Transcript Money

Money and Inflation
He realised well that the abundance of money makes
everything dear, but he did not analyse how that takes
place. The great difficulty of this analysis consists in
discovering by what path and in what proportion the
increase of money raises the price of things.
RICHARD CANTILLON (died 1734),
Essai sur la nature du commerce en général, II, 6.
Money and Inflation






Price = amount of money required to buy a good.
Inflation rate = ΔP/P = the percentage increase in
the average level of prices (e.g. π = 5 % p.a.).
Deflation = decrease in the average level of prices.
(e.g. π = - 1 % p.a.)
Disinflation = decrease in the inflation rate
(e.g. π1 = 5 % → π2 = 3 %)
Price level stability: π = 0 % p.a.
Because prices are defined in terms of money, we
need to consider the nature of money, the supply of
money, the demand for money, and what impact it
has on the economy.
Price of beer in the Czech Republic
CPI in the Czech Republic
150
140
130
120
110
100
90
80
70
60
50
I.13
I.12
I.11
I.10
I.09
I.08
I.07
I.06
I.05
I.04
I.03
I.02
I.01
I.00
I.99
I.98
I.97
I.96
I.95
I.94
I.93
Price level has more than
doubled since 1993
12,0%
10,0%
Inflation rate, Czech Republic
8,0%
6,0%
4,0%
2,0%
0,0%
1996
1997
1998 1999
2000
2001 2002
2003
2004 2005
2006
2007 2008
2009
2010
Inflation rate in the Czech Republic
8,00%
7,00%
6,00%
5,00%
4,00%
3,00%
2,00%
1,00%
I.14
I.13
I.12
I.11
I.10
I.09
I.08
I.07
I.06
I.05
I.04
I.03
I.02
-1,00%
I.01
0,00%
I.13
VII.12
I.12
VII.11
I.11
VII.10
I.10
VII.09
I.09
VII.08
I.08
VII.07
I.07
VII.06
I.06
VII.05
I.05
VII.04
110
I.04
120
VII.03
140
I.03
150
VII.02
I.02
VII.01
I.01
VII.00
I.00
Food and rents in the CR
Food and nonalcoholic beverages
130
Housing, water,
electricity, gas and
other fuels
100
90
80
70
U.S. inflation rate
(% per year)
25
20
15
10
5
0
-5
-10
-15
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000
Money



1.
2.
3.
What is money?
Money is the stock of assets that can
be readily used to make transactions.
Money has three functions:
Medium of exchange
Unit of account
Store of value
Medium of exchange



People accept money in exchange for
the items they are selling.
Hence, money is generally accepted
medium of exchange.
The ease with which money is
converted into goods and services is
called money’s liquidity.
Unit of account







Money provides the terms in which prices are
quoted and debts are recorded…
… Stores post their prices in CZK (or EUR, $, etc.)
E.g. TV set costs 10,000 CZK; beer costs 20 CZK
→ relative price is 10,000/20 => TV costs 500
bottles of beer.
Resources are allocated according to relative
prices. Money prices enable an immediate
calculation.
Most debts require the debtor to deliver a specified
number of CZK (or EUR,$ etc.) in the future.
Money is a standard of deffered payments.
Hence, money is the yardstick with which we
measure economic transactions.
Store of value

Money is a way to transfer purchasing
power from the present to the future.
Money (imperfectly) retains its value over
time, so you need not spend all your
money as soon as you receive it.

Obviously, money is not the only store of value in

the economy.
Money





In an economy without money- barter economy,
trade requires the double coincidence of wants:
The unlikely situation of two people each having a
good that the other wants at the right time and
place.
A barter economy permits only simple
transactions.
Money makes more indirect transactions possible.
In a modern complex economy, trade is indirect
and requires the use of money.
Money





How money became
fiat?
(HW,
pp.78-79)
In the past most societies used commodity
money (e.g. gold, silver), with some intrinsic
value (metal could be used for other purposes).
Modern money is fiat money:
It has no intrinsic value.
It is established as money by government
decree.
Everyone values (accepts) fiat money because
they expect everyone else to value (accept) it
as well.
What is money?




Money is what money does.
Empirical definition of money:
Money supply = the available quantity
of liquid assets that can be „readily“
used to make transactions.
The problem is that in modern
economies no single asset is used for
all transactions.
Money






Legal restrictions give the
government a monopoly
on the printing of money.
Currency (cash) … C
The sum of outstanding paper money and
coins.
Demand deposits … D
Funds people hold in their checking
(current) accounts.
They are almost as convenient as currency
in paying for goods and services.
M1 = C + D
Money




Savings accounts (and time deposits)
Cannot be used for payments, but can
be easily transferred into checking
(current) accounts.
M2 = M1 + SA + TD
M3, M4 … every higher aggregate
contains assets of lower liquidity, and it
also includes the previous monetary
aggregate.
Money



It is hard to judge which assets should
be included in the money stock.
There is also no consensus about
which measure of the money stock is
the best.
Economists usually work with M1 or
M2.
Monetary aggregates in the Czech Republic, Jan 2015
(in mil. of CZK)
3 292 084
3500000
2 772 848
3000000
2 339 356
2500000
2000000
1500000
1000000
500000
433 491
+
0
Currency in
circulation
=
Overnight
deposits
+
M1
218 117
+
301 119
=
Deposits with
Deposits
agreed
redeemable at
maturity up to notice up to 3
2 years
months
M2
Money creation process

{See the BB}

In the fractional-reserve banking, banks create
money because with each deposit and loan more
money is created.
However, this system doesn’t create wealth:
Bank loans give borrowers some new money and
an equal amount of new debt, so loans do not make
them wealthier.
Creation of money increases (nominal!) liquidity in
the economy, not wealth.



Monetary Base in the Czech Republic in Jan 2015 (in mil. of
CZK)
600000
522 300
500000
465 500
400000
300000
200000
100000
+
56 800
0
CURRENCY
RESERVES
=
MONETARY BASE
Monetary pyramid in the Czech Republic
2 772 848
M1
Money multiplier = 5.3
522 300
MONETARY BASE
0
500 000 1 000 000 1 500 000 2 000 000 2 500 000 3 000 000
Money supply
cr 1
M  m B
M
B
deposit less of
Reserve-If households
High
Currencycr  rr
their money, then banks can’t

depositmake as many
powered
-deposit
loans, so the
 We have derived that Ms is a function of 3 exogenous variables:
ratio banking system
money
won’t be able
ratio
cr=C/D
rr=R/D
M  m  B
M  B
to “create” as much money.
B ... monetary base
 cr   m   M
 rr   m   M
Control of Ms by the CB



Open-market operations:
The purchase or sale of government
bonds (assets) by the central bank.
If CB buys bonds from the public,
it pays with new dollars, increasing B
and then (when?) M (always?) by higher
amount.
Control of Ms by the CB



Reserve requirements:
CB´s regulations that require banks to
hold a minimum reserve-deposit ratio.
If CB reduces reserve requirements →
↓rr → then banks can make more
loans and “create” more money from
each deposit.
Control of Ms by the CB

The discount rate:

The interest rate that the CB charges on
loans it makes to banks.

When banks borrow from the CB, their
reserves increase, allowing them to make
more loans and “create” more money.

The CB can increase B by lowering the
discount rate to induce banks to borrow
more reserves from the CB.
Control of Ms by the CB

Can the CB perfectly control the money supply?
Households can change cr, e.g. loss of confidence in
banks causes preference of C over D: ↑cr → ↓m → ↓Ms

cr 1
M
B
cr  rr
Banks can hold excess reserves (reserves above
the reserve requirement). ↑rr → ↓m → ↓Ms

HW - Bank failures in the Great Depression (pp. 488 - 489)
HW - Financial Innovation, Near Money, and the Demise of the Monetary
Aggregates (pp. 496 - 497)
The Quantity Theory of Money




o

Stock


How does the quantity of money affect the economy?
QTM - the quantity of money in the economy is related
to the number of dollars exchanged in transactions.
Suppose that the supply of money in the economy is
$10. In the first half of the year, 5 bottles of beer are
sold for $2. The owners of money then buy 1 lb. of
ham for $10.
The total value of transactions over the year:
$2×5 + $10×1 = $20
M Velocity
= $10, of
socirculation
each unit of M was transacted twice/year.
$10 × 2 = $2×5 + $10×1
M × V = ∑piqi
Flow
The Quantity Theory of Money
Fisher (1911): The Purchasing Power of Money:
Let us begin with the money side. If the number of dollars in a country is
5,000,000, and their velocity of circulation is twenty times per year, then the
total amount of money changing hands (for goods) per year is 5,000,000
times twenty, or $100,000,000. This is the money side of the equation of
exchange…
200,000,000 loaves of bread at $ .10 a loaf,
10,000,000 tons of coal at 5.00 a ton, and
30,000,000 yards of cloth at 1.00 a yard.
The value of these transactions is evidently $100,000,000, i.e. $20,000,000
worth of bread plus $50,000,000 worth of coal plus $30,000,000 worth of
cloth. The equation of exchange therefore (remember that the money side
consisted of $5,000,000 exchanged 20 times) is as follows:—
$5,000,000 × 20 times a year
= 200,000,000 loaves × $ .10 a loaf
+10,000,000 tons × 5.00 a ton
+30,000,000 yards × 1.00 a yard.
The Quantity Theory of Money

If we aggregate over the entire economy (and over
all transactions), we may write:
M × VT = P × T IDENTITY





T … the total number of transactions during some
period of time
P … price of a typical transaction
PT … number of dollars exchanged in a year
M … quantity of money
VT … transactions velocity of money
The
rate at which money circulates in the economy
The Quantity Theory of Money







Number of transactions T is difficult to measure so it
is replaced by the total output in the economy Y.
Assume that Y is proportional to T: T = aY
M × VT = P × T
M × VT = P × aY
M × VT/a = P × Y
M × VY = P × Y
VY …Income velocity of money
Number
of times a dollar bill enters someone’s
income in a given period of time.
The Quantity Theory of Money



V can be viewed as a ratio of nominal GDP (PY),
to the quantity of money (M): V = PY/M
Assume that V is constant and exogenousV V
M×V=P×Y
If V is constant, a change in the quantity of
money (M) must cause a proportionate change
in nominal GDP (PY).
U.S. Nominal GDP, M2, and Velocity
1960–2011
3,000
1960=100
2,500
Velocity is fairly
stable over the
long run.
Nominal GDP
2,000
M2
1,500
1,000
500
Velocity
0
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
The Quantity Theory of Money
Recall that in the classical model:

Y*=F(Kfixed,Lfixed)

M×V=P×Y
Classical Dichotomy (HW, p. 107)
Fixed
 M  P
The quantity theory implies that the price
level is proportional to the money supply.
MONEY IS NEUTRAL
-Does not affect Y
-Does not affect relative prices
The Quantity Theory of Money

M×V=P×Y

See the BB:
Thus,
the quantity
money states that
 %ΔM
+ %ΔV =theory
%ΔP +of
%ΔY
the central
controls(?) the money
%ΔV =bank,
0 by which
assumption
supply,
has ultimate control over the rate of
 %ΔY depends on the growth of K,L and A. All
inflation.
If thebycentral
bank =>
keeps
constant
assumption
%ΔYthe
= 0money
supply stable, the price level will be stable. If
 Hence, the growth in the money supply (%ΔM)
the central bank increases the money supply
determines
ratewill
of inflation
(%ΔP = π).
rapidly,
the pricethe
level
rise rapidly.
U.S. inflation and money growth,
1960-2006
15%
12%
Over the long run, the inflation and
money growth rates move together,
M2 growth
as the quantity
theory rate
predicts.
9%
6%
3%
0%
1960 1965
inflation
rate
1970 1975
1980 1985
1990 1995
2000 2005
slide 36
I.13
I.12
I.11
I.10
I.09
I.08
I.07
I.06
I.05
I.04
M2
I.03
160
I.02
CPI
I.01
180
I.00
I.99
I.98
I.97
I.96
I.95
I.94
I.93
Money and prices in the CR
240
220
200
140
120
100
80
60
40
I.13
I.12
I.11
I.10
I.09
I.08
I.07
I.06
I.05
I.04
I.03
20,0%
I.02
I.01
I.00
I.99
I.98
I.97
I.96
I.95
I.94
Money and prices in the CR
25,0%
Inflation
Money growth
15,0%
10,0%
5,0%
0,0%
I.13
I.12
I.11
I.10
I.09
I.08
I.07
I.06
I.05
I.04
Inflation
I.03
I.02
I.01
I.00
I.99
I.98
I.97
I.96
I.95
I.94
Money and prices (MA-12)
25,0%
20,0%
15,0%
Money growth
10,0%
5,0%
0,0%
International data on inflation and
HW (p.88) Seigniorage:
money
growthThe Revenue From Printing Money
Turkey
100
Ecuador
Inflation rate
Indonesia
Belarus
(percent,
logarithmic scale)
10
1
Argentina
U.S.
Singapore
Switzerland
0.1
Milton Friedman:
“Inflation 10
1
is always and everywhere a
monetary phenomenon.’’
100
Money Supply Growth
(percent, logarithmic scale)
The Demand for Money






The relationship between Ms and P has
been rather technical so far.
We need a more subtle explanation.
The key question is: Why do people hold
money?
Acquisition of income and its successive
spending are not usually synchronized.
Holding money makes it easier to make
transactions.
Hence, people demand money and we will
model their money demand function.
The Demand
for
Money
An increase in (real) income (other



things equal) causes an increase in
the consumer’s consumption and
The money demand
function
like the
therefore spending.
To is
facilitate
this
extrafor
spending,
the consumer
will
demand function
a
particular
good.
require more money.
Here the “good’’ is the convenience of
holding money balances.
Just as higher income leads to a greater
demand for goods, higher income also leads
to a greater demand for money.
Md=kPY
k … how much money people want to
hold for every dollar of income.
The Demand for Money
Md=kPY
P
… to keep their real money
balances M/P constant.
With higher prices
People must hold more
(nominal) money balances…
M
The Demand for Money
Md=kPY1
P
Md=kPY2
With higher real income
People want to hold more
(nominal) money balances
M
For P1>P*, the excess of money demand
over money supply will push the price
level down as people reduce their
purchases of goods in the effort to get
more money balances.
The equlibrium Price level
MS
Md=kPY
P
P1
P*
The nominal money supply is given
by the central bank (banking
system).
At P*: Ms=Md
P2
For P2<P*, the excess of money supply
There is only one price level,
over for
money demand will increase the price
which the given amount of money
level as people raise their purchases of
Ms is voluntarily held by people;
goods in the effort to spend the excess of
Ms=Md
money balances.
M
The equlibrium Price level
P
… At a
higher price
level P2*,
people will
be satisfied
with their
higher
nominal
money
balances
and the
process of
spending
and
increasing
the price
level halts.
P2*
P1*
MS M´S Md=kPY
…people hold more money than
they want…
At the new equilibrium level P2*,
Ms=Md again.
Money is neutral: ↑M→↑P
If the central bank raises the
nominal money supply…
M
…they will spend the excess of money on
goods and services. If Y=Y*, P must go up.
The equlibrium Price level
MS
Md=kPY
P
P*
HW: Impact of ↑Y on P*
M
The Demand
for
Money
An increase in real income (other







things equal) causes an increase in
The foregoing analysis
suggests that people are
the consumer’s consumption and
Ifinterested
the nominal
amount
of his
money is(M/P)
doubled
to M=$20
in real
money
balances
than
d rather
therefore spending. To facilitate
this
in
nominal
money
balances
Mdthe
:as well
and
the price
of beer
doubled
(to P=$4),
extraisspending,
consumer
will then
real demand for money
is the
same
(M/P)d=5, even
Mhis
require
more
money.
d=kPY
though
his nominal demand for money has been
(M/P)
d=kY
(due
to higher
prices).
Real moneydoubled
balances
(M/P)
measure
the purchasing
power of the stock of money.
If the quantity of money is $10, and the price of a
bottle of beer is $2, then real money balances are 5
bottles of beer that our representative agent keeps in
Hence,
real demand for money (M/P)d ≡ L = kY does not
his wallet.
depend on the price level.
Notice that demand for real money balances (M/P)d is
proportional to real income Y.
(Demand for nominal money balances Md was
proportional to nominal income PY).
Demand for Money and QTM

In equilibrium, the demand for real money balances (M/P)d=kY
must equal the supply MS/P:
MS/P = kY
The growth rate
approach – see the BB
M(1/k) = PY

which can be written as:
MV = PY,



where V = 1/k.
It shows the link between the demand for money and the velocity of
money.
When people want to hold a lot of money for each dollar of income (k
is large), money changes hands infrequently (V is small).
When people want to hold only a little money (k is small), money
changes hands frequently (V is large).
Inflation and interest rates
Suppose you deposit $100 in a bank account that
pays i=8 % interest annually. Assume that the price
of beer this year is P1=$2.
 Next year, you withdraw your savings and the
accumulated interest: $100×(1+i)= $108
 Assume that the price of beer next year is P2=$2.04
 Are you 8 percent richer than you were when you
made the deposit a year earlier?
 In the first year, you could buy: $100/$2 = 50 bottles
What
In is
the
thesecond year, you can buy: $108/$2.04 = 53
bottles.
inflation
rate in
this
o economy?
=> You can buy 53/50-1 = 0.06 = 6 % more

Inflation and interest rates
100  (1  i )
P2
1  0.06 
100
P1
Number of bottles next year = 53
Number of bottles this year = 50
100  (1  0.08 )
53
2
.
04
1  0.06 

100
50
2
Inflation and interest rates
100  (1  i )
P2
1  0.06 
100
P1
r … real interest rate
(1  i )
1  0.06 
P2
1
P1
1  0.06 
(1  i )
P2
P1
1 r 
(1  i )
1 
P2
1  
P1
Inflation and interest rates




Nominal interest rate, i … the interest rate
that the bank pays:
is not adjusted for inflation
Real interest rate, r … the interest rate that
reflects the true increase in the purchasing
power (6 % in our example):
is adjusted for inflation.
Inflation and interest rates
1 r 
(1  i )
1 
(1  r)  (1   )  (1  i )
1 r     r  1 i
i  r 
Fisher equation
If we neglect π×r = 0.02 × 0.06 = 0.0012
r  i
Fisher equation and the Fisher effect



According to the Fisher equation, a 1-percent
i = r+π
increase in the rate of inflation in turn causes
a 1-percent increase in the nominal interest rate.
r is determined
by S = I(long-run)
(Classical model)theory,
Hence,
in the classical
changes
in money
growth
or inflation
do
π is determined
by the
money
growth (QTM)
to the QTM, an
increase in the
not affect theAccording
real interest
rate.


rate of money growth of 1 percent causes a
1-percent increase in the rate of inflation.
The one-for-one relation between the
inflation rate and the nominal interest rate is
called the Fisher effect.
Fisher effect *
i=r+π
Nominal interest rate rises
keeping the real S and I at
the previous level (due to
constant r).
S (r)
i*
I(r)
I=S
S,I
Higher inflation rate
decreases the willingness
of savers to save at the
given nominal interest rate
i (their loan will be repaid
with money with lower
purchasing power).
… Higher inflation
increases the willingness
of investing firms to
(borrow and) invest more at
the given nominal interest
rate i (their debts will be
repaid with money with
lower purchasing power).
Exercise:
Suppose V is constant, M is growing 5% per year,
Y is growing 2% per year, and r = 4.
a. Solve for i.
b. If the central bank increases the money growth rate by
2 percentage points per year, find i.
c. Suppose the growth rate of Y falls to 1% per year.
 What will happen to  ?
 What must the central bank do if it wishes to
keep  constant?
Inflation and nominal interest
rates in the U.S., 1955-2006
percent
per year
15
nominal
interest rate
10
5
0
inflation rate
-5
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
Inflation and nominal interest
rates across countries
Nominal 100
Interest Rate
Romania
(percent,
logarithmic scale)
Zimbabwe
Brazil
10
Bulgaria
Israel
U.S.
Germany
Switzerland
1
0.1
1
10
100
1000
Inflation Rate
(percent, logarithmic scale)
Two Real Interest Rates: Ex Ante
and Ex Post



o


o

o
When a borrower and lender agree on a nominal interest rate,
they do not know what the inflation rate over the term of the loan
will be.
Suppose that they expect πe= 3 %. If the agreed r is 4 %, then:
i = r + πe = 7 %
If the realised inflation differs, e.g. π = 5 %, then the ex post real
interest rate will be:
Who lost and who
rex post = 7 % - 5 % = 2 %
gained when π > πe ?
Hence, we must distinguish between two concepts of the real
interest rate:
The real interest rate the borrower and lender expect when the
loan is made:
… ex ante real interest rate = i – πe = 4 %
and the real interest rate actually realized:
… ex post real interest rate = i – π = 2 %
Two Real Interest Rates: Ex Ante
and Ex Post

Because the nominal interest rate agreed by lender and
borrower can adjust only to expected inflation (not to the
realized inflation), the Fisher effect is more precisely
written as:
i = r + πe


The ex ante real interest rate r is determined by
equilibrium in the market for goods and services (or I=S).
The nominal interest rate i moves one-for-one with
changes in expected inflation πe.
Money demand and
the nominal interest rate




In the quantity theory of money,
the demand for real money balances
depends only on real income Y.
Money demand refers to the fraction of
wealth the representative agent would like
to hold in the form of money.
Wealth consists of many assets:
Bonds, stocks, physical capital (e.g.houses),
human capital…
Money demand and
the nominal interest rate



The other assets typically generate some
type of income (e.g. interest income in the
case of bonds), but are much less liquid
than money.
The more money the consumer holds in his
portfolio, the more interest income he
foregoes.
The less money he holds, the more interest
income he makes, but the less liquid is his
portfolio.
Money demand and
the nominal interest rate


The higher the nominal interest rate (e.g.
on bonds) the higher is the opportunity
cost of holding money.
Hence, i   in money demand.
(M P )  L (i ,Y )
d
LY  0
Li  0
Money demand and
the nominal interest rate




Why does the real demand for money L(i,Y)
that during deflation (π<0), the
dependNotice
negatively
on the nominal interest
real return on money is positive.
rate?
Money earns an expected real return of (-πe),
because its real value declines at the rate of
What is the nominal return on money?
inflation.
Assets other than money earn the real return r.
Thus, the cost of holding money is r - (- πe),
which (as the Fisher equation tells us) is the nominal
interest rate i.
Money demand and
the nominal interest rate
Microeconomic foundations of
demand
for money:
*Friedman the
(196???)
demonstrated
that the optimum
i
quantity of money implies that money should earn the same
Transactions theories – Baumol
real return as the other assets: r = -πe => i = r – (-πe) = 0 %
Tobin model (visit the Seminar)
Portfolio theories – HW (p.490)
Liquidity preference theory
(Keynes 1936)
L(i,Y)
M/P
Money demand and
the nominal interest rate
Increase in real income…
i
… will shift the entire curve
outward.
L(i,Y1)
L(i,Y2)
M/P
The money demand function
d
(M P )  L (i ,Y )
e
 L (r   , Y )
When people are deciding whether to
hold money or bonds, they don’t know
what inflation will turn out to be.
Hence, the nominal interest rate relevant
for money demand is r +  e.
Equilibrium on the money market
M
 L (r   e , Y )
P
The supply of real
money balances
Real money
demand
What determines what
M
 L (r   e , Y )
P
variable how determined (in the
long run)
M
exogenous (the CB …)
r
adjusts to make S = I
Y
Y  F (K , L )
P
M
 L (i ,Y )
adjusts to make
P
The equlibrium Price level
MS
Md=P×L(i,Y)
P
Equilibrium M/P:
P*
Ms/P*
CB determines the nominal Ms …
… but people decide about the
real money balances M/P
M
How P responds to M
M
 L (r   e , 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.
Neutrality of money
P
MS M´S Md=P×L(i,Y)
P2*
Money is neutral: ↑M→↑P
P1*
In the end, people hold
more nominal money
balances (M), but the
same amount of real
money balances (M/P)
M
What about expected inflation?






Over the long run, people don’t consistently
over- or under-forecast inflation,
so  e =  on average.
In the short run,  e may change when people
get new information.
EX: CB announces it will increase M next year.
People will expect next year’s P to be higher,
so  e rises.
This affects P now, even though M hasn’t
changed yet….
How P responds to  e
M
 L (r   e , 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 re-establish eq'm
How P responds to
P
MS Md´=P×L(i2,Y)
P2*
Md=P×L(i1,Y)
P1*
e

In the end, people hold
the same amount of
nominal money
balances (M), but a
lower amount of real
money balances (M/P)
Ms/P2* < Ms/P1*
* Money is not super-neutral: Different growth rate of the
money supply ΔM/M (nominal variable) (→ e) will change
L≡Md/P (real variable).
M the level of the money
However, it is neutral,
supply has no influence on real magnitudes.
    i   L  Md/P
e
The Linkages Among Money,
Prices, and Interest Rates
The social costs of inflation
…fall into two categories:
1. costs when inflation is expected
2. costs when inflation is different than
people had expected
The costs of expected inflation :

HW (pp. 95-98)
1.
2.
3.
4.
5.
Shoeleather cost
Menu costs
Relative price distortions
Unfair tax treatment
General inconvenience
Cost of unexpected inflation:

HW (pp. 98-100)

Arbitrary redistribution of purchasing
power
Hyperinflation

HW, pp.102-107
The Determinants of the Nominal
Exchange Rate

Start with the expression for the real
exchange rate:
E
Er 
P
P*

Solve for the nominal exchange rate:
P
E  Er *
P
The Determinants of the Nominal
Exchange Rate
 So E depends on the real exchange
rate and the price levels at home and
abroad…
…and we know how eachM *
*
*

L
(
r
*


*,
Y
)
of them is determined: *
P P
E  Er *
P
M
NX(Er) = NS(r*) - I(r*)
P
 L (r *   , Y )
The Determinants of the Nominal
Exchange Rate
P
E  Er *
P

Rewrite this equation in growth rates
(see “arithmetic tricks for working with percentage changes,” Chap 2 ):
%ΔE = %ΔEr + %ΔP - %ΔP*
=> %ΔE = %ΔEr + π – π*
Relative version of purchasing power parity

For a given value of Er
the growth rate of E equals the
difference between domestic and
foreign inflation rates.
Inflation differentials and nominal
exchange rates
35
Percentage
30
change in
nominal 25
exchange
20
rate
15
Mexico
Iceland
Singapore
10
South Africa
Canada
5
South Korea
_
0
U.K.
Japan
-5
-5
0
5
10
15
20
25
30
Inflation differential