Introduction to Political Economy: Macroeconomics Fall 2008

1. Moneyand Inflation Introduction to Political Economy: Macroeconomics Fall 2008 Mr. Vaughan

2. Lecture Outline • What is inflation? • Does it vary across countries? …across time in U.S.? • What causes inflation? (An Introduction) • What is money / who controls its supply? • How is the Fed structured? Is it “independent”? • Is the Fed independence desirable? • What are the Fed’s policy tools? • What is the equation of exchange? • What causes inflation? (An Advanced Treatment)

3. Inflation Definition: A sustained increase in the general level of prices • Most commonly measured by year-over-year changes in Consumer Price Index (CPI)

4. InflationStylized Facts (Cross Country) Large Differences around the World (32 countries had double digit inflation rates)

5. InflationStylized Facts (U.S.) Large Differences across Time in the U.S.

6. What Causes Inflation? Short Answer “Excessive” Growth of Money Supply …But, who cares? Source: McCandless and Weber, 1995

7. Reduce saving / investment Why is Inflation Costly? • Shoeleather costs • Transactions costs of economizing on money • Menu costs • Cost of resetting prices • Resource misallocation due to relative-price distortions • Inflation lowers relative prices between nominal changes • Inflation generates confusion about whether observed nominal price changes are relative price changes • Distortions from imperfectly indexed tax code • Nominal capital gains taxed • Nominal interest taxed • Arbitrary redistribution of wealth • Unexpected inflation transfers from lenders to borrowers 3, 4, & 5 most important: ↑Inflation by 10% → ↓ real GDP growth by 0.3-0.4%

8. What is (and is not) money? Any asset functioning as: 1. Medium of exchange (key) 2. Unit of account • Store of value To an economist, money is not same thing as: • Wealth (too broad) • Income (flow not stock)

9. Why Hold Money? “Liquidity” reduces transactions costs of exchange. • Eliminates double coincidence of wants • Facilitates computation of relative prices

10. Money in the U.S. Economy Money Supply: total quantity (i.e., dollar volume) of assets providing “medium of exchange” services • Currency: is paper bills & coins in public hands. • Checkable Deposits: bank balances depositors can access on demand by writing check (demand deposits, NOWs)

11. As of October 2008 (Seasonally Adjusted) $ Billions M2 = $7,878.9 billion $7,878.9 • Savings Deposits = $4032.3 • Small Time Deposits = 1,314.0 • Money Market Mutual Funds = $1059.6 • Total = $6,405.8 billion M1 = $1,473.1 billion $1,473.1 • Currency = $795.0 • Checkable Deposits = $672.4 • Traveler’s Checks = $5.8 Everything in M1 0 U.S. Money StockTwo Measures

12. Who “Controls” the Money Supply? Federal Reserve System(U.S. central bank) • Founded 1914 • Byzantine structure (reflecting U.S. history / politics) • Principal Functions • Conduct Monetary Policy • Supervise Banks / Bank Holding Companies • Serve as “Lender of Last Resort”

13. 2,400 Federal ReserveFormal Structure

14. Federal Reserve SystemRegional Structure

15. Federal Reserve SystemIndependence from Politics Sources: • Political structure • Governors appointed to long terms by President • Reserve Bank presidents appointed by boards of directors. • Funding sources • Not reliant on Congress for appropriations (Key)

16. Fed Policy ToolsOpen Market Operations • FOMC sets Fed funds target (every 6-8 weeks) • Fed buys/sells Treasuries daily to hit target • Purchase → increases money supply • Sale → decreases money supply Key tool for implementation of monetary policy!

17. Fed Policy ToolsReserve Requirements • Fed sets % of transactions deposits to hold as reserves • Currently 10% • Acceptable Reserves = Vault cash + Deposits at Federal Reserve Banks • Reserve requirements put upper limit on money creation • Bank’s create deposits by lending out excess reserves • Upper limit = (1/ reserve requirement) x reserves • Small change in reserve requirements have big impact • RR’s doubled 1937-38, money supply collapsed • Almost never changed now. Not important as monetary or “lender of last resort” policy tool

18. Reserves Principal Use of Funds Principal Source of Funds Highly Levered SignificantLiquidity Risk A Snapshot of U.S. DIsCollective Balance Sheet Note:

19. Excess Reserve HoldingsU.S. Depository Institutions (1929-2008) Note spike due to liquidity crisis.

20. Fed Policy ToolsDiscount Window Administration • Primary Credit: “normal” program • Loans of reserves at spread over Fed funds rate • Usually very short term • Current rate = 1.25% (Fed funds target = 1.00%) • Sound collateral required • Term Auction Facility (TAF): • Bi-monthly auction of fixed quantity of reserves for fixed term • Amounts have ranged from $20 billion to $150 billion • Terms have ranged from 17 to 85 days (usually 28) • Must be collateralized • Rate varies by auction (can be below Fed funds rate) Fed currently running many other temporary liquidity facilities.

21. Borrowings from Fed (1921-2008) Note spike due to liquidity crisis.

22. Money and InflationQuantity Theory of Money “Inflation is always and everywhere a monetary phenomenon.” Milton Friedman His Point? • In the short run, many factors can lead to change in general level of prices • Only sustained growth in money supply can produce sustained rise in prices.

23. Money and InflationQuantity Theory of Money M x V = P x Y Quantity Theory starts with equation of exchange: M = Money Supply V = Income Velocity of Money • Average number of times per period each dollar of money supply is spent on nominal GDP P = GDP Deflator / 100 (general price level) Y = Real GDP Note: • P x Y = Nominal GDP • Equation is tautology (needs assumptions)

24. Quantity Theory of MoneyAssumptions • M: Exogenously determined (by government) • V: Not influence by money; relatively stable • Determined by “real” factors such as payments technology/institutions, tastes, etc. • Y: Not influenced by money • Determined by “real” factors such as technology, factor endowments, societal commitment to markets/property rights, etc.

25. Quantity Theory of MoneyAssumptions Equation of Exchange (rate of change form): Note: • If growth in velocity and real output are determined exogenously by real factors, then changes in prices (only endogenous variable) must be determined by changes in money supply %ΔM +%ΔV = %ΔP +%ΔY

26. Quantity Theory of MoneyU.S. Evidence NOTE: Money growth and inflation higher in period (2)!

27. Quantity Theory of MoneyCross-Country Evidence • Note: • Each point represents 30-year average annual money growth and 30-year average annual inflation • All points lie near/on 45-degree line. Source: McCandless and Weber, 1995

28. What about Zimbabwe? • David Hume noted excessive monetary growth caused inflation in the 18th century! • So why allow excessive monetary growth? • Answer: • Developed countries (1960s-70s): mistaken belief permanently lower unemployment could be “purchased” with higher inflation • Less-developed countries: “Inflation tax” is only government’s only revenue source

29. Deficit is 24.6% of GDP! What about Zimbabwe? • Real GDP growth = -5.5% (3rd lowest in world) • Unemployment rate = 80% (3rd highest in world) • Public debt = 218.2% of GDP (highest in world) • Government finance: Revenues: $2.442 billion Expenditures: $3.017 billion GDP: $2.342 billion Government spending can be financed via: • Taxes • Borrowing • Printing money Deficit is 24.6% of GDP! No choice but to print money!

30. Moneyand Inflation? Questionsover Introduction to Political Economy: Macroeconomics Fall 2008 Mr. Vaughan