MONEY AND INFLATION

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In this chapter you will learn :

Money: Definition and functions

The quantity theory of money

The classical theory of inflation

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Money and Inflation: Evidence

«Inflation is always and everywhere a monetary

phenomenon»

Milton Friedman

Whenever a country’s inflation rate is extremely high

for a sustained period of time,

its rate of money supply growth is also extremely high.

Reduced-form evidence.

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The connection between money and prices :

Price

amount of money required to buy a good.

Inflation rate

the percentage increase in the average level of prices.

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Money is the stock of assets that can be

readily used to make transactions.

Money : definition

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Money : functions

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Fiat, or token, money Items designated as money that are intrinsically

worthless.

Commodity monies Items used as money that also have intrinsic value

in some other use.

Money : types

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Discussion question:

Which of these are money?

a. Currency

b. Checks

c. Deposits in checking accounts (called demand deposits)

d. Credit cards

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The money supply & monetary policy money supply

the total stock of money circulating in an economy.

The circulating money involves the currency, printed notes, money in the deposit accounts and in the form of other liquid assets.

Monetary policy

is the control over the money supply.

It involves management of money supply and interest rate and is used by the government of a country to achieve macroeconomic objectives like inflation,

consumption, growth and liquidity.

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Open-Market Operations The purchase and sale of Government Bonds

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Quantitative Easing :

Quantitative easing is the monetary policy of central banks that prints large amounts of money and then buying financial assets to inject additional liquidity into the national

economy.

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The two most common measures of money are :

transactions money, also called M1, andbroad money, also called M2.

Exact classifications of M1 and M2 depend on the country.

M1 - Money that can be directly used for transactions.

M2 - M1 plus savings accounts, money market accounts, and other near monies.

near monies Close substitutes for transactions money,

such as savings accounts and money market accounts.

Money Supply measures :

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Money Supply measures :

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Money Supply and the role of the banking system :

Monetary Base:The total amount of a currency that is either

circulated in the hands of the public or in the commercial

bank deposits held in the central bank's reserves.

This measure of the money supply typically only includes

the most liquid currencies.

The central bank controls directly only the monetary base monetary base

that is defined as:

B = C + RC – currency, R - reserves.

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Money Supply and the role of the banking system :

The money stock in the economy :M = C + D

C - currency. D - deposits (all deposits: demand deposits, saving deposits, etc. etc.)

The main assets of a bank are LoansLoans and the ReservesReserves it needs to keep in an

account at the central bank.

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Money Supply and the role of the banking system :

If the Central Bank wants to increase the money supply by 100$. They do is to buy government bonds for 100

$. Bond dealer now has a cheque of 100 $. Bond dealer deposit this cheque in a Firstbank. By law a bank must keep 10% of its deposits as Reserves and can lend all

the rest.

Now we have 90 $ that are lent to someone . This person get this 90 $ and will deposit them in

Secondbank.

Now there are 81 $ that are lent to someone and that will be deposited in some other bank.

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The Quantity Theory of Money

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basic concept: the rate at which money circulates

definition: the number of times the average dollar bill

changes hands in a given time period

example: In 2013,

• $500 billion in transactions

• money supply = $100 billion

• The average dollar is used in five transactions in 2013

• So, velocity = 5

Velocity

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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 dollar value of output is PY.

We encountered measures for these variables when we discussed the national income

accounts.

This version of the quantity equation is called the incomeincome

velocity of moneyvelocity of money, which tells us the number of times a dollar

bill enters someone’s income in a given time.

Money Velocity = Price Output M V = P Y

The Quantity Theory of Money, cont.

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The quantity equationThe quantity equation

M V = P Y

follows from the preceding definition of velocity.

It is an identity: it holds by definition of the variables.

Starts with quantity equation and assumes V is constant & exogenous:

With this assumption, the quantity equation can be written as

V V

M V P Y

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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 (capital) and L (labour) and the production function

The price level is

P = (nominal GDP)/(real GDP)

M V P Y

The Quantity Theory of Money, cont.

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The Quantity Theory of Money: what determines inflation in the long-run

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The Quantity Theory of Money, 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.

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The Quantity Theory of Money, cont.

Y/Y depends on growth in the factors of production

and on technological progress

(all of which we take as given, for now).

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.

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“Inflation is always and everywhere

a monetary phenomenon”

A continuous rise of the general price level.

General price level is measured by the CPI or GDP Deflator.

Percentage change of the general price level over the previous period.

INFLATION

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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

AngolaBrazil

Bulgaria

Georgia

Kuwait

USA

Japan Canada

Germany

Oman

Democratic Republicof Congo

International Data On Inflation And Money Growth

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0%

2%

4%

6%

8%

10%

12%

14%

1960 1965 1970 1975 1980 1985 1990 1995 2000

Inflation rate M2 growth rate Inflation rate trend M2 growth rate trend

U.S. Inflation & Money Growth

The trends of the two series tend to move together.

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Is the Velocity of Money Constant?

Velocity is not fixed in reality. Velocity rises with

financial innovation financial innovation and with the nominal nominal interest rateinterest rate.

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Economists call the interest rate that the bank pays the

nominal interest rate and the increase in your purchasing power the real interest

rate.

This shows the relationship between the nominal interest rate

and the rate of inflation, where :r is real interest rate, i is the nominal interest rate and is the rate of inflation.Remember that is simply the percentage change of the price level P.

Economists call the interest rate that the bank pays the

nominal interest rate and the increase in your purchasing power the real interest

rate.

This shows the relationship between the nominal interest rate

and the rate of inflation, where :r is real interest rate, i is the nominal interest rate and is the rate of inflation.Remember that is simply the percentage change of the price level P.

r =r = ii - - π

Real and Nominal Interest Rates

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Real Interest Rate

Nominal interest rate, i not adjusted for inflation

Real interest rate, r adjusted for inflation : r = i

= actual inflation rate (not known until after it has occurred)

e = expected inflation rate

i – e = ex ante real interest rate: real interest rate when loan are made (known)

i – = ex post real interest rate:real interest rate when loans are paid

(unknown, but measured by forecasting inflation rate)

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The Fisher Effect

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The quantity theory and the Fisher equation together tell us how money growth affects the

nominal interest rate.

Quantity Theory of Money: Quantity Theory of Money:

a 1% increase in the money supply causes a 1% increase in inflation

Fisher Effect: Fisher Effect:

a 1% increase in the inflation causes a 1% increase in the nominal interest rate

Money, Inflation, Interest Rate

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U.S. Inflation And Nominal Interest Rates

Inflation and the nominal interest rate are very highly correlated.

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Use the Internet to identify a country that has had high inflation over the past year and another country that has had low inflation. For these two countries, find the rate of money growth and the current level of the nominal interest rate. Relate your findings to the theories presented in this chapter.

Homework:(due to next week)