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MACROECONOMICSMACROECONOMICS

Chapter 4Chapter 4

Money and InflationMoney and Inflation

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Long Run ViewLong Run View

Money and inflation are related closely in Money and inflation are related closely in the long run.the long run.

Classical economists used Quantity Classical economists used Quantity Theory of Money to explain the Theory of Money to explain the connection.connection.

We start with definitions and go to QTM We start with definitions and go to QTM and proceed to modern adjustments.and proceed to modern adjustments.

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What Is Money?What Is Money? Money (=money supply) any vehicle used as a Money (=money supply) any vehicle used as a

means of exchange to pay for goods, services means of exchange to pay for goods, services or debts.or debts.

In today’s society, any asset that can quickly be In today’s society, any asset that can quickly be transferred into cash is considered money.transferred into cash is considered money.

The more liquid an asset is, the closer it is to The more liquid an asset is, the closer it is to money.money.

In economics,money does not mean wealth nor In economics,money does not mean wealth nor does it mean income.does it mean income.

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Functions of MoneyFunctions of MoneyMedium of exchangeMedium of exchangeUnit of AccountUnit of AccountStore of ValueStore of Value

What Is Money?What Is Money?

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What Is Money?What Is Money?Medium of exchangeMedium of exchange

By eliminating barter, this function of money By eliminating barter, this function of money increases efficiency in a society. increases efficiency in a society.

As human societies started to engage in As human societies started to engage in exchange money had to be invented.exchange money had to be invented.

Any technological change that reduces Any technological change that reduces transaction costs increases the wealth of transaction costs increases the wealth of the society.the society.

Any technological change that allows Any technological change that allows people to specialize also increases wealth.people to specialize also increases wealth.

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What Is Money?What Is Money? Unit of AccountUnit of Account

We use money to measure the value of goods and We use money to measure the value of goods and services.services.

Suppose we had 4 goods and no money. How do we Suppose we had 4 goods and no money. How do we measure the price of each good?measure the price of each good?

A in terms of BA in terms of B B in terms of CB in terms of C N!/2(N-2)! C in terms of DC in terms of D A in terms of CA in terms of C A in terms of DA in terms of D B in terms of DB in terms of D

Money allows to quote prices in terms of currency only.Money allows to quote prices in terms of currency only.

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What Is Money?What Is Money? Store of ValueStore of Value

All assets are stored value.All assets are stored value. Money, although without any return, is still desirable to Money, although without any return, is still desirable to

hold because it allows purchases immediately.hold because it allows purchases immediately. Other assets take time (transaction costs) to use as a Other assets take time (transaction costs) to use as a

payment for purchases.payment for purchases. The more liquid an asset is, the less transaction cost it The more liquid an asset is, the less transaction cost it

carries.carries. Inflation erodes the value of money.Inflation erodes the value of money.

Return on money: -Return on money: -ππ

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What Is Money?What Is Money?

Commodity moneyCommodity moneyGold certificatesGold certificatesBank notesBank notesFiat moneyFiat moneyChecksChecksElectronic PaymentElectronic PaymentE-moneyE-money

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What Is Money?What Is Money? M1: Currency, demand deposits, travelers checks.M1: Currency, demand deposits, travelers checks. M2: M1, saving deposits, small time deposits, retail M2: M1, saving deposits, small time deposits, retail

MMMF.MMMF. M3: M2, large time deposits, repos, Eurodollar M3: M2, large time deposits, repos, Eurodollar

deposits, institutional MMMF.deposits, institutional MMMF. MZM: M2, institutional MMMF minus small time MZM: M2, institutional MMMF minus small time

deposits. deposits. Growth rates of these aggregates do not always go Growth rates of these aggregates do not always go

hand in hand, making monetary policy difficult since hand in hand, making monetary policy difficult since signals are conflicting.signals are conflicting.

http://research.stlouisfed.org/publications/mt/page16.pdf

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Monetary PolicyMonetary Policy

Central Bank is responsible for monetary Central Bank is responsible for monetary policy.policy.Open-market operationsOpen-market operationsChanges in required reserveChanges in required reserveChanges in the discount rateChanges in the discount rateQuantitative easingQuantitative easing

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Quantity Theory of MoneyQuantity Theory of Money

MVMVTT=PT=PT MVMVYY=PY=PY

The Classical economists included all The Classical economists included all transactions in this definition. If one transactions in this definition. If one includes only the transactions that includes only the transactions that create GDP, one gets the second one.create GDP, one gets the second one.

%%ΔΔ in M + in M + %%ΔΔ in V = in V = %%ΔΔ in P + in P + %%ΔΔ in Y in Y

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Quantity Theory of MoneyQuantity Theory of Money

In the classical approach, Y is determined by In the classical approach, Y is determined by labor, capital, and technology.labor, capital, and technology. These resources are fixed in the short run, so Y is These resources are fixed in the short run, so Y is

fixed.fixed.

Like every other market, the monetary sector is in Like every other market, the monetary sector is in equilibrium, i.e. money supply is equal to money equilibrium, i.e. money supply is equal to money demand.demand. Money supply, Money supply, M,M, is determined by the central bank. is determined by the central bank.

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Quantity Theory of MoneyQuantity Theory of Money

In the short run Y is fixed.In the short run Y is fixed.Velocity was thought to be constant by the Velocity was thought to be constant by the

Classical economists. Milton Friedman Classical economists. Milton Friedman revised it to be “stable” easily forecast.revised it to be “stable” easily forecast.

If in the short run both Y and V were fixed, If in the short run both Y and V were fixed, then %then %ΔΔ in M = in M = %%ΔΔ in P in P

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Quantity Theory of MoneyQuantity Theory of Money

How to test the hypothesis that %How to test the hypothesis that %ΔΔ in M is in M is roughly equal to %roughly equal to %ΔΔ in P? (% in P? (%ΔΔ in P is in P is defined as inflation).defined as inflation).Longitudinal dataLongitudinal data

Figure 4-1 for USA: On average, %Figure 4-1 for USA: On average, %ΔΔ in M = 7%, in M = 7%,%%ΔΔ in P = 3%. Why not equal? in P = 3%. Why not equal?

Cross-sectional dataCross-sectional dataFigure 4-2Figure 4-2

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Money Demand FunctionMoney Demand Function

Suppose real money balances Suppose real money balances depend on real incomedepend on real income

But, by definition, MV=PY.But, by definition, MV=PY. Therefore, Therefore,

It is useful to remember that It is useful to remember that velocity and money demand velocity and money demand are inversely related.are inversely related.

kYPM d }{

Vk

1

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Examples of k ChangesExamples of k Changes

Credit card usage increasesCredit card usage increasesPeople hold less real money balances => k People hold less real money balances => k

falls => V rises.falls => V rises.ATMs introducedATMs introduced

Same as aboveSame as aboveNominal interest rates riseNominal interest rates rise

Same as above. WHY? Same as above. WHY?

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SeigniorageSeigniorage

How government gets revenue?How government gets revenue?1.1. TaxesTaxes

2.2. BorrowingBorrowing

3.3. Printing money = seignioragePrinting money = seigniorage M increase leads to P increase but because M increase leads to P increase but because

nominal assets lose value, government transfer nominal assets lose value, government transfer that value to itself.that value to itself.

http://www.npr.org/blogs/money/2009/01/http://www.npr.org/blogs/money/2009/01/what_is_seigniorage_1.htmlwhat_is_seigniorage_1.html

http://en.wikipedia.org/wiki/Seignioragehttp://en.wikipedia.org/wiki/Seigniorage

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http://research.stlouisfed.org/publications/usfd/page16.pdf

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Inflation and Interest RatesInflation and Interest Rates

When a borrower and a lender agree on a When a borrower and a lender agree on a real return on the loan (r), they still have to real return on the loan (r), they still have to agree on the expected inflation (agree on the expected inflation (ππee) to ) to determine the nominal interest rate (i).determine the nominal interest rate (i).

(1+r ) (1+(1+r ) (1+ππe e ) = (1+i)) = (1+i)

1 + r + 1 + r + ππe e + r + r ππe e = 1 + i = 1 + i

For simplicity, we use the Fisher equation: For simplicity, we use the Fisher equation: i = r + i = r + ππe e

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Inflation and Interest RatesInflation and Interest Rates

What happens if the borrower and lender What happens if the borrower and lender misjudged the expected inflation? Who gains misjudged the expected inflation? Who gains and who loses? and who loses? See slide 24.See slide 24.

What happens when actual inflation (instead of What happens when actual inflation (instead of expected) exceeds the nominal interest rate?expected) exceeds the nominal interest rate? See Figure 4-3 See Figure 4-3

How do people form expectations, anyway?How do people form expectations, anyway? Static, adaptive, rationalStatic, adaptive, rational

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Demand for Money and iDemand for Money and i

What does one give up by holding money?What does one give up by holding money? The opportunity to earn r The opportunity to earn r

What does one gain from holding money?What does one gain from holding money? Deflation makes money more valuableDeflation makes money more valuable Inflation: -Inflation: -ππe e

What is the net opportunity cost?What is the net opportunity cost? r – (-r – (-ππe e ) = r + ) = r + ππee = i. = i.

Therefore, as i increases, opportunity cost of Therefore, as i increases, opportunity cost of holding money increases.holding money increases. Money demand should decrease.Money demand should decrease.

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Demand for MoneyDemand for Money

),( YiLPM

The demand for real money balances (liquidity preference) is a negative function of i and a positive function of Y.

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Demand Responds to iDemand Responds to i Increase Money Supply => Y fixed means i has Increase Money Supply => Y fixed means i has

to go down to equate the higher M/P to demand.to go down to equate the higher M/P to demand. However, Quantity Theory of Money says money However, Quantity Theory of Money says money

demand is not affected by interest rates.demand is not affected by interest rates. This was Keynes’ objection to Classical Theory.This was Keynes’ objection to Classical Theory.

i

M/P

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Classical RevengeClassical RevengeM increase => P increase => M increase => P increase => ππ increase increase

=> i increase => M/P decrease.=> i increase => M/P decrease. In the long run, M increase does not In the long run, M increase does not

create a lower i.create a lower i.

i

M/P

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The Costs of Expected InflationThe Costs of Expected Inflation

Shoe leather costsShoe leather costsMenu costsMenu costsFirms not changing “menus” are not Firms not changing “menus” are not

keeping up with inflation. Relative prices keeping up with inflation. Relative prices change creating inefficiencies.change creating inefficiencies.

Tax liability increasesTax liability increasesUncertainty increases undermining Uncertainty increases undermining

planningplanning

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The Costs of Unexpected InflationThe Costs of Unexpected Inflation

Impact on debtorsImpact on debtors Impact on creditorsImpact on creditors Impact on fixed incomesImpact on fixed incomes Impact on risk takingImpact on risk taking

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Benefit of InflationBenefit of Inflation

Money illusion can adjust real wages and Money illusion can adjust real wages and reduce unemploymentreduce unemployment

L

W/P