of inflation: Real interest rate < 10%, Yr. 2011 Price = $10/pcs Yr. 2012 Price = $12/pcs Buy now 10 pens Buy later 9 pens Repay: $1100 Loan out: $100 (Nominal interest rate=10%) B A A

  34. Inflation and interest rates Formula: Realized real interest rate = Nominal interest rate – Actual inflation rate (Note that “realized” and “actual” are used because the value are already known.) Cases: • Nominal interest rate = Actual inflation rate, Realized real interest rate = 0% • Nominal interest rate > Actual inflation rate, Realized real interest rate > 0% • Nominal interest rate <Actual inflation rate, Realized real interest rate < 0%

  35. Inflation and interest rates Question: If Peter borrow money from the bank with nominal interest rate 5%p.a. and the actual inflation rate in this year this is 3%, what is the realised real interest rate? Answer: Realized real interest rate = Nominal interest rate – Actual inflation rate = 5% - 3% = 2%

  36. Inflation and interest rates Question: Martin borrowed $50,000 from the bank a year ago. He paid back $54,000 to the bank when the loan was due. Given the inflation rate was 2% in that year. Calculate the realised real interest rate? Answer: Nominal interest = $54,000 - $50,000 = $4000 Nominal interest rate = Realized real interest rate = Nominal interest rate – Actual inflation rate = 8% - 2% = 6%

  37. The Fisher equation * Irving Fisher (1867-1947) Relationship between • nominal interest rate • real interest rate • the anticipated inflation rate (預期通脹率) Fisher equation Nominal interest rate = Real interest rate – Anticipated inflation rate • If anticipated inflation rate = 3% • To compensate lender, borrower needs to pay 3% on top of the real interest rate to lender for the loss of purchasing power • This 3% is known as inflation premium. 通脹溢價

  38. The Fisher equation * From Fisher equation Nominal interest rate = Real interest rate – Anticipated inflation rate Real interest rate = Nominal interest rate – Anticipated inflation rate Example • Nominal interest rate = 10% • Anticipated inflation rate = 4% By using Fisher equation • Real interest rate = 10% - 4% = 6% Explanation • Making a loan is “expected” to yield a real return of 6%

  39. The Fisher equation * Real interest rate in Fisher equation Real interest rate = Nominal interest rate – Anticipated inflation rate • Inflation is anticipated only. • Not accurate in reality. • Real interest rate determined before making loan. Realized real interest rate when loan is due Realized real interest rate = Nominal interest rate – Actual inflation rate • Inflation actually happened. • Actual inflation rate in reality.

  40. The Fisher equation * Real interest rate vs. Realized real interest rate Real interest rate = Nominal interest rate – Anticipated inflation rate Assume nominal interest rate = 10% If anticipated inflation rate = 3%, but actual inflation rate is 7% • Base on the anticipation, lender agrees Real interest rate = 10% - 3% = 7% • But when the loan is due, lender gets Realized real interest rate = 10% - 7% = 3% • Lender has loss of 4% purchasing power because of the inaccurate anticipation of inflation.

  41. The Fisher equation * Question: Suppose the real interest rate and the anticipated inflation rate are 8% and 10% respectively. • Find the nominal interest rate. • Suppose the actual inflation rate is 15%. Find the realized real interest rate. Answer: (a) From Fisher equation Nominal interest = Real interest rate + Anticipated inflation rate = 8% + 10% = 18% (b) Realized real interest rate = Nominal interest rate – Actual inflation rate = 18% - 15% = 3%

  42. Redistributive effects* Unanticipated inflation (非預期通脹) • A situation that Actual inflation rate > Anticipated inflation rate • Causes income of some people to be transferred to others. • Known as “redistribution effects” • Think about • Will there be the transfer of purchasing power? • Who will gain? • Who will lose?

  43. Redistributive effects* Illustration • Suppose there’s a loan agreement between two people. • Mr. A (borrower) borrows $10,000 from Mr. B (lender) • Mr. B: • Wants to get 5% (real) interest from $10,000 loan • Anticipated inflation rate = 3% From Fisher equation: • Nominal interest rate = 5% + 3% = 8% • i.e. Mr. B contracts with Mr. A $10,000 loan in return 8% nominal interest rate Case 1 • One year later when the loan is due • Actual inflation rate is 6% • Realized real interest rate = nominal interest rate – actual inflation rate = 8% - 6% = 2%

  44. Redistributive effects* Case 1: Inflation rate > Expected [i.e. Actual inflation rate (6%) > Anticipated inflation rate (3%)] • To Mr. B (lender) • Expected to get 5% real interest • Finally got 2% real interest • Lose • To Mr. A (borrower) • Expected to pay 5% real interest • Finally paid 2% real interest • Gain • Conclusion Because of unanticipated inflation • Real income transfers from lender to borrower • Redistributive effects can be found

  45. Redistributive effects* Illustration • Suppose there’s a loan agreement between two people. • Mr. A (borrower) borrows $10,000 from Mr. B (lender) • Mr. B: • Wants to get 5% (real) interest from $10,000 loan • Anticipated inflation rate = 3% From Fisher equation: • Nominal interest rate = 5% + 3% = 8% • i.e. Mr. B contracts with Mr. A $10,000 loan in return 8% nominal interest rate Case 2 • One year later when the loan is due • Actual inflation rate is 1% • Realized real interest rate = nominal interest rate – actual inflation rate = 8% - 1% = 7%

  46. Redistributive effects* Case 2: Inflation rate < Expected [i.e. Actual inflation rate (1%) < Anticipated inflation rate (3%)] • To Mr. B (lender) • Expected to get 5% real interest • Finally got 7% real interest • Gain • To Mr. A (borrower) • Expected to pay 5% real interest • Finally paid 7% real interest • Lose • Conclusion Because of unanticipated inflation • Real income transfers from borrower to lender • Redistributive effects can be found

  47. Redistributive effects* Illustration • Suppose there’s a loan agreement between two people. • Mr. A (borrower) borrows $10,000 from Mr. B (lender) • Mr. B: • Wants to get 5% (real) interest from $10,000 loan • Anticipated inflation rate = 3% From Fisher equation: • Nominal interest rate = 5% + 3% = 8% • i.e. Mr. B contracts with Mr. A $10,000 loan in return 8% nominal interest rate Case 3 • One year later when the loan is due • Actual inflation rate is 3% • Realized real interest rate = nominal interest rate – actual inflation rate = 8% - 3% = 5%

  48. Redistributive effects* Case 3: Inflation rate = Expected [i.e. Actual inflation rate (3%) = Anticipated inflation rate (3%)] • To Mr. B (lender) • Expected to get 5% real interest • Finally got 5% real interest • No gains or loses • To Mr. A (borrower) • Expected to pay 5% real interest • Finally paid 5% real interest • No gains or loses • Conclusion Because of unanticipated inflation • No real income transfers between borrower and lender • No redistributive effects

  49. Redistributive effects* Case study (p.149) • Mr. Wong gives a 1-year loan to his friend • Market interest rate = 9% per annum • Anticipated inflation rate = 3% • What is the real interest rate and the inflation premium? Real interest rate = 9% - 3% = 6% Inflation premium = anticipated inflation rate = 3% • Suppose the actual inflation rate = 1% • Inflation premium high enough to offset the loss of purchasing power? ( Yes / No ) • What is the realized real interest rate? Realized real interest rate = Nominal interest rate – Actual inflation rate = 9% - 1% = 8%, which is higher than anticipated.

  50. Redistributive effects* Conclusion: Lenders vs. Borrows • If actual inflation rate > anticipated inflation rate • Lenders lose • Borrowers gain • If actual inflation rate < anticipated inflation rate • Lenders gain • Borrowers lose • If actual inflation rate = anticipated inflation rate • No one gains or loses

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