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Lecture 03 Notes - Spring 2009 PDF

This lecture discusses money, inflation, and the money market. It defines inflation as the overall increase in the consumer price index over time. To understand inflation, we must understand money - its supply and demand. Money serves three main functions: as a store of value, a unit of account, and a medium of exchange. Money supply is controlled by central banks through open market operations. The quantity theory of money states that the money supply determines the price level in the long run. Money demand depends on both income and interest rates. The nominal interest rate is determined by the real interest rate and expected inflation.

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45 views

Lecture 03 Notes - Spring 2009 PDF

This lecture discusses money, inflation, and the money market. It defines inflation as the overall increase in the consumer price index over time. To understand inflation, we must understand money - its supply and demand. Money serves three main functions: as a store of value, a unit of account, and a medium of exchange. Money supply is controlled by central banks through open market operations. The quantity theory of money states that the money supply determines the price level in the long run. Money demand depends on both income and interest rates. The nominal interest rate is determined by the real interest rate and expected inflation.

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6doit
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© © All Rights Reserved
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Download as PDF, TXT or read online on Scribd
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Lecture 3: Money and Inflation

February 9, 2009
In this lecture we analyze the money market. In most of the lecture, I will
assume flexible prices and develop the so-called classical theory of money and
inflation. However, as I did at the end of the previous lecture, I will touch upon
the case where prices a fixed and introduce the LM curve. We call inflation the
overall increase in CPI over time. In the US, prices rose on average by 2.4%
in the 1960s, 7.1% in the 1970s, 5.5% in the 1980s, and 3% in the 1990s. We
call hyperinflation a very fast increase in the CPI. Given that CPI is a rate at
which money is exchanged for goods and services, to understand inflation we
must understand money: its supply and demand and the role it plays in the
economy.

What is Money?

1.1

Three main functions

Store of value: money transfers purchasing power from present to future;


if I earn X dollars today, I can hold the money and spend it tomorrow or
a day after. Money is an imperfect store of value however because prices
rise over time and therefore the purchasing power of X dollars depreciates
over time. .
Unit of account: money provides the terms in which prices are quoted and
the yardstick whereby to measure economic transactions.
Medium of exchange: money is what we use to buy goods and services.
The ease with which money is converted into goods is called liquidity.
Without money, trade requires double coincidence of wants, that is: party
A selling to B must want the good sold by B. An economy without money
is called barter economy.

1.2

Types of money

Money that does not have intrinsic value, is called fiat money, because its
value relies on the government authority (decree, confidence).

Money that takes the form of commodity, for example gold, is called commodity money. When people use gold or paper that is redeemable for gold,
we say that the economy is on gold standard.
Advantage of bills is that it saves on transaction costs (lighter, avoids
evaluation of gold purity problem) but it requires peoples trust that government will redeem the bills for gold at any time....unless there is so
much trust in the governments and countrys authority that people do
not bother to redeem the bills for gold
= move from gold standards to pure fiat money.

1.3

Money supply

In an economy that uses commodity money, money supply is quantity of


that commodity. But in an economy with fiat money, it the government
that fixes money supply through how much money it decides to print.
Monetary policy is delegated to a central bank, here the Federal Reserve.
The Fed controls money supply through open-market operations, that is
the purchase or sells of government bonds.
1. Fed increases money supply by purchasing government bonds from
the public with the money it has or prints; this in turn increases the
amount of dollars in circulation;
2. Fed reduces money supply by selling government bonds from its own
portfolio. This takes dollars from the public and therefore reduces
the amount of dollars in circulation.

1.4

Composition of the stock of money


1. C for Currency (C): that is, the sum of outstanding paper money
and coins.
2. M1 for Demand deposits: that is, the funds people hold in their
checking accounts
3. M2: M1 plus mutual funds balances, savings deposits,..
4. M3: M2 plus large time deposits, repurchase agreements,...

The quantity theory of money

2.1

Quantity equation as an identity

Quantity equation:
money velocity = price transactions,
2

or
M V = P T,
where:
1. T is the total number of transactions during a period of time, say a
year.
2. P is the typical price of a transaction
= P T is the total amount of dollars exchanged in a year
3. M is the quantity of money in circulation
4. V is the transaction velocity of money, which measures the rate at
which money circulates in the economy: number of times a dollar
changed hand during the one year period.
The above equation is an identity because it is always true by definition
of the four variables.
This equation is useful because it shows how the change in one variable
must be accompanied by the change in other variables
e,g an increase in money supply at constant velocity, must be accompanied either by increase in volume of transactions or by increase in
price.

2.2

From transactions to income

From transactions to income: the volume of transaction T is hard to


measure, so what we do is replace T by total nominal GDP Y
= but you already know that the two are not identical, in particular
because GDP does not include used goods although they are transacted;
however, it is reasonable to believe that the two variables are proportional,
so that replacing one by the other boils down to redefining velocity
= in the equation
money velocity = price ouput,
or
M V = P Y,
the variable V is called income velocity of money.

2.3

Money demand for transaction

What matters for consumers is how much a given quantity of money can
buy, i.e its purchasing power, and thus in turn is measured by
M/P
which we call real money balances.
3

A money demand equation is an equation that shows what determines how


much real balances people want to hold.
Money demand for transaction only: the simplest possible money demand
equation:
(M/P )d = kY.
according to this equation, the only reason people want to hold money
is for transactions purposes
if we believe in this equation, then the quantity equation tells us
something about k in equilibrium of the money market:
(M/P )d = M/P
=
kY =

Y
V

=
k = 1/V
= the money demand parameter and the velocity of money are two sides
of the same coin.

2.4

Long run equilibrium under the quantity theory of


money

The quantity theory of money is the theory that combines;


1. the assumption of constant velocity of money
2. the assumption of pure transaction money demand
Long-run equilibrium: in the long run price are flexible and output is
determined by the supply of capital and labor, thus:
1.
Y = Y = F (K, L);
2.
M sV = P Y ;
=
P =

(1)

M sV
MV
=
Y
Y

= in particular any increase in money supply will translate into


inflation; the faster the government increases money supply over time,
the higher the rate of inflation.
figures 4-1 and 4-1
4

Why would governments want to increase money supply?

to finance its own purchases (building roads or providing transfers)

the revenue raised through printing of money is called seigniorage,


from the French word seigneur, as middle-age lords had the exclusive
right to coin money; today this right belongs to government or the central
bank if it is independent.
in fact, when government prints money to finance expenditures, it
increases money supply and therefore inflation, thereby reducing the value
of money holdings: it thus operates a transfer of real wealth from the
public to itself, which we call inflation tax.

The speculation motive for holding money

3.1

The choice of money versus bonds

We mentioned the governments purchase and sale of government bonds


as the main instrument of monetary policy. But why would individuals
want to hold bonds?
because they pay interest, and the higher the nominal interest rate
the more bonds you want to hold, and therefore the lower your demand
for money (see below the relationship between nominal and real interest
rates).
Why not hold our whole wealth in the form of bonds?

because we need cash for transactions, and to avoid going through


bond sales all the time; therefore the higher the volume of transaction
the higher the demand for money as in the previous transaction theory of
money

Overall, money demand takes the more general form:


(M/P )d = L(i, Y ),
where

L
L
< 0,
> 0,
i
Y
and i denotes the nominal interest rate on bonds.

3.2

Nominal versus real interest rate

If I save one dollars today in government bond or in a savings account at


the bank, between today and tomorrow the purchasing power of my saved
dollar will increase by an amount equal to the nominal interest rate on the
bond minus the rate of inflation. This rate at which my purchasing power
increases between today and tomorrow, I called the real interest rate, and
5

it is nothing but the rate of interest r that influences investment demand


(see previous chapter).
Thus:

r = i e ,

or equivalently
i = r + e .
This latter equation is called the Fisher Equation: it shows that the nominal interest rate is decomposed into a real interest rate component (determined in the long run by the goods market equilibrium), and the expected
inflation rate.
Under the quantity theory of money, the inflation rate is equal to the rate
of increase of money supply. Thus in this case, a one percent increase
in money supply causes a one percent increase in the inflation rate and
therefore to a one percent increase in the nominal interest rate.

3.3

Equilibrium

Under the more assumption that money demand depends on both, Y and
i, the nominal interest rate is determined, together with P, by the two
equations:
M s /P = L(i, Y )
and
i = r + e ;
or equivalently
M s /P = L(r + e , Y ).

(2)

Two remarks about this latter equation:


1. First, government bonds in fact yield real return r, whereas money
earns rate ( e ); thus the opportunity cost of holding money is:
r (e ) = r + e = i;
2. Equation (2) tells a more sophisticated story than (1). The latter
equation, i.e the quantity theory of money, simply says that todays
money supply determines todays price level. But it does not tell
the whole story because the nominal interest rate does not remain
constant: it depends upon expected inflation which itself depends
on growth in money supply. In fact what (2) says is that the price
level does not depend only upon todays money supply, but also upon
money supply expected in the future.
for example, announcement of future increase in money supply
causes people to expect higher inflation, which in turn raises the

nominal interest rate and therefore reduces the demand for cash balances today. This, in turn leads to an increase in the price level if
money supply today has remained invariant. Hence, the expectation
of future increases in money supply, raises the price level today
In the short-run, the price level is fixed and output Y is not fully determined by factor supply. Then, equation (2) must be rewritten as
M s = P L(i, Y ),

(3)

which defines a relationship between Y and i which we call the LM curve.

Conclusion: costs and benefits of inflation


Distortion linked to the inflation cost

reducing the value of money holdings forces people to go to the cash


machine more often, thereby increasing transaction costs
shoe-leather cost of inflation

High inflation forces firms to change posted prices more often


menu costs of inflation

Forces people to write more complicated contracts or to avoid long-term


contracts
Higher risk if inflation is variable and partly unanticipated over time
all these costs are of house magnified under hyperinflation

One potential benefit of inflation:

it makes labor markets work a little better, because nominal wages


are very rigid downward (it is very hard to cut nominal wage without
employees feeling somewhat humiliated). Then, inflation with moderate
wage increase is the only way to reduce the real wage in a situation of
excess supply of labor.

Hyperinflation:
1. how it comes about:
comes about because government needs to make large spending
which it cannot finance through debt because of lack of credibility
nor through tax because it has inadequate tax revenues
= government resorts to seigniorage and the inflation tax
= inflation reduces real tax revenues, thereby forcing government
to print even more money tomorrow, and this in turn generates inflationary spiral

2. solution:
reduce government spending and increase tax revenues in order
to reduce money supply credibly and durably.

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