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Chapter 5

Chapter 5. Money and Inflation. Preview. To understand the meaning of money and how it is measured To examine the link between money, inflation, and the interest rate To understand the costs of inflation for households and businesses. What is Money?.

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Chapter 5

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  1. Chapter 5 Money and Inflation

  2. Preview To understand the meaning of money and how it is measured To examine the link between money, inflation, and the interest rate To understand the costs of inflation for households and businesses

  3. What is Money? Economists define money as an asset that is generally accepted in payment for goods and services or in the repayment of debts When people talk about money, they usually refer to currency Money is not the same as: Wealth: the total collection of property that serves as a store of value Income: a flow of earnings per unit of time (money is a stock)

  4. Box: Unusual Forms of Money Beads (wampum) used by AmericanIndians Tobacco and whisky used by early American colonists Big stone wheels used by residents on the island of Yap Cigarettes used by prisoners of war in a POW camp during World War II

  5. Functions of Money Money has three primary functions: Medium of exchange Unit of account Store of value

  6. Functions of Money (cont’d) Money as a medium of exchange: Without money, people would barter, which requires a “double coincidence of wants” Money promotes economic efficiency by minimizing transaction costs

  7. Functions of Money (cont’d) Money as a unit of account: we measure the value of goods and services in terms of money as we measure weight in pounds and distance in miles

  8. Functions of Money (cont’d) Money as a store of value: Money saves purchasing power from the time income is received until the time it is spent Money as a medium of exchange makes money the most liquid of all assets: It does not have to be converted into a medium of exchange to immediately make purchases

  9. The Federal Reserve System and the Control of the Money Supply The money supply is the amount of money in the economy The key player in the money supply process is the Federal Reserve System (Fed), which consists of: 12 Federal Reserve Banks Board of Governors

  10. Federal Reserve Banks Federal Reserve Banks are involved in monetary policy: 5 of the 12 bank presidents (on rotation basis) each have a vote in the Federal Open Market Committee (FOMC)

  11. FIGURE 5.1 Federal Reserve System

  12. Board of Governors of the Federal Reserve System As head of the Federal Reserve System Has 7 members Headquartered in Washington, D.C. Each governor is appointed by the president of the United States and confirmed by the Senate The chairman of the Board of Governors serves a 4-year, renewable term

  13. Federal Open Market Committee (FOMC) Usually meets 8 times a year Makes decisions on open market operations Consists of 7 members of the Board of Governors, the president of the Federal Reserve Bank of New York, and the presidents of 4 other Federal Reserve banks Chairman of the Board of Governors presides as the FOMC chairman

  14. Box:TheEuropean Central Bank European Central Bank (ECB) patterns its central banking system after the Fed: Run by an Executive Board similar in structure to the Board of Governors of the Fed National Central Banks (NCBs) have similar functions to the Federal Reserve Banks Its Governing Council, comprised of the Executive Board and presidents of the National Central Banks, is similar to the FOMC

  15. Control of the Money Supply The Fed controls the money supply through open market operations, which are purchases or sales of government bonds When the Fed buys government bonds, the money supply increases When the Fed sells government bonds, the money supply decreases

  16. Measuring Money The Fed’s monetary aggregates: M1 The Fed’s narrowest measure of money Includes only the most liquid assets Consists of currency, traveler’s checks, demand deposits, and checking account deposits. M2 Consists of M1 plus money market deposit accounts, money market mutual fund shares with check-writing features, savings deposits, and certificates of deposit in denominations of less than $100,000

  17. TABLE 5.1 Measures of the Monetary Aggregates

  18. Macroeconomics in the News: The Monetary Aggregates Every week on Thursday, the Federal Reserve publishes the data for M1 and M2 in its H-6 release and these numbers are often reported on in the media The H-6 release can be found at http://www.federalreserve.gov/releases/h6/current/h6.htm

  19. The Fed’s Use of M1 Versus M2 in Practice It’s not obvious whether M1 or M2 is a better measure of money The growth rates of M1 and M2 move in tandem through the 1980s but then diverge since then Because the two monetary aggregates give different stories about the course of monetary policy in recent years, the Fed now focuses on interest rates rather than money supply in conducting monetary policy

  20. FIGURE 5.2 Growth Rates of M1 and M2, 1960-2010

  21. Box: Where Is All the U.S. Currency? The $872 billion in outstanding U.S. currency in 2010 means, on average, a U.S. citizen holds $2800 in cash Who actually have so much of U.S. dollars? People engaging in illegal activities Foreigners, especially those living in countries with high inflation

  22. Quantity Theory of Money The quantity theory of money is the product of the classical economists, also known as classicals, who assumed that wages and prices were completely flexible American economist Irving Fisher gave a clear exposition of this theory in his influential book, The Purchasing Power of Money, published in 1911

  23. Velocity of Money and the Equation of Exchange The link between the total quantity of money (M) and the total amount of spending on goods and services produced (P x Y) is the velocity of money (V):

  24. Velocity of Money and the Equation of Exchange (cont’d) The equation of exchange relates nominal income to the quantity of money and velocity:

  25. Velocity of Money and the Equation of Exchange (cont’d) The demand for money (Md) is the quantity of money that people want to hold Mdcan be obtained from dividing the equation of exchange by V:

  26. Velocity of Money and the Equation of Exchange (cont’d) Assuming V is constant, the demand for real money balances: where k=1/V

  27. From the Equation of Exchange to the Quantity Theory of Money According to Fisher, V is fairly constant at in the short run This transforms the equation of exchange into the quantity theory of money—nominal income is determined solely by movements in the quantity of money:

  28. The Classical Dichotomy Classical economists viewed wages and prices as flexible, so that prices of goods and service and factor prices would fully adjust to the level that equates the supply and demand for a particular good or service in the long run

  29. The Classical Dichotomy (cont’d) Classical dichotomy: In the long run there is a complete separation between the real side of the economy and the nominal side The amounts of goods and services produced in an economy in the long run is not affected by the price level

  30. Quantity Theory and the Price Level Assuming that Y is fixed at so that in the price level in the quantity theory of money becomes: This implies that, in the long run, changes in the quantity of money lead to proportional changes in the price level This view is also known as the neutrality of money—the money supply has no impact on real variables

  31. Quantity Theory and Inflation A theory of inflation can be obtained by rewriting the equation of exchange as: If V is constant, the inflation rate ( ) becomes: The quantity theory of inflation indicates that the inflation rate equals the growth rate of the money supply minus the growth rate of aggregate output

  32. Application: Testing the Quantity Theory of Money Because the quantity theory of money provides a long-run theory of inflation, it explains differing long-run inflation rates across countries However, the relationship between inflation and money growth on an annual basis is not strong at all The conclusion: Milton Friedman’s statement that “inflation is always and everywhere a monetary phenomenon” is accurate in the long run, but is not supported by the data for the short run

  33. FIGURE 5.3Relationship Between Inflation and Money Growth (a)

  34. FIGURE 5.3Relationship Between Inflation and Money Growth (b)

  35. FIGURE 5.4 Annual U.S. Inflation and Money Growth Rates, 1965-2010

  36. Hyperinflation Hyperinflation occurs when a country experiences extremely rapid price increases of more than 50 percent per month (over 1000 percent per year) Except for the United States, many economies – both poor and developed – have experienced hyperinflation over the last century

  37. Policy and Practice: The Zimbabwean Hyperinflation In 2000s, the Zimbabwean government paid for its excessive spending by raising its money supply rapidly As predicted by the quantity theory, the surge in the money supply led to a rapidly rising price level: The inflation rate hit over 1,500 percent in March 2007, over 2 million percent by 2008

  38. Inflation and Interest Rates The Fisher equation in Chapter 2 states that the nominal interest rate i equals the real interest rate r plus the expected rate of inflation : The Fisher effect occurs at a result of the Fisher equation and the classical dichotomy: When expected inflation rises, interest rates will rise

  39. Application: Testing the Fisher Effect The U.S. evidence demonstrates that the Fisher effect prediction that nominal rates rise along with expected inflation is accurate in the long run, but over shorter time periods, expected inflation and nominal interest rates do not always move together

  40. FIGURE 5.5 Expected Inflation and the Nominal Interest Rate (a)

  41. FIGURE 5.5 Expected Inflation and the Nominal Interest Rate (b)

  42. The Cost of Inflation Costs from anticipated inflation Shoe-leather costs Menu costs Tax distortions Increased Variability of Relative Prices Loss of the dollar yardstick

  43. The Cost of Inflation (cont’d) Costs from unanticipated inflation Increased uncertainty Increased variability of relative prices Higher inflation uncertainty when the level of inflation is higher

  44. Chapter 5Appendix The Money Supply Process

  45. The Fed’s Balance Sheet • Liabilities • Currency in circulation: in the hands of the public • Reserves: bank deposits at the Fed and vault cash • Assets • Government securities: holdings by the Fed that affect money supply and earn interest • Discount loans: bank borrowings from the Fed, i.e., borrowed reserves, at the discount rate

  46. Monetary base is the sum of the Fed’s monetary liabilities and the U.S. Treasury’s monetary liabilities (Treasury currency in circulation, mostly coins) Reserves consist of deposits at the Fed plus currency that is held in bank vaults (or vault cash) Total reserves = required reserves + excess reserves The Fed’s Balance Sheet (cont’d)

  47. Control of the Monetary Base Themonetary base equals currency in circulation (C) plus the total reserves in banking system (R): MB = C + R MB is also called high-powered money because the Fed exercises control over it through open market operations, and through its extension of discount loans to banks.

  48. Federal Reserve Open Market Operations An open market purchase is a purchase of bonds by the Fed An open market sale is a sale of bonds by the Fed Suppose that the Fed purchases $100 of bonds from a bank and pays for them with a $100 check. How does this transaction affect the monetary base? Let’s look at a T-account.

  49. Federal Reserve Open Market Operations (cont’d) • Reserves increase by $100 • Monetary base increases by $100

  50. Shifts from Deposits into Currency • A shift from $100 deposits to currency affects the reserves in the banking system, but the shift will have no net effect on the monetary base

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