Chapter Four

A PowerPointTutorialto Accompany macroeconomics, 5th ed.

N. Gregory Mankiw

Mannig J. Simidian

®

CHAPTER FOURMoney and Inflation

Chapter Four

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Geld noodzakelijk voor specialisatie

Chapter Four

Chapter Four

Fiduciair (fiat) geld: heeft geen intrinsieke Waarde, maar moet het hebben van vertrouwen

Goederen geld: geld met intrinsieke waardeVoorbeeld: gouden standaard

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De maatschappelijke geldhoeveelheid (M1):1.Chartaal geld, de hoeveelheid munt en papiergeld in handen van het

publiek2.Giraal geld: direct opeisbare vorderingen op geldscheppende

instelling binnenlandse liquiditeitenmassa M3 :M1 + Brede geldhoeveelheid die bestaat uit chartaal en giraal geld, deposito’s en substituten van deposito’s. Toelichting:Deposito’s met een looptijd tot en met twee jaar en met een opzegtermijn tot en met drie maanden. Substituten van deposito’s zijn aandelen/participaties in geldmarktfondsen, schuldbewijzen met een looptijd tot en met twee jaar en repo’s.

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• Open marktbeleid:

Kopen verkopen van waardepapieren (swaps).

• Veranderingen rente (disconto)

• geldmarktkasreserveregeling

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Definitievergelijking

Money Velocity = Price Output M V = P Y

De V is cruciaal: omloopsnelheid van het geld

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M/P is de reele geldhoeveelheid (real money balances)Vraagfunctie van geld dat mensen willen aanhouden is (fischer anders geschreven:

Mensen willen een bepaald deel (k) van hun nominaal inkomen aanhouden (Y*P) aanhouden. De reele vraag wordt dan:

Md = k Y*P

Relatie geldvraag en fischer (blz 103):

(M/P)d = k Y

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The money demand function is like the demand function for a particular good. Here the “good” is the convenience of holding real money balances. Higher income leads to a greater demand for real money balances. The money demand equation offers another way to view the quantity equation (MV= PY) where V = 1/k.

This shows the link between the demand for money and the velocityof money. When people hold a lot of money for each dollar of income (k is large), money changes hands infrequently (V is small).Conversely, when people want to hold only a little money (k is small), money changes hands frequently (V is large). In other words, the money demand parameter k and the velocity of money V are opposite sides of the same coin.

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The Assumption of Constant Velocity

The quantity equation can be viewed as a definition: it defines velocity V as the ratio of nominal GDP, PY, to the quantity of money M. But, if we make the assumption that the velocity of money is constant, then the quantity equation MV=PY becomes a useful theory of the effects of money.

The quantity equation can be viewed as a definition: it defines velocity V as the ratio of nominal GDP, PY, to the quantity of money M. But, if we make the assumption that the velocity of money is constant, then the quantity equation MV=PY becomes a useful theory of the effects of money.

So, let’s hold it constant!MV = PY

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Three building blocks that determine the economy’s overall level of prices:

1) The factors of production and the production function determinethe level of output Y.

2) The money supply determines the nominal value of output, PY.This follows from the quantity equation and the assumption thatthe velocity of money is fixed.

3) The price level P is then the ratio of the nominal value of output,PY, to the level of output Y.

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In other words, if Y is fixed (from Chapter 3) because it dependson the growth in the factors of production and on technological progress, and we just made the assumption that velocity is constant,

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 Yif V is fixed and Y is fixed, then it reveals that % Change in M is what induces % Changes in P.The quantity theory of money states that the central bank, whichcontrols 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.

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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.

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Economists call the interest rate that the bank pays the nominalinterest rate and the increase in your purchasing power the

real interest rate.

This shows the relationship between the nominal interest rateand the rate of inflation, where r is real interest rate, i is the

nominal interest rate and is the rate of inflation, and rememberthat is simply the percentage change of the price level P.

Economists call the interest rate that the bank pays the nominalinterest rate and the increase in your purchasing power the

real interest rate.

This shows the relationship between the nominal interest rateand the rate of inflation, where r is real interest rate, i is the

nominal interest rate and is the rate of inflation, and rememberthat is simply the percentage change of the price level P.

r = i –

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The Fisher Equation illuminates the distinction between the real and nominal rate of interest.Fisher Equation: Fisher Equation: ii = = rr + +

Actual (Market)Actual (Market)Nominal rate ofNominal rate of

interestinterest

Real rateReal rateof interestof interest

InflationInflation

The one-to-one relationshipbetween the inflation rate and the nominal interest rate isthe Fisher Effect.

It shows that the nominal interest can change for two reasons: becausethe real interest rate changes or because the inflation rate changes.

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

i = r +

The quantity theory and the Fisher equation together tell us how money growth affects the nominal interest rate. According to the quantity theory, an increase in the rate of money growth of one percent causes a 1% increase in the rate of inflation.

According to the Fisher equation, a 1% increase in the rate of inflation in turn causes a 1% increase in the nominal interest rates.

Here is the exact link between our two familiar equations: The quantity equation in percentage change form and the Fisher equation.

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The real interest rate the borrower and lender expect when a loan is made is called the ex ante real interest rate. The real interestrate that is actually realized is called the ex post real interest rate.Although borrowers and lenders cannot predict future inflation withcertainty, they do have some expectation of the inflation rate. Let denote actual future inflation and e the expectation of future inflation.The ex ante real interest rate is i - e, and the ex post real interest rate isi - The two interest rates differ when actual inflation differs fromexpected inflation e.

How does this distinction modify the Fisher effect? Clearly the nominalinterest rate cannot adjust to actual inflation, because actual inflationis not known when the nominal interest rate is set. The nominal interestrate can adjust only to expected inflation. The next slide presents amore precise version of the the Fisher effect.

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ii = = rr + + ee ii = = rr + + ee

The ex ante real interest rate r is determined by equilibrium in themarket for goods and services, as described by the model in

Chapter 3. The nominal interest rate i moves one-for-one withchanges in expected inflation e.

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The quantity theory (MV = PY) is based on a simple money demand function: it assumes that the demand for real money balances is proportional to income. But, we need another determinant of the quantity of money demanded– the nominal interest rate.

The nominal interest rate is the opportunity cost of holding money:it is what you give up by holding money instead of bonds. So, the newgeneral money demand function can be written as:

(M/P)d = L(i, Y)

This equation states that the demand for the liquidity of real moneybalances is a function of income (Y) and the nominal interest rate (i).The higher the level of income Y, the greater the demand for realmoney balances.

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The inconvenience of reducing moneyholding is metaphorically called theshoe-leather cost of inflation, becausewalking to the bank more often inducesone’s shoes to wear out more quickly.

When changes in inflation require printingand distributing new pricing information,then, these costs are called menu costs.

Another cost is related to tax laws. Oftentax laws do not take into considerationinflationary effects on income.

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Unanticipated inflation is unfavorable because it arbitrarily redistributes wealth among individuals.

For example, it hurts individuals on fixed pensions. Often thesecontracts were not created in real terms by being indexed to a particular measure of the price level.

There is a benefit of inflation– many economists say that someinflation may make labor markets work better. They say it“greases the wheels” of labor markets.

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Hyperinflation is defined as inflation that exceeds 50 percent per month, which is just over 1% 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.

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Economists call the separation of the determinants of real and nominal variables the classical dichotomy. It suggests that 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.

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InflationHyperinflationMoneyStore of valueUnit of accountMedium of exchangeFiat moneyCommodity moneyGold StandardMoney supplyMonetary policy

Central BankFederal ReserveOpen-market operationsCurrencyDemand depositsQuantity equationTransactions velocity of moneyIncome velocity of moneyReal money balancesMoney demand functionQuantity theory of money

SeigniorageNominal andreal interest ratesFisher equationFisher effectEx ante and ex postreal interest ratesShoeleather costsMenu costsReal and nominalvariablesClassical dichotomyMonetary neutrality