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Macroeconomics & The global economy
Ace Institute of Management
Chapter 4: Money and Inflation
InstructorSandeep Basnyat
Sandeep_basnyat@yahoo.com9841 892281
Stock of assetsStock of assets
Used for transactionsUsed for transactions
A type of wealthA type of wealthMoney
• Store of value:Store of value: You can postpone your purchase for next period. You can postpone your purchase for next period.• Unit of account: Unit of account: units in which prices are quoted and debts units in which prices are quoted and debts
recordedrecorded• A medium of exchangeA medium of exchange.: .: used to buy goods and servicesused to buy goods and services
The ease with which money is converted into other things such as goods and services--is sometimes called money’s liquidity.
•Measures economic transactions like yardsticks. Without it, we would be forced to barter.
• Problem with barter: requires the double coincidence of wants.
Fiat money is money by declaration.It has no intrinsic value.
Commodity money is money thathas intrinsic value. Eg. Gold or cigarettes in P.O.W. camps
When people use gold as money, the economy is said to be on a gold standard.
• The money supply: quantity of money available in an economy.• Monetary policy: The control over the money supply (increasing
or decreasing).• Central Bank: Institution that conduct monetary policy.• Open Market Operation: Primary way of controlling Money
Supply
To expand the money supply: Central banks buys government bonds and pays for them with new money.
To reduce the money supply: Central banks sells government bonds and receives the existing money and then destroys them.
Other instrument of Monetary Policy
• Changing the Reserve requirements.Minimum reserves each Commercial bank must hold
• Changing the Discount rate (which member banks (not meeting the reserve requirements) pay to borrow from the Central Banks.)
The bearer o
f the United
States
Treasury bon
d is hereby
promised
the repaymen
t of the pri
nciple
value plus t
he interest
which it
incurs throu
gh the terms
stated
thereof.
The United S
tates will j
ustly repay
its bearers
in its entir
ety and
will not def
ault under a
ny
circumstance
s.
Signature of
the Preside
nt
____________
_______
US. Treasury Bond
• Currency• Demand Deposits• M1, M2, M3
For Nepal: For Nepal: • Broad Money (M2) and Narrow
Money (M1)
Monetary Statistics for US and Nepal for 2008/2009 Nepal US
Monetary Base (M1)
Rs. 18307 million or
Approx. $250 million
$1.99 trillion
M2
Rs. 67644 million or
Approx. $926 million
$8.36 trillion
Reserve Requirements 5.50% 10%FYI: Prepare a list of countries with their Money Supply, Reserve Requirements and Central Banks monetary instruments in monetary policy operations.
Equilibrium in Money Market
Quantity ofMoney
Value ofMoney, 1/P
Price Level, P
Quantity fixedby the Central Bank
Money supply
0
1
(Low)
(High)
(High)
(Low)
1/2
1/4
3/4
1
1.33
2
4
Equilibriumvalue ofmoney
Equilibriumprice level
Moneydemand
A
Quantity Theory of Money• The Quantity Theory of Money states that there is a
direct relationship between the quantity of money in an economy and the level of prices of goods and services sold.
– If the amount of money in an economy doubles, price levels also double, causing Inflation (the percentage rate at which the level of prices is rising in an economy).
– The consumer therefore pays twice as much for the same amount of the good or service.
– Money is like any other commodity: increases in its supply decrease marginal value (the buying capacity of one unit of currency).
– So an increase in money supply causes prices to rise (inflation) as they compensate for the decrease in money’s marginal value.
Quantity Theory of Money-Derivation• Md = T x P– T = Number of transactions in an economy – P = General price Level. It is the nominal GDP
• Ms = M x V – M = Amount of Money in circulation– V = Velocity of money (the number of times
money changes hands)
From Equilibrium condition, Md = Ms
T x P = M x VT x P = M x V
• Transactions calculation not easy• Replaces with Total Output (Transactions and output are related as
the more the economy produces, the more goods are bought and sold).
Money Velocity = Price Output M V = P Y
The Quantity Theory of Money
MV = PY M α P
Fixed Y = as K, L are fixed, and Fixed V : supposed constant over time
Price Level is directly proportional to the Quantity of Money in the Economy.
Price Level is directly proportional to the Quantity of Money in the Economy.
or in percentage change form:
MV = PY
% Change in M + % Change in V = % Change in P + % Change in Y% Change in M + % Change in V = % Change in P + % Change in Y
If V is fixed and Y is fixed, then it reveals that % Change in M is what induces % Changes in P.
M α PThe Quantity Theory of Money
The 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.
• The revenue raised through the printing of money is called seigniorage.
•When the government prints money to finance expenditure, it increases the money supply. The increase in the money supply, in turn, causes inflation. Printing money to raise revenue is like imposing an inflation tax.
• The revenue raised through the printing of money is called seigniorage.
•When the government prints money to finance expenditure, it increases the money supply. The increase in the money supply, in turn, causes inflation. Printing money to raise revenue is like imposing an inflation tax.
The Effects of Monetary Injection
Quantity ofMoney
Value ofMoney, 1/P
Price Level, P
Moneydemand
0
1
(Low)
(High)
(High)
(Low)
1/2
1/4
3/4
1
1.33
2
4
M1
MS1
M2
MS2
2. . . . decreasesthe value ofmone y . . . 3. . . . and
increasesthe pricelevel.
1. An increasein the moneysupply . . .
A
B
Money and Prices During Four Hyperinflations
(a) Austria (b) Hungary
Money supply
Price level
Index(Jan. 1921 = 100)
Index(July 1921 = 100)
Price level
100,000
10,000
1,000
10019251924192319221921
Money supply
100,000
10,000
1,000
10019251924192319221921
Money and Prices During Four Hyperinflations
(c) Germany
1
Index(Jan. 1921 = 100)
(d) Poland
100,000,000,000,000
1,000,000
10,000,000,0001,000,000,000,000
100,000,000
10,000100
Moneysupply
Price level
19251924192319221921
Price levelMoneysupply
Index(Jan. 1921 = 100)
100
10,000,000
100,000
1,000,000
10,000
1,000
19251924192319221921
•Nominal interest rate: interest rate that the bank pays• Real interest rate: increase in purchasing power
• The relationship between the nominal interest rate and the rate of inflation:
r = real interest rate; I = nominal interest rate; and, = inflation rate of inflation
•Nominal interest rate: interest rate that the bank pays• Real interest rate: increase in purchasing power
• The relationship between the nominal interest rate and the rate of inflation:
r = real interest rate; I = nominal interest rate; and, = inflation rate of inflation
rr = = ii - - π
Fisher Equation: Fisher Equation: ii = = rr + +
Actual (Market)Actual (Market)nominal rate ofnominal rate of
interestinterestReal rateReal rateof interestof interest
InflationInflation
The one-to-one relationshipbetween the inflation rate and the nominal interest rate is the Fisher effect.
It shows that the nominal interest can change for two reasons: because the real interest rate changes because the real interest rate changes or because the inflation rate because the inflation rate changes.changes.
i = r + • According to the quantity theory, a 1% increase in the According to the quantity theory, a 1% increase in the
money supply causes a 1% increase in money supply causes a 1% increase in inflation. inflation.
• According to the Fisher equation, a 1% increase in the According to the Fisher equation, a 1% increase in the rate of inflation in turn causes a 1% increase in the rate of inflation in turn causes a 1% increase in the nominal interest rates. nominal interest rates.
• Simplified:Simplified: r = i -
•People have expectation of the inflation rate.
Let = actual future inflation and e = expectation of future inflation.
Adjustment to Fisher Effects
ii = = rr + + ee ii = = rr + + ee
• Actual inflation is not known when the nominal interest rate is set. But people can adjust to expected inflation.
• The nominal interest rate i moves one-for-one with changes in expected inflation e.
Shoe-leather cost of inflation:walking to the bank more often induces one’s shoes to wear out more quickly.
Menu costs: When changes in inflation require printing and distributing new pricing information.
Tax Laws:Often tax laws do not take into considerationinflationary effects on income.
• Unanticipated inflation is unfavorable because it arbitrarily redistributes wealth among individuals. For example, it hurts individuals on fixed pensions.
• There is a benefit of inflation—many economists say that some• inflation may make labor markets work better. They say it
“greases the wheels” of labor markets.
Hyperinflation: inflation that exceeds 50 percent per month, which is just over 1percent a day.
Costs such as shoe-leather and menu costs are much worse with hyperinflation—and tax systems are grossly distorted. Eventually, when costs become too great with hyperinflation, the money loses its role as store of value, unit of account and medium of exchange. Bartering or using commodity money becomes prevalent.
• Separation of the determinants of real and nominal variables: changes in the money supply do not influence real variables.
• This irrelevance of money for real variables is called monetary neutrality. For the purpose of studying long-run issues--monetary neutrality is approximately correct.
The Classical dichotomyThe Classical dichotomy
N
N
W/P
Y Y
P
P
W
Increase in Wage Level
No Change in Output
No Change in Level of Employment
There is a dichotomy between real and monetary sector.
Increase in Price
Thank You
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