Chapter Four

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CHAPTER 4 Money and Inflation

®

A PowerPointTutorial

To Accompany

MACROECONOMICS, 7th. EditionN. Gregory Mankiw

Tutorial written by:

Mannig J. SimidianB.A. in Economics with Distinction, Duke University

M.P.A., Harvard University Kennedy School of GovernmentM.B.A., Massachusetts Institute of Technology (MIT) Sloan School of

Management

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Stock of assetsStock of assets

Used for transactionsUsed for transactions

A type of wealthA type of wealth

Money

As a medium of exchange, money is used to buy goods and services. The ease at which an asset can be converted into a medium of exchange and used to buy other things is sometimes called an asset’s liquidity. Money is the economy’s most liquid asset.

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Inflation is an increase in the average level of prices, and a price is the rate at which money is exchanged for a good or service.Here is a great illustration of the power of inflation:In 1970, the New York Times cost 15 cents, the median price of a single-family home was $23,400, and the average wage in manufacturing was $3.36 per hour. In 2008, the Times cost $1.50, the price of a home was $183,300, and the average wage was $19.85 per hour.

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It serves as a store of value, unit of account, and a medium of exchange. The ease with which money is converted into other things such as goods and services--is sometimes called money’s liquidity.

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Money is the yardstick with which we measureeconomic transactions. Without it, we would beforced to barter. However, barter requires the double coincidence of wants—the unlikelysituation of two people, each having a good thatthe other wants at the right time and place to makean exchange.

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Fiat money is money by declaration.It has no intrinsic value.

Commodity money is money thathas intrinsic value.

When people use gold as money, the economy is said to be on a gold standard.

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The government may get involved in the monetary system to help people reduce transaction costs. Using gold as a currency is costly because the purity and weight has to be verified. Also,coins are more widely recognized than gold bullion.

The government then accepts gold from the public in exchange for gold-certificates— pieces of paper that can be redeemed for actual gold. If people trust that the government will give them the gold upon request, then the currency will be just as valuable as the gold itself—plus, it is easier to carry around the paper than the gold. The end result is that because no one redeems the gold anymore and everyone accepts the paper, they will have value and serve as money.

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The money supply is the quantity of money available in an economy.The control over the money supply is called monetary policy.In the United States, monetary policy is conducted in a partially independent institution called the central bank. The central bank in theU.S. is called the Federal Reserve, or the Fed.

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To expand the money supply:

The Federal Reserve buys U.S. Treasury Bonds and pays for them with new money.

To reduce the money supply:

The Federal Reserve sells U.S. Treasury Bonds and receives the existing dollars and then destroys them.

The bearer of the United States

Treasury bond is hereby promised

the repayment of the principle

value plus the interest which it

incurs through the terms stated

thereof.

The United States will justly repay

its bearers in its entirety and

will not default under any

circumstances.

Signature of the President

___________________

US. Treasury Bond

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The Federal Reserve controls the money supply in 3 ways:

Conducting Open Market Operations

(buying and selling U.S. Treasury bonds).

Changing the Reserve requirements (never really used).

Changing the Discount rate which member banks (not meeting the reserve requirements) pay to borrow from the Fed.

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

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The quantity equation is an identity: the definitions of the four variables make it true. If one variable changes, one or more of the others must also change to maintain the identity. The quantity equation we will use from now on is the money supply (M) times the velocity of money (V) which equals price (P) times the number of transactions (T):

Money Velocity = Price Transactions M V = P T

V in the quantity equation is called the transactions velocity of money. This tells us the number of times a dollar bill changes hands in a given period of time.

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Transactions and output are related, because the more theeconomy produces, the more goods are bought and sold.

If Y denotes the amount of output and P denotes the price of oneunit of output, then the dollar value of output is PY. Weencountered measures for these variables when we discussedthe national income accounts.

Money Velocity = Price Output M V = P Y

This version of the quantity equation is called the incomevelocity of money, which tells us the number of times a dollarbill enters someone’s income in a given time.

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Let’s now express the quantity of money in terms of the quantity ofgoods and services it can buy. This amount, M/P is called real money balances. Real money balances measure the purchasing power of the stock of money.A money demand function is an equation that shows the determinants of real money balances people wish to hold. Here is a simple money demand function:

where k is a constant that tells us how much money people want to hold for every dollar they earn. This equation states that the quantity of real money balances demanded is proportional to real income.

(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 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 bar over the V means that velocity is fixed.

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 bar over the V means that velocity is fixed.

So, let’s hold it constant! Remembera change in the quantity of money causesa proportional change in nominal GDP.

MV = PY

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

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

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.

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 Y

if 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 Nominal interest 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 Nominal interest 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.

rr = = ii - - π

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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

interestinterestReal 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 + E + E ii = = rr + E + E

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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As the quantity theory of money explains, money supply and money demand together determine the equilibrium price level. Changes in the price level are, by definition, the rate of inflation. Inflation, in turn, affects the nominal interest rate through the Fisher effect. But now, because the nominal interest rate is the cost of holding money, the nominal interest rate feeds back into the demand for money.

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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 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.

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Economists call the separation of the determinants of real and nominal variables the classical dichotomy. A simplification of economic theory, 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