Transcript Money and Inflation I

 In this chapter, we learn:
 what inflation is, and how costly it can be.
 Freshwater bias: didn’t bewail cost of unemployment--ch7
 how the quantity theory of money and the classical dichotomy allow
us to understand source of inflation
– Nominal variables, e.g., money, have only nominal effects, e.g., on prices
and nominal interest rates, no real effects.
– Money cannot call forth goods. David Ricardo, Works, volume III.
 Freshwater bias: classical dichotomy holds in long-run
 how the nominal interest rate, the real interest rate, and inflation are
related through the Fisher equation.
 Irving Fisher: Chained price indexes, Fisher equation
… and debt deflation  debt burden  vicious circle
 the important link between fiscal policy and high inflation.
 Freshwater bias: blame government
 Inflation is the percentage change in an economy’s overall price level:
πt = Pt/Pt-1 – 1 = (Pt - Pt-1 )/ Pt-1
 Hyperinflation is an episode of extremely high inflation, usually greater
than 500 percent per year…a 6-fold increase
 From 1919 to 1923, prices in Germany rose by over a factor of a trillion
and were rising 300-fold each month toward the end of 1923.
 Excess of claims on reduced German output capacity
 Reparations claims
 Labor claims…the 8-hour day
 Bondholder claims
 Passive resistance claims
 Printing money to meet claims
 Money to meet bloated government payrolls
– Assassination of minister who tried to raise taxes
– Declining real value of tax collections
 Money for the Reichbank’s friends
~1.4%
The Consumer Price Index (CPI) is a price index for a bundle of
consumer goods.
•Conceptually, the “market basket” is held constant
•In practice, the market basket is adjusted as consumption patterns change.
•Core CPI: exclude food and energy prices, which are volatile
2010
111.69
Measures of the Money Supply
 Think of Money as Currency in your wallet and Deposits in your checking account
 The balance on your RebelCard should also be thought of as “money,” but it’s not yet counted
 The monetary base (MB) includes currency (C) and reserves (R) held by private banks
 Banks a hold a fraction of the deposits (D) they owe you as reserves R = fD
 Reserves include Vault Cash and deposits banks themselves hold at their Central Banks
 Our Central Bank is the Federal Reserve Bank
CHAPTER 8 Inflation
The Federal Reserve’s Balance Sheet
Owns
(Assets)
Owes
(Liabilities)
Gold
Foreign Exchange
Federal Reserve Notes
Currency in circulation
Vault cash
Bank IOUs on
Discount Loans
=C
=R
Bank deposits at Fed
Bank A deposits @ fed
Bank B deposits @ fed
Bank C deposits @ fed
Government Bonds
Mortgage Backed Securities
Government deposits @ Fed
Fixed Assets
Total Assets = Monetary Base = MB = H = High Powered Money = Total Liabilities
The Functions of a Modern Central Bank
The Government's Bank:
–Manages government transactions.
–Controls availability of money and credit.
The Banker’s Bank:
Lender of last resort in crises
Operates clearing system for interbank payments.
Oversees financial intermediaries
- ensure their soundness.
- ensure public confidence
The Federal Reserve’s Balance Sheet
Owns
(Assets)
Owes
(Liabilities)
Gold
Foreign Exchange
Federal Reserve Notes
Currency in circulation
Vault cash
Bank IOUs on
Discount Loans
=C
=R
Bank deposits at Fed
Bank A deposits @ fed
Bank B deposits @ fed
Bank C deposits @ fed
Government Bonds
Mortgage Backed Securities
Government deposits @ Fed
Fixed Assets
Total Assets = Monetary Base = MB = H = High Powered Money = Total Liabilities
Functions of Federal Reserve District Banks
 Clear checks
 Issue new currency/withdraw damaged currency
 Make discount loans to banks in district
 Evaluate mergers/expansions of bank activities
 Liaison between business community and the Fed
 Examine bank holding companies and state-chartered member banks
 Collect data on local business conditions
 Research Money, Banking and the Financial System
FRBNY’s special roles
 Bond and currency open market operations
 Supervise bank holding companies in NY district
 Member of Bank for International Settlements
Measures of the Money Supply
 Think of Money as Currency in your wallet and Deposits in your checking account
 The balance on your RebelCard should also be thought of as “money,” but it’s not yet counted
 The monetary base (MB) includes currency (C) and reserves (R) held by private banks
 Banks a hold a fraction of the deposits (D) they owe you as reserves R = fD
 Reserves include Vault Cash and deposits banks themselves hold at their Central Banks
 Our Central Bank is the Federal Reserve Bank
 Banks receive no interest on Vault Cash (mostly held in ATM machines)
 They now receive some interest on their deposits at the Fed
 Currency (Federal Reserve Notes in circulation) and bank Reserves are liabilities of the
Central Bank. Think of them as High Powered Money (=Monetary Base)
 Central Bank Liabilities (the Monetary Base) are necessarily matched by its Assets
 When the Fed buys something, say a government bond (T-bill or T-bond) or a mortgage backed
security (MBS), its assets increase by the amount of the purchase.
 The Fed pays for what it buys by “writing a check” to whoever sells it the asset. The check ends
up deposited in a bank which then deposits it in its reserve account.
 The Fed’s Assets (the T-bill) and its Liabilities (bank Reserves) increase by the same amount.
 An increase in the Monetary Base (high powered money) usually multiplies through a
fractional reserve banking system to a greater increase in Money Supply.
 The Fed buys something and pays with a check; the check is deposited in a bank; the bank holds a
fraction of the deposit in reserve and loans out the rest; the borrower buys something; some of
what he pays is held in Currency while the rest is Deposited in another bank which holds a fraction
in Reserve and loans out the rest…
In general
Money Supply = Money multiplier x Monetary Base
M = m x MB
 Flavors of money:
 M1 = Currency + Demand Deposits + Travelers Checks
 M1 is most liquid = means of payment
 M2 = M1 + Savings Accounts + Money Market Accounts + Small CDs
 M2 = M1 + “Near monies”
 M3 = M2 + Large CDs + Short term repos + …
The Quantity Equation
 Let Mt = money supply in year t; Vt = velocity of money turnover in t;
Pt = price level in t; Yt = real GDP in t
MtVt = PtYt
 MtVt = Money held ($) x Turns/year = $ spent in year
= $GDP ($/year)
 PtYt = Stuff bought (units/year) x Price paid ($/unit)
= $ purchases in year = $GDP ($/year)
 Thus,
$ Purchases/year = $ Spent/year
The Quantity Theory of Money:
P = (V/Y) M