Copyright © 2012 Pearson Addison-Wesley. All rights reserved. Chapter 5 Money and Inflation.

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Chapter 5

Money and Inflation

Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 5-2

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• To understand the meaning of money and how it is measured

• To examine the link between money, inflation, and the interest rate

• To understand the costs of inflation for households and businesses


What is Money?

• Economists define money as an asset that is generally accepted in payment for goods and services or in the repayment of debts

• When people talk about money, they usually refer to currency

• Money is not the same as:– Wealth: the total collection of property that

serves as a store of value– Income: a flow of earnings per unit of time

(money is a stock)


Box: Unusual Forms of Money

• Beads (wampum) used by American Indians• Tobacco and whisky used by early American

colonists • Big stone wheels used by residents on the

island of Yap• Cigarettes used by prisoners of war in a

POW camp during World War II


Functions of Money

• Money has three primary functions:– Medium of exchange – Unit of account– Store of value


Functions of Money (cont’d)

• Money as a medium of exchange:– Without money, people would barter, which

requires a “double coincidence of wants”– Money promotes economic efficiency by

minimizing transaction costs



• Money as a unit of account:– we measure the value of goods and services in

terms of money as we measure weight in pounds and distance in miles



• Money as a store of value:– Money saves purchasing power from the time

income is received until the time it is spent– Money as a medium of exchange makes money

the most liquid of all assets: It does not have to be converted into a medium of exchange to immediately make purchases


The Federal Reserve System and the Control of the Money Supply

• The money supply is the amount of money in the economy

• The key player in the money supply process is the Federal Reserve System (Fed), which consists of:– 12 Federal Reserve Banks– Board of Governors


Federal Reserve Banks

• Federal Reserve Banks are involved in monetary policy:– 5 of the 12 bank presidents (on rotation basis)

each have a vote in the Federal Open Market Committee (FOMC)


FIGURE 5.1 Federal Reserve System


Board of Governors of the Federal Reserve System

• As head of the Federal Reserve System• Has 7 members• Headquartered in Washington, D.C.• Each governor is appointed by the president

of the United States and confirmed by the Senate

• The chairman of the Board of Governors serves a 4-year, renewable term


Federal Open Market Committee (FOMC)

• Usually meets 8 times a year• Makes decisions on open market operations• Consists of 7 members of the Board of

Governors, the president of the Federal Reserve Bank of New York, and the presidents of 4 other Federal Reserve banks

• Chairman of the Board of Governors presides as the FOMC chairman


Box: The European Central Bank

• European Central Bank (ECB) patterns its central banking system after the Fed:

• Run by an Executive Board similar in structure to the Board of Governors of the Fed

• National Central Banks (NCBs) have similar functions to the Federal Reserve Banks

• Its Governing Council, comprised of the Executive Board and presidents of the National Central Banks, is similar to the FOMC


Control of the Money Supply

• The Fed controls the money supply through open market operations, which are purchases or sales of government bonds– When the Fed buys government bonds, the

money supply increases– When the Fed sells government bonds, the

money supply decreases


Measuring Money

• The Fed’s monetary aggregates:– M1

• The Fed’s narrowest measure of money• Includes only the most liquid assets• Consists of currency, traveler’s checks, demand

deposits, and checking account deposits.

– M2 • Consists of M1 plus money market deposit accounts,

money market mutual fund shares with check-writing features, savings deposits, and certificates of deposit in denominations of less than $100,000


TABLE 5.1 Measures of the Monetary Aggregates


Macroeconomics in the News: The Monetary Aggregates

• Every week on Thursday, the Federal Reserve publishes the data for M1 and M2 in its H-6 release and these numbers are often reported on in the media

• The H-6 release can be found at http://www.federalreserve.gov/releases/h6/current/h6.htm


The Fed’s Use of M1 Versus M2 in Practice

• It’s not obvious whether M1 or M2 is a better measure of money

• The growth rates of M1 and M2 move in tandem through the 1980s but then diverge since then

• Because the two monetary aggregates give different stories about the course of monetary policy in recent years, the Fed now focuses on interest rates rather than money supply in conducting monetary policy


FIGURE 5.2 Growth Rates of M1 and M2, 1960-2010


Box: Where Is All the U.S. Currency?

• The $872 billion in outstanding U.S. currency in 2010 means, on average, a U.S. citizen holds $2800 in cash

• Who actually have so much of U.S. dollars?– People engaging in illegal activities– Foreigners, especially those living in countries

with high inflation


Quantity Theory of Money

• The quantity theory of money is the product of the classical economists, also known as classicals, who assumed that wages and prices were completely flexible

• American economist Irving Fisher gave a clear exposition of this theory in his influential book, The Purchasing Power of Money, published in 1911


Velocity of Money and the Equation of Exchange

• The link between the total quantity of money (M) and the total amount of spending on goods and services produced (P x Y) is the velocity of money (V):

P YV

M


Velocity of Money and the Equation of Exchange (cont’d)

• The equation of exchange relates nominal income to the quantity of money and velocity:

M V P Y



• The demand for money (Md) is the quantity of money that people want to hold

• Md can be obtained from dividing the equation of exchange by V:

1M PY

V



• Assuming V is constant, the demand for real money balances:

where k=1/V

dMk Y

P


From the Equation of Exchange to the Quantity Theory of Money

• According to Fisher, V is fairly constant at in the short run

• This transforms the equation of exchange into the quantity theory of money—nominal income is determined solely by movements in the quantity of money:

V

P Y M V


The Classical Dichotomy

• Classical economists viewed wages and prices as flexible, so that prices of goods and service and factor prices would fully adjust to the level that equates the supply and demand for a particular good or service in the long run


The Classical Dichotomy (cont’d)

• Classical dichotomy: – In the long run there is a complete separation

between the real side of the economy and the nominal side

– The amounts of goods and services produced in an economy in the long run is not affected by the price level


Quantity Theory and the Price Level

• Assuming that Y is fixed at so that in the price level in the quantity theory of money becomes:

• This implies that, in the long run, changes in the quantity of money lead to proportional changes in the price level

• This view is also known as the neutrality of money—the money supply has no impact on real variables

Y

M VP

Y


Quantity Theory and Inflation

• A theory of inflation can be obtained by rewriting the equation of exchange as:

• If V is constant, the inflation rate ( ) becomes:

• The quantity theory of inflation indicates that the inflation rate equals the growth rate of the money supply minus the growth rate of aggregate output

%M %V %P %Y

%P %M %Y


Application: Testing the Quantity Theory of Money

• Because the quantity theory of money provides a long-run theory of inflation, it explains differing long-run inflation rates across countries

• However, the relationship between inflation and money growth on an annual basis is not strong at all

• The conclusion: Milton Friedman’s statement that “inflation is always and everywhere a monetary phenomenon” is accurate in the long run, but is not supported by the data for the short run


FIGURE 5.3 Relationship Between Inflation and Money Growth (a)


FIGURE 5.3 Relationship Between Inflation and Money Growth (b)


FIGURE 5.4 Annual U.S. Inflation and Money Growth Rates, 1965-2010


Hyperinflation

• Hyperinflation occurs when a country experiences extremely rapid price increases of more than 50 percent per month (over 1000 percent per year)

• Except for the United States, many economies – both poor and developed – have experienced hyperinflation over the last century


Policy and Practice: The Zimbabwean Hyperinflation

• In 2000s, the Zimbabwean government paid for its excessive spending by raising its money supply rapidly

• As predicted by the quantity theory, the surge in the money supply led to a rapidly rising price level: The inflation rate hit over 1,500 percent in March 2007, over 2 million percent by 2008


Inflation and Interest Rates

• The Fisher equation in Chapter 2 states that the nominal interest rate i equals the real interest rate r plus the expected rate of inflation :

• The Fisher effect occurs at a result of the Fisher equation and the classical dichotomy: When expected inflation rises, interest rates will rise

e

ei r


Application: Testing the Fisher Effect

• The U.S. evidence demonstrates that the Fisher effect prediction that nominal rates rise along with expected inflation is accurate in the long run, but over shorter time periods, expected inflation and nominal interest rates do not always move together


FIGURE 5.5 Expected Inflation and the Nominal Interest Rate (a)


FIGURE 5.5 Expected Inflation and the Nominal Interest Rate (b)


The Cost of Inflation

• Costs from anticipated inflation

– Shoe-leather costs

– Menu costs

– Tax distortions

– Increased Variability of Relative Prices

– Loss of the dollar yardstick


The Cost of Inflation (cont’d)

• Costs from unanticipated inflation

– Increased uncertainty

– Increased variability of relative prices

– Higher inflation uncertainty when the level of inflation is higher

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Chapter 5Appendix

The Money Supply Process


The Fed’s Balance Sheet

• Liabilities– Currency in circulation: in the hands of the public– Reserves: bank deposits at the Fed and vault cash

• Assets– Government securities: holdings by the Fed that affect

money supply and earn interest– Discount loans: bank borrowings from the Fed, i.e.,

borrowed reserves, at the discount rate


• Monetary base is the sum of the Fed’s monetary liabilities and the U.S. Treasury’s monetary liabilities (Treasury currency in circulation, mostly coins)

• Reserves consist of deposits at the Fed plus currency that is held in bank vaults (or vault cash)

• Total reserves = required reserves + excess reserves

The Fed’s Balance Sheet (cont’d)


Control of the Monetary Base

• The monetary base equals currency in circulation (C) plus the total reserves in banking system (R):

MB = C + R

• MB is also called high-powered money because the Fed exercises control over it through open market operations, and through its extension of discount loans to banks.


Federal Reserve Open Market Operations

• An open market purchase is a purchase of bonds by the Fed

• An open market sale is a sale of bonds by the Fed

• Suppose that the Fed purchases $100 of bonds from a bank and pays for them with a $100 check. How does this transaction affect the monetary base? Let’s look at a T-account.


Federal Reserve Open Market Operations (cont’d)

• Reserves increase by $100• Monetary base increases by $100


Shifts from Deposits into Currency

• A shift from $100 deposits to currency affects the reserves in the banking system, but the shift will have no net effect on the monetary base


Discount Loans

• A $100 discount loan to a bank increases the monetary base by $100


Discount Loans (cont’d)

• If the bank pays off the $100 discount loan, then borrowings from the Fed and the monetary base will reduce by $100


Overview of the Fed’s Ability to Control the Monetary Base

• The monetary base has two components:1. Nonborrowed monetary base

• Created through open market operations• The Fed can control completely

2. Borrowed reserves• Created through banks’ borrowings from the Fed

(discount loans)• The Fed has less control over


Multiple Deposit Creation: A Simple Model

• An increase in the monetary base leads to a multiple expansion of the money supply

• The money supply process is multiple deposit creation: For each $1 additional reserves that the Fed supplies the banking system, deposits increase by a multiple of this amount


Deposit Creation: The Single Bank

• Suppose the Fed buys $100 bonds from the First National Bank


Deposit Creation: The Single Bank (cont’d)

• A bank cannot safely make loans for an amount greater than the excess reserves it has before it makes the loan

• The First National Bank’s final T-account is:


Deposit Creation: The Banking System

• Assumptions:– The $100 deposits created by the First National

Bank is deposited at Bank A – no excess reserves– Required reserve ratio (rr) = 10%


Deposit Creation: The Banking System (cont’d)



• If the money spent by the borrower to whom Bank A lent the $90 is deposited in Bank B, then:



• If Bank A had taken its excess reserves and purchased securities instead of making loans, then:

• Whether a bank chooses to use its excess reserves to make loans or to purchase securities, the effect on deposit expansion is the same


TABLE 5A1.1 Creation of Deposits (assuming 10% reserve requirement and a $100 increase in reserves)


Critique of the Simple Model

• In reality, the multiple deposit creation may be smaller than that implied by the model because:1. Borrowers hold loan proceeds as cash and never

deposit them, so there is no multiple deposit expansion

2. Banks choose not to use all their excess reserves to buy securities or make loans


Factors that Determine the Money Supply

• Changes in the nonborrowed monetary base– The money supply is positively related to the non-

borrowed monetary base MBn

• Changes in borrowed reserves from the Fed– The money supply is positively related to the

level of borrowed reserves, BR, from the Fed


• Changes in the required reserves ratio– The money supply is negatively related to the

required reserve ratio rr

• Changes in currency holdings– The money supply is negatively related to

currency holdings

• Changes in excess reserves– The money supply is negatively related to the

amount of excess reserves

Factors that Determine the Money Supply (cont’d)


TABLE 5A1.2 Money Supply Response


Application: The Great Depression Bank Panics and the Money Supply, 1930-1933

• In 1930, the U.S. experienced a bank panic, in which there were simultaneous failures of multiple banks

• Depositors who anticipated substantial losses on deposits sought to shift their deposit holdings into currency

• For a relatively constant MB, the money supply decreased due to the fall of the money multiplier


FIGURE 5A1.1 Excess Reserves Ratio and Currency Ratio, 1929–1933


FIGURE 5A1.2 M1 and the Monetary Base, 1929–1933


M m MB

The Money Multiplier

• Define money as currency plus checkable deposits: M1

• The money multiplier (m) tells us how much the money supply (M) changes for a given change in the monetary base (MB):


Deriving the Money Multiplier

• Assume that the desired holdings of currency (C) and excess reserves (ER) grow proportionally with checkable deposits (D), then:

c = {C/D} = currency ratioe = {ER/D} = excess reserves ratio


Deriving the Money Multiplier (cont’d)

The total amount of reserves ( ) equals the sum of

required reserves ( ) and excess reserves ( ).

The total amount of required reserves equals the required

reser

R

RR ER

R = RR + ER

ve ratio times the amount of checkable deposits

Subsituting for RR in the first equation

The Fed sets to less than

RR = rr × D

R = (rr × D) + ER

rr 1


• Because the monetary base MB equals currency (C) plus reserves (R):

MB = R + C= (rr x D) + ER + C

• This equation reveals the amount of the monetary base needed to support the existing amounts of checkable deposits, currency and excess reserves.




= { } =

Substituting in the previous equation:

( ) ( ) ( ) ( )

Divide both sides by the term in parentheses:

c = {C / D} C = c D

e ER / D ER e D

MB rr D e D c D r e c D

1

Because and :

( ) (1 )

Substituting again:

1

The money multiplier is therefore:

1

D MBr e c

M D C C c D

M D c D c D

cM MB

r e c

cm

r e c


Intuition Behind the Money Multiplier

required reserve ratio = 0.10

currency in circulation = $400 billion

checkable deposits = $800 billion

excess reserves = $0.8 billion

money supply (M1) = = $1,200 billion

rr

C

D

ER

M C D

• What is the value of the money multiplier given the following information?


Intuition Behind the Money Multiplier (cont’d)

• The money multiplier is less than the multiple deposit expansion of 10 in the simple model.

• Although there is multiple expansion of deposits, there is no such expansion for currency

$400 billion0.5

$800 billion$0.8 billion

0.001$800 billion1 0.5 1.5

2.50.1 0.001 0.5 0.601

c

e

m


Money Supply Response to Changes in the Factors

• Because the monetary base (MB) is the sum of nonborrowed base (MBn) and borrowed reserves (BR):

MB=MBn+BR

• A rise in MBn or BR raises the money supply by m


Money Supply Response to Changes in the Factors (cont’d)

• If rr increases from 10% to 15%, then m falls to:

• If c rises from 0.5 to 0.75, then m falls to:

• If e rises from 0.001 to 0.005, then m falls to:

1 0 5 1 52 3

0 15 0 001 0 5 0 651. .

m .. . . .

1 0 75 1 752 06

0 1 0 001 0 75 0 851. .

m .. . . .

1 0 5 1 52 48

0 1 0 005 0 5 0 605. .

m .. . . .

Copyright © 2012 Pearson Addison-Wesley. All rights reserved. Chapter 5 Money and Inflation.

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