Transcript ECN 2003 MACROECONOMICS

ECN 2003
MACROECONOMICS
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CHAPTER 4
MONEY AND INFLATION
Assoc. Prof. Yeşim Kuştepeli
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 The rate of inflation is the percentage change in the
overall prices, it varies substantially over time and across
countries.
 In Germany in 1932, prices rose an average of 500 % per
month. Such an episode of extra ordinary high inflation is
called hyperinflation.
 We ignore short run price stickiness for this chapter. The
classical theory of inflation not only provides a good
description of the long run , it also provides a useful
foundation for short run analysis.
 Inflation is an increase in average level of prices and a
price is the rate at which money is exchanged for a good
or a service.
Assoc. Prof. Yeşim Kuştepeli
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
To understand inflation, we must understand
money; what it is , its supply and demand and its
effects on the economy.
1.
Concept of money
Determination of price and inflation
Inflation tax
Effect of inflation on interest rate
Effect of interest rate on money demand
Inflation, a major problem ?
hyperinflation
2.
3.
4.
5.
6.
7.
Assoc. Prof. Yeşim Kuştepeli
WHAT IS MONEY?
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
Money is the stock of assets that can be readily used
to make transactions.
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1)
Functions of money
Store of value : money is a way to transfer
purchasing power from present to future.
Unit of account: terms in which prices are quoted
and debts are recorded.
Medium of exchange: what is used to buy goods and
services (liquidity)
2)
3)

Barter economy-double coincidence of wants
Assoc. Prof. Yeşim Kuştepeli
WHAT IS MONEY?
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
a.
b.
Types of money
Fiat money-no intrinsic value
Commodity money - intrinsic value – ex. Gold standard
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How fiat money evolves:
People are willing to accept a commodity currency such
as gold due to its intrinsic value.
Using raw gold as money is costly as it takes time to
verify the purity of gold and to measure the correct
quantity.
Government can mint gold coins to reduce these costs.
Government accepts gold from public in exchange for
gold certificates
Gold backing becomes irrelevant.
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Assoc. Prof. Yeşim Kuştepeli
WHAT IS MONEY?
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 How the quantity of money is controlled?
 The quantity of money available is called the money
supply.
 The control over money supply by the government is
monetary policy.
 The Central Bank is the partially independent
institution that decides on the monetary policy.
 Open market operations
 Discount rate
 Required reserve ratio
Assoc. Prof. Yeşim Kuştepeli
WHAT IS MONEY?
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
1.
2.
The measurement of quantity of money:
Currency: sum of outstanding paper money and
coins.
Demand deposits: the funds people hold in their
checking accounts.
M1= currency +demand deposits+traveler’s
checks+other checkable deposits
M2= M1+money market mutual fund balances+saving
deposits+small time deposits
M3= M2+large time deposits+eurodollars
L= M3+other liquid assets (saving bonds, short term
Treasury securities)
Assoc. Prof. Yeşim Kuştepeli
THE QUANTITY THEORY OF MONEY
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 The quantity equation:
 Money*velocity = price*transactions; M*V = P*T
 T is number of times in a period that goods and services
are exchanged for money.
 P is the price of a typical transaction.
 V is transactions velocity of money and measures the rate
at which money circulates in the economy.
 Ex: 60 loaves of bread = T ; 0,50 per loaf = P; M=10
P*T=60*0,5= 30/year = value of transactions; then ,
10*V=30
V=3
Assoc. Prof. Yeşim Kuştepeli
THE QUANTITY THEORY OF MONEY
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 Transactions and output are closely related as the more
the economy produces the more goods are bought and
sold. The value of transactions is roughly proportional to
the value of output.
 M*V=P*Y where Y= output
 V=(P*Y)/M
 V is income velocity of money, the number of times 1 TL
enters someone’s income in a given time.
 M/P= real money balances=purchasing power of the
stock of money
Assoc. Prof. Yeşim Kuştepeli
THE QUANTITY THEORY OF MONEY
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 Money demand function shows the determinants of the
quantity of real money balances people wish to hold.
 Ex: (M/P)d= k*Y where k is a constant that tells how
much money people want to hold for every 1 TL.
 Equilibrium in the money market :
(M/P)d= (M/P)s ; M/P = k*Y ; M*V=P*Y
M(1/k)=P*Y ; V= 1/k
 When people want to hold a lot of money for 1 TL of
income (k is high), money changes hands infrequently
(V is small).
Assoc. Prof. Yeşim Kuştepeli
THE QUANTITY THEORY OF MONEY
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 Constant velocity of money :
 M*V=P*Y
 Change in M +change in V =Chang in (P*Y)
 Change in V = 0; thus
 The quantity of money determines the value of
output.
Assoc. Prof. Yeşim Kuştepeli
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
The determination of the economy’s overall level of prices
depend on three assumptions:
1.
2.
3.
Y =f(K, L) ; productive capacity determines real GDP
M*V=P*Y; money determines nominal GDP
P=PY/Y ; GDP Deflator = nominal GDP/Real GDP
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As velocity is constant, any change in the money supply
leads to a proportionate change in nominal GDP.
Because inputs and production function have already
determines real GDP, change in nominal GDP must
present a change in P.
Hence the quantity theory implies that the price level is
proportional to the money supply.
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Assoc. Prof. Yeşim Kuştepeli
SEIGNIORAGE
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
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a)
b)
c)
Why does government increase the money supply?
A government can finance its spending in three ways:
Through taxes
Borrowing from public by selling bonds
Printing money

The revenue raised through printing money is called
seigniorage.
When the government prints money to finance
expenditures, it increases the money supply, this in
turn causes inflation.
Printing money to raise revenue is like imposing an
inflation tax.
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Assoc. Prof. Yeşim Kuştepeli
INFLATION and INTEREST RATES
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 The interest rate that the bank pays is the nominal
interest rate and the increase in the purchasing power
is the real interest rate.
 Fisher effect : nominal interest rate can change either
because the real interest rate changes or because
inflation changes.
 According to Fisher equation, an increase in inflation
rate causes an increase in the nominal interest rate.
 This one-to-one relationship between inflation and
nominal interest rate is called the Fisher effect.
Assoc. Prof. Yeşim Kuştepeli
INFLATION and INTEREST RATES
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 When a borrower and a lender agree on a nominal
interest rate, they do not know what the inflation rate
over the term of the loan will be.
 The real interest rate that the borrower and the lender
expect when the loan is made is called the ex ante real
interest rate.
 The real interest rate actually realized is called ex post
interest rate.
 Ex ante interest rate = i –expected inflation
 Ex post interest rate = i – actual inflation.
Assoc. Prof. Yeşim Kuştepeli
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 The costs of holding money :
 The nominal interest rate is the opportunity cost of
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holding money.
Assets other than money such as gıovernment bonds
earn th real return r.
Money earns an expected real return of (–expected
inflation).
The cost of holding money is r-(-exp.inf.) = i
As interest rate goes up, the quantity of money
demanded goes down.
Assoc. Prof. Yeşim Kuştepeli
SOCIAL COSTS OF INFLATION
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 The Layman’s view: If the governmnet reduced inflation
by slowing the rate of money growth, workers would not
see their real wager increasing more rapidly. Instead
when inflation slows, firms would increase the prices of
their products less each year and would give their
workers less raises each year.
 According to the classical theory of money, a change in
the overall price level is like a change in the unit of
measurement.
 Then why is inflation a social problem?
Assoc. Prof. Yeşim Kuştepeli
THE COSTS OF EXPECTED INFLATION
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1.
2.
3.
4.
5.
Distortion of inflation tax on money held: shoeleather cost
Menu costs
İnefficient allocation of resources due to variablity
in relative prices
Changes in tax liability (taxes are due nominal
income)
Inconvenience of changing living standards
Assoc. Prof. Yeşim Kuştepeli
THE COSTS OF UNEXPECTED INFLATION
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1.
2.
3.
4.
5.
Redistribution of wealth
People on fixed income are worse off
Uncertainty
Unstable currency-less contracts
Varaible inflation leads to high varaible inflation
Assoc. Prof. Yeşim Kuştepeli
THE CLASSICAL DICHOTOMY
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 Seperation of real and nominal variables is
crucial.
 Real variables can be explained without introducing
nominal variables or money.
 In classical theory, cahnges in money supply do not
influence real variables. This irrelevance of money
for real variables is called monetary neutrality.
Assoc. Prof. Yeşim Kuştepeli