Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 15 Money, Inflation and Banking.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

Chapter 15

Money, Inflation and Banking

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 15-2

Chapter 15 Topics

• Alternative forms of money.

• Money and the absence of double coincidence of wants.

• The causes and effects of long-run inflation.

• Financial intermediation and banking.


Alternative Forms of Money

• Commodity money

• Circulating private bank notes

• Commodity-backed paper currency

• Fiat money

• Transactions deposits at banks


The Double-Coincidence Problem and the Role of Money

• Barter exchange is difficult in highly-developed, specialized economies.

• Economic exchange requires search costs, and these costs are high when economic agents are specialized in consumption and production, and can only trade a good or service for another good or service.

• Search costs are reduced dramatically if everyone accepts money in exchange for goods and services.


Figure 15.1 An Absence-of-Double-Coincidence Economy


Figure 15.2 Good 1 as a Commodity Money in the Absence-of-Double-Coincidence Economy


Figure 15.3 Fiat Money in the Absence-of-Double-Coincidence Economy


The Effects of Long-Run Inflation

• Use the monetary intertemporal model from Chapter 10.

• Show that money is not superneutral – higher money growth causes higher inflation, which affects real economic variables.

• An increase in the money growth rate increases the inflation rate and the nominal interest rate, and reduces employment and output.


Figure 15.4 Scatterplot of the Inflation Rate vs. the Growth Rate in M0 for the United States, 1960–2006


Equation 15.1

Assume that the central bank causes the money supply to grow at a constant rate.


Equation 15.2

In equilibrium, money supply equals money demand.


Equation 15.3

Money supply also equals money demand in the future period.


Equation 15.4

Combine the previous two equations.


Equation 15.5

The consumer’s intertemporal marginal condition.


Equation 15.6

Marginal condition reflecting the consumer’s tradeoff between current leisure and future consumption:


Equation 15.7

Marginal condition reflecting the consumer’s tradeoff between current leisure and current consumption:


Figure 15.5 The Long-Run Effects of an Increase in the Money Growth Rate


The Friedman Rule

• Inflation causes an inefficiency, in that it distorts intertemporal decisions.

• The Friedman rule is a prescription for monetary growth that eliminates the inefficiency caused by inflation.

• The Friedman rule specifies that the money stock grow at a rate that makes the nominal interest rate zero.

• In practice, no central bank appears to have adopted a Friedman rule to guide monetary policy.


Equation 15.9

Pareto optimality requires that


Equation 15.10

In a competitive equilibrium,


Equation 15.11

Also, in a competitive equilibrium,


Properties of Assets

• Rate of return

• Risk

• Maturity

• Liquidity


Defining Characteristics of Financial Intermediaries

1. Borrow from one group of economic agents and lend to another.

2. Well-diversified with respect to both assets and liabilities.

3. Transform assets.

4. Process information.


The Diamond-Dybvig Banking Model

• Three periods, 0, 1, and 2.• Two types of consumers: early (consume in period

1) and late (consume in period 2)• Efficient economic arrangement is for consumers

to set up a bank in order to share risk.• Given the bank’s deposit contract, the bank is

open to a run, which is a bad equilibrium.


Figure 15.6 The Utility Function For a Consumer in the Diamond–Dybvig Model


Figure 15.7 The Preferences of a Diamond–Dybvig Consumer


Equation 15.12

• The marginal rate of substitution of early consumption for late consumption is


Equation 15.13

• First constraint that a deposit contract must satisfy is


Equation 15.14

Second constraint that a deposit contract must satisfy is


Equation 15.15

Combine the two constraints to get one:


Equation 15.16

Re-write the constraint:


Figure 15.8 The Equilibrium Deposit Contract Offered by the Diamond–Dybvig Bank

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 15 Money, Inflation and Banking.

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Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 15 Money, Inflation and Banking.