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COURSE OUTLINE
Part 1. Overview of economics
•Chapter 1. Introduction to macroeconomics
MACROECONOMICS •Chapter 2. The data of macroeconomics
Part 2. Real economy in long run
•Chapter 3. Production and growth
•Chapter 4. Open economy: Basic concepts
•Chapter 5. Money and inflation
Tran Thi Thanh Huyen (Dr.)
Part 3. Short run Fluctuation
Faculty of Economics - Banking Academy of Vietnam
Mobile number: 098 383 0104 •Chapter 6. Aggregate Demand and Aggregate Supply
Email: [email protected] •Chapter 7. IS – LM model
Interactive PowerPoint Slides by:
V. Andreea Chiritescu •Chapter 8. Macroeconomic policy in open economy
Eastern Illinois University
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Reading materials

Chapter 29, 30. Mankiw, N.G (2021), Principles

of Economics, 9th Edition, Cengage Learning.

CHAPTER

5 Money and inflation

Interactive PowerPoint Slides by:

V. Andreea Chiritescu
Eastern Illinois University
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Purpose Learning objectives

Help students develop an understanding of By the end of this chapter, students should:
– Define the three functions of money; identify an example of
what money is, what forms money takes, how the money as commodity money or fiat money.
banking system helps create money, and how – Identify the responsibilities of the Central Bank; describe
the organizational structure of the banking system. Explain
the Central Bank controls the quantity of money. money creation process; calculate the value of the money
Acquaint students with the causes and costs multiplier.
– Examine the instruments of monetary policy, the role of
of inflation. monetary policy in governing an economy.
– Interpret the quantity theory of money. Given a graph of
the market for money, show the effect of a change in the
money supply on the market equilibrium. Determine the
effect of a change in the money supply on inflation using
the quantity equation.
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Contents I THE MEANING OF MONEY

Definition
1. The meaning of money • Barter
– Exchange one good or service for another
– Requires a double coincidence of wants: unlikely
occurrence that two people each have a good the other
2. Central bank and money supply wants.
– Waste of resources: people spend time searching for
others to trade with
• Using money
3. Inflation – Solves those problems

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I THE MEANING OF MONEY I THE MEANING OF MONEY

Definition The Functions of Money

Money has three functions to distinguish money from
other assets:
- Medium of exchange
- A store of value.
- A unit of account

Money is the stock of assets that can be readily used to

make transactions.

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I THE MEANING OF MONEY I THE MEANING OF MONEY

The Functions of Money The Functions of Money

Item that buyers give to sellers when they want to
purchase goods and services

2. Store of Value: a way to keep some of our wealth in a

readily spendable form for future needs.
You can transfers purchasing power from the present to the
1. Medium of Exchange: Money is acceptable as payment, future. Money retains its value over time, so you need not
and we use it to buy stuff spend all your money as soon as you receive it
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I THE MEANING OF MONEY I THE MEANING OF MONEY

The Functions of Money The Kinds of Money

GOLD

WHAT IS WORTH MORE?

Fiat Money: something that Commodity Money: something

30,000 VND 110 million VND serves as money but has no that performs the function of
intrinsic value. money and has intrinsic value
Examples: Coins, the paper (The item would have value even if it
3. Unit of Account: the common unit by which everyone were not used as money)
currency we use
measures prices and values Examples: Gold, silver…

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II CENTRAL BANK AND MONEY SUPPLY BANKING SYSTEM

• Central bank Central Bank Issuing money

An institution designed to oversee the banking system
and regulate the quantity of money in the economy Borrowing and
Commercial Banks Lending money

The Federal The Bank of

Reserve - FED England

The Bank of The Bank of

Canada Japan
The State Bank of Vietnam (SBV)

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II CENTRAL BANK AND MONEY SUPPLY II CENTRAL BANK AND MONEY SUPPLY

Functions of the Central Bank Monetary base: is the money issued by the central bank,
MONETARY including Cash and Reserves
BASE
1. Issue currency/ banknotes.
Currency
2. Act as a banker’s bank, making loans to other (C )
commercial banks: Lender of last resort House holds, businesses,
Government (Economy )
3. Control the money supply with monetary policy. Reserves in
Monetary the
base banking
system
Commercial banks (R)

Monetary base, MB = C + R
MB is controlled by the central bank
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Reserves: The portion of deposits that banks have not lent

II CENTRAL BANK AND MONEY SUPPLY II CENTRAL BANK AND MONEY SUPPLY

Money Supply Money Supply

Currency
The money supply is the quantity of money available in (C)
the economy Economy

The money supply equals currency plus deposits

Money supply (MS)

MS = C + D

base (MB)
Monetary
Reserves
Currency Deposits (R)
Commercial banks

Since the money supply includes deposits, the

give
banking system plays an important role to Demand
Receive loans deposits
create deposits MB = C + R deposits in
MS = C + D banking
system
(D)

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Economy

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II CENTRAL BANK AND MONEY SUPPLY II CENTRAL BANK AND MONEY SUPPLY

The Money Stock Money creation process

1. Central Bank issue Money base
• M1 = $3.8 trillion (July 2019)
2. Commercial Banks get deposit and lending
– Currency, demand deposits, traveler’s checks, and 3. Money supply (money stock) = Currency + Deposit
other checkable deposits.
MS = C + D
• M2 =$14.9 trillion (July 2019)
– Everything in M1 plus savings deposits, small time Answer: No
Question: Should Central
deposits, money market mutual funds, and a few minor Commercial banks have to keep a
bank allow Commercial
categories. banks lend out 100% significant reserve ratio to keep
The distinction between M1 and M2 will often not matter their deposits? their deposit and lends in safe.
when we talk about “the money supply” in this course. Reserves in banks are actual
reserves, including required
reserve (imposed by the Central
bank) and excess reserve
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II CENTRAL BANK AND MONEY SUPPLY II CENTRAL BANK AND MONEY SUPPLY

Money creation process Money creation process

• Fractional reserve banking system:
• T-account: a simplified accounting statement that shows a
– Banks keep a fraction of deposits as reserves and use bank’s assets and liabilities.
the rest to make loans.
• The CB establishes reserve requirements FIRST NATIONAL BANK
– Regulations on the minimum amount of reserves that Assets Liabilities
banks must hold against deposits. Reserves $ 10 Deposits $100
• Banks may hold more than this minimum Loans $ 90
• The reserve ratio, r
• Banks’ liabilities include deposits
=fraction of deposits that banks hold as reserves
• Assets include loans and reserves.
=total reserves as a percentage of total deposits
• Notice that r = $10/$100 = 10%
= R/D
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II CENTRAL BANK AND MONEY SUPPLY II CENTRAL BANK AND MONEY SUPPLY

EXAMPLE 1: Changes in money supply

EXAMPLE 1: Solution, A
Suppose the Central bank issued $1,000 of currency.
To determine banks’ impact on money supply, we calculate the A. No banking system
money supply in 3 different cases: • Public holds the $1,000 as currency.
• Money supply = $1,000.
A. No banking system
B. 100% reserve banking system (banks hold 100% of deposits
as reserves, make no loans)
C. Fractional reserve banking system, r = 20%

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II CENTRAL BANK AND MONEY SUPPLY II CENTRAL BANK AND MONEY SUPPLY

EXAMPLE 1: Solution, B EXAMPLE 1: Solution, C – 1

B: 100% reserve banking system. Public deposits the $1,000 at C: Fractional reserve banking system, R = 20% FNB loans all but
First National Bank (FNB). 20% of the deposit to Isabella:
FIRST NATIONAL BANK FIRST NATIONAL BANK
Assets Liabilities Assets Liabilities
Reserves $1,000 Deposits $1,000 Reserves $200 Deposits $1,000
Loans $ 0 Loans $800
• FNB holds 100% of deposit as reserves
• Money supply = currency + deposits = $0 + $1,000 = $1,000 • Depositors have $1,000 in deposits, Isabella (the borrower)
has $800 in currency.
In a 100% reserve banking system, banks do not affect size of
money supply. Money supply = currency + deposits = $800 + $1,000 = $1,800
(!!!)

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II CENTRAL BANK AND MONEY SUPPLY II CENTRAL BANK AND MONEY SUPPLY

EXAMPLE 1: Solution, C – 2
How did the money supply suddenly grow?
• When banks make loans, they create money. C: Fractional reserve banking system
• Isabella (the borrower) gets: • Isabella deposits the $800 at Second National Bank. So, SNB’s
T-account looks like this:
• $800 in currency—an asset counted in the money
supply • If r = 20% for SNB, it will loan all but 20% of the deposit to
Kerem, and it’s T-account will change to:
• $800 in new debt (loans)—a liability that does not
have an offsetting effect on the money supply. SECOND
SECOND NATIONAL
NATIONAL BANK
BANK
Assets
Assets Liabilities
Liabilities
Reserves
Reserves $160
$800 Deposits
Deposits $800
$800
Loans $640
Loans $ 0

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II CENTRAL BANK AND MONEY SUPPLY II CENTRAL BANK AND MONEY SUPPLY

EXAMPLE 1: Solution, C – 3 EXAMPLE 1: Solution, C – 4

C: Fractional reserve banking system C: Fractional reserve banking system
• Kerem (SNB’s borrower) deposits the $640 at Third National The process continues, and money is created with each new loan.
Bank. So, TNB’s T-account looks like this: Original deposit = $1,000.00
• If r = 20% for TNB, it will loan all but 20% of the deposit to FNB lending = $ 800.00
Dalia, and it’s T-account will change to: SNB lending = $ 640.00
THIRD NATIONAL
THIRD NATIONAL BANK
BANK TNB lending = $ 512.00
Assets
Assets Liabilities
Liabilities ………………………………………………………….
Reserves $640
Reserves Deposits $640
$128 Deposits $640 Total money supply = $5,000.00
Loans
Loans $$512
0 In this example, $1,000 of MB generates $5,000 of money.

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II CENTRAL BANK AND MONEY SUPPLY II CENTRAL BANK AND MONEY SUPPLY

The Money Multiplier The Money Multiplier MS = m * MB

MS = m * MB MB = C + R MS C+D cr + 1
• Money multiplier MS = C + D  m = MB = C+R = cr + r
– Amount of money the banking system generates with
each dollar of monetary base • Currency ratio, cr = C/D
(currency/deposits)
depends on households’ preferences
• Reserve ratio, r = R/D
(reserves/ deposits)
depends on regulations & bank policies

If Monetary base changes by MB,

then MS = m  MB
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Active Learning 3: Banks and the money supply II CENTRAL BANK AND MONEY SUPPLY

Problems in Controlling the Money Supply

While cleaning his apartment, Nam finds a $50 bill under
the couch. He deposits the bill in his checking account at Central bank can’t totally control money supply
Chase Bank.
cr + 1
The Fed’s reserve requirement is 10% of deposits. M S = m * MB where m =
cr + r
A. What is the maximum amount that the money supply
• Households can change cr, causing m and MS to change.
could increase?
• Banks often hold excess reserves (reserves above the reserve
B. What is the minimum amount that the money supply requirement by the central bank). If banks change their excess
could increase? reserves, then r, m, and MS change.
C. How would your answers to A and B change if r = 5%? • The amount that bankers choose to lend
Yet, the central bank can compensate for household
and bank behavior to retain fairly precise control over
the money supply.
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II CENTRAL BANK AND MONEY SUPPLY II CENTRAL BANK AND MONEY SUPPLY

Monetary policy is the control over the money supply, The instruments of monetary policy
conducted by the central bank
The central bank can change the money supply using
A policy is referred to as contractionary if it monetary policy instruments
reduces the size of the money supply, or if it raises
the interest rate. DISCOUNT
OPEN
RATE
An expansionary policy increases the size of the MARKET RESERVE
charged on
OPERATIONS REQUIREMENTS
money supply more rapidly, or decreases the (OMO)
loans to
interest rate banks

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II CENTRAL BANK AND MONEY SUPPLY II CENTRAL BANK AND MONEY SUPPLY

The instruments of monetary policy The instruments of monetary policy

1. Open market operations : The central bank buy/ sell
bonds with commercial banks 2. The discount rate: the interest rate the Central bank
charges on loans to banks
MB = C + R
To increase Money supply: To increase Money supply, the Central bank could
the Central bank could buy Government bonds, paying lower the discount rate, encouraging banks to borrow
with new dollar (currency). So, the Monetary base MB more
increases, and then MS increases
This instrument is the most preferred
method of monetary control

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II CENTRAL BANK AND MONEY SUPPLY II CENTRAL BANK AND MONEY SUPPLY

The instruments of monetary policy The instruments of monetary policy - summary

1. Open Market Operations: Central bank buy or sell bonds in Open market
3. Reserve requirements:  If Central Bank sells bonds: Monetary base (MB) reduces  MS decrease
the Central bank regulations that impose a minimum  If Central Bank buys bonds: Monetary base increases  MS increases
Reserve on Deposit (R/D) ratio - r 2. Reserve requirement: regulations on the minimum amount of reserves that
banks must hold against deposits
To reduce Money supply, the central bank:
 If the Central bank increases Reserve requirement ratio actual reserve ratio
increases reserve requirements, it causes the rise of increases  money multiplier decreases MS decreases
the reserve ratio - r, so the MS decrease  If the Central bank decreases Reserve requirement ratio actual reserve ratio
decreases  money multiplier increases MS increases
reduces reserve requirements, it causes the fall of
3. Discount rate: the interest rate on the loans that Central bank makes to
the reserve ratio - r, so increase the money commercial banks
multiplier and MS.  If Central Bank raises discount rate commercial banks will borrow less
cr + 1  Monetary base (MB) reduces  MS decrease
MS = m * MB where m =  If Central Bank lowers discount rate commercial banks will borrow more
cr + r  Monetary base (MB) increase MS increase
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III INFLATION III INFLATION

(?) Do you remember

Definition the calculation of Definition

inflation in chapter 2?
• Inflation • 2018, inflation rates:
– Increase in the overall level of prices – 2.4 percent in the United States
– Substantial variation over time: – 1.2 percent in Japan
• 2008 – 2018: average rate of 1.5% per year – 3.5 percent in Vietnam
• 1970s: average rate of 7.8% per year. – 12 percent in Nigeria
• Deflation – 15 percent in Turkey
– Decrease in the overall level of prices – 32 percent in Argentina
– Average level of prices in the U.S. economy was 23% – 1.4 million percent per year in Venezuela
lower in 1896 than in 1880 • Hyperinflation
– An extraordinarily high rate of inflation

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III INFLATION 1 The Classical Theory of Inflation

1. The Classical Theory of Inflation

Prices rise when the government prints too much money.
– Most economists rely on the quantity theory of money to
explain long-run determinants of the price level and the
inflation rate Money Supply- Demand Diagram
(the first approach to the quantity theory of money)
• Quantity theory of money: A theory asserts that the
quantity of money determines the value of money
• We study this theory using two approaches:
1. A supply-demand diagram
2. An equation

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1.1 Money Supply- Demand Diagram 1.1 Money Supply- Demand Diagram

The Level of Prices and the Value of Money Money Supply (MS)
• Price level, P: Number of dollars needed to buy a basket • Money supply in the real world
of goods and services – Determined by the central bank, the banking system,
– When the price level rises, people have to pay more for and consumers.
the goods and services they buy. • Money supply in this model
• Value of money, 1/P: The quantity of goods and services – We assume the central bank precisely controls MS and
that can be bought with $1 sets it at some fixed amount.
– A rise in the price level: lower value of money because
each dollar in your wallet now buys a smaller quantity
of goods and services.
Inflation drives up prices and drives down the value of
money.
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1.1 Money Supply- Demand Diagram The money supply-demand diagram – 1

Money Demand (MD)

Value of Price
• Money demand Money, 1/P Level, P
(High) As the value of money (Low)
– How much wealth people want to hold in liquid form
rises, the price level falls.
– Depends on P: an increase in P reduces the value of 1 1

money, so more money is required to buy goods and ¾ 1.33

services.
• Quantity of money demanded ½ 2

– Is negatively related to the value of money ¼ 4

– And positively related to P, other things equal. (Low) (High)
Quantity of Money

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The money supply-demand diagram – 2 The money supply-demand diagram – 3

Value of Money, Price Value of Price

Money A fall in value of money (or
1/P Level, P Money, 1/P Level, P
Supply increase in P) increases the
(High) (Low) (High) (Low)
MS1 quantity of money
1 1 1 demanded: 1

¾ 1.33 ¾ 1.33

The Centranl bank

½ 2 ½ 2
sets MS at some Money
fixed value, demand
¼ 4 ¼ 4
regardless of P. MD1
(Low) (High) (Low) (High)
$1,000 Quantity of Money Quantity of
Money

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The equilibrium price level The effects of a monetary injection

Value of Price Value of If the CB Price

Money, 1/P Level, P Money, 1/P Level, P
MS P adjusts to equate MS1 MS2 increases
(High) 1 quantity of money (Low) (High) the money (Low)
demanded with supply.
1 1 1 1
money supply. Then the
¾ 1.33 ¾ value of 1.33
eq’m money falls,
value A eq’m A and P rises.
½ 2 price New ½ 2
of New
mone level eq’m
B eq’m
y ¼ 4 value ¼ 4
MD1 of MD1 price
(Low) (High) mone level
0
$1,000 Quantity of Money y $1,000 $2,000 Quantity of
Money

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A brief look at the adjustment process 1.1 Money Supply- Demand Diagram
 At the initial P, an increase in MS causes an excess supply of money.
 People get rid of their excess money: spend it on goods and services • The Money Supply – Money Demand Diagram
or give loans to others, who spend it. shows that: quantity of money available
 Result: increased
demand for goods determines the price level and that the growth rate
and services. in the quantity of money available determines the
 But supply of goods inflation rate
does not increase,
so prices must rise. The Diagram has
proved The Quantity
 Therefore, the
Theory of Money
quantity of money
demanded
increases because
people are using
more money for
every transaction
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1 The Classical Theory of Inflation 1.2 The Quantity Equation

The Classical Dichotomy – 1

• Classical dichotomy
– The theoretical separation of nominal variables and real
variables
The Quantity Equation
(the second approach to the quantity theory of money)
• Nominal variables: measured in monetary units.
– Nominal GDP, nominal interest rate (rate of return
measured in $), nominal wage ($ per hour worked)
• Real variables: measured in physical units.
– Real GDP, real interest rate (measured in output), real
wage (measured in output)

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1.2 The Quantity Equation EXAMPLE 1: The relative price of a good

The Classical Dichotomy – 2 The relative price of a good is the price of one good in terms
of another.
• Classical dichotomy:
• The price of a smartphone is $450 and the price of a
– Theoretical separation of nominal and real variables
pepperoni pizza is $10.
– Monetary developments affect nominal variables but • What is the relative price of a smartphone?
not real variables:
The relative price of a smartphone is:
• If central bank doubles the money supply:
= P smartphone / P pizza
– Then all nominal variables—including prices—will = ($450/smartphone ) / ($10/pizza)
double
= 45 pizzas per smartphone
– But all real variables—including relative prices—will
remain unchanged.

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EXAMPLE 2: Real vs. nominal wage The Neutrality of Money

The real wage is the price of labor relative to the price of Monetary neutrality: The proposition that changes in the
output. money supply do not affect real variables
• The nominal wage, W = $15/hour (the price of labor), and Because, as mentioned before, doubling money supply:
the price level, P = 5 (the price of goods and services, so it’s
$5/unit of output).
Causes all nominal prices to double but relative prices
unchanged
• Calculate the real wage.
• Real wage = W / P  Mosteconomists believe that the classical dichotomy and
= ($15/hour) / ($5/unit of output) neutrality of money describe the economy in the long run.
= 3 units of output per hour  In
later chapters we will see that monetary changes can
have important short-run effects on real variables.

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Active Learning 1: The neutrality of money 80

EXAMPLE 3: The neutrality of money

If the central bank doubles the money supply, what

happens with the inflation and real wage?

• Doubling the money supply:

->Nominal wages double
->Price level doubles -> inflation increase
-> Real wage is W/P remains unchanged

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1.2 The Quantity Equation 1.2 The Quantity Equation

The Quantity Equation The Velocity of Money

• The quantity equation: M x V = P x Y • Velocity of money:

– The rate at which money changes hands
Where: M is quantity of money • Notation:
V is velocity P x Y = nominal GDP = (price level) x (real GDP)
P is price level M = money supply
Y is output V = velocity
V reflects how many times a year a note moves around in the • Velocity formula: PxY
V =
economy from one person's wallet to another. M

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EXAMPLE 4: The velocity of money 1.2 The Quantity Equation

Assume there is only one good in the economy, pizza. In The Quantity Equation
2019, money supply is $10,000, real GDP is 3,000 pizzas • The quantity equation: M x V = P x Y
and the price of pizza is $10. What was the velocity of
– Relates the quantity of money (M) to the nominal
money?
value of output (P × Y)
• Y = real GDP = 3,000 pizzas
– Shows that an increase in the quantity of money in an
• P = price level = price of pizza = $10
economy must be reflected in one of the other three
• P x Y= nominal GDP = value of pizzas = $30,000
variables:
• Velocity, V = P × Y / M = nominal GDP / money supply
• The price level must rise
= $30,000/$10,000 = 3
The average dollar was used in 3 transactions. • The quantity of output must rise
• Or the velocity of money must fall

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The Quantity Theory of Money 1.2 The Quantity Equation

M xV = P xY • The inflation tax

– Revenue the government raises by creating (printing)
1. V is relatively stable over time. money
2. A change in M causes nominal GDP (P x Y) to change – Like a tax on everyone who holds money
by the same percentage.
• When the government prints money
3. A change in M does not affect Y: Because money is
• The price level rises
neutral, Y is determined by technology & resources
• The dollars in your wallet are less valuable
4. So, P changes by same percentage as P x Y and M.
– In the U.S., the inflation tax today accounts for less than
5. As a result, rapid money supply growth causes rapid
3% of total revenue
inflation.

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1.2 The Quantity Equation 1.2 The Quantity Equation

The Fisher Effect – 1 The Fisher Effect – 2

• Principle of monetary neutrality
• Fisher effect
– An increase in the rate of money growth raises the
rate of inflation but does not affect any real variable – One-for-one adjustment of nominal interest rate to
inflation rate
• Because
– When the Fed increases the rate of money growth,
Real interest rate = Nominal interest rate – Inflation rate
the long-run result is:
• We get
• Higher inflation rate
Nominal interest rate = Real interest rate + Inflation rate
• Higher nominal interest rate

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1.2 The Quantity Equation 2 The cost of inflation

Inflation fallacy Inflation costs – Shoe leather costs

• Inflation fallacy • Inflation
– “Inflation robs people of the purchasing power of his – Is like a tax on the holders of money
hard-earned dollars” • Avoid the inflation tax
• When prices rise – By holding less money (and go to the bank more often)
– Buyers pay more • Shoeleather costs
– Sellers get more – Resources wasted when inflation encourages people to
• Inflation does not in itself reduce people’s real reduce their money holdings
purchasing power – Can be substantial

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2 The cost of inflation

Inflation costs – Menu costs

• Menu costs
– Costs of changing prices
– Inflation increases menu costs firms must bear
– Deciding on new prices
– Printing new price lists and catalogs
– Sending the new price lists and catalogs to dealers and
customers
– Advertising the new prices
– Dealing with customer annoyance over price changes

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