Topic10-Money_AAP

Topic10-Money_AAP - Money and Inflation What is Money?...

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Unformatted text preview: Money and Inflation What is Money? Velocity and the Quantity Theory of Money, Nominal Interest Rate and the Demand for Money, Hyperinflation Topic 10 (Text:Chapter 7; except 7.2) 1 Inflation Histories Inflation Rates 20% Infl_France Infl_Germany Infl_Japan Infl_US 15% Infl_Italy 10% 5% 06 04 20 02 20 20 00 98 19 20 96 94 19 19 92 90 19 19 86 19 19 88 84 82 19 19 78 19 19 80 76 74 19 19 70 19 19 72 0% -5% 7 Inflation Histories Inflation Rates 5000% Infl_AG BV Max = 11,749% PE Max = 7,481% 4500% Infl_TK Infl_PE 4000% Infl_BV 3500% 3000% 2500% 2000% 1500% 1000% 500% 20 0 6 4 2 20 0 20 0 0 8 19 9 20 0 6 4 19 9 19 9 2 0 19 9 19 9 8 6 19 8 19 8 2 0 4 19 8 19 8 8 19 7 19 8 6 2 4 19 7 19 7 19 7 19 7 0 0% 8 1 1 U.S. CPI Inflation U.S. Inflation 25% CPI-S Growth CPI Growth 20% 15% 10% 5% 0% 53 -55 -57 -59 -61 -63 -65 -67 -69 -71 -73 -75 -77 -79 -81 -83 -85 -87 -89 -91 -93 -95 -97 -99 -01 -03 -05 -07 r r r r r r r r r r r r r r r r r r r r r r r r r r rr Ap Ap Ap Ap Ap Ap Ap Ap Ap Ap Ap Ap Ap Ap Ap Ap Ap Ap Ap Ap Ap Ap Ap Ap Ap Ap Ap Ap -5% -10% 9 What is Money? • Money can be any asset which is used to make payments (facilitate transactions) • Money is what money does. It is: A medium of exchange Many economists believe that the only purpose of money is to make transactions and avoid costly and inefficient systems such as bartering A store of value Transfers purchasing power from the present to the future A unit of account Yardstick with which we measure economic transactions 10 What is Money? (cnt.) cnt.) • Historically, economies had commodity money commodity (e.g. gold standard) • Modern economies have fiat money fiat It has value by government decree • The government has monopoly over the supply of money This wasn’t always so! wasn’ The authority to control the money supply is delegated to an (possibly) independent institution called the central bank central In the U.S., it is the Federal Reserve Bank (the Fed) European Central bank, Bank of Japan, Bank of England, etc. • Currency is not the only form of money Checking accounts, travelers’ checks, etc. travelers’ 11 2 2 What is Money? (cnt.) cnt.) • Since money is used for transactions, any instrument that is liquid can be counted as part of liquid money There are several measures of money. Different measures are used, depending on the application • Measures of money: (Jan '09) C (M0 with reserves) Bank Reserves Currency M1 C + demand & $ 1,575 B checking deposits M1 + saving & $ 8,242 B time deposits $ 837 B $ 870 in 8/08 was 96 B M2 “Near” Money? Near” GDP RGDP Q4:08 Q4:08 (2000 $s) $14,200 B $11,525 B in Q3 was 11,712 19 Monetary Data • The St. Louis Fed issues weekly, monthly, and quarterly bulletins on: Financial conditions US Financial Data –Weekly Monetary Trends –Monthly Economic conditions National Economic Trends –Monthly International conditions International Economic Trends –Quarterly Also a more comprehensive “Annual” edition Annual” 20 Overview --1 --1 • The “price level” (think CPI) is determined level” by the Demand of Money = Supply of Money Demand • The supply of money is largely determined supply by the Fed in $s (Topic 11) • The demand for money comes from the demand private sector That demand is based on the purchasing power of money (i.e., it is for real money) real What the money can buy 21 3 3 Overview --2 --2 Example: • Consumers decide they want to hold 20 20 “boxes” worth of money boxes” the real demand for money • The supply of money is $500 $500 The $ supply of money; the Fed’s job Fed’ • These consumers have to hold $500 No choice! • The only POSSIBLE equilibrium is if the price/box is $25 22 Overview --3 --3 How Is the Equilibrium Reached? • Say the price of a box is $20! $20 It means consumers hold 250 boxes (500/20) worth of 250 (500/20) money But they want only $20 worth $20 • They will liquidate the extra money into something else This boosts demand for everything But no matter what, the $500 don’t go away! don’ As demand rises prices of boxes rise! • When the price reaches $25 consumers are happy with the money the hold 20 boxes worth 23 Overview --4 --4 • So we have {Real Md} = {$ Ms}/P • P, the “price level” is the quantity that level” adjusts to allow for equilibrium Similar to what we did for the capital markets • The equilibrating “price” is the “Price of price” Money” or 1/P Money” 24 4 4 Overview --5 --5 • We can also write this as: {Real Md}* P = {$ Ms} Note that {Real Md}* P {$Md} So, $ demand = $ Supply • Now P has a more intuitive interpretation: It is the “price level” level” 25 The Money Market • The price of money is what you have to give price up to get $1 • But that is 1/Price of Goods • That is why the equilibrating “price” is price” really the general price level of goods (P) In the data, it is the CPI or the GDP deflator CPI GDP 26 The Supply of Money • For now we’ll assume that the quantity of we’ money (the supply) is fixed at “Ms ” in nominal ($) terms Later we’ll see how the Fed changes the supply we’ 27 5 5 Money Demand Money demand function • {Real Md} L(i, Y) where L is a function that in Y (more transactions require more money), and in i higher nominal interest rate higher cost of holding money lower money demand M dd/Pis real money demand M /P is real money demand Why not r? M //Pis real money balances M P is real money balances Mss= Mdd= M M =M =M 28 Money Demand (cnt.) cnt.) • We usually write Md / P = L(i, Y) This emphasizes that the demand for money is based on its purchasing power, or “real” money purchasing real” • It follows that the demand for $s is Md = P L(i, Y) The demand for nominal money is of course nominal proportional to P 29 Money Demand (cnt.) cnt.) • What does real demand really mean? real demand You make your purchase plan for the day You decide how much money (cash) to carry around You go to your ATM and make sure you have that cash • You base your cash-carrying decision on cashthe (items you want to buy)*(their price) Real money demand is precisely the “items you want to buy” buy” The $ demand is the $s you need to do that 30 6 6 An Analogy • You have a car, you need to travel You put in a certain amount of gas Like going to the ATM You use up some gas, you add more You purchase stuff, you go back to the ATM Some people go around with a full tank of gas Some people go around with a wallet-full of cash wallet- Some people buy gas $5 at a time Some people take cash out $40 at a time 31 An Analogy (cnt) cnt) • Each car, carries a certain amount of gas ON AVERAGE • That would be the average inventory of gas the driver has Each person carries a certain amount of cash ON AVERAGE That is that person’s average inventory of cash person’ • The average inventory of cash + average average checking account balance is that person’s person’ demand for money (M1) 32 Money Demand Example • Suppose that people want to hold (about their person) enough money to buy 250 250 “boxes” of goods boxes” Notice it doesn’t matter how many $s that is! doesn’ • P (the CPI) is $20/box $20/box • Md/P = ?? (real demand for money) ?? • Md = ?? • Suppose that Ms = $6,000 (the Fed) $6,000 • Ms / P = ?? (the real supply of money) ?? 33 7 7 Money Market Equilibrium • • • • To recap: Money market equilibrium: Ms = Md M Thus: Ms = Md = P L(i, Y) The price level comes from P = Ms / Real Money Demand Real or P = M / L(i, Y) 37 Example #0 • • • Real money demand is 100 units of output Money supply is $1,500 Price per unit of output is: 38 Example #1 • Money demand is: Md/P = L( i,Y) = 500 + 0.2Y - 1,000 i P = 100, Y = 1,000, i = 10% What are 1. The real demand for money? 1. 2. Nominal ($) demand for money? 40 8 8 Review (cnt) cnt) P/P = M/M - L/L • In the long run, Y (RGDP) is determined by Labor supply and Population Population Savings and Investment behavior Investment behavior TFP • L is determined by the GDP Overall level of Interest rates Interest Payments technology Financial market innovations • The Fed’s job is to forecast ΔL and to set money Fed’ growth to achieve a target inflation rate 48 The Quantity Theory • A traditional, but predominant way to think about money demand is the Quantity Theory of Money approach: where, M V = P Y, M is a monetary aggregate such as M1 P is the general price level of goods Y is the real output (GDP) Note that P Y is nominal GDP GDP V is the income velocity of money velocity # of times a dollar changes hands per year from the per transactions that generate PY PY Milton Friedman exhumed this from the classicals 49 Quantity Identity MV=PY • At one level you can think of this as an identity that defines velocity V defines M is determined by the central bank Measurable Y is determined by the real side of the economy real Production, saving, technology, etc. Y = GDP is measurable GDP P is the price level Measurable 50 9 9 Quantity Identity MV=PY • At another level it is a particular and convenient representation of the demand for money Any demand for money function can be represented this way In Fed-think velocity is how they do it Fed- 51 Quantity Identity • The connection with the earlier notation is from MV PY • In general, we have Md Y L P V Md Y P V i, Y , FS where FS stands for “financial structure” FS structure” • In early literature, some people postulated V = constant, and defined k = 1/V, the “Cambridge-k” Cambridge- 52 The Quantity Theory (cnt.) cnt.) • From M V = P Y, the price level is P = MV /Y How does M affect P? How does Y affect P? • Inflation is determined by P/P = M/M + V/V - Y/Y Notice that a higher growth rate of Y means lower inflation! 54 10 10 Example #2 • P = 100, Y = 1,000, i = 10% Md/P = 500 + 0.2Y - 1,000 i What are 1. The real demand for money? 1. 500 + 0.2*1,000 – 1,000*0.10 = 600 2. Nominal ($) demand for money? 600 *100 = $60,000 3. What is velocity? V = PY/M PY 55 The Quantity Theory (cnt.) cnt.) P = M * ( V /Y ) • Key implication of the Quantity Theory: An increase in the money supply results in An a one-to-one increase in the price level one- to All else equal • The central bank (Fed) has ultimate control over the price level and therefore over the inflation rate • This is long-run proposition long57 The Quantity Theory (cnt.) cnt.) • This is clear from: M/M + V/V = P/P + Y/Y Growth in output Y comes from input and TFP TFP growth, The Fed has to forecast velocity, V; it may be 0 • Then the Fed chooses M/M to achieve its target P/P (inflation) P/P = M/M + V/V - Y/Y 58 11 11 The Quantity Theory (cnt.) cnt.) • If velocity is constant, then P/P = M/M - Y/Y • A 1 % increase in the money supply by the Fed will become a 1 % increase in the price level If that happens within 1 year, the inflation rate will be 1% for that year • This prompted Milton Friedman to observe: “Inflation is always and everywhere a monetary phenomenon” phenomenon” 59 The Quantity Theory (concl.) concl.) P/P = M/M - Y/Y • This discussion focuses only on long-run longissues • We’ll discuss short-run considerations under We’ shortmonetary policy monetary 60 Example #3 • Let, Y/Y = 6%, M/M = 8% 1. According to the quantity theory, what is the implied inflation rate? Start with constant velocity 62 12 12 Figure 7.1 Velocity of M1 and M2, 1959-2005 64 Quantity Theory and Long Run Inflation • In the long run, the higher the money growth rate the higher the resulting inflation rates 65 Quantity Theory and Long Run Inflation (cnt.) cnt.) • In the long run higher money growth rates do not lead to higher growth of output 67 13 13 Quantity Theory and Long Run Inflation (cnt.) cnt.) • The irrelevance of monetary policy for real variables is called money neutrality money It means that monetary policy does not affect output in the long run Most economists agree that money is neutral in the is long run • Many believe monetary policy is not neutral is in the short run 68 Quantity Theory and Long Run Inflation (concl.) concl.) • Governments increase the money supply (and get more revenues) by “printing” it printing” Such revenues are called seigniorage seigniorage • According to the Quantity theory, printing money always causes inflation Inflation is a tax because it decreases the decreases purchasing power of money Inflation tax 69 Nominal Interest Rate and the Demand for Money • So far we didn’t say too much about the role didn’ of interest rates in the demand for money • We know that the demand for money has to has depend on the nominal interest i rate rate i is the opportunity cost of holding $1 in cash • The more general money specification: Md / P = L(i, Y) demand where L in Y and in i We’ve seen this earlier We’ 82 14 14 Nominal Interest Rates • Recall that the interest rate is given by: i = r + e where e is the expected inflation rate expected Called the Fisher equation Therefore, Md/P = M/P = L(r + e, Y) 83 The TIPS Version 1-Year "Real" & Market Interest Rates 6.0 5.0 DGS1 DTP5A10 Implied Inflation Percent 4.0 3.0 2.0 1.0 0.0 8 5 5 6 5 6 7 7 6 7 04 06 05 07 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 7/ 7/ 7/ 7/ 27 27 27 27 27 27 27 27 27 27 /2 /2 /2 /2 7/ 7/ 4/ 1/ 4/ 7/ 4/ 1/ 1/ -1.0 1/ 10 10 10 10 87 Nominal Interest Rate (cnt.) cnt.) • In the Quantity Theory, current money supply alone determines current prices alone determines given real output only if the nominal real only interest rate i is constant In the more general specification, i is not a constant It depends on expected future inflation, which Depends on expected future money growth • This implies that an announcement by the Fed on future increases in money supply future will increase the current price level current 88 15 15 Hyperinflation • A very high level of inflation (50% or more per month) is called hyperinflation hyperinflation • It is usually caused by the government printing huge amounts of money to make up for insufficient tax revenues 89 Average Average monthly monthly growth growth in of money prices 49.3% Russia (Dec.1921-Jan.1924) 314% Germany (Aug.1922-Nov.1923) 12,200% Hungary (July 1945-July 1946) 57.0% 322% 19,800% Maximum monthly rise in prices 213% Jan. 1924 32,000% Oct. 1923 4,200,000% July 1946 Minimum ratio of real balances to beginning real balances 0.27 0.03 0.003 90 Recent Hyperinflations in Latin America 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 - Data are percent annual inflation rates 93 16 16 Costs of Inflation • Costs of high inflation: Huge costs involved with economizing on cash holdings Taxes distort returns even more with inflation Makes it hard to compare values Goods, services, real assets, etc. Surprise inflation redistributes wealth from creditors to debtors since debtors repay loan with less valuable dollars Surprise inflation is not reflected in interest rates 96 Monetary Equilibrium • A useful way to think equilibrium is determined: about how Saving behavior, population growth, depreciation, and TFP determine Y (GDP) and its growth rate The same real variables determine r (MPK) real r will not grow with the economy not Y and r constitute the real equilibrium (y, c, k, G) real and Saving and Investment M and its growth rate determine P and its growth rate (given the real equilibrium), also e r and e determine the nominal rate; i = r + e 97 Glossary of Notation C or M0 M1 M2 M Md P Y V k i r e L Currency Currency + checking deposits M1 + time deposits Money supply (usually M1) Money demand General price level Real GDP GDP Money velocity (V when fixed) Constant in simple money demand fn. Nominal interest rate Real interest rate Actual & expected inflation General money demand function 98 17 17 THE END 99 18 18 ...
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