Transcript Money Supply and Inflation

Learning Targets:
•Neutrality of Money
•Real Goods vs. Nominal Goods
Money Supply and Inflation
Chap. 30
How does an increase in money
supply cause inflation?
What is Inflation?
• Inflation has more to do with money losing
value than goods increasing in price.
•How tall is a regulation basketball net?
10 ft. (12 inches = 1 foot)
•What if the government decided that 6
inches now equal 1 foot instead of 12
inches. Now, how tall is a regulation
basketball net?
20 ft
•Did the “real” height of the basketball net
change?
The real height didn’t change, but the
nominal height doubled, because the
value of a foot was cut in half.
Money is like the “feet” in the last example!
Money is merely a “unit of measurement.”
Question:
If money loses ½ its value and it costs twice as
much to get a haircut, has the real value of that
haircut changed?
This is the idea behind …
THE “NEUTRALITY” OF MONEY
Changes in the value of money only affect the
“nominal” value of goods, not the “real” value.
Real Variables vs. Nominal Variables
•Goods measured in dollars are “nominal”
variables.
•Goods measured in units are “real”
variables.
Example
A farmer grows 10 bushels of corn = Real
Variable
The Farmer’s income from selling the 10
bushels of corn for $70 = Nominal Variable
The Neutrality of Money
If 1 bu. of corn costs $7 and 1 bu. of Wheat costs
$3.5
Then the “real” value of 1 bu. of corn is 2 bu. of
Wheat …(1bu. Corn = 2 bu. Wheat)
If money loses ½ its value…
then 1 bu. Corn = $14
and 1 bu. Wheat = $7
So, what is the “real” value of corn and wheat now?
1 bu. Corn = 2 bu. Wheat
The real values of real variables have not changed!! It
still takes 1 bu. Corn to buy 2 bu. Wheat!
So, the quantity of money people demand
= price of goods = value of $
• If the value of money goes down by 50%, what
happens to prices?
–PRICES DOUBLE
– What happens to the quantity of money people
will demand?
–QUANTITY OF MONEY PEOPLE
DEMAND WILL DOUBLE
Let’s try another example
• 1 oz. Gold = $1300
• 1 Ford Mustang (2014 Convertible) = $26,000
1 Mustang = 20 Oz. Gold
If Money loses ½ its value, how much will each
good cost?
($2,600 and $52,000)
How many ounces of gold will it now take to buy
one Mustang?
20 ounces!
What’s the moral of this story????
If you think the value of money is going to
decrease…
• Don’t store your wealth in NOMINAL goods
(money)- Inflation hurts people who hold money.
• Store your wealth in REAL goods!
The Price of
Gold is up
100% in 6
years!
Remind
me…When did the
Fed. announce
their first round of
Quantitative
easing?
THE VALUE OF REAL GOODS DOESN’T
CHANGE WITH INFLATION!
• So, if you are worried about inflation, where
should you choose to store your wealth?
MONEY? OR REAL GOODS?
REAL GOODS
Can money really lose value that fast?
• Hyperinflation = Periods of time when
inflation is 50% per month or more!
Hyperinflation in Zimbabwe (2007-2008)
Supply and Demand for MONEY
• Money has a demand curve and a supply
curve.
• What factors determine the demand for
money?
– People demand money to buy things
– If what you want to buy costs many dollars, your
demand for dollars will be greater.
What factors determine the supply of money?
•The Supply of Money is fixed at any given time by
the Fed.
Figure 1 Money Supply, Money Demand, and the Equilibrium
Price Level
Money has a demand curve and a supply curve.
Value of
Money, 1/P
(High)
Money supply
In the long run, prices
adjust to the
equilibrium between
money supply and
money demand.
1
3
/4
12
/
Equilibrium
value of
money
(Low)
Price
Level, P
1
(Low)
1.33
A
2
Equilibrium
price level
14
4
/
Money
demand
0
Quantity fixed
by the Fed
Quantity of
Money
(High)
Copyright © 2004 South-Western
The Quantity Theory of Money
• The quantity of money in the economy
determines the value of money.
• So, if there is a lot of money available in the
economy, will the value of money be high or low?
– low
• What affect will that have on prices?
– Higher Prices
– (Value of Money = 1/Price of Goods)
Figure 2 The Effects of Monetary Injection
The Fed decides to increase the money supply. What will be the
affect on prices and the value of money?
Value of
Money, 1/P
(High)
MS1
MS2
1
1
1. An increase
in the money
supply . . .
3
2. . . . decreases
the value of
money . . .
Price
Level, P
/4
12
/
1.33
A
2
B
14
/
(Low)
3. . . . and
increases
the price
level.
4
Money
demand
(High)
(Low)
0
M1
M2
Quantity of
Money
Copyright © 2004 South-Western
Figure 4 Money and Prices During Four Hyperinflations
(a) Austria
(b) Hungary
Index
(Jan. 1921 = 100)
Index
(July 1921 = 100)
100,000
100,000
Price level
Price level
10,000
10,000
Money supply
1,000
100
Money supply
1,000
1921
1922
1923
1924
1925
100
1921
1922
1923
1924
Copyright © 2004 South-Western
1925
Figure 4 Money and Prices During Four Hyperinflations
(c) Germany
(d) Poland
Index
(Jan. 1921 = 100)
100,000,000,000,000
1,000,000,000,000
10,000,000,000
100,000,000
1,000,000
10,000
100
1
Index
(Jan. 1921 = 100)
10,000,000
Price level
Money
supply
Price level
1,000,000
Money
supply
100,000
10,000
1,000
1921
1922
1923
1924
1925
100
1921
1922
1923
1924
Copyright © 2004 South-Western
1925
The Velocity Theory of Money
Velocity and the Quantity Equation
• The velocity of money refers to the speed at
which the typical dollar bill travels around the
economy from wallet to wallet.
Velocity and the Quantity Equation
V = (P  Y)/M
– Where: V = velocity
P = the price level
Y = the quantity of output
M = the quantity of money
VELOCITY IS CONSIDERED TO BE FAIRLY
CONTSTANT
Velocity and the Quantity Equation
• Rewriting the equation gives the quantity
equation:
MV=PY
What happens if output increases, but Money
Supply stays the same?
Prices decrease
What happens if Money Supply increases, but
output stays the same?
Prices increase
What happens if output increases 10%, and
Money Supply also increases 10%?
Figure 3 Nominal GDP, the Quantity of Money, and the
Velocity of Money
Indexes
(1960 = 100)
2,000
Nominal GDP
1,500
M2
1,000
500
Velocity has remained stable over time
Velocity
0
1960
1965
1970
1975
1980
1985
1990
1995
2000
Copyright © 2004 South-Western
Velocity and the Quantity Equation
• Rewriting the equation gives the quantity
equation:
MV=PY
So, if velocity has remained stable over time,
an increase in the money supply must result
in either an increase in prices or an increase
in real output!
Velocity and the Quantity Equation
• The quantity equation relates the quantity of
money (M) to the nominal value of output
(P  Y).
Velocity and the Quantity Equation
• The quantity equation shows that an increase
in the quantity of money in an economy must
be reflected in one of three other variables:
– the price level must rise,
– the quantity of output must rise, or
– the velocity of money must fall.
How Does Inflation Affect Interest
Rates?
Some Basic Vocabulary
Nominal Interest Rate =
the official interest rate on a loan or investment
Real Interest Rate =
real return after taking inflation into account
So, the nominal interest rate is created by the
lender/borrower, but the real interest rate is
derived…
Real Interest Rate (return) = Nominal rate – Inflation
rate
How Does Inflation Affect Interest Rates?
Fisher Effect
• Nominal Interest Rate = Real Interest Rate + Inflation Rate
Remember: Real variables are unaffected by inflation.
So, the nominal rate MUST change 1 to 1, with inflation
over the long term
Who wins and who loses with unexpected
inflation??
• Inflation benefits borrowers who borrow at fixed
rates.
Borrowers PAY the nominal rate, but pay off the loan in
“cheaper” dollars in the future.
Example: Borrow at nominal 6%, inflation = 10%,
the borrowers effective real rate = -4%
• Inflation hurts lenders if they lend at lower interest
rates and then get paid off in money that has lost its
value.
Example: LEND at nominal 6%, inflation = 10%, the
lenders effective real rate of return = -4%!!
So, if you think inflation will increase where do
you want to store your wealth ?
•In your piggy bank?
NO
•In gold or silver?
YES
•In corn, wheat or other agricultural futures?
YES
•In real estate?
YES, but be careful
• In Stocks?
Think about it… What does stock ownership
represent?
How about stocks of oil companies??
• In Bonds?
Definitely not long-term at fixed rates!
• In a New Car?
Sure
• In artwork or other collectibles?
O.K.
What Lessons Can be Learned by all this?
If you expect inflation to be higher you don’t want to hold
money, because it will lose value.
You want to have your money in assets that will increase if
prices of everything goes higher.
Like what?
Mineral Resources, like oil, copper, gold, silver
Real Estate
Commodities like farm products (rice, corn, wheat,
soybeans)
Stocks of companies with good products
What’s your answer?
If inflation = 50%
The cost of all goods increases by 50%
Now, what would you rather be paid in, bikes or money?
If you receive payment in dollars you have a negative 50%
return on your investment, because your $1000 is now worth
50% less.
What if you receive payment in bikes?
Now, 1 Bike = $150
You would rather be paid in 10 Bikes (Real Variable)
Real Variables are not affected by changes in the value of
money!!
Does Inflation Hurt Everybody?
No.
Workers often will get paid more money to
compensate for inflation.
If workers wages increase at the same rate as
inflation there is no loss to them
What about your savings?
Your savings lose value if they don’t earn a rate of
interest that matches inflation.
The Federal Funds Rate : The interest rate the Fed charges to lend money to banks.
“It’s the rate the Fed can move if it wants to implement changes to money supply.