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CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 0
Chapter 4Chapter 4
Money and InflationMoney and Inflation
CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 1
In this chapter you will learnIn this chapter you will learn
The classical theory of inflation
– causes
– effects
– social costs
What is money? How is it related toinflation?
CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 2
U.S. inflation & its trend,U.S. inflation & its trend, 19601960--20012001
0
2
4
6
8
10
12
14
16
1960 1965 1970 1975 1980 1985 1990 1995 2000
% p
e r y e a r
inflation rate
CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 3
The connection betweenThe connection betweenmoney and pricesmoney and prices
Inflation rate = the percentageincrease in the average level of prices.
price = amount of money required tobuy a good.
Because prices are defined in terms of money, we need to consider thenature of money, the supply of money,and how it is controlled.
CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 4
Money: definitionMoney: definition
MoneyMoney is the stock is the stock
of assets that can beof assets that can be
readily used to makereadily used to make
transactions.transactions.
CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 5
Money: functionsMoney: functions
1. medium of exchangewe use it to buy stuff
2. store of valuetransfers purchasing power from the present to the future
3. unit of accountthe common unit by which everyone measures prices and values
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CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 6
Money: typesMoney: types
1. fiat money
• has no intrinsic value
• example: the paper currency we use
2. commodity money
• has intrinsic value • examples: gold coins,
cigarettes in P.O.W. camps
CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 7
Money supply measures,Money supply measures, April 2002April 2002
_Symbol Assets included Amount (billions)_
C Currency $598.7
M1 C + demand deposits, 1174.0travelers’ checks,other checkable deposits
M2 M1 + small time deposits, 5480.1savings deposits,money market mutual funds,money market deposit accounts
M3 M2 + large time deposits, 8054.4repurchase agreements,institutional money marketmutual fund balances
CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 8
The money supply and the central bankThe money supply and the central bank
Monetary policy, control over the money supply,is conducted by a country’s central bank .
In the U.S.,
the central
bank is called
the Federal
Reserve
(“the Fed”).
The Federal Reserve Building
Washington, DC
CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 9
The Quantity Theory of MoneyThe Quantity Theory of Money
A simple theory linking the inflationrate to the growth rate of themoney supply.
Begins with a concept called “velocity”…
CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 10
VelocityVelocity
basic concept: the rate at which moneycirculates
definition: the number of times the averagedollar bill changes hands in a given timeperiod
example: In 2001,
• $500 billion in transactions
• money supply = $100 billion
• The average dollar is used in fivetransactions in 2001
• So, velocity = 5CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 11
Velocity,Velocity, cont.cont.
Use nominal GDP as a proxy for totaltransactions.
Then, P Y V
M
×=
where
P = price of output (GDP deflator)
Y = quantity of output (real GDP)
P ×Y = value of output (nominal GDP)
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CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 12
The quantity equationThe quantity equation
The quantity equation
M ×V = P ×Y
follows from the preceding definition of
velocity.
It is an identity: it holds by definition of the variables.
CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 13
back to the Quantity Theory of Money back to the Quantity Theory of Money
starts with quantity equation
assumes V is constant & exogenous:
=V V
With this assumption, the quantityequation can be written as
× = ×M V P Y
CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 14
The Quantity Theory of MoneyThe Quantity Theory of Money, cont., cont.
How the price level is determined:
With V constant, the money supply
determines nominal GDP (P ×Y )
Real GDP is determined by the economy’s
supplies of K and L and the production
function (chap 3)
The price level isP = (nominal GDP)/(real GDP)
× = ×M V P Y
CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 15
The Quantity Theory of MoneyThe Quantity Theory of Money, cont., cont.
Recall, the growth rate of a product equals
the sum of the growth rates.
The quantity equation in growth rates:
M V P Y
M V P Y
∆ ∆ ∆ ∆+ = +
The quantity theory of money assumes
is constant, so = 0.V V V
∆
CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 16
The Quantity Theory of MoneyThe Quantity Theory of Money, cont., cont.
Let π (Greek letter “pi”)
denote the inflation rate:
M P Y
M P Y
∆ ∆ ∆= +
P
P
∆=π
π
∆ ∆= −
M Y
M Y
The result from the
preceding slide was:
Solve this result
for π to get
CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 17
The Quantity Theory of MoneyThe Quantity Theory of Money, cont., cont.
Normal economic growth requires a
certain amount of money supply growth
to facilitate the growth in transactions.
Money growth in excess of this amount
leads to inflation.
π
∆ ∆= −
M Y
M Y
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CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 18
The Quantity Theory of MoneyThe Quantity Theory of Money, cont., cont.
π
∆ ∆= −
M Y
M Y
Hence, the Quantity Theory of Money predicts a one-for-one relation between changes in the money
growth rate and changes in the inflation rate .
CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 19
International data onInternational data oninflation and money growthinflation and money growth
Inflation rate(percent,logarithmicscale)
1,000
10,000
100
10
1
0.1
Money supply growth (percent, logarithmic scale
0.1 1 10 100 1,000 10,000
Nicaragua
Angola
Brazil
Bulgaria
Georgia
Kuwait
USA
JapanCanada
Germany
Oman
Democratic Repubof Congo
CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 20
U.S. data onU.S. data oninflation and money growthinflation and money growth
0 2 4 6
Growth in money supply (percent)
8 10 12
8
6
4
2
0
- 2
- 4
1970s
1910s
1940s
1980s
1960s1950s
1990s
1930s
1920s1870s
1890s
1880s
1900s
Inflationrate(percent)
CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 21
SeigniorageSeigniorage
To spend more without raising taxes or
selling bonds, the govt can print money.
The “revenue” raised from printing money
is called seigniorage
(pronounced SEEN-your-ige)
The inflation tax:
Printing money to raise revenue causes
inflation. Inflation is like a tax on peoplewho hold money.
CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 22
Inflation and interest ratesInflation and interest rates
Nominal interest rate, i not adjusted for inflation
Real interest rate, r adjusted for inflation:
r = i − π
CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 23
The Fisher EffectThe Fisher Effect
The Fisher equation: i = r + π
Chap 3: S = I determines r .
Hence, an increase in π
causes an equal increase in i .
This one-for-one relationship
is called the Fisher effect.
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CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 24
U.S. inflation and nominal interest rates,U.S. inflation and nominal interest rates,19521952--19981998
Percent
16
14
12
10
86
4
2
0
-2
Nominal interest rate
Inflationrate
1950 1955 1960 1965 1970
Year
1975 1980 1985 1990 20001995
CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 25
Two real interest ratesTwo real interest rates
π = actual inflation rate
(not known until after it has occurred)
πe = expected inflation rate
i – πe = ex ante real interest rate:
what people expect at the time they buy abond or take out a loan
i – π = ex post real interest rate:what people actually end up earning on theirbond or paying on their loan
CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 26
Money demand andMoney demand andthe nominal interest ratethe nominal interest rate
The Quantity Theory of Money assumes thatthe demand for real money balancesdepends only on real income Y .
We now consider another determinant of money demand: the nominal interest rate.
The nominal interest rate i is theopportunity cost of holding money (insteadof bonds or other interest-earning assets).
Hence, ↑i ⇒ ↓ in money demand.
CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 27
The money demand functionThe money demand function
(M / P )d = real money demand, depends
negatively on i
i is the opp. cost of holding money
positively on Y
higher Y ⇒ more spending
⇒ so, need more money
(L is used for the money demand functionbecause money is the most liquid asset.)
( ) ( , )dM P L i Y =
CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 28
The money demand functionThe money demand function
When people are deciding whether to hold
money or bonds, they don’t know what
inflation will turn out to be.
Hence, the nominal interest rate relevant
for money demand is r + πe.
( ) ( , )dM P L i Y =
( , )e L r Y += π
CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 29
EquilibriumEquilibrium
( , )e M L r Y P
= + π
The supply of real
money balances Real money
demand
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CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 30
What determines what What determines what
variable how determined (in the long run)
M exogenous (the Fed)
r adjusts to make S = I
Y
( , )e M
L r Y P
= + π
( , )Y F K L =
P adjusts to make ( , )M
L i Y P
=
CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 31
HowHow P P responds toresponds to ∆M M
For given values of r , Y , and πe,
a change in M causes P to change bythe same percentage --- just like in the
Quantity Theory of Money.
( , )e M
L r Y P
= + π
CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 32
What about What about expected inflationexpected inflation? ?
Over the long run, people don’t consistently
over- or under-forecast inflation,
so πe = π on average.
In the short run, πe may change when people
get new information.
EX: Suppose Fed announces it will increase
M next year. People will expect next year’s P
to be higher, so πe rises.
This will affect P now, even though M hasn’tchanged yet.
(continued…)
CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 33
Why is inflation bad?Why is inflation bad?
Common misperception:inflation reduces real wages
This is true only in the short run, whennominal wages are fixed by contracts.
(Chap 3) In the long run,the real wage is determined by labor supplyand the marginal product of labor,not the price level or inflation rate .
Consider the data…
CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 34
Average hourly earnings & the CPIAverage hourly earnings & the CPI
0
2
4
6
8
10
12
14
16
18
1964 1968 1972 1976 1980 1984 1988 1992 1996 2000
$ p e r h o u r
0
25
50
75
100
125
150
175
200
225
250
C P I ( 1 9 8 3 = 1 0 0 )
Average
hourly
earnings
Hourly earningsin 2001 dollars
Consumer
Price Index
0
2
4
6
8
10
12
14
16
18
1964 1968 1972 1976 1980 1984 1988 1992 1996 2000
$ p e r h o u r
0
25
50
75
100
125
150
175
200
225
250
C P I ( 1 9 8 3 = 1 0 0 )
Average
hourly
earnings
Hourly earningsin 2001 dollars
Consumer
Price Index
CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 35
The social costs of inflationThe social costs of inflation
…fall into two categories:
1. costs when inflation is expected
2. additional costs when inflation isdifferent than people had expected.
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CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 36
The costs of expected inflation:The costs of expected inflation:11.. shoeleathershoeleather costcost
def: the inconvenience of reducing moneybalances to avoid the inflation tax.
↑π ⇒ ↑i ⇒ ↓ real money balances
Remember: In long run, inflation doesn’t
affect real income or real spending.
So, same monthly spending but lower averagemoney holdings means more frequent trips tothe bank.
CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 37
The costs of expected inflation:The costs of expected inflation:22.. menu costsmenu costs
def: The costs of changing prices.
Examples:
– print new menus
– print & mail new catalogs
The higher is inflation, the more frequentlyfirms must change their prices and incurthese costs.
CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 38
The costs of expected inflation:The costs of expected inflation:33.. relative price distortionsrelative price distortions
Firms facing menu costs change pricesinfrequently.
Different firms change their prices atdifferent times, leading to relative pricedistortions…
…which cause microeconomicinefficiencies in the allocation of
resources.
CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 39
The costs of expected inflation:The costs of expected inflation:44.. unfair tax treatmentunfair tax treatment
Some taxes are not adjusted to account forinflation, such as the capital gains tax.
Example: 1/2001: you bought $10,000 worth of
Starbucks stock 12/2001: you sold the stock for $11,000, so
your nominal capital gain was $1000 (10%). Suppose π = 10% in 2001. Real capital gain is $0. But the govt. requires you to pay taxes on your
$1000 nominal gain!!
CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 40
The costs of expected inflation:The costs of expected inflation:55.. General inconvenienceGeneral inconvenience
Inflation makes it harder to comparenominal values from different time periods.
This complicates long-range financialplanning.
CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 41
Additional cost of Additional cost of unexpected unexpected inflation:inflation:
arbitrary redistributions of purchasing power arbitrary redistributions of purchasing power
Many long-term contracts not indexed,but based on πe .
If π turns out different from πe ,
then some gain at others’ expense.
Example: borrowers & lenders
• If π > πe , then purchasing power is
transferred from lenders to borrowers.
• If π < πe , then purchasing power is
transferred from borrowers to lenders.
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CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 42
Additional cost of high inflation:Additional cost of high inflation:increased uncertaintyincreased uncertainty
When inflation is high, it’s more variableand unpredictable:
π turns out different from πe more often,
and the differences tend to be larger(though not systematically positive or negative)
Arbitrary redistributions of wealthbecome more likely.
This creates higher uncertainty, whichmakes risk averse people worse off.
CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 43
One benefit of inflationOne benefit of inflation
Inflation allows equilibrium real wages to
fall without nominal wage cuts.
Therefore, moderate inflation improves
the functioning of labor markets.
Inflation allows equilibrium real wages toInflation allows equilibrium real wages to
fall without nominal wage cuts.fall without nominal wage cuts.
Therefore, moderate inflation improvesTherefore, moderate inflation improves
the functioning of labor markets.the functioning of labor markets.
CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 44
HyperinflationHyperinflation
def: π ≥ 50% per month
All the costs of moderate inflation described
above become HUGE under hyperinflation.
Money ceases to function as a store of value.
People may conduct transactions with barteror a stable foreign currency.
CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 45
What causes hyperinflation?What causes hyperinflation?
Hyperinflation is caused by excessivemoney supply growth:
When the central bank prints money, theprice level rises.
If it prints money rapidly enough, theresult is hyperinflation.
1
10
100
1000
10000
p e r c e n t g r o w t h
Israel
1983-85
Poland
1989-90
Brazil
1987-94
Argentina
1988-90
Peru
1988-90
Nicaragua
1987-91
Bolivia
1984-85
inflation growth of money supply
Recent episodes of hyperinflationRecent episodes of hyperinflation
slide 46 CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 47
Why governments create hyperinflationWhy governments create hyperinflation
When a government cannot raise taxes orsell bonds,
it must finance spending increases byprinting money.
In theory, the solution to hyperinflation issimple: stop printing money.
In the real world, this requires drastic andpainful fiscal restraint.
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CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 48
The Classical DichotomyThe Classical Dichotomy
Classical Dichotomy : the theoreticalseparation of real and nominal variablesin the classical model, which impliesnominal variables do not affect real
variables. Neutrality of Money : Changes in the
money supply do not affect realvariables. In the real world, money isapproximately neutral in the long run.