Transcript Lecture 4
Lecture 4 Money and inflation Example: Zimbabwe hyperinflation Example: Zimbabwe hyperinflation Example: Zimbabwe hyperinflation What happened? A dramatic increase in government expenditure. For example, in 2006: Soldiers salary was raised by 300% Police’ salary was raised by 200% Government had no money to do that – they print money. Right now Since April 2009, all transactions are done in foreign currencies, such as the US dollar or South Africa’s Rand. Price of a daily newspaper Jan 1921: 0.30 mark May 1922: 1 mark Oct 1922: 8 marks Feb 1923: 100 marks Sep 1923: 1,000 marks Oct 1, 1923: 2,000 marks Oct 15, 1923: 1 million marks Nov 17, 1923: 17 million marks This lecture Quantity theory of money how inflation is determined. Demand for money a link between output and money Fisher equation Why could this happen? What is money? A store of value A medium of exchange A unit of account Money supply measure C Currency M1 Currency + demand deposits + Checking accounts $715.4 billion $1363.4 billion M2 M1 + retail money market mutual fund + Saving deposits $6587.9 billion M3 M2 + repurchase agreements $9976.2 billion Note: US GDP is 14.256 trillion Money supply in US Open market operations Sell bond decrease money supply Buy bond increase money supply Reserve requirement The discount rate Money supply in US M1 Money Supply (08/08 -- 07/10) 1750 1700 Billions of US$ 1650 1600 1550 1500 1450 1400 08/08 1350 Month Banks borrowing from Fed 2008 Banks borrowing from Fed 800 700 Billions 600 500 400 300 200 100 0 0 2 4 6 8 Month 10 12 14 US money supply Changes in Fed Discount Rate 7 2006-6-29 6 2007-8-17 2007-9-18 2007-10-31 2007-12-11 5 4 2008-1-22 2008-1-30 2008-3-17 3 2008-3-18 2008-4-30 2 2008-10-8 2008-10-29 1 2008-12-16 0 3-24-06 7-2-06 10-10-06 1-18-07 4-28-07 8-6-07 11-14-07 2-22-08 6-1-08 9-9-08 12-18-08 3-28-09 Velocity Basic concept: the rate at which money circulates. Example: In 2009, US GDP: $14000 billion Money supply = $700 billion (M1) The average dollar is used 20 times. So velocity = 20 Quantity theory of money V = velocity T = value of all transactions (T = PY) M = money supply. Money * Velocity = Price * Output M * V = P * Y Quantity theory of money Take the log of previous equation: log M t log Vt log Pt log Yt Since it works for time t, it also works for time t-1: (2) log M log V log P log Y t 1 (1) t 1 t 1 t 1 Equations (1) – (2), we have: log M t log Vt log Pt log Yt (3) Quantity theory of money Equation (3) says: % change in M + % change in V = % change in P + % change in Y Inflation and money supply Inflation and money supply Demand for money Consider the “trip to the bank” story: People would have some of their income in their pocket, and the rest in a bank. When the money in his pocket is lower than some number, he would take a trip to the bank to “refill” his pocket. Therefore, factors that affect the number of the trips would affect his demand for money. Demand for money Income effect: When a person has a higher income, it is more costly for him to go to the bank (opportunity cost is high). When a person has a higher income, he would typically consume more – therefore he needs more money in his pocket. Demand for money Interest effect: When the nominal interest rate is higher, putting money in the bank would earn more interests less money in his pocket. Price effect: Higher price would require more money in the pocket. Demand for money Money demand equation d M Li, Y Y i P α and β are two positive numbers: α represents the relationship between money demand and the income β represents the relationship between money demand and nominal interest rate. Discussion: If, because of increasing popularity of credit use, people carry almost no cash in their pockets, regardless of their income. What would happen to the money demand equation? The value of α would be reduced to almost zero -- people’s income levels would no longer have any effects on their demand for money in their pockets. Fisher equation At the beginning of a year, Bill has 1 million dollars. Two options: Option #1: Deposit into a bank to earn a preset nominal interest. At the end of the year, he would have: $ (1 + i) million Fisher equation Option #2: Invest. At the current price p, he would buy 1/p million units machines. Each unit of machine would produce (1+r) units of output. At the end of the year, he would produce total output: 1/p x (1+r) Fisher equation: Option #2 (continued): At the end of the year, the new price is px(1+π ) He would sell the output at the new price to get money: 1/p x (1 + r) x px(1+π) = (1+r) x(1+π) Fisher equation: Two options should generate exact same amount of money: (1 + i) = (1+r) x(1+π) 1+i=1+r+π+rxπ Since r x π is generally very small, we have the Fisher equation: i≈r+π Fisher equation Since at the beginning of the year we do not know the inflation, so we use expected inflation: i r e Discussions: Since real interest rate does not vary much across time, nominal interest rate and the inflation should be highly correlated. See graphs next. The Fisher equation: time series evidence The Fisher equation: cross country evidence Cost of expected inflation Cost of expected inflation Menu cost: first may have to change their posted prices more often. Tax laws: many provision of the tax code do not account for the inflation. Cost of unexpected inflation Unexpected redistribution. Summary Quantity theory suggests that inflation is almost entirely due to the money supply. Demand for money depends on income, price level, and nominal interest rate. Fisher equation suggests that nominal interest = real interest + expected inflation