Transcript Chapt4

Class Slides for EC 204
Spring 2006
To Accompany Chapter 4
The Quantity Theory of Money
Money x Velocity = Price x Transactions
M x V
= P x T
V = PT/M
Transactions Velocity
Dollar value of transactions ~ Dollar value of output
Money x Velocity = Price x Output
M x V
= P x Y
V = PY/M
Income Velocity
Money Demand and the Quantity
Equation
Money Demand: (M/P)d = kY
Money Supply: M/P
M/P = kY
M(1/k) = PY
MV = PY
where V=(1/k)
Constant Velocity implies that V is constant, so M
determines PY
Money, Prices and Inflation
Three Building Blocks for Model Determining Price Level
1. Production function and factor supplies determine Y.
2. Money Supply determines nominal value of output, PY,
since velocity is fixed.
3. Price Level is then the ratio of PY to Y.
MV = PY implies:
%Change in M + %Change in V =
%Change in P + % Change in Y.
Empirical Evidence on MoneyInflation Relationship
• Holds for the U.S. over long periods of time
as seen when comparing inflation and
money growth over a various decades
• Holds across countries when comparing
inflation and money growth over a given
decade of time
• Doesn’t hold over short periods of time
Money Growth and Inflation in the U.S.
(Average Rates for Various Decades)
Money Growth and Inflation Across Countries
(Average Rates for the 1990s)
Money Growth and Inflation in the United States
1960-2003
14%
12%
10%
M2
8%
6%
4%
2%
0%
0.0%
2.0%
4.0%
6.0%
PCE Price Index
8.0%
10.0%
12.0%
Money Growth and Inflation in the United States
1960-2003
16%
14%
12%
10%
M1
8%
6%
4%
2%
0%
-2%
-4%
-6%
0.0%
2.0%
4.0%
6.0%
PCE Price Index
8.0%
10.0%
12.0%
Money Growth and Nominal GDP Growth
1960 to 2003
(Annual Percent Change, Year-over-year)
16%
14%
GDP
M1
M2
12%
10%
8%
6%
4%
2%
0%
-2%
-4%
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-6%
Seignorage: Revenue from Printing
Money
Inflation is like a tax on real balances
People hold less real balances than otherwise
Value of revenue is approximately equal to inflation rate
times the level of real balances: p(M/P)
Inflation and Interest Rates
Real Interest Rate = Nominal Interest Rate - Inflation
Rate
r
=
i - p
The Fisher Effect:
i=r+p
Ex Ante versus Ex Post Real Interest Rates: Expected
versus Actual Inflation.
Fisher Effect Becomes: i = r + pe
Evidence Supports Fisher Effect
• Evidence for U.S. shows correlation
between inflation and both short and longterm interest rates
• Evidence across countries shows
relationship between inflation and interest
rates over a given decade of time
Nominal Interest Rate and Inflation
1962-2003
16%
14%
PCE Price Index
3-Month Treasury Bill
12%
10%
8%
6%
4%
2%
20
02
20
00
19
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70
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68
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66
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64
19
62
0%
Nominal Interest Rate and Inflation
1962-2003
16%
14%
PCE Price Index
12%
10-Yr Govt Bond
10%
8%
6%
4%
2%
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19
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0%
Inflation and Interest Rates Across Countries
(Average Rates for the 1990s)
The Nominal Interest Rate and the
Demand for Money
(M/P)d = L(i, Y)
“i” is relevant interest rate since we are comparing real
return on bonds (r) with real return on money (-p):
r - (-p) = i - p - (-p) = i
Future Money and Current Prices:
M/P = L(r + pe, Y)
(See Appendix for details)
Social Costs of Inflation
Costs of Expected Inflation:
Shoeleather Costs
Menu Costs
Relative Price Variability
Tax Code is not Fully Indexed
Inconvenience for Measuring Economic Transactions
Costs of Unexpected Inflation:
Arbitrary Redistribution of Wealth
Examples: Creditors and Debtors
Fixed Pensions
Why specify contracts in nominal terms?
Some indexing in U.S.: Social Security,
Indexed Treasury Bonds, Part of Tax System
High Inflation also Tends to be highly variable inflation
So, further reason why high inflation may be a problem.