Sanja Samirana PattnayakIIM Trichy

Money and Inflation

What is money?A financial asset that is universally accepted as a means of payment in transactions and settlement of debt.

It represents general purchasing power in the most liquid form in the sense that it does not need to be converted to anything else before it can be used for transaction.

So most important function of money is to act as a means of payment.

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Function of MoneyIt serves as a store of value (wealth can be held in the form of money for the future use).unit of account (values goods and services are expressed in units of money) and a medium of exchange (exchange for goods and services)

The ease with which money is converted into other things such as goods and services-is sometimes called moneys liquidity.*

Increases EfficiencyMoney is the yardstick with which we measure economic transactions. Without it, we would be forced to barter.

However, barter requires the double coincidence of wantsthe unlikely situation of two people, each having a good that the other wants at the right time and place to make an exchange.

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Components of Monetary Aggregate1. Currency: consists of coins and notes in circulation

2. Demand deposits: Non-interest bearing checking accounts at commercial banks. They are payable on demand through cheques. All other deposits have fixed term of maturity and cannot be withdrawn on demand.

3. Travelers checks: Travelers checks issued by banks are included in demand deposits. They are called time deposits.*

Components of Monetary AggregateM1= 1+2+3+other checkable deposits

5. Money market mutual fund shares: Interest-earning checkable deposits in mutual funds that invest in short-term assets. Some money market mutual fund shares held by institutions; these are excluded from M2.

6. savings deposits7. small time depositsM2=M1+5+6+7*

Components of Monetary AggregateM3=M2+net time deposits of banksM4=M3+total deposits with post office savings organizations

M1 is called narrow money and M3 is known as broad money or aggregate monetary resources. M2 and M4 have been devised to accommodate post office deposits.

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Measures of Money supply in IndiaM1=C+DC= currency (coins plus notes) held by the public and D= demand deposits of the public in the banks

M2= M1+savings deposits with post office savings banks

M3= M1+ net time deposits of banks

M4= M3+ total deposits with post office savings organizations*

Quantity Theory of MoneyNeed to know how the qty. of money affects economy.

We need to know a theory that explains the relationship among qty. of money and other economic variables such as prices and income.

People hold money to buy goods and services. The more money they need for any such transactions implies that the more money they hold.

Qty. of money in the economy is related to the number of currency units exchanged in transactions.

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Quantity Theory of MoneyTransaction and quantity equation: The link between transactions and money is expressed in the following equation.MV = PT

Thus the quantity equation is the money supply (M) times the velocity of money (V) which equals price (P) times the number of transactions (T):

M is the quantity of moneyV in the above equation is called the transaction velocity of money and measure the rate at which money circulates in the economy.P is the price of transaction

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Quantity Theory of MoneyLeft hand side tells us about the money used to make the transactions.The right hand side tells us about transaction

Example: Lets say 60 loaves of bread are sold in a given year at $0.50 per loaf.

Then T equals to 60 loaves per year and P equals to $0.50 per loaf. The total number of dollar exchanged is

PT = $0.50/loaf multiplied by 60loaves/year = $30/year*

Quantity Theory of MoneyThe right hand side of the quantity equation equals $30 per year, which is the dollar value of all transactions.

Suppose further that the quantity of money in the economy is $10. By rearranging the equation, we can compute the velocity as follows:V = PT/M($30/year)/($10)= 3 timesIt implies that for $30 transactions per year to take place with $10 of money , each dollar must change hands 3 times*

Quantity Theory of MoneyMore generally:Velocity of money is usually measured as a ratio of GDP to a country's total supply of money.

For example, if GDP is $1000 billion (PY = $1000 billion) and quantity of money is $250 billion, then V = 4.This helps investors gauge how robust the economy is, and is a key input in the determination of an economy's inflation calculation.

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Quantity Theory of MoneyThe problem with the quantity equation is that the number of transactions are difficult to measure.

So this problem is solved by replacing T with Y which is the total output of the economy.

Transactions and output are related, because the more the economy produces, the more goods are bought and sold.

If Y denotes the amount of output and P denotes the price of one unit of output, then the money value of output is PY.

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Quantity Theory of MoneyMoney Velocity = Price Output

MV =PY

V in this version of the quantity equation is called the income velocity of money, which tells us the number of times a currency note (rupee or dollar) enters someones income in a given time period.

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The money demand function and quantity equationWhen we talk about how money affects the economy, it is often useful to express the quantity of money in terms of the quantity of goods and services it can buy.

Lets now express the quantity of money in terms of the quantity of goods and services it can buy.

This amount, M/P is called real money balances. Real money balances measure the purchasing power of the stock of money.

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The money demand function and quantity equationExample: lets say an economy produces only good X. If the Qty. of money is $10 and price of X is $0.50 then real money balances are M/P = 20

A money demand function is an equation that shows the determinants of real money balances people wish to hold. A simple money demand equation is given below(M/P)d = k Y

where k is a constant that tells us how much money people want to hold for every unit of currency they earn.

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The money demand function and quantity equationThis equation states that the quantity of real money balances demanded is proportional to real income.

The money demand function is like the demand function for a particular good.

Here the good is the convenience of holding real money balances.

Higher income leads to a greater demand for real money balances.*

The money demand function and quantity equationThe money demand equation offers another way to view the quantity equation (MV= PY) where V = 1/k.

This shows the link between the demand for money and the velocity of money.

When people hold a lot of money for each dollar of income (k is large), money changes hands infrequently (V is small).

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The money demand function and quantity equationConversely, when people want to hold only a little money (k is small), money changes hands frequently (V is large).

In other words, the money demand parameter k and the velocity of money V are opposite sides of the same coin (inversely related).

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Assumption of constant velocityThe quantity equation can be viewed as a definition:

It defines velocity V as the ratio of nominal GDP, PY, to the quantity of money M.

As with many assumptions in economics, the assumption of constant velocity is an approximations to reality.

Velocity does change if the money demand function changesFor example, when ATM machines were introduced, people could reduce their average money holdings which meant a fall in K and increase in V. *

Assumption of constant velocityBut experience shows that the assumption of constant velocity is useful one in many situations.

But, if we make the assumption that the velocity of money is constant, then the quantity equation MV = PY becomes a useful theory of the effects of money.

Therefore, a change in the quantity of money (M) must cause a proportionate change in nominal GDP (PY). That is if V is fixed, then quantity of money (M) determines the dollar value of the economys output.

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Money prices and InflationThree building blocks that determine the economys overall level of prices:

The factors of production and the production function determine the level of output Y.

The money supply determines the nominal value of output, PY.

This follows from the quantity equation and the assumption that the velocity of money is fixed.

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Money prices and InflationThe price level P is then the ratio of the nominal value of output, PY, to the level of output Y.

In other words, if Y is fixed because it depends on the growth in the factors of production and on technological progress, and we just made the assumption that velocity is constant,

if V is fixed and Y is fixed, then it reveals that % Change in M is what induces % Changes in P.

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Money prices and InflationThe quantity theory of money states that the central bank, which controls the money supply, has the ultimate control over the inflation rate.

If the central bank keeps the money supply stable, the price level will be stable.

If the central bank increases the money supply rapidly, the price level will rise rapidly.

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Inflation and interest rateReal and Nominal Interest Rates:

Economists call the interest rate that the bank pays the NOMINAL Interest Rate.

And the increase in your purchasing power the REAL interest rate.

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Inflation and interest rater = i - This shows the relationship between the Nominal interest rate and rate of inflation.

where r is real interest rate, i is the nominal interest rate and p is the rate of inflation

p is simply the percentage change of the price level P*

The Fisher EquationThe Fisher Equation illuminates the distinction between the real and nominal rate of interest.

The one-to-one relationship between the inflation rate and the nominal interest rate is the Fisher effect.i is actual (nominal) interest rate.r is real rate of interestp is inflation

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The Fisher EffectIt shows that the nominal interest can change for two reasons:

because the real interest rate changes or because the inflation rate changes.

In our earlier lecture we know that real interest rate adjusts to equilibrate savings and investment.

Fisher equation tells us to add the real interest rate and the inflation together to determine nominal interest rate.

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Ex-Ante versus Ex-Post interest rateInflation rate is unknown over the term of the loan when borrower and lender agree on a nominal interest rate.

The real interest rate the borrower and lender expect when a loan is made is called the ex- ante real interest rate.

The real interest rate that is actually realized is called the ex- post real interest rate.

Although borrowers and lenders cannot predict future inflation with certainty, they do have some expectation of the inflation rate.

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Ex-Ante versus Ex-Post interest rateLet p denote actual future inflation and pe the expectation of future inflation.

The ex ante real interest rate is i - pe, and the ex post real interest rate is i - p.

The two interest rates differ when actual inflation p differs from expected inflation pe.

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Ex-Ante versus Ex-Post interest rate

Clearly the nominal interest rate cannot adjust to actual inflation, because actual inflation is not known when the nominal interest rate is set.

The nominal interest rate can adjust only to expected inflation.

So we can re write the Fisher effect more precisely as:Nominal interest rate = ex-ante real int. rate + expected inflation*

The cost of Holding moneyWhy do household hold money?

Mere holding money does not yield any return.

So instead of holding money if you deposit in a savings account or buy bonds then you would earn nominal interest rate.

The nominal interest rate is the opportunity cost of holding money: it is what you give up by holding money instead of bonds.

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The cost of Holding moneyThe quantity theory (MV = PY) is based on a simple money demand function:

it assumes that the demand for real money balances is proportional to income.

But, we need another determinant of the quantity of money demandedthe nominal interest rate.

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The cost of Holding moneySo, the new general money demand function can be written as: (M/P)d = L(i, Y)

This equation states that the demand for the liquidity of real money balances is a function of income (Y) and the nominal interest rate (i).L is used to denote money demand since it is the most liquid asset in the economy.The higher the level of income Y, the greater the demand for real money balances.

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The cost of expected inflationDistortion of the inflation tax on the amount of money people hold.

We know a higher inflation rate causes higher nominal interest rate and that in turn causes lower real money balance.

If people hold lower real money balances on average, they have to make frequent trips to banks to withdraw money.Example: they might withdraw $50 twice a week rather than $100 once a week*

Cost of expected inflationThe inconvenience of reducing money holding is metaphorically called the shoe-leather cost of inflation, because walking to the bank more often induces ones shoes to wear out more quickly.

When changes in inflation require printing and distributing new pricing information by the businesses/firms, then, these costs are called menu costs.Another cost is related to tax laws. Often tax laws do not take into consideration inflationary effects on income.

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Cost of expected inflationInflation can alter individuals tax liability.

Example: failure of the tax code in dealing with the issue of capital gains. Suppose you buy some stock today and sell it a year from now at the same real price.

It would seem reasonable for the government not to levy a tax, because you have not earned any real gain/income from this investment.With zero inflation, a zero tax liability would be the outcome.*

Cost of expected inflationBut suppose the inflation rate is 12% and you initially paid $100 per share for the stock, for the real price to be same a year later, you must sell for $112 per share.

In this case the tax code which ignores the effect of inflation, tax you on that extra income of $12 which is not really a capital gain.

In the above example and many such others, inflation distorts how taxes are levied.*

Cost of unexpected inflationUnanticipated inflation is unfavorable because it arbitrarily redistributes wealth among individuals.

Example: Most of the loan agreements are made based on the expected inflation. If it turns out differently from what was expected, then ex-post real return that the debtor pays to the creditor differs.

Case1: if inflation turns out to be higher than expected, the debtor wins and creditor loses because the debtor repays loan with less valuable dollar.

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Cost of unexpected inflationCase2: If inflation turns out to be lower than expected then converse happens.

Example: A person taking out a mortgage in 1970. At that time a 30 year mortgage had an interest rate of about 6 percent per year. This rate was based on a low rate of expected inflation- inflation over the previous decade had average only 2.5 percent.

The creditor expected to receive a real return of about 3,5 percent and a debtor is expected to pay that real return.*

Cost of unexpected inflationIn fact, over the life of the mortgage, the inflation rate averaged 5 percent, as a result ex-post real return was only 1 percent. This unanticipated inflation benefited the debtor.

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Inflation in IndiaIn an inflationary situation, the general trend of prices is upwards.

This is statistically captured by the persistent upward movement of some aggregate price index, usually, WPI, CPI, or GDP deflator.

When inflation is measured by some index that uses all prices (usually WPI) it is called headline inflation.*

Inflation in IndiaPrices of food and fuel items are considered to be particularly vulnerable to sectoral supply shocks and hence more volatile on average than rest.

Core inflation is obtained by subtracting food and fuel inflation from headline inflation.

India is the only major country that uses WPI to calculate inflation. Other countries use CPI.*

Inflation in IndiaUse of WPI is not appropriate for several reasons:

It uses wholesale prices which are not the prices that ultimate consumer will face

Many items out of the 430 odd commodities included in our WPI do not have much relevance for consumers

WPI does not include services which are now important components of consumption of households.

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Inflation in IndiaMost economists are recommending an immediate switch from WPI based to CPI based inflation measurement in India.

The headline inflation, year-on year, for any month in a given year (say December 2013) is calculated as the percentage change in the value of WPI in December 2013 over its value in December 2012.

Low inflation has contributed to social welfare by protecting the real income of the poorer section of the society*

Inflation control by RBIInflation destabilizes the macroeconomic environment: rising prices harm long term growth prospect.

Therefore, price stability figures high among the policy priorities.

Expected inflation plays a major role in governing increase in wages, interest rate and other factor costs. So controlling inflationary expectation has become a major pillar of anti-inflationary policy. *

Inflation control by RBIVariations in the repo rate and reverse repo rate (the short term lending and borrowing rate by RBI) and backed by CRR (cash reserve ratio) if deemed necessary are the chief instruments used.

Recently, RBI announces a hike in REPO rate by 25 basis point to 8 percent. A unit that is equal to 1/100th of 1%.1% change = 100 basis points, and 0.01% = 1 basis point.

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Inflation control by RBIThere are some serious problems with this approach!

Irrespective of origin or nature of inflation, a tight monetary policy is invariably put into operation whenever WPI inflation move above some range.

But this blunt instrument of demand control is not appropriate if inflation is of cost-push variety (say driven by rising food or oil prices)*

Inflation control by RBIPrivate investment in India is primarily constrained by lack of infrastructural facilities. If that lack persists tinkering with the cost of borrowing is not likely to have much influence on the private sectors willingness to spend on new projects.

Therefore, change in repo and reverse repo rate often act as a signal of the Banks intentions than as effective means of controlling aggregate demand.*

Inflation control by RBICredit squeeze may actually be counter productive because higher cost of working capital loans may induce firms to cutback on production.

This will actually stoke the fire of inflation.

India raises interest rates to combat inflation A news reported in most of the news papers recently.

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Seigniorage or Inflation taxGrowth in the money supply causes inflation. With inflation as a consequence, what would ever induce a central bank to increase the money supply so much?

Govt. expenditures can be divided into two broad categories: (a) to buy goods and services and (b) to provide transfer payments.

It can do so by raising taxes (both personal and corporate income taxes) or it can borrow from the public by selling govt. bond or it can print money.*

Seigniorage or Inflation taxThe revenue raised by the printing of money is called Seigniorage.

This right belongs to the central government and it is one source of revenue.

When the government prints money to finance expenditure it increases the money supply, in turn, causes inflation.

Printing money to raise revenue is like imposing an inflation tax.*

Seigniorage or Inflation taxWho pays the inflation tax?

The holder of the money pays the tax.

As the price rises, the real value of money/purchasing power falls. When the Government prints new money for its use, it makes the old money in the hands of the public less valuable. Thus inflation is like a tax on holding money.*

Seigniorage or Inflation taxIn countries experiencing hyperinflation, seigniorage is often governments chief source of revenue. The need to print money to finance expenditure is a primary cause of inflation.

In India the seigniorage ratio (seignorage/GDP) has remained 2-3 percent on average. This is fairly low by developing country standard. For Latin American countries, the figure has often touched the level of 5-6 percent.*