Money, Money Growth, And Inflation

8/12/2019 Money, Money Growth, And Inflation

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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/


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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.htm


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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/


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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

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Money, Money Growth, And Inflation

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