Transcript 19-Inflation

Money
What is money?
Anything people will accept in place of the goods
and services they seek to obtain.
Money is a stock of assets that can be readily
used to make transactions.
Examples from history: salt in Egypt; rice in Japan;
dried fish in Iceland; cigarettes in Romania in the
1970s; liquor in Germany after World War II; online
game “money”; rocks such as gold and silver.
Fiat money—paper currency from government.
Commodity money—gold and other things of value
In the U.S.
M1 = Currency (cash) + Demand Deposits (checking accounts)
+ other checkable deposits
M2 = M1 + savings accounts, time deposits, money market
mutual funds
How much money?
M1 = $2.1 trillion 7/11 (up 30% since early ‘09). Feel rich?
M2 = $9.3 trillion 7/11
Roles of Money
 Account keeping
 The way we keep track of prices and values
 Store of Value
 Transfer purchasing power through time
 Medium of Exchange
 Use money to buy things—better than barter.
If people do not trust official money, they use
other things when possible
Money Creation
 Governments create money
 Role of central banks (Federal Reserve in U.S.)
 Independence from politics important? Ask
the central bank of Argentina (and the U.S.?)
 Many views on how the banks should
manage money creation — fixed rules versus
flexibility — most use flexibility
Inflation
What is inflation? It is a general rise in prices.
Not all prices rise the same percent, but in
general prices are rising.
 Usually it is caused by more money in the
hands of people who are trying to buy the
same quantity of goods in an economy.
Inflation Is Not an
Increase in One Price
 If the price of one good rises, it does not cause
inflation. It is a change in relative prices.
 People have no more money to spend than
before, they change spending mix.
 Example: Price of gasoline up in U.S. 2007: 4.6%
of personal expenditures on gas; in 1997: 2.6%
 Where does the extra money spent on gas (2% of
personal income) come from? Less spending on
other goods.
MV = PT
 The quantity theory of money is:
MV = PT
 M = money in circulation
 V = velocity (# of times money spent per year)
 P = average price level
 T = number of transactions
 Note: this (MV or PT) is national income.
When velocity drops, so does the economy
 M1 velocity down from about 10 to 8
M2 also huge drop
 People holding on to money
Monetary Base (currency plus bank reserves)
have exploded in three years. No inflation yet
as bank reserves way up. What will happen?
What happens if this money comes out of
reserves?
Suppose Price of Gas Rises Because Price of
Oil Has Gone Up (Globally)
 MV = PT
 Assume M and V constant.
 P of gasoline rises; assume T constant
 If quantity demanded of gasoline constant (T not
changing), since more spent on gas, other
transactions must fall (and their prices may too as a
result).
One Price Goes Up —
What Goes Down?
 Consumers do not make money, so M constant.
 Velocity changes little in stable economies.
 Price of gas goes up; but Demand relatively constant, so
something gives—in U.S. the drop occurred in spending at
higher class stores and nicer restaurants. Spending on
luxury goods dropped (boat sales and jewelry). Lower
income people cut spending at Wal-Mart.
 It hurts, but it is not inflation.
So What Causes Inflation?
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In general, inflation is caused by more money
(M) chasing the same quantity of goods.
If M rises and V constant then PT must rise to
balance equation.
People have more money so willing to make
more transactions (T rises). That means more
demand for same level of goods in existence,
so prices (P) bid higher.
Value of money falls if quantity pushed up
 General picture”
Origins of Inflation
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1.
2.
So why do we get inflation?
The government creates more money.
Why? Not stupidity. It is deficit spending.
Print money.
Borrow money from Central Bank or from
citizens or from foreigners.
[Ex.: If U.S. government budget is $3.8 trillion and
revenue is $2.2 trillion—need to get $1.6 trillion
more money for the government to spend.]
Deficit Spending
1. Government (Treasury) sells bonds to get cash—
sell to foreigners (China and Japan especially)—or
to U.S. citizens (thereby “crowding out” private
sector borrowing (investment), which hurts growth).
2. If cannot sell enough bonds to the public—Treasury
sells bonds to Federal Reserve which gives the
Treasury new money—cash (via checking accounts)
that is injected into the economy by the
government—more cash can pushes prices up.
Real vs. Nominal
Interest Rate
 Suppose inflation averages 10% per year (the
value of the currency falls by 10% each year).
 If interest rate paid is 12%, that is the nominal
interest rate.
 What is real (after inflation) interest rate?
12% – 10% = 2%
Destructive Effects
 When inflation rising (and is expected to
continue to rise):
▲ spending and borrowing
▼ savings and investment
▲ incentive to inflate currency even more,
depending on political forces
Inflation Hurts People,
Business, and Society
 Businesses have a difficult time planning for
future — which means less investment.
 How do you time payments?
 Do you accept currency?
 There are winners and losers in every
transaction just due to changes in the value of
the currency — up or down.
Real World Example
 Assume a person in the U.S. invested $10,000 in
1971 for their retirement in 1991 when the
investment is worth $35,000 — a normal rate of
return.
 What is the gain? Due to inflation, $10,000 in 1971 =
$34,000 in 1991. So gain is only $1,000. But the
entire “gain” of $25,000 is subject to taxes of about
$7,000, leaving $28,000 in 1991 — less than the
original investment in real spending power.
 So if people think there will be inflation—what
actions do they rationally take?
Rational Decision Makers
 People try to avoid losses imposed by inflation:
● invest in hard assets
● invest in other countries
● avoid currency of own country
Due to international flows of currency, inflation is
punished in the market. Local people with few
options suffer the most. Political instability more
likely if currency unstable.