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Chapter 4: Money and Inflation. Functions of Money. Medium of Exchange Store of Value Unit of Account Standard of Deferred Payment. Types of Money. Commodity money : a commodity with some intrinsic value used as a medium of exchange (e.g., cigarettes in POW camps)

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Presentation Transcript
functions of money
Functions of Money
  • Medium of Exchange
  • Store of Value
  • Unit of Account
  • Standard of Deferred Payment
types of money
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)
characteristics of money
Characteristics of Money
  • Limited in supply
  • Widely accepted
  • Portable
  • Divisible
  • Uniform
  • Durable
money supply
Money Supply
  • M1
    • Currency: coins & bills (25%)
    • Demand Deposits: checking account deposits (75%)
  • M2
    • M1
    • Time Deposits: savings account deposits less than $100,000
money supply1
Money Supply
  • M3
    • M2
    • Time Deposits: savings account deposits more than $100,000
  • L
    • M3
    • Liquid assets (e.g., T-Bills)
the measures of money
The Measures of Money
  • C $434 billion in April 1998
  • M1 $1,081
  • M2 $4,165
  • M3 $5,574
  • L $6,826
money supply line
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

money demand
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
money demand line
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

money market equilibrium
Money Market Equilibrium

Interest Rate (%)

(M/P)s

5

(M/P)d

80

Quantity of Money

federal reserve system fed
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
tools of monetary policy
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
tools of monetary policy1
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
tools of monetary policy2
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
expansionary monetary policy
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
expansionary monetary policy1
Expansionary Monetary Policy

Interest Rate (%)

(M1/P)s

(M2/P)s

5

4

(M/P)d

85

80

Quantity of Money

quantity theory of money
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
income velocity of money
(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
money supply growth inflation
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%
inflation
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
inflationary trend
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
money and inflation
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
sources of gov t revenues
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
fisher effect
Fisher Effect
  • Define
    • i = nominal rate of interest
    • r = real rate of interest
    • π = inflation rate

i = r + π

r = i - π

money inflation interest rate
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
real interest rate
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)
revised fisher effect
Revised Fisher Effect
  • Define
    • i = nominal rate of interest
    • r = real rate of interest
    • π* = expected inflation rate

i = r + π*

r = i – π*

revised demand for money
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 (+)
linkage among money prices and interest rates
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
linkage among money prices and interest rates1
Linkage Among Money, Prices, and Interest Rates

Money

Supply

Price

Level

Inflation

Rate

Nominal

Interest

Rate

Money

Demand

cost of expected inflation
Cost of Expected Inflation
  • Inflation Tax
  • Menu Cost
  • Inefficiency due to inflation variability
  • Increase in tax liability
  • Consumer inconvenience
cost of unexpected inflation
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
hyperinflation
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