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Money and Inflation
Money Demand
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Price Indices: P t Two most commonly used price indices
are GDP Deflator and Consumer PriceIndex (CPI)
The CPI is the price of a representative
market basket of goods relative to theprice of that same basket during abenchmark/base year (multiplied by 100).
The GDP deflator is the ratio of nominalGDP to Real GDP (multiplied by 100). Nominal GDP GDP
P GDP Deflator Real GDP Y
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Hong Kong CPI vs. GDP Deflator
0
20
40
60
80
100
120
1 9 7 5
1 9 7 7
1 9 7 9
1 9 8 1
1 9 8 3
1 9 8 5
1 9 8 7
1 9 8 9
1 9 9 1
1 9 9 3
1 9 9 5
1 9 9 7
1 9 9 9
2 0 0 1
2 0 0 3
CPI
GDP Deflator
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CPI vs. GDP Deflator CPI is calculated monthly, GDP deflator is
calculated quarterly. CPI measures the price of consumer goods.
GDP deflator measures the price of all goodsproduced including investment or governmentgoods.
CPI measures the change in price of a constantmarket basket. Market basket of GDP deflatorchanges as goods produced changes.
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The Data
Data on money supply is inevitablymeasured by the central bank and usuallythe data is available for free.
Example: Hong Kong Monetary Authority Data on
Listing of Central Bank Websites .
http://dir.yahoo.com/Business_and_Economy/Finance_and_Investment/Banking/Central_Banking/Central_Banks/http://dir.yahoo.com/Business_and_Economy/Finance_and_Investment/Banking/Central_Banking/Central_Banks/8/12/2019 Money, Money Growth, And Inflation
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What is a central bank? Central banks have two main roles:
Banker to the government Manage many financial assets of the government. Monopoly on the issue of banknotes/currency (true
almost everywhere, but not HK) Arm of government policymaking
Banker to commercial banks. Operate the Payment System Regulate Banking System Lender of Last Resort during a crisis
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Central Bank : A special
governmentalorganization orquasi-governmentalinstitution within
the financialsystem thatcontrols themedium ofexchange.
Economy Central BankHK Hong Kong
Monetary AuthorityUSA Federal Reserve
EU EuropeanCentral Bank
PRC People
s Bank ofChina
UK,Canada,Japan,Korea
Bank of .
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Readings
Money Demand Branson, Chapter 14, especially p.335-339 Sachs Chapter 8
Inflation
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Money
Financial Asset Used inTransactions
Legal Tender: Governmentaccepts money as payment fortaxes and a transfer of money as asettlement for a contract.
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Characteristics of Money
1. Medium of Exchange Token that can be offeredas a payment for goods.
2.Unit of Account All goods will have a value inmoney and, thus, can be used to measure allgoods
3.Store of Value If money is to be accepted forgoods today it must have durable value. (Money isan Asset).
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Two categories of money
1. Definitive Money (sometimes known asmonetary base): Money that can be usedimmediately for transactions without
conversion to more basic forms of money. Currency+ Reserve accounts
2. Broad Money: A set of assets, typically
some form of bank deposit, which can beeasily converted to definitive money. Checking Accounts, Savings Accounts, Liquid
Time Deposits and CDs
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Categoriesof BroadMoney
M1
M2
M3
M1 Currency+ Checking Acct.
M2 +Savings Acct.+
More Liquid
Time Deposit
M3 +
Less Liquid
Time Deposit
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China
-0.05
0
0.05
0.1
0.15
0.2
0.25
0.3
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Inflation Money
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Velocity
0.45
0.5
0.55
0.6
0.65
0.7
0.75
0.8
0.85
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
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Mpney Types in HK
M1
M2
M3
Incremental M3 is trivial in HK
http://www.info.gov.hk/hkma/gdbook/eng/m/money_supply_index.htmhttp://www.info.gov.hk/hkma/gdbook/eng/m/money_supply_index.htmhttp://www.info.gov.hk/hkma/gdbook/eng/m/money_supply_index.htm8/12/2019 Money, Money Growth, And Inflation
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HK$ Money CategoriesSource: HKMA http://www.info.gov.hk
Legaltender notes
and coinsin hands
of public
Demanddeposits
withlicensed
banks M1
145,852 207,444 353,297
Savingsdeposits
withlicensed banks
Timedeposits
withlicensed banks
NCDsissued by
licensed
banksand held by public M2
788,211 1,288,193 76,342 2,506,043
http://www.info.gov.hk/http://www.info.gov.hk/8/12/2019 Money, Money Growth, And Inflation
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Broad Money vs. Narrow Money
Broad money has grown much faster thannarrow money.
Narrow money is money directly controlledby the government.
Broad money includes money printed by the
government plus deposits at banks. Money multiplier is ratio of broad money tonarrow money.
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Categories
M0 = R eserves + Cash M2 = C ash + Demand Deposits + Savings
Deposits
11
C D S MM R C
C S D D
R C
D D
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Determinant of the Multiplier.
The greater is the currency-deposit ratio thesmaller is the multiplier.
The greater is the savings to demanddeposit ratio the greater is the multiplier.
The higher is the fraction of deposits kepton reserve, the smaller is the multiplier.
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Money Multiplier in China
0
4000
8000
12000
16000
20000
24000
4
6
8
10
12
14
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
MULTIPLIER M2 M0
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Monetary Theory
Two Assets Money (M) can be used for transactions but
pays no interest.
Bonds (B) will pay a nominal interest rate of ibut cannot be used for transactions.
If you buy a bond with $1, you will get $(1+i)
from the issuer of the bond.
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Liquidity Problem
The household earns an income equal to (PQ)which they will spend evenly over the course of amonth.
If they keep their whole income in their back-pocket to do shopping they will lose interestincome.
If they buy interest earning bonds with all of theirincome, they will have to make many costly tripsto the bank when they want to buy goods. Thecost of each trip to the bank will be P b.
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Liquidity Strategy
Household strategy will be to keep ashare of their income in the form of
money, M*, and put the rest into bonds.
They will spend that money until it is
gone, return to the bank, and convertbonds into M * again.
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Choose # of trips to the bank.
The household will have to maketrips to the bank.
The average balances held by thehousehold will be
*
P Y M
*
2
M
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Money holdings over the month
time
Money
M*
*
2
M
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Bond holdings over the month
time
Bonds
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Costs of Strategy
If the household is on average holdingthey will forego the opportunity to earninterest equal to
The total transactions costs of convertingtheir bonds into cash is
*
2
M
*
2 M i
*
P Y P b
M
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Minimize Total Costs
Total liquidity costs of holding M *
Choose the number of trips that wouldminimize the total costs (including interestcosts).
*
* 2 P Y M P b i M
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Cost Minimization
Trade-off: The more trips you make, themore interest you will earn but the less willbe the transactions cost. Choosing the number of trips is equivalent to
choosing M *
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Optimal Money Demand
Money demand is an increasing function of theprice level, and output and a decreasingfunction of interest rates.
1
2
*
***
*2
*
*
min ( ) 2
2' 0
2
2
M P Y M TC M P b i M
P Y i bY TC P b M P
i M
M bY
P i
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Money Demand
Intuition: The greater is P and Y, the greaterare the need for money for transactions. Thegreater is i, the greater the interest ratecosts.
Money Demand is typically represented in
terms of money divided by the price level,referred to as real balances. M
P
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Money Demand Curve
i
M
P
Y
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Velocity
Velocity is defined as the speed at whichmoney circulates or as the number oftransactions that each unit of money isused in per period.
Velocity is measured as the ratio of currentdollar GDP to the money supply.
t t t
t t
t
PY Y V
M M
P
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BT Theory and Velocity According to Baumol-Tobin theory, money
velocity should grow with output. Asian experience suggests the opposite. Possible reason: If b represents the costs
of goods that could have been produced inthe absence of a trip to the bank, b would
likely grow with productivity.
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Long Run
Demand for real balances a proportionalfunction of GDP as well as a function ofinterest rates.
The higher is the interest rate, the more willingthe household is to incur the costs of not
holding cash.
1( ) .t t t t t t t t
M M Y f i ex v Y
i P P
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Empirical Studies of MoneyDemand
The Baumol Tobin model suggests a log-linear form.
0 1 2
0 1 2
ln ln ln
ln
t t t
t
t t
M a a Y a i
P
m a a y a i
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Empirical Studies of MoneyDemand
The Baumol Tobin model suggests a log-linearform.
Empirical reality suggests that this does notcapture short-term endogeneity between money,interest rates, and output.
0 1 2
0 1 2
ln ln ln
ln
t t t
t
t t
M a a Y a i
P m a a y a i
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Inflation
We are concerned with explaining the rateof change of the price level or the inflationrate
First difference the log of the moneydemand function
1
1ln
t t t t
t
P P P P P P
log log logt t t t M Y it t t t
M Y i
g g g
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Money Growth and the NominalInterest Rate
Define the real interest rate, as the amountof extra goods that can be gained, if yougive up 1 good today.
11
11
111 1
1
1
t
t
t t t t P
t P
t t t t
t
ir i P
P
ir i
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Long Run Inflation Rate
Assume that there is a long run inflationrate and real variables are unaffected byinflation in the long run.
ln i = 0
Then long run inflation is money growthminus output growth.
M Y g g
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Neo-classical Dichotomy
Assume given Y and r which is not affected bymoney supply or growth rate. Money is just paper which should not affect real
outcomes. Then, in the long run, we can solve for the
price level as a function of the level of moneyand output and their growth rates (in additionto the real interest rate).
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Price Level
Then, in the long run, we can solve for theprice level as a function of the level ofmoney and output and their growth rates(in addition to the real interest rate).
1 M Y M
P r g g v Y
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Socially Optimal Inflation Rate
Friedman Rule: Socially optimal inflation ratesets the interest rate equal to zero.
If the interest rate were zero, workers inBaumol and Tobin model would keep all oftheir pay in cash and not have to make any
costly trips to the bank. Set money growth g M = r - g Y
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Zero Lower Bound
Friedman rule interest rate is also theoreticallower bound on the interest rate.
Nominal interest rates on bonds cannot gobelow 0 because there is a freely available assetthat always pays an interest rate at least equal tozero.
Main objection to Friedman rule is that if we havea long run zero interest rate, the central bank willnever be in a position to reduce interest rates.
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ZIRP: Japan
Jul-1985 Jul-1988 Jul-1991 Jul-1994 Jul-1997 Jul-2000 Jul-2003 Jul-2006
10
9
8
7
6
5
4
3
2
1
0
JP: Call Rate: Uncollaterized: Overnight% pa
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Why inflation?
If zero or negative inflation is sociallyoptimal, why is it so pervasive.
Possible reason (especially in developingworld): It is a source of governmentrevenue (called seignorage ).
When the government prints new currency,it can use the money to pay off its old debtsor buy new goods.
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Real Seignorage
Amount of goods purchased by the printingof money
The higher is the money growth rate, the
higher is the fraction of real balances thatcan be collected through seignorage.
1 1 1
1 1
M t t t t t t
M t t t t
M M M M M M g M P M M P g P
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Substitution Effect
Higher money growth reduces demand forreal balances. Higher inflation will meanhigher interest rates, which will mean thatpeople will spend money more quickly whichdrives up prices at a given output level.
Assume r = g Y, i=gM
11 1 1
M M M M
M M M
g g M g g Y Y
g P g g
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Inflation Tax
% of Y
g M
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How does declining money demandreduce the seignorage revenue?
Consumers facing high inflation and thushigh interest rates, want to hold relatively low
money balances and are willing to makemore trips to the bank.
With a given amount of money chasing a
given amount of output more quickly, priceswill be higher and the amount that any newlyprinted dollar will buy will be reduced.
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Hyper Inflation
Hyperinflation occurs when inflation increases ata rate of 50% or more per month. In the long run, this rate of inflation is counter-
productive to the government in terms of raisingseignorage.
Usually, a sign of a government trying tomaximize short-term revenue by acceleratingmoney growth faster than inflationaryexpectations. Prices in China rose 250000% in Chungking from
1937-1945.
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Current Chinese Inflation Rates
Between 1984 and 1996, China frequentlyhad very high inflation rates, reaching to
levels of 20% or more per year. Since then inflation has been steady or
decreasing.
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Chinese CPI and Broad Money
150
200
250
300
350
400
0
5000
10000
15000
20000
25000
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
CPICHINA M2
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Velocity in China
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
5
1 9 7 9
1 9 8 1
1 9 8 3
1 9 8 5
1 9 8 7
1 9 8 9
1 9 9 1
1 9 9 3
1 9 9 5
1 9 9 7
1 9 9 9
2 0 0 1
2 0 0 3
M1 Velocity
M2 Velocity
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Deposits are major channel forsaving in PRC
Bank Deposits as Share of GDP
0.0%
20.0%
40.0%60.0%
80.0%
100.0%
120.0%
140.0%
160.0%
180.0%
200.0%
China USA
M & I fl ti 1975 1994
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Money & Inflation: 1975-1994
Inflation & Money OECD Countries
0
0.02
0.04
0.06
0.08
0.1
0.12
0.14
0.16
0.18
0.2
0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18
Average Money Growth
A v e r a g e
I n f l a t i o
n R a
t e
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Causes of Extremely Rapid Inflation
Government generates revenues by printingnew money (referred to as seignorage).
Government facing borrowing constraintsmay be forced to rely on inflation tax fordeficit financing.
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Israel 1970-1990Inflation
0
50
100
150
200
250
300
350
400
1 9 7 0
1 9 7 1
1 9 7 2
1 9 7 3
1 9 7 4
1 9 7 5
1 9 7 6
1 9 7 7
1 9 7 8
1 9 7 9
1 9 8 0
1 9 8 1
1 9 8 2
1 9 8 3
1 9 8 4
1 9 8 5
1 9 8 6
1 9 8 7
1 9 8 8
1 9 8 9
1 9 9 0
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Israel 1970-1990Surplus (% of GDP)
-30.00%
-25.00%
-20.00%
-15.00%
-10.00%
-5.00%
0.00%
5.00%
1 9 7 0
1 9 7 1
1 9 7 2
1 9 7 3
1 9 7 4
1 9 7 5
1 9 7 6
1 9 7 7
1 9 7 8
1 9 7 9
1 9 8 0
1 9 8 1
1 9 8 2
1 9 8 3
1 9 8 4
1 9 8 5
1 9 8 6
1 9 8 7
1 9 8 8
1 9 8 9
1 9 9 0
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Hyperinflation
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Mid-term Exam III
Monday, December 13 th 4:30-7:30PM Lecture Theater A Semi-open Book (Bring 1 A4 size paper
with handwritten notes)) also calculatorand writing instruments.
Coverage. Lecture notes including thisone.
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Lecture Theater A, 4:30-7:30