In this chapter, we learn:what inflation is, and how costly it can be.

Freshwater bias: didn’t bewail cost of unemployment--ch7how the quantity theory of money and the classical dichotomy allow

us to understand source of inflation– Nominal variables, e.g., money, have only nominal effects, e.g., on prices

and nominal interest rates, no real effects.– Money cannot call forth goods. David Ricardo, Works, volume III.

Freshwater bias: classical dichotomy holds in long-runhow the nominal interest rate, the real interest rate, and inflation are

related through the Fisher equation. Irving Fisher: Chained price indexes, Fisher equation

… and debt deflation debt burden vicious circlethe important link between fiscal policy and high inflation.

Freshwater bias: blame government

Inflation is the percentage change in an economy’s overall price level:

πt = Pt/Pt-1 – 1 = (Pt - Pt-1 )/ Pt-1

Hyperinflation is an episode of extremely high inflation, usually greater than 500 percent per year…a 6-fold increase

From 1919 to 1923, prices in Germany rose by over a factor of a trillion and were rising 300-fold each month toward the end of 1923.Excess of claims on reduced German output capacity

Reparations claims Labor claims…the 8-hour day Bondholder claims Passive resistance claims

Printing money to meet claims Money to meet bloated government payrolls

– Assassination of minister who tried to raise taxes– Declining real value of tax collections

Money for the Reichbank’s friends

~1.4%

The Consumer Price Index (CPI) is a price index for a bundle of consumer goods.

• Conceptually, the “market basket” is held constant• In practice, the market basket is adjusted as consumption patterns change.

• Core CPI: exclude food and energy prices, which are volatile

2010 111.69

Measures of the Money Supply Think of Money as Currency in your wallet and Deposits in your checking account

The balance on your RebelCard should also be thought of as “money,” but it’s not yet counted

The monetary base (MB) includes currency (C) and reserves (R) held by private banks Banks a hold a fraction of the deposits (D) they owe you as reserves R = fD Reserves include Vault Cash and deposits banks themselves hold at their Central Banks

Our Central Bank is the Federal Reserve Bank

CHAPTER 8 Inflation

The Federal Reserve’s Balance SheetOwns

(Assets)Owes

(Liabilities)

Federal Reserve Notes

Currency in circulation = C

Vault cash

Bank deposits at Fed= R

Bank A deposits @ fed

Bank B deposits @ fed

Bank C deposits @ fed

Government deposits @ Fed

GoldForeign Exchange

Bank IOUs onDiscount Loans

Government BondsMortgage Backed Securities

Fixed Assets

Total Assets = Monetary Base = MB = H = High Powered Money = Total Liabilities

The Functions of a Modern Central BankThe Government's Bank:

–Manages government transactions.–Controls availability of money and credit.

The Banker’s Bank:Lender of last resort in crisesOperates clearing system for interbank payments.Oversees financial intermediaries - ensure their soundness. - ensure public confidence

The Federal Reserve’s Balance SheetOwns

(Assets)Owes

(Liabilities)

Federal Reserve Notes

Currency in circulation = C

Vault cash

Bank deposits at Fed= R

Bank A deposits @ fed

Bank B deposits @ fed

Bank C deposits @ fed

Government deposits @ Fed

GoldForeign Exchange

Bank IOUs onDiscount Loans

Government BondsMortgage Backed Securities

Fixed Assets

Total Assets = Monetary Base = MB = H = High Powered Money = Total Liabilities

Functions of Federal Reserve District Banks Clear checks

Issue new currency/withdraw damaged currency

Make discount loans to banks in district

Evaluate mergers/expansions of bank activities

Liaison between business community and the Fed

Examine bank holding companies and state-chartered member banks

Collect data on local business conditions

Research Money, Banking and the Financial System

FRBNY’s special roles Bond and currency open market operations

Supervise bank holding companies in NY district

Member of Bank for International Settlements

Measures of the Money Supply Think of Money as Currency in your wallet and Deposits in your checking account

The balance on your RebelCard should also be thought of as “money,” but it’s not yet counted

The monetary base (MB) includes currency (C) and reserves (R) held by private banks Banks a hold a fraction of the deposits (D) they owe you as reserves R = fD Reserves include Vault Cash and deposits banks themselves hold at their Central Banks

Our Central Bank is the Federal Reserve Bank Banks receive no interest on Vault Cash (mostly held in ATM machines) They now receive some interest on their deposits at the Fed

Currency (Federal Reserve Notes in circulation) and bank Reserves are liabilities of the Central Bank. Think of them as High Powered Money (=Monetary Base)

Central Bank Liabilities (the Monetary Base) are necessarily matched by its Assets When the Fed buys something, say a government bond (T-bill or T-bond) or a mortgage backed

security (MBS), its assets increase by the amount of the purchase. The Fed pays for what it buys by “writing a check” to whoever sells it the asset. The check ends

up deposited in a bank which then deposits it in its reserve account. The Fed’s Assets (the T-bill) and its Liabilities (bank Reserves) increase by the same amount.

An increase in the Monetary Base (high powered money) usually multiplies through a fractional reserve banking system to a greater increase in Money Supply.

The Fed buys something and pays with a check; the check is deposited in a bank; the bank holds a fraction of the deposit in reserve and loans out the rest; the borrower buys something; some of what he pays is held in Currency while the rest is Deposited in another bank which holds a fraction in Reserve and loans out the rest…

In general

Money Supply = Money multiplier x Monetary Base

M = m x MB

Flavors of money:M1 = Currency + Demand Deposits + Travelers Checks

M1 is most liquid = means of payment

M2 = M1 + Savings Accounts + Money Market Accounts + Small CDs M2 = M1 + “Near monies”

M3 = M2 + Large CDs + Short term repos + …

The Quantity Equation

Let Mt = money supply in year t; Vt = velocity of money turnover in t;

Pt = price level in t; Yt = real GDP in t

MtVt = PtYt

MtVt = Money held ($) x Turns/year = $ spent in year

= $GDP ($/year)

PtYt = Stuff bought (units/year) x Price paid ($/unit)

= $ purchases in year = $GDP ($/year)

Thus,

$ Purchases/year = $ Spent/year

The Quantity Theory of Money:

P = (V/Y) M