chapter 4: money and inflation. functions of money medium of exchange store of value unit of account...
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Chapter 4: Chapter 4: Money and InflationMoney and InflationChapter 4: Chapter 4: Money and InflationMoney and Inflation
Functions of Money
Medium of ExchangeStore of ValueUnit of AccountStandard 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 supplyWidely acceptedPortableDivisibleUniformDurable
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 $100,000L– M3– Liquid assets (e.g., T-Bills)
The Measures of Money
C $434 billion in April 1998M1 $1,081M2 $4,165M3 $5,574L $6,826
Money Supply Line
The quantity of money in circulation is controlled by the central bank in real value = M/P
Quantity of Money
Interest Rate (%)
(M/P)s
80
5
10
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
Quantity of Money
Interest Rate (%)
(M/P)d
10
5
10080
M/P = f(Y, r)Y = incomer = real interest rate
Money Market Equilibrium
Quantity of Money
Interest Rate (%)
(M/P)d
5
80
(M/P)s
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: FED’s 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
Quantity of Money
Interest Rate (%)
(M/P)d
5
80
(M1/P)s (M2/P)s
4
85
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 transactionsEquilibrium (M/P)s = (M/P)d
M/P = kY M/k = PYSo, 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
Inflation
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
%ΔM * %ΔV = %ΔP * %ΔYV = 1/k and Y at full employment are constant
%ΔM = %ΔP : a 1% increase in the money supply causes a 1% increase in the general price level
Sources of Gov’t Revenues
Taxes
Public Debt
Seigniorage or printing money: operates like an inflation tax on money holding as money loses real value
Fisher Effect
Define – i = nominal rate of interest– r = real rate of interest– π = inflation rate
i = r + π r = i - π
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
Define – i = nominal rate of interest– r = real rate of interest– π* = expected inflation rate
i = r + π* r = i – π*
Revised Demand for Money
(M/P)d = L(i, Y) where L is for liquidity
(M/P)d = L(r + π* , 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 levelChanges in the price level determine the inflation rateThe inflation rate affects the interest rateThe nominal interest rate affects the money demand
Linkage Among Money, Prices, and Interest Rates
Money Supply
Money Demand
PriceLevel
Inflation Rate
NominalInterestRate
Cost of Expected Inflation
Inflation Tax Menu CostInefficiency due to inflation variabilityIncrease in tax liabilityConsumer inconvenience
Cost of Unexpected Inflation
Loss of returns: – creditors lose if π* > π– borrowers lose if π* < π
Loss of real income when income is fixed
Hyperinflation
When π > 50% per monthAll unexpected costs get largerDelay in tax collectionInflation psychologyCaused by excessive printing press
Cure required fiscal reform
Hyperinflation in Germany