Lecture07 - Money and Inflation Front Page of the NY Times...

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Unformatted text preview: Money and Inflation Front Page of the NY Times Today How Bad Is Inflation in Zimbabwe? By MICHAEL WINES Published: May 2, 2006 HARARE, Zimbabwe, April 25 -- How bad is inflation in Zimbabwe? Well, consider this: at a supermarket near the center of this tatterdemalion capital, toilet paper costs $417. No, not per roll. Four hundred seventeen Zimbabwean dollars is the value of a single twoply sheet. A roll costs $145,750 -- in American currency, about 69 cents. ECN 101 MACROECONOMICS slide 1 ECN 101 MACROECONOMICS slide 2 Roadmap to this Lecture Money: definitions and properties The Quantity Theory of Money Seignorage: the inflation tax g g Interest rates and the Fisher effect Money Demand: determinants and d d d equilibrium Costs of inflation: hyperinflation ECN 101 MACROECONOMICS slide 3 1923 Germany 5 Billion Marks Billion ECN 101 MACROECONOMICS slide 4 1993 Yugoslavia 10 Billion Dinars ECN 101 MACROECONOMICS slide 5 U.S. inflation: 1960-2003 196014% 12% 10% 8% 6% 4% 2% 0% 1960 1965 1970 1975 1980 1985 1990 1995 2000 Inflation rate ECN 101 MACROECONOMICS slide 6 Money: definition Money is the stock of assets that can be readily used to make transactions. ECN 101 MACROECONOMICS slide 7 Money: functions 1. medium of exchange we use it to buy stuff 2. store of value transfers purchasing power from the f h f h present to the future the common unit by which everyone measures prices and values i d l 3. unit of account ECN 101 MACROECONOMICS slide 8 Money: types 1. fiat money has no intrinsic value example: the paper currency 2. commodity money has intrinsic value examples: gold coins, l ld i we use cigarettes in P.O.W. camps ECN 101 MACROECONOMICS slide 9 The money supply & monetary policy The money supply is the quantity of money available in the economy. Monetary policy is the control over yp y the money supply. ECN 101 MACROECONOMICS slide 10 The central bank Monetary policy is conducted by a country's central bank. bank In the U.S., the th central t l bank is called the Federal Reserve ( e ed ) ("the Fed"). The Federal Reserve Building Washington, Washington DC ECN 101 MACROECONOMICS slide 11 Money supply measures, May 2004 _Symbol C M1 Assets included Currency C + demand deposits, travelers' checks, other checkable deposits Amount (billions)_ $671.7 1319.2 M2 M1 + small time deposits, 6268.9 savings deposits, money market mutual funds, money market deposit accounts M2 + large time deposits, repurchase agreements, institutional money market mutual fund balances ECN 101 MACROECONOMICS M3 9193.8 slide 12 Money Stock To reduce the monetary base, the Federal Reserve sells short term short-term government bonds To i T increase the monetary b th t base, the th Federal Reserve buys short-term government bonds These transactions are called open market operations ECN 101 MACROECONOMICS slide 13 Open Market Operations To I T Increase the Monetary Base To D T Decrease the Monetary Base Federal Reserve Buy bonds Federal Reserve Sell bonds For cash For cash ECN 101 MACROECONOMICS slide 14 The Money Stock The Federal Reserve directly controls the monetary base The money stock is determined by the interaction of th monetary b i t ti f the t base with th ith the banking sector regulatory requirements the incentive of financial institutions to have enough funds on hand to satisfy depositors' demands ECN 101 MACROECONOMICS slide 15 The Quantity Theory of Money A simple theory linking the inflation rate to the growth rate of the money supply. Begins with a concept called "velocity"... ECN 101 MACROECONOMICS slide 16 Velocity basic concept: the rate at which money circulates definition: the number of times the average example: In 2003, $500 billion in transactions money supply = $100 billion The average dollar is used in five transactions in 2003 So, velocity = 5 ECN 101 MACROECONOMICS dollar bill changes hands in a given time period slide 17 Velocity, cont. This suggests the following definition: T V = M where V = velocity y T = value of all transactions M = money supply ECN 101 MACROECONOMICS slide 18 Velocity, cont. Use nominal GDP as a proxy for total transactions. transactions Then, where P Y V = M P = price of output i f (GDP d fl deflator) ) Y = quantity of output (real GDP) P Y = value of output (nominal GDP) ECN 101 MACROECONOMICS slide 19 Velocity 30 30 Mean = 22 25 20 15 10 5 0 50 55 60 65 70 75 80 85 90 95 00 05 Currency Velocity M3 Velocity 25 20 15 10 5 0 Mean = 1.5 ECN 101 MACROECONOMICS slide 20 The quantity equation The quantity equation M V = P Y follows from the preceding definition of velocity. velocity It is an identity: it holds by definition of the variables. ECN 101 MACROECONOMICS slide 21 Money demand and the quantity equation M/P = real money balances, the purchasing power of the money supply. h i f th l A simple money demand function: p y (M/P )d = k Y where k = how much money people wish to hold for each dollar of income. (k is exogenous) ECN 101 MACROECONOMICS slide 22 Money demand and the quantity equation money demand: (M/P )d = k Y quantity equation: M V = P Y The connection between them: k = 1/V When people hold lots of money relative to their incomes (k is high), money changes hands infrequently (V is low). low) ECN 101 MACROECONOMICS slide 23 back to the Quantity Theory of Money starts with quantity equation assumes V is constant & exogenous: V =V With this assumption the quantity assumption, equation can be written as M V = P Y ECN 101 MACROECONOMICS slide 24 The Quantity Theory of Money, cont. M V = P Y How the price level is determined: 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 The i l Th price level is li P = (nominal GDP)/(real GDP) ECN 101 MACROECONOMICS slide 25 The Quantity Theory of Money, cont. Recall: The growth rate of a product equals the sum of the growth rates. The quantity equation in growth rates: M V P Y M + V = P + Y The qua t ty t eo y o money assu es e quantity theory of o ey assumes V V is constant, so = 0. V ECN 101 MACROECONOMICS slide 26 The Quantity Theory of Money, cont. Let (Greek letter "pi") denote th i fl ti rate: d t the inflation t The result from the preceding slide was: Solve this result for to get = M = P P P + Y P M Y = M M - Y Y ECN 101 MACROECONOMICS slide 27 The Quantity Theory of Money, cont. = M M - Y Y Normal economic growth requires a certain amount of money supply growth to facilitate the growth in transactions transactions. Money growth in excess of this amount leads t i fl ti l d to inflation. ECN 101 MACROECONOMICS slide 28 The Quantity Theory of Money, cont. = M M - Y Y 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 of Money predicts a one-for-one relation between changes in the money growth rate and changes in the inflation rate. ECN 101 MACROECONOMICS slide 29 International data on inflation and money growth Inflation rate 10,000 (percent, logarithmic l ith i scale) 1,000 Democratic Repub of Congo Nicaragua Georgia Angola Brazil Bulgaria 100 10 Kuwait 1 USA Oman 0.1 0.1 1 Japan 10 Canada Germany 100 1,000 10,000 Money supply growth (percent, logarithmic scale) (percent ECN 101 MACROECONOMICS slide 30 U.S. data on inflation and money growth Inflation rate (percent) 8 6 1980s 4 2 0 -2 -4 1930s 1920s 1870s 1950s 1990s 1960s 1900s 1910s 1970s 970s 1940s 1890s 1880s 0 2 4 6 8 10 12 Growth in money supply (percent) ECN 101 MACROECONOMICS slide 31 U.S. Inflation & Money Growth, 1960-2003 196014% 12% 10% 8% 6% 4% 2% 0% 1960 1965 1970 1975 Inflation rate ECN 101 MACROECONOMICS 1980 1985 1990 1995 2000 Inflation rate trend slide 32 U.S. Inflation & Money Growth, 1960-2003 196014% 12% 10% 8% 6% 4% 2% 0% 1960 1965 1970 1975 Inflation rate ECN 101 MACROECONOMICS 1980 1985 1990 1995 2000 Inflation rate trend slide 33 U.S. Inflation & Money Growth, 1960-2003 196014% 12% 10% 8% 6% 4% 2% 0% 1960 1965 1970 1975 1980 1985 1990 1995 2000 Inflation rate M2 growth rate Inflation rate trend M2 growth rate trend slide 34 ECN 101 MACROECONOMICS U.S. Inflation & Money Growth, 1960-2003 196014% 12% 10% 8% 6% 4% 2% 0% 1960 1965 1970 1975 1980 1985 1990 1995 2000 Inflation rate M2 growth rate Inflation rate trend M2 growth rate trend slide 35 ECN 101 MACROECONOMICS Seigniorage To spend more without raising taxes or selling bonds, the govt can print money. bonds money The "revenue" raised from printing money is called seigniorage ll d i i The inflation tax: Printing money to raise revenue causes inflation. Inflation is like a tax on people who hold money. ECN 101 MACROECONOMICS slide 36 Seignorage: An example Suppose Ms doubles from $100 billion to $200 billion. From the QTM we know the price level Q p will double, e.g. $1/loaf to $2/loaf What is the real value of the extra purchases the government can make? t k ? $50 billion of the original dollars. Why? Govt. printed $ $100 billion but prices are now double ($2/loaf) A real life example: Bolivia, 1980-1985 had = Bolivia 1980 1985 500% and seignorage of 6% of GNP ECN 101 MACROECONOMICS slide 37 Inflation and interest rates When a borrower and a lender agree on a nominal interest rate on a loan they do loan, not know what the future rate of will be Nominal i t N i l interest rate: i t t Real interest rate, r r = i - ECN 101 MACROECONOMICS slide 38 Two real interest rates = actual inflation rate (not known until after it has occurred) e = expected inflation rate i e = ex ante real interest rate: the real interest rate people expect at the time they buy a bond or take out a loan i = ex post real interest rate: the real interest rate people actually end up earning on their bond or paying on their loan ECN 101 MACROECONOMICS slide 39 The Fisher Effect The Fisher equation: i = r + e Hence, an increase in causes an equal increase in i. q This one-for-one relationship is called the Fisher effect. effect ECN 101 MACROECONOMICS slide 40 U.S. inflation and nominal interest rates, since 1954 Percent 18 16 14 12 10 8 6 4 2 0 Nominal interest rate Inflation rate -2 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 ECN 101 MACROECONOMICS slide 41 Inflation and nominal interest rates across countries 100 Nominal interest rate (percent, logarithmic scale) Italy France 10 Nigeria Ni i United Kingdom United States Japan Germany 1 Singapore 1 10 100 1000 Inflation rate (percent, logarithmic scale) Kazakhstan Kenya Uruguay Armenia ECN 101 MACROECONOMICS slide 42 Exercise: Suppose V is constant, M is growing 5% per year, Y is growing 2% per year, and r = 4. g g p y , a. Solve for i (the nominal interest rate). First, First notice = 5% - 2% = 3% and i = r + = 4% + 3% = 7%. b. b If the Fed increases the money growth rate by 2 percentage points per year, find i . i = 2, same as the increase in the money growth 2 rate ECN 101 MACROECONOMICS slide 43 Exercise (cont.) Suppose V is constant, M is growing 5% per year, Y is growing 2% per year, and r = 4. c. Suppose the growth rate of Y falls to 1% per year. What will happen to ? If the Fed does nothing, = 1 What must the Fed do if it wishes to keep constant? To prevent inflation from rising Fed must reduce the rising, money growth rate by 1 percentage point per year. ECN 101 MACROECONOMICS slide 44 Money demand and the nominal interest rate The Quantity Theory of Money assumes that the demand for real money balances depends only on real income Y. We W now consider another determinant of id th d t i t f money demand: the nominal interest rate. The Th nominal interest rate i i the i li is h opportunity cost of holding money (instead of bonds or other interest-earning assets). assets) Hence, i in money demand. ECN 101 MACROECONOMICS slide 45 The money demand function (M P ) = L (i , Y ) d (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.) y q ) ECN 101 MACROECONOMICS slide 46 The money demand function (M P ) = L (i , Y ) d = L (r + , Y ) e When people are deciding whether to hold money or bonds, they don't know what inflation ill i fl i will turn out to be. b Hence, the nominal interest rate relevant for money demand is r + e. ECN 101 MACROECONOMICS slide 47 Equilibrium M e = L (r + , Y ) P The supply of real money balances Real money demand ECN 101 MACROECONOMICS slide 48 What determines what M e = L (r + , Y ) P variable how determined (in the long run) exogenous (the Fed) adjusts to make S = I M r Y P Y = F (K , L ) adjusts to make M = L (i , Y ) P slide 49 ECN 101 MACROECONOMICS How P responds to M M e = L (r + , Y ) P 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. ECN 101 MACROECONOMICS slide 50 What about expected inflation? inflation? Over the long run, people don't consistently over over- or under-forecast inflation, under forecast so e = on average. In the short run e may change when people run, get new information. EX: Suppose Fed announces it will increase M next year. People will expect next year's P to be higher, so e rises. g , This will affect P now, even though M hasn't changed yet. (continued...) ECN 101 MACROECONOMICS slide 51 How P responds to e M e = L (r + , Y ) P For given values of r, Y, and M , e i (the Fisher effect) (M P ) d P to make (M P ) fall to t re-establish eq'm t bli h ' ECN 101 MACROECONOMICS slide 52 Gasoline Prices Ratio of Personal Consumption Expenditures on Gasoline and F l R l i to All I G li d Fuel Relative Items 7 Percent 6 5 4 3 2 45 50 55 60 65 70 75 80 85 90 95 00 05 RATIO ECN 101 MACROECONOMICS slide 53 Price at the Pump ECN 101 MACROECONOMICS slide 54 Now using Calculus Ms P L i e , Y Consider what happens to the price level when e increase inc ease Taking total differentiation on both sides with respect to P and e M s dP L i d e - 2 P dP -L i P 2 0 Ms d e ECN 101 MACROECONOMICS slide 55 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. Think like an economist. economist ECN 101 MACROECONOMICS slide 56 A common misperception Common misperception: inflation reduces real wages This is true only in the short run, when nominal wages are fixed by contracts contracts. In the long run, the real wage is d h l determined by labor supply db l b l and the marginal product of labor, not the price level or inflation rate. Consider the data... ECN 101 MACROECONOMICS slide 57 Average hourly earnings & the CPI Average hourly earnings & the CPI, 1964-2004 20 18 16 250 Hourly earnings in 2004 dollars 200 Wage ($ per hour) e 14 12 10 8 6 4 2 0 Average hourly earnings (nominal) 150 100 Consumer Price Index 50 0 ECN 101 MACROECONOMICS 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 slide 58 CPI (1 1982-84= =100) The classical view of inflation A change in the price level is merely a change in the units of measurement. The classical view: So why, then, is inflation a social problem? ECN 101 MACROECONOMICS slide 59 The social costs of inflation ...fall into two categories: 1. costs when inflation is expected 2. additional costs when inflation is different than people had expected. ECN 101 MACROECONOMICS slide 60 The costs of expected inflation: 1. shoeleather cost def: the costs and inconveniences of reducing money balances to avoid the inflation tax. tax i real money balances Remember: In long run, inflation doesn't g , affect real income or real spending. So, same monthly spending but lower average , y p g g money holdings means more frequent trips to the bank to withdraw smaller amounts of cash. ECN 101 MACROECONOMICS slide 61 The costs of expected inflation: 2. menu costs def: The costs of changing prices. Examples: print new menus print & mail new catalogs The higher is inflation, the more frequently inflation firms must change their prices and incur these costs. ECN 101 MACROECONOMICS slide 62 The costs of expected inflation: 3. relative price distortions Firms facing menu costs change prices infrequently. infrequently Example: Suppose a firm issues new catalog each January January. As the general price level rises throughout the year, the firm's relative price will fall. Different firms change their prices at different times, leading to relative price distortions... ...which cause microeconomic inefficiencies in the allocation of resources. ECN 101 MACROECONOMICS slide 63 The costs of expected inflation: 4. unfair tax treatment Some taxes are not adjusted to account for inflation, such as the capital gains tax. Example: Jan 1: you bought $10,000 worth of Starbucks $10 000 stock y $11,000, , Dec 31: you sold the stock for $ , so your nominal capital gain was $1000 (10%). Suppose = 10% during the year. Your real capital gain is $0. But the govt requires you to pay taxes on your $1000 nominal gain!! i l i !! ECN 101 MACROECONOMICS slide 64 The costs of expected inflation: 5. General inconvenience Inflation makes it harder to compare nominal values from different time periods periods. This complicates long-range financial planning. l ECN 101 MACROECONOMICS slide 65 Additional cost of unexpected inflation: arbitrary redistributions of purchasing power Many long-term contracts not indexed, but based on e. If turns out different from e, then some gain at others' expense. expense Example: borrowers & lenders If > e, then (i - ) < (i - e) and purchasing power is transferred from lenders bo o e s lende s to borrowers. If < e, then purchasing power is transferred from borrowers t n fe ed f om bo o e to lende lenders. ECN 101 MACROECONOMICS slide 66 Additional cost of high inflation: c eased uncertainty increased u ce ta ty When inflation is high, it's more variable and unpredictable: turns out different from e more often, g and the differences tend to be larger (though not systematically positive or negative) Arbitrary redistributions of wealth become more likely. This creates higher uncertainty which uncertainty, makes risk averse people worse off. ECN 101 MACROECONOMICS slide 67 One benefit of inflation Nominal wages are rarely reduced, even when the equilibrium real wage falls. Inflation allows the real wages to reach equilibrium levels without nominal wage cuts. cuts Therefore, moderate inflation improves the functioning of labor markets. markets ECN 101 MACROECONOMICS slide 68 Hyperinflation 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 ( y (unit of account, medium of exchange). People may conduct transactions with barter or a stable foreign currency. ECN 101 MACROECONOMICS slide 69 What causes hyperinflation? Hyperinflation is caused by excessive money supply growth: When the central bank prints money, the price level rises. i l l i If it prints money rapidly enough, the g result is hyperinflation. ECN 101 MACROECONOMICS slide 70 Recent episodes of hyperinflation 10000 1000 perc cent grow wth 100 10 1 Israel 1983-85 Poland 1989-90 Brazil Argentina Peru Nicaragua Bolivia 1987-94 1988-90 1988-90 1987-91 1984-85 inflation growth of money supply slide 71 Why governments create hyperinflation When a government cannot raise taxes or sell bonds bonds, it must finance spending increases by printing money. money In theory, the solution to hyperinflation is simple: stop printing money. l In the real world, this requires drastic and painful fiscal restraint. ECN 101 MACROECONOMICS slide 72 The Classical Dichotomy Real variables are measured in physical units: quantities and relative prices, e.g. quantity o tp t produced q antit of output p od ced real wage: output earned per hour of work real interest rate: output earned in the future by lending one unit of output today 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 slide 73 Nominal variables: measured in money units, e.g. units e g The Classical Dichotomy Note: Real variables were explained in Chap 3, nominal ones in Chap 4. 4 Classical Dichotomy : the theoretical separation of real and nominal variables in the classical model, which implies nominal variables do not affect real variables. supply do not affect real variables. In the real world, money is approximately neutral in the long run. ECN 101 MACROECONOMICS Neutrality of Money : Changes in the money slide 74 ...
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