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Chapter 4: Money and Inflation

Functions of Money
Medium of Exchange Store of Value Unit of Account Standard of Deferred Payment

Types of Money
Commodity money: a commodity with some intrinsic value used as a medium of exchange (e.g., cigarettes in POW camps) Fiat money: a commodity with no intrinsic value established by a government decree as money (e.g., coins & bills)

Characteristics of Money
Limited in supply Widely accepted Portable Divisible Uniform Durable

Money Supply
M1 Currency: coins & bills (25%) Demand Deposits: checking account deposits (75%) M2 M1 Time Deposits: savings account deposits less than $100,000

Money Supply
M3 M2 Time Deposits: savings account deposits more than $100,000 L M3 Liquid assets (e.g., T-Bills)

The Measures of Money

C M1 M2 M3 L $434 billion in April 1998 $1,081 $4,165 $5,574 $6,826

Money Supply Line

The quantity of money in circulation is controlled by the central bank in real value = M/P
Interest Rate (%)

(M/P)s 10 5 80

Quantity of Money

Money Demand
The amount of money demanded for transaction and speculation purposes depends on personal income and interest rate At any level of personal income, quantity demanded of money is a negative function of interest rate

Money Demand Line

Interest Rate (%)

10 5

M/P = f(Y, r) Y = income r = real interest rate

(M/P)d 80
Quantity of Money

Money Market Equilibrium

Interest Rate (%)

(M/P)s 5

(M/P)d 80
Quantity of Money

Federal Reserve System, FED

The central bank of the U.S.

Independent decision making unit with regional banks

In charge of money supply management and economic stabilization

Tools of Monetary Policy

Legal reserve ratio: ratio of cash reserves to deposits that banks are required to maintain By lowering the ratio, banks will have more reserves to lend and invest, increasing the money supply

Tools of Monetary Policy

Discount rate: rate of interest the FED charges on loans to banks By lowering the rate, banks encourage borrowing from the FED and lending to the public, increasing the money supply

Tools of Monetary Policy

Open Market Operations: FEDs purchases and sales of government bonds By purchasing bonds and paying the sellers, the FED increases the money supply

Expansionary Monetary Policy

Increase the money supply by any one or combination of the above tools Reduce the interest rate to encourage investment Increase investment expenditures, thus creating employment & income

Expansionary Monetary Policy

Interest Rate (%)

(M1/P)s (M2/P)s

5 4 (M/P)d 80 85
Quantity of Money

Quantity Theory of Money

Equation of Exchange: MV = PY
M = money supply V = income velocity of money: the rate of turn over of money P = general price level Y = output of goods & services

Income Velocity of Money

(M/P)d = kY where k is the percentage of money balances held for transactions Equilibrium (M/P)s = (M/P)d M/P = kY M/k = PY So, V = 1/k If k = 0.10, then V = 10: a $1 changes hands 10 time a year

Money Supply Growth & Inflation

In 1960s, inflation was low and money supply growth constant at about 7% In the 1970s, inflation rose as the money supply grew at an increasing rate to reach 10% In the 1980s and 1990s, inflation fell as money supply grew at a declining rate to reach about 6%

Historical Data

International Data

A continuous rise of the general price level

General price level is measured by the CPI or GDP Deflator

Percentage change of the general price level over the previous period

Inflationary Trend
Inflation stayed under 5% during the 1960s

It averaged 7.7% in the first half and 10.6% in the second half of the 1970s
Since the early 1980s, inflation rate has declined to as low as 3% in the late 1990s

Money and Inflation

Take percentage change from MV = PY

%M * %V = %P * %Y
V = 1/k and Y at full employment are constant

%M = %P : a 1% increase in the money supply causes a 1% increase in the general price level

Sources of Govt Revenues


Public Debt
Seigniorage or printing money: operates like an inflation tax on money holding as money loses real value

Fisher Effect
i = nominal rate of interest r = real rate of interest = inflation rate

i=r+ r=i-

Money, Inflation, Interest Rate

Quantity Theory of Money: a 1% increase in the money supply causes a 1% increase in inflation Fisher Effect: a 1% increase in the inflation causes a 1% increase in the nominal interest rate

Historical Data

International Data

Real Interest Rate

Ex-ante: real interest rate when loan are made (known) Ex-post: real interest rate when loans are paid (unknown, but measured by forecasting inflation rate)

Revised Fisher Effect

i = nominal rate of interest r = real rate of interest * = expected inflation rate

i = r + * r = i *

Revised Demand for Money

(M/P)d = L(i, Y) where L is for liquidity (M/P)d = L(r + * , Y) Money demand depends on the
real rate of interest (-) expected inflation rate (-) personal income (+)

Linkage Among Money, Prices, and Interest Rates

Changes in money demand and supply determine the price level Changes in the price level determine the inflation rate The inflation rate affects the interest rate The nominal interest rate affects the money demand

Linkage Among Money, Prices, and Interest Rates

Money Supply

Price Level

Inflation Rate

Nominal Interest Rate

Money Demand

Cost of Expected Inflation

Inflation Tax Menu Cost Inefficiency due to inflation variability Increase in tax liability Consumer inconvenience

Cost of Unexpected Inflation

Loss of returns:
creditors lose if * borrowers lose if

> * <

Loss of real income when income is fixed

When > 50% per month All unexpected costs get larger Delay in tax collection Inflation psychology Caused by excessive printing press Cure required fiscal reform

Hyperinflation in Germany