Monetary Policy

Part I: Money and Inflation

Chris EdmondNYU Stern

Spring 2007

1

Agenda

• Two classes on money, inflation, and monetary policy

– introduction: basic concepts and hyperinflation (today)– monetary policy: goals, instruments, central banking, transmission

2

Today

• Basic concepts

– quantity theory of money: money and inflation in the long run– Fisher e!ect: interest rates and inflation in the long run

• Hyperinflation

– examples– connection to fiscal policy– role of momentum in expectations: Cagan’s model

3

Money

• What is money? Traditional answers

– a ‘medium of exchange’– a ‘store of value’

• Consider assets safe in nominal terms (at face value)

– more liquid, zero or low interest-bearing assets (‘money’)– less liquid, higher interest-bearing assets (‘bonds’)

4

Money

• Why is money accepted in exchange?

– alternative is a barter economy– money overcomes the ‘double coincidence of wants’ problem– facilitates specialization

• What monetary assets solve this problem?

– cash?– credit?

5

The price level and inflation

• Given some money, how many real goods can I consume?

– answer depends on the ‘price level’– measured by the consumer price index or GDP deflator

• Higher price level means can consume less goods for any given amount of money

• We will use the symbol P for the price level and ! for inflation

• Inflation is the rate of growth in the price level

!t = "P,t = log(Pt)! log(Pt!1)

6

Prices and inflation

-0.2

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

2

1959 1962 1964 1966 1969 1971 1974 1976 1979 1981 1984 1986 1989 1991 1994 1996 1999 2001 2004 2006

0

0.02

0.04

0.06

0.08

0.1

0.12

price level (left axis)

cumulative growth

inflation rate (right axis)

annual rate

!t

log(Pt)

Source: Bureau of Economic Analysis, 2007

7

Monetary regimes

• Commodity money (gold standard, etc)

– historical notion: actual use of commodity in exchange– modern notion: paper money backed by government reserves of commodity

‘one US dollar worth135

of a troy ounce (889 mg) of gold’

– if credible, pins down price level– problems?

• Fiat money

– historical notion: paper money with legal status by government decree– modern notion: paper money unbacked by government reserves– problems?

8

Monetary neutrality

• Thought experiment

– government replaces each dollar with a ‘new’ dollar

$n1 = $2

– expect price level to halve, nothing real changes– if so, money is neutral

• Analogy

– two-for-one stock split

• Questions

– is money neutral?– if money is neutral, why worry about inflation?

9

Costs of high inflation

• Time and energy devoted to avoiding holding money

– costs of changing nominal prices– in extreme cases, money no longer useful for transactions– if so, revert to barter economy (or dollarize)

• With high and/or variable inflation, need to index contracts (wages, bond payments)

– otherwise, inflation redistributes from lenders to borrowers

10

Monetarism

• Milton Friedman, winner 1976 Nobel Prize in economics:

The fact is that inflation is always and everywhere a monetary phe-nomenon. There has never been an inflation in the course of history whichhas not been produced by an excessively rapid rate of increase in the quan-tity of money. The quantity of money has gone up faster than total outputand the result inevitably has been a rise in prices.

• What does this mean? Why does he say this?

– he is articulating the ‘quantity theory of money’– what’s that?

11

Velocity

• One dollar can be uses to execute several transactions per period of time

• Velocity, V is defined by

V =PC

M

where PC is nominal consumption

• Often written

MV = PC

(and called the ‘exchange equation’)

• So far, this is just a definition. To go further we need to add content

12

‘Quantity theory of money’ (first take)

• Exchange equation

MV = PC

• Assumptions

1. level of velocity is approximately constant2. growth rate of real consumption is independent of monetary forces3. money supply is controlled by the government

• Implication: inflation is a monetary phenomenon

! " "P = "M + "V ! "C

= "M ! "C

• Money growth in excess of consumption growth causes inflation

– ‘too many dollars chasing too few goods’

13

Long run evidence on the quantity theory

-0.2

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

2

1959 1962 1964 1966 1969 1971 1974 1976 1979 1981 1984 1986 1989 1991 1994 1996 1999 2001 2004 2006

cumulative growth

log(Mt/Ct)

log(Pt)

log(Vt)velocity

money/real consumption

price level

Source: Bureau of Economic Analysis, 2007

14

Inflation and interest rates

• Nominal interest rates. Example

– bond pays $100 in one year– current price is $96.15– annualized interest rate i solves

96.15 =1001 + i

# i = 0.04

• Real interest rates

r = i! E{!}

where E{!} is expected inflation (why ‘expected’?)

15

‘Fisher e!ect’

• Real and nominal interest rates

i = r + E{!}

• Irving Fisher

– real rate independent of monetary forces– determined by

$ time discounting$ growth rate of real output, productivity$ demographics, etc

• Implications

– monetary policy can only influence expected inflation– nominal rates and (expected) inflation should move together

16

Evidence

• Evidence?

– OK or for high inflation or in long run– not so good for low inflation or in short run

• Implication

– with low inflation, monetary policy influences real rate, not just expected infla-tion, in short run

17

Fisher e!ect with high inflation

!

"

#!

#"

$!

$"

%&'(&)*+,&

#-."/# #--!/# #--"/# $!!!/# $!!"/#0

12&3405)06!/5)*708!9233 :+*&05;02);3+*25)

<'&&(&0!0=);3+*25)0+)40>5/2)+30:+*&?

18

US nominal interest rates and inflation

-3

0

3

6

9

12

15

18

1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005

inflation

nominal interest T3M

annual percentage

Source: Board of Governors, 2007

19

Inflation and expected inflation

-3

0

3

6

9

12

15

18

1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005

inflation

annual percentage

expected inflation(Michigan survey)

Source: University of Michigan, 2007

20

Nominal and real interest rates

-3

0

3

6

9

12

15

18

1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005

annual percentage

nominal interest

real interest

Source: University of Michigan, 2007

21

TIPS: market real interest rates

0

1

2

3

4

5

6

2003 2004 2005 2006

TIPS10Y

T10Y nominal rate

inflation-protected rate

annual percentage

Source: Board of Governors, 2007

22

Bond market inflation expectations

0

1

2

3

4

5

6

2003 2004 2005 2006

TIPS10Y

T10Y nominal rate

inflation-protected rate

annual percentage

implied expected inflation

Source: Board of Governors, 2007

23

Market vs. consumer expectations

0

1

2

3

4

5

6

2003 2004 2005 2006

annual percentage

Michigan survey

Source: Board of Governors and University of Michigan, 2007

24

What have we learned so far?

• In the long run

– inflation caused by money growth in excess of consumption growth– nominal interest rates determine expected inflation

• But in the short run, especially if inflation is low

– money may not be neutral– real interest rates and nominal interest rates move together

25

Rest of this class

• Hyperinflation

– examples– connection to fiscal policy– role of momentum in expectations: Cagan’s model

26

Argentina

This note is from the 1980s. What’s it worth today? Why?

27

Germany

October 1923: 20 dollars = 100,000,000,000 marks

28

Germany

Progression of stamps in Weimar Germany

29

German hyperinflation

End result of a hyperinflation?

30

Open market operations (‘OMOs’)

• ‘Base’ money supply controlled by central banks

• Introduce money via open market operations: exchanges of money for governmentdebt (Treasury bonds)

– open market sale: sell government debt, receive money– open market purchase: buy government debt, pay money

• Implies

– fiscal deficits can be financed with a mix of new bond issues and increases in themoney supply

• ‘Seignorage’

– revenue obtained by monetizing government fiscal deficits

31

Fiscal origins of hyperinflation

• Financing government deficits

deficit = (Mt+1 !Mt) + (Bt+1 !Bt)

where

Mt = money supply at date t

Bt = bonds outstanding at date t

• Why would government finance deficit with money? (‘monetize’)

– intractable deficit (for whatever reason)– no buyers for government debt

32

German experience

1914-1918 borrowed to finance WWI

1914 suspended convertibility of currency for gold

1919-1923 high fiscal deficits continue after war (reparations), deficits monetized

1922 inflation peaks at 3.35 million percent per month

1923 fiscal-monetary reform: 1 ‘gold’ mark = 1012 paper marks (tied to bank assets)

33

European hyperinflation

Country Dates Average inflation (per month)Austria 1921-1922 47%

Germany 1922-1923 322%

Greece 1943-1944 365%

Hungary 1923-1924 46%

Hungary 1945-1946 19,800%

Poland 1923-1924 81%

Russia 1921-1924 57%

34

Latin American hyperinflation

Argentina Bolivia Brazil Nicaragua Peru

1984 627 1,281 192 35 110

1985 672 11,750 226 219 163

1986 90 276 147 681 78

1987 131 14 228 911 86

1988 343 16 629 10,205 667

1989 3,080 15 1,430 47,770 3,399

1990 2,314 17 2,947 7,485 7,482

1991 172 21 432 2,945 410

1992 25 12 951 23 74

1993 10.6 9 1,977 20 49

1994 0.16 12 16 11.6 12

Source: IMF, annual rate in percentage points

35

Brazilian example

!!"""

"

!"""

#$%%$&'()&*)+,-$(

!."""

!!""

"

!""

."""

/,01,'2-3,

.44"5. .44!5. 6"""5. 6""!5.)

7'*%-2$&')+-2, 80&92:)+-2,)&*);6

8&<=)>,*$1$2)?@,*2)A1-%,B

CDE,0$'*%-2$&')$')#0-F$%

36

‘Quantity theory of money’ (second take)

• For many purposes, assumption of constant velocity is inappropriate

– in the middle of a hyperinflation, for example

• Another specification often used is

V (i), V "(i) > 0

– velocity increasing with nominal interest rate i

– intuition: higher i induces substitution towards bonds, away from money– i measures opportunity cost of holding money

37

‘Quantity theory of money’ (second take)

• Exchange equation

MV = PC

• Or in logs

m + v = p + c

where m = log(M), v = log(V ), p = log(P ), etc

• Then from exchange equation

m! p = c! v(i)

• This represents the demand curve for real money, m! p

38

Phillip Cagan’s model of hyperinflation

• Idea

– monetized deficits get hyperinflation started– reinforced by ‘momentum’ in inflation expectations?

• Pieces of the model

– demand curve for real money– adaptive expectations– supply of money controlled by government

39

Demand for real money

• From exchange equation and Fisher equation

mt ! pt = ct ! v(it)it = rt + !e

t

where !et is expected inflation

• Cagan’s specification

v(it) = #it, # > 0ct = 0rt = 0

so in short

mt ! pt = !#!et

40

Adaptive expectations

• Inflation expectations a weighted average of past expectations and current inflation

!et = $!e

t!1 + (1! $)(pt ! pt!1), 0 < $ < 1

– $ % 0: inflation expectations update fast– $ % 1: inflation expectations update slow

41

After some algebra (in notes)

• Solution

pt = %1pt!1 + %2mt + %3mt!1

where

%1 =#(1! $)! 1#(1! $)! $

, increasing in #, decreasing in $

• Prices are ‘dynamically stable’ if

|%1| < 1

meaning, if money supply process stabilizes, so will prices

• Solution is a linear equation we can estimate with a regression

42

Results on dynamic stability

Country Dates Stability coe"cient (%1)Austria 1921-1922 0.93

Germany 1922-1923 3.17

Greece 1943-1944 0.61

Hungary 1923-1924 0.23

Hungary 1945-1946 0.67

Poland 1923-1924 0.03

Russia 1921-1924 5.92

• All except German and Russian hyperinflation dynamically stable

• These episodes had significant momentum component, not just fiscal impetus

43

Preventing hyperinflation

• Inflation caused by excessive money growth

• Money growth because of monetized fiscal deficits

• Orthodox solution

– independent central bank (separate from government)– goal of central bank: price stability– fiscal discipline

• Even mild inflation can get out of hand because of momentum

– need to ‘anchor’ inflation expectations

44