Macroeconomics & The global economy Ace Institute of Management Chapter 4: Money and Inflation Instructor Sandeep Basnyat [email protected] 9841.

Macroeconomics & The global economy

Ace Institute of Management

Chapter 4: Money and Inflation

InstructorSandeep Basnyat

[email protected] 892281

Stock of assetsStock of assets

Used for transactionsUsed for transactions

A type of wealthA type of wealthMoney

• Store of value:Store of value: You can postpone your purchase for next period. You can postpone your purchase for next period.• Unit of account: Unit of account: units in which prices are quoted and debts units in which prices are quoted and debts

recordedrecorded• A medium of exchangeA medium of exchange.: .: used to buy goods and servicesused to buy goods and services

The ease with which money is converted into other things such as goods and services--is sometimes called money’s liquidity.

•Measures economic transactions like yardsticks. Without it, we would be forced to barter.

• Problem with barter: requires the double coincidence of wants.

Fiat money is money by declaration.It has no intrinsic value.

Commodity money is money thathas intrinsic value. Eg. Gold or cigarettes in P.O.W. camps

When people use gold as money, the economy is said to be on a gold standard.

• The money supply: quantity of money available in an economy.• Monetary policy: The control over the money supply (increasing

or decreasing).• Central Bank: Institution that conduct monetary policy.• Open Market Operation: Primary way of controlling Money

Supply

To expand the money supply: Central banks buys government bonds and pays for them with new money.

To reduce the money supply: Central banks sells government bonds and receives the existing money and then destroys them.

Other instrument of Monetary Policy

• Changing the Reserve requirements.Minimum reserves each Commercial bank must hold

• Changing the Discount rate (which member banks (not meeting the reserve requirements) pay to borrow from the Central Banks.)

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US. Treasury Bond

• Currency• Demand Deposits• M1, M2, M3

For Nepal: For Nepal: • Broad Money (M2) and Narrow

Money (M1)

Monetary Statistics for US and Nepal for 2008/2009 Nepal US

Monetary Base (M1)

Rs. 18307 million or

Approx. $250 million

$1.99 trillion

M2

Rs. 67644 million or

Approx. $926 million

$8.36 trillion

Reserve Requirements 5.50% 10%FYI: Prepare a list of countries with their Money Supply, Reserve Requirements and Central Banks monetary instruments in monetary policy operations.

Equilibrium in Money Market

Quantity ofMoney

Value ofMoney, 1/P

Price Level, P

Quantity fixedby the Central Bank

Money supply

0

1

(Low)

(High)

(High)

(Low)

1/2

1/4

3/4

1

1.33

2

4

Equilibriumvalue ofmoney

Equilibriumprice level

Moneydemand

A

Quantity Theory of Money• The Quantity Theory of Money states that there is a

direct relationship between the quantity of money in an economy and the level of prices of goods and services sold.

– If the amount of money in an economy doubles, price levels also double, causing Inflation (the percentage rate at which the level of prices is rising in an economy).

– The consumer therefore pays twice as much for the same amount of the good or service.

– Money is like any other commodity: increases in its supply decrease marginal value (the buying capacity of one unit of currency).

– So an increase in money supply causes prices to rise (inflation) as they compensate for the decrease in money’s marginal value.

Quantity Theory of Money-Derivation• Md = T x P– T = Number of transactions in an economy – P = General price Level. It is the nominal GDP

• Ms = M x V – M = Amount of Money in circulation– V = Velocity of money (the number of times

money changes hands)

From Equilibrium condition, Md = Ms

T x P = M x VT x P = M x V

• Transactions calculation not easy• Replaces with Total Output (Transactions and output are related as

the more the economy produces, the more goods are bought and sold).

Money Velocity = Price Output M V = P Y

The Quantity Theory of Money

MV = PY M α P

Fixed Y = as K, L are fixed, and Fixed V : supposed constant over time

Price Level is directly proportional to the Quantity of Money in the Economy.

Price Level is directly proportional to the Quantity of Money in the Economy.

or in percentage change form:

MV = PY

% Change in M + % Change in V = % Change in P + % Change in Y% Change in M + % Change in V = % Change in P + % Change in Y

If V is fixed and Y is fixed, then it reveals that % Change in M is what induces % Changes in P.

M α PThe Quantity Theory of Money

The quantity theory of money states that the central bank, which controls the money supply, has the ultimate control over the inflation rate. If the central bank keeps the money supply stable, the price level will be stable. If the central bank increases the money supply rapidly,

the price level will rise rapidly.

• The revenue raised through the printing of money is called seigniorage.

•When the government prints money to finance expenditure, it increases the money supply. The increase in the money supply, in turn, causes inflation. Printing money to raise revenue is like imposing an inflation tax.

• The revenue raised through the printing of money is called seigniorage.

•When the government prints money to finance expenditure, it increases the money supply. The increase in the money supply, in turn, causes inflation. Printing money to raise revenue is like imposing an inflation tax.

The Effects of Monetary Injection

Quantity ofMoney

Value ofMoney, 1/P

Price Level, P

Moneydemand

0

1

(Low)

(High)

(High)

(Low)

1/2

1/4

3/4

1

1.33

2

4

M1

MS1

M2

MS2

2. . . . decreasesthe value ofmone y . . . 3. . . . and

increasesthe pricelevel.

1. An increasein the moneysupply . . .

A

B

Money and Prices During Four Hyperinflations

(a) Austria (b) Hungary

Money supply

Price level

Index(Jan. 1921 = 100)

Index(July 1921 = 100)

Price level

100,000

10,000

1,000

10019251924192319221921

Money supply

100,000

10,000

1,000

10019251924192319221921

Money and Prices During Four Hyperinflations

(c) Germany

1

Index(Jan. 1921 = 100)

(d) Poland

100,000,000,000,000

1,000,000

10,000,000,0001,000,000,000,000

100,000,000

10,000100

Moneysupply

Price level

19251924192319221921

Price levelMoneysupply

Index(Jan. 1921 = 100)

100

10,000,000

100,000

1,000,000

10,000

1,000

19251924192319221921

•Nominal interest rate: interest rate that the bank pays• Real interest rate: increase in purchasing power

• The relationship between the nominal interest rate and the rate of inflation:

r = real interest rate; I = nominal interest rate; and, = inflation rate of inflation

•Nominal interest rate: interest rate that the bank pays• Real interest rate: increase in purchasing power

• The relationship between the nominal interest rate and the rate of inflation:

r = real interest rate; I = nominal interest rate; and, = inflation rate of inflation

rr = = ii - - π

Fisher Equation: Fisher Equation: ii = = rr + +

Actual (Market)Actual (Market)nominal rate ofnominal rate of

interestinterestReal rateReal rateof interestof interest

InflationInflation

The one-to-one relationshipbetween the inflation rate and the nominal interest rate is the Fisher effect.

It shows that the nominal interest can change for two reasons: because the real interest rate changes because the real interest rate changes or because the inflation rate because the inflation rate changes.changes.

i = r + • According to the quantity theory, a 1% increase in the According to the quantity theory, a 1% increase in the

money supply causes a 1% increase in money supply causes a 1% increase in inflation. inflation.

• According to the Fisher equation, a 1% increase in the According to the Fisher equation, a 1% increase in the rate of inflation in turn causes a 1% increase in the rate of inflation in turn causes a 1% increase in the nominal interest rates. nominal interest rates.

• Simplified:Simplified: r = i -

•People have expectation of the inflation rate.

Let = actual future inflation and e = expectation of future inflation.

Adjustment to Fisher Effects

ii = = rr + + ee ii = = rr + + ee

• Actual inflation is not known when the nominal interest rate is set. But people can adjust to expected inflation.

• The nominal interest rate i moves one-for-one with changes in expected inflation e.

Shoe-leather cost of inflation:walking to the bank more often induces one’s shoes to wear out more quickly.

Menu costs: When changes in inflation require printing and distributing new pricing information.

Tax Laws:Often tax laws do not take into considerationinflationary effects on income.

• Unanticipated inflation is unfavorable because it arbitrarily redistributes wealth among individuals. For example, it hurts individuals on fixed pensions.

• There is a benefit of inflation—many economists say that some• inflation may make labor markets work better. They say it

“greases the wheels” of labor markets.

Hyperinflation: inflation that exceeds 50 percent per month, which is just over 1percent a day.

Costs such as shoe-leather and menu costs are much worse with hyperinflation—and tax systems are grossly distorted. Eventually, when costs become too great with hyperinflation, the money loses its role as store of value, unit of account and medium of exchange. Bartering or using commodity money becomes prevalent.

• Separation of the determinants of real and nominal variables: changes in the money supply do not influence real variables.

• This irrelevance of money for real variables is called monetary neutrality. For the purpose of studying long-run issues--monetary neutrality is approximately correct.

The Classical dichotomyThe Classical dichotomy

N

N

W/P

Y Y

P

P

W

Increase in Wage Level

No Change in Output

No Change in Level of Employment

There is a dichotomy between real and monetary sector.

Increase in Price

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