mac

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Money and Inflation

U.S. inflation and its trendU.S. inflation and its trend, 1960-2006, 1960-2006

0%

3%

6%

9%

12%

15%

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

long-run trend

% change in CPI from 12 months earlier

Money: FunctionsMoney: Functions

medium of exchange

store of value

unit of account

Money: TypesMoney: Types

1. fiat money– has no intrinsic value– example: the paper currency we use

2. commodity money– has intrinsic value– examples:

gold coins, cigarettes in P.O.W. camps

The central bankThe central bank

In the U.S., the central bank is called the Federal Reserve (“the Fed”).

Open Market Operations are the primary monetary policy tool

The Federal Reserve Building Washington, DC

Money supply measures, Money supply measures, Dec. 2007Dec. 2007

$7447

M1 + small time deposits, savings deposits, money market mutual funds, money market deposit accounts

M2

$1364C + demand deposits, travelers’ checks, other checkable deposits

M1

$759CurrencyC

amount ($ billions)assets includedsymb

ol

The Quantity Theory of MoneyThe Quantity Theory of Money

A simple theory linking the inflation rate to the growth rate of the money supply.

David Hume Milton Friedman

The quantity equationThe quantity equation

assumes V is constant & exogenous

With V constant, the money supply determines nominal GDP: (P Y )

Real GDP is determined by the economy’s supplies of K and L and the production function

M, therefore, determines the price level, P

M V P Y

The quantity theory of moneyThe quantity theory of money

The quantity equation in growth rates:

M V P YM V P Y

The quantity theory of money assumes

is constant, so = 0.V

VV

The quantity theory of moneyThe quantity theory of money

(Greek letter “pi”) denotes the inflation rate:

M P YM P Y

PP

The result from the preceding slide was:

Solve this result for to get

The quantity theory of moneyThe quantity theory of money

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.

The quantity theory of moneyThe quantity theory of money

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 predicts a one-for-one relation between

changes in the money growth rate and changes in the inflation rate.

Hence, the Quantity Theory predicts a one-for-one relation between

changes in the money growth rate and changes in the inflation rate.

Confronting the quantity theory Confronting the quantity theory with datawith dataThe quantity theory of money implies

1. countries with higher money growth rates should have higher inflation rates.

2. the long-run trend behavior of a country’s inflation should be similar to the long-run trend in the country’s money growth rate.

Are the data consistent with these implications?

International data on inflation and International data on inflation and money growthmoney growth

0.1

1

10

100

1 10 100Money Supply Growth (percent, logarithmic scale)

Inflation rate (percent,

logarithmic scale)

0.1

1

10

100

1 10 100Money Supply Growth (percent, logarithmic scale)

Inflation rate (percent,

logarithmic scale)

Singapore

U.S.

Switzerland

Argentina

Indonesia

Turkey

BelarusEcuador

U.S. inflation and money growth, U.S. inflation and money growth, 1960-20061960-2006

0%

3%

6%

9%

12%

15%

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

M2 growth rate

inflation rate

Over the long run, the inflation and money growth rates move together,

as the quantity theory predicts.

Over the long run, the inflation and money growth rates move together,

as the quantity theory predicts.

Inflation and interest ratesInflation and interest rates

Nominal interest rate, inot adjusted for inflation

Real interest rate, radjusted for inflation:

r = i

The Fisher effectThe Fisher effect

The Fisher equation: i = r + Chap 3: S = I determines r .

Hence, an increase in causes an equal increase in i.

This one-for-one relationship is called the Fisher effect.

Irving Fisher

Inflation and nominal interest rates Inflation and nominal interest rates in the U.S., in the U.S., 1955-20061955-2006

percent per year

-5

0

5

10

15

1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

inflation rate

nominal interest rate

Inflation and nominal interest rates Inflation and nominal interest rates across countriesacross countries

1

10

100

0.1 1 10 100 1000

Inflation Rate (percent, logarithmic scale)

Nominal Interest Rate

(percent, logarithmic scale)

1

10

100

0.1 1 10 100 1000

Inflation Rate (percent, logarithmic scale)

Nominal Interest Rate

(percent, logarithmic scale)

Switzerland

Germany

Brazil

Romania

Zimbabwe

Bulgaria

U.S.

Israel

Exercise:Exercise:

Suppose V is constant, M is growing 5% per year, Y is growing 2% per year, and r = 4.

a. Solve for i.

b. If the Fed increases the money growth rate by 2 percentage points per year, find i.

c. Suppose the growth rate of Y falls to 1% per year. • What will happen to ? • What must the Fed do if it wishes to

keep constant?

Answers:Answers:

a. First, find = 5 2 = 3. Then, find i = r + = 4 + 3 = 7.

b. i = 2, same as the increase in the money growth rate.

c. If the Fed does nothing, = 1. To prevent inflation from rising, Fed must reduce the money growth rate by 1 percentage point per year.

V is constant, M grows 5% per year, Y grows 2% per year, r = 4.

Money demand and Money demand and the nominal interest ratethe nominal interest rate In the quantity theory of money,

the demand for real money balances depends only on real income Y.

Another determinant of money demand: the nominal interest rate, i. – the opportunity cost of holding money

(instead of bonds or other interest-earning assets).

Hence, i in money demand.

The money demand functionThe money demand function

(M/P )d = real money demand, depends– negatively on i

i is the opp. cost of holding money– positively on Y

higher Y more spending so, need more money

(“L” is used for the money demand function because money is the most liquid asset.)

( ) ( , )dM P L i Y

The money demand functionThe money demand function

When people are deciding whether to hold money or bonds, they don’t know what inflation will turn out to be.

Hence, the nominal interest rate relevant for money demand is r +

e.

( ) ( , )dM P L i Y

( , )eL r Y

EquilibriumEquilibrium

( , )eML r Y

P

The supply of real money balances Real money

demand

What determines whatWhat determines what

variable how determined (in the long run)

M exogenous (the Fed)

r adjusts to make S = I

Y

P adjusts to make

( , )eML r Y

P

( , )Y F K L

( , )M

L i YP

How How PP responds to responds to MM

For given values of r, Y, and e,

a change in M causes P to change by the same percentage – just like in the quantity theory of money.

( , )eML r Y

P

Discussion question Discussion question

Why is inflation bad? What costs does inflation impose on

society? List all the ones you can think of.

Focus on the long run.

A common misperceptionA common misperception

Common misperception: inflation reduces real wages

This is true only in the short run, when nominal wages are fixed by contracts.

(Chap. 3) In the long run, the real wage is determined by labor supply and the marginal product of labor, not the price level or inflation rate.

Consider the data…

Average hourly earnings and the CPI, Average hourly earnings and the CPI, 1964-20061964-2006

$0

$2

$4

$6

$8

$10

$12

$14

$16

$18

$20

1964 1970 1976 1982 1988 1994 2000 2006

ho

url

y w

age

0

50

100

150

200

250

CP

I (1

982-

84 =

100

)

CPI (right scale)wage in current dollarswage in 2006 dollars

The classical view of inflationThe classical view of inflation

The classical view: A change in the price level is merely a change in the units of measurement.

So why, then, is inflation a social

problem?

The social costs of inflationThe social costs of inflation

…fall into two categories:

1. costs when inflation is expected

2. costs when inflation is different than people had expected

The costs of expected inflation:The costs of expected inflation:

Shoeleather cost

Menu costs

Relative price distortions

Unfair tax treatment

General inconvenience

The cost of The cost of unexpectedunexpected inflation: inflation:

Arbitrary redistribution of purchasing power– Ex: From lenders to borrowers

Increased uncertainty

One One benefitbenefit of inflation of inflation

Nominal wages are rarely reduced, even when the equilibrium real wage falls.

This hinders labor market clearing.

Inflation allows the real wages to reach equilibrium levels without nominal wage cuts.

Therefore, moderate inflation improves the functioning of labor markets.

HyperinflationHyperinflation

def: 50% per month

All the costs of moderate inflation described

above become HUGE under hyperinflation.

Money ceases to function as a store of value, and may not serve its other functions (unit of account, medium of exchange).

People may conduct transactions with barter or a stable foreign currency.

Germany 1923Germany 1923

What causes hyperinflation?What causes hyperinflation?

Hyperinflation is caused by excessive money supply growth:

When the central bank prints money, the price level rises.

If it prints money rapidly enough, the result is hyperinflation.

A few examples of hyperinflationA few examples of hyperinflation

money growth

(%)

inflation (%)

Israel, 1983-85 295 275

Poland, 1989-90 344 400

Brazil, 1987-94 1350 1323

Argentina, 1988-90

1264 1912

Peru, 1988-90 2974 3849

Nicaragua, 1987-91

4991 5261

Bolivia, 1984-85 4208 6515

Why governments create Why governments create hyperinflationhyperinflation When a government cannot raise

taxes or sell bonds,

it must finance spending increases by printing money.

In theory, the solution to hyperinflation is simple: stop printing money.

In the real world, this requires drastic and painful fiscal restraint.

The Classical DichotomyThe Classical Dichotomy

Real variables: Measured in physical units – quantities and relative prices, for example:

– quantity of output produced

– real wage: output earned per hour of work

– real interest rate: output earned in the future by lending one unit of output today

Nominal variables: Measured in money units, e.g., nominal wage: Dollars per hour of work. nominal interest rate: Dollars earned in future

by lending one dollar today. the price level: The amount of dollars needed

to buy a representative basket of goods.

The Classical DichotomyThe Classical Dichotomy

Note: Real variables were explained in Chap 3, nominal ones in Chapter 4.

Classical dichotomy: the theoretical separation of real and nominal variables in the classical model, which implies nominal variables do not affect real variables.

Neutrality of money: Changes in the money supply do not affect real variables. In the real world, money is approximately neutral in the long run.

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UnemploymentUnemployment

Actual and natural rates of Actual and natural rates of unemployment in the U.S., unemployment in the U.S., 1960-20061960-2006

Per

cent

of l

abor

forc

e

0

2

4

6

8

10

12

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Unemployment rate

Natural rate of unemployment

A first model of the natural rateA first model of the natural rate

Notation:

L = # of workers in labor force

E = # of employed workers

U = # of unemployed

U/L = unemployment rate

Assumptions:Assumptions:

1. L is exogenously fixed.

2. During any given month,

s = fraction of employed workers that become separated from their jobs

s is called the rate of job separations

f = fraction of unemployed workers that find jobs

f is called the rate of job finding

s and f are exogenous

The transitions between The transitions between employment and unemploymentemployment and unemployment

Employed Unemployed

s E

f U

The steady state conditionThe steady state condition

Definition: the labor market is in steady state, or long-run equilibrium, if the unemployment rate is constant.

The steady-state condition is:

s E = f U

# of employed people who lose or leave their jobs

# of unemployed people who find jobs

Finding the “equilibrium” U rateFinding the “equilibrium” U rate

f U = s E

= s (L – U )

= s L – s U

Solve for U/L:

(f + s) U = s L

so,

Example:Example:

Each month, – 1% of employed workers lose their jobs

(s = 0.01)– 19% of unemployed workers find jobs

(f = 0.19)

Find the natural rate of unemployment:

0 010 05, or 5%

0 01 0 19

U sL s f

..

. .

Policy Implication: A policy will reduce the natural rate of unemployment only if it lowers s or increases f.

Why is there unemployment?Why is there unemployment? If job finding were instantaneous (f

= 1), then all spells of unemployment would be brief, and the natural rate would be near zero.

There are two reasons why f < 1:

1. job search

2. wage rigidity

Job search & frictional unemploymentJob search & frictional unemployment

frictional unemployment: caused by the time it takes workers to search for a job

occurs even when wages are flexible and there are enough jobs to go around

occurs because– workers have different abilities, preferences– jobs have different skill requirements– geographic mobility of workers not instantaneous– flow of information about vacancies and job

candidates is imperfect

Sectoral shiftsSectoral shifts

def: Changes in the composition of demand among industries or regions.

example: Technological change more jobs repairing computers, fewer jobs repairing typewriters

example: A new international trade agreement labor demand increases in export sectors, decreases in import-competing sectors

Result: frictional unemployment

CASE STUDY: CASE STUDY: Structural change over the long runStructural change over the long run

4.2%

28.0%9.9%

57.9%

Agriculture

Manufacturing

Other industry

Services

1960

1.6%

17.2%7.7%

73.5%

2000

Public policy and job searchPublic policy and job search

Govt programs affecting unemployment

– Govt employment agencies:disseminate info about job openings to better match workers & jobs.

– Public job training programs:help workers displaced from declining industries get skills needed for jobs in growing industries.

Unemployment insurance (UI)Unemployment insurance (UI)

UI pays part of a worker’s former wages for a limited time after losing his/her job.

UI increases search unemployment, because it reduces– the opportunity cost of being unemployed– the urgency of finding work– f

Studies: The longer a worker is eligible for UI, the longer the duration of the average spell of unemployment.

By allowing workers more time to search,

UI may lead to better matches between jobs and workers,

which would lead to greater productivity and higher incomes.

Benefits of UIBenefits of UI

Why is there unemployment?Why is there unemployment?

Two reasons why f < 1:

1. job search

2. wage rigidityDONE Next

The natural rate of unemployment:

Unemployment from real wage Unemployment from real wage rigidityrigidity

Labor

Real wage

Supply

Demand

Unemployment

Rigid

real wage

Amount of labor willing to work

Amount of labor hired

If real wage is stuck above its eq’m level, then there aren’t enough jobs to go around.

Reasons for wage rigidityReasons for wage rigidity

1. Minimum wage laws

2. Labor unions

3. Efficiency wages

The duration of U.S. unemployment, The duration of U.S. unemployment, average over 1/1990-5/2006average over 1/1990-5/2006

# of weeks unemploye

d

# of unemployed

persons as % of total

# of unemployed

amount of time these workers

spent unemployed as % of total

time all workers spent

unemployed

1-4 38% 7.2%

5-14 31% 22.3%

15 or more 31% 70.5%

The duration of unemploymentThe duration of unemployment

The data: – More spells of unemployment are short-term

than medium-term or long-term.– Yet, most of the total time spent

unemployed is attributable to the long-term unemployed.

This long-term unemployment is probably structural and/or due to sectoral shifts among vastly different industries.

Knowing this is important because it can help us craft policies that are more likely to work.

TREND: TREND: The natural rate rises during The natural rate rises during 1960-1984, then falls during 1985-20061960-1984, then falls during 1985-2006

3

4

5

6

7

8

9

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

EXPLAINING THE TREND:EXPLAINING THE TREND:

The minimum wageThe minimum wage

0

1

2

3

4

5

6

7

8

9

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Dol

lars

per

hou

r

minimum wage in current dollars

minimum wage in 2006 dollars

The trend in the real minimum wage is similar to that of the natural rate of unemployment.

The trend in the real minimum wage is similar to that of the natural rate of unemployment.

EXPLAINING THE TREND:EXPLAINING THE TREND:

Union membershipUnion membership

Since the early 1980s, the natural rate of unemploy-ment and union membership have both fallen.

But, from 1950s to about 1980, the natural rate rose while union membership fell.

Since the early 1980s, the natural rate of unemploy-ment and union membership have both fallen.

But, from 1950s to about 1980, the natural rate rose while union membership fell.

Union membershipselected years

year percent of labor force

1930 12%

1945 35%

1954 35%

1970 27%

1983 20%

2005 12%

EXPLAINING THE TREND: EXPLAINING THE TREND:

Sectoral shiftsSectoral shifts

$0

$20

$40

$60

$80

$100

1970 1975 1980 1985 1990 1995 2000 2005

Price per barrel of oil,

in 2006 dollars

From mid 1980s to early 2000s, oil prices less volatile, so fewer sectoral shifts.

From mid 1980s to early 2000s, oil prices less volatile, so fewer sectoral shifts.

EXPLAINING THE TREND:EXPLAINING THE TREND:

DemographicsDemographics 1970s:

The Baby Boomers were young. Young workers change jobs more frequently (high value of s).

Late 1980s through today: Baby Boomers aged. Middle-aged workers change jobs less often (low s).

Unemployment in Europe,Unemployment in Europe, 1960-2005 1960-2005P

erce

nt o

f lab

or fo

rce

Italy

Germany

France

U.K.

0

3

6

9

12

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

The rise in European unemploymentThe rise in European unemployment

Shock Technological progress has shifted labor demand from unskilled to skilled workers in recent decades.

Effect in United StatesAn increase in the “skill premium” – the wage gap between skilled and unskilled workers.

Effect in EuropeHigher unemployment, due to generous govt benefits for unemployed workers and strong union presence.

Percent of workers covered by Percent of workers covered by collective bargainingcollective bargaining

United States 18%

United Kingdom 47

Switzerland 53

Spain 68

Sweden 83

Germany 90

France 92

Austria 98