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Chapter 4: Money and Inflation. Functions of Money. Medium of Exchange Store of Value Unit of Account Standard of Deferred Payment. Types of Money. Commodity money : a commodity with some intrinsic value used as a medium of exchange (e.g., cigarettes in POW camps)
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Functions of Money • Medium of Exchange • Store of Value • Unit of Account • Standard of Deferred Payment
Types of Money • Commodity money: a commodity with some intrinsic value used as a medium of exchange (e.g., cigarettes in POW camps) • Fiat money: a commodity with no intrinsic value established by a government decree as money (e.g., coins & bills)
Characteristics of Money • Limited in supply • Widely accepted • Portable • Divisible • Uniform • Durable
Money Supply • M1 • Currency: coins & bills (25%) • Demand Deposits: checking account deposits (75%) • M2 • M1 • Time Deposits: savings account deposits less than $100,000
Money Supply • M3 • M2 • Time Deposits: savings account deposits more than $100,000 • L • M3 • Liquid assets (e.g., T-Bills)
The Measures of Money • C $434 billion in April 1998 • M1 $1,081 • M2 $4,165 • M3 $5,574 • L $6,826
Money Supply Line • The quantity of money in circulation is controlled by the central bank in real value = M/P Interest Rate (%) (M/P)s 10 5 80 Quantity of Money
Money Demand • The amount of money demanded for transaction and speculation purposes depends on personal income and interest rate • At any level of personal income, quantity demanded of money is a negative function of interest rate
Money Demand Line M/P = f(Y, r) Y = income r = real interest rate Interest Rate (%) 10 5 (M/P)d 100 80 Quantity of Money
Money Market Equilibrium Interest Rate (%) (M/P)s 5 (M/P)d 80 Quantity of Money
Federal Reserve System, FED • The central bank of the U.S. • Independent decision making unit with regional banks • In charge of money supply management and economic stabilization
Tools of Monetary Policy • Legal reserve ratio: ratio of cash reserves to deposits that banks are required to maintain • By lowering the ratio, banks will have more reserves to lend and invest, increasing the money supply
Tools of Monetary Policy • Discount rate: rate of interest the FED charges on loans to banks • By lowering the rate, banks encourage borrowing from the FED and lending to the public, increasing the money supply
Tools of Monetary Policy • Open Market Operations: FED’s purchases and sales of government bonds • By purchasing bonds and paying the sellers, the FED increases the money supply
Expansionary Monetary Policy • Increase the money supply by any one or combination of the above tools • Reduce the interest rate to encourage investment • Increase investment expenditures, thus creating employment & income
Expansionary Monetary Policy Interest Rate (%) (M1/P)s (M2/P)s 5 4 (M/P)d 85 80 Quantity of Money
Quantity Theory of Money • Equation of Exchange: MV = PY • M = money supply • V = income velocity of money: the rate of turn over of money • P = general price level • Y = output of goods & services
(M/P)d = kY where k is the percentage of money balances held for transactions Equilibrium (M/P)s = (M/P)d M/P = kY M/k = PY So, V = 1/k If k = 0.10, then V = 10: a $1 changes hands 10 time a year Income Velocity of Money
Money Supply Growth & Inflation • In 1960s, inflation was low and money supply growth constant at about 7% • In the 1970s, inflation rose as the money supply grew at an increasing rate to reach 10% • In the 1980s and 1990s, inflation fell as money supply grew at a declining rate to reach about 6%
Inflation • A continuous rise of the general price level • General price level is measured by the CPI or GDP Deflator • Percentage change of the general price level over the previous period
Inflationary Trend • Inflation stayed under 5% during the 1960s • It averaged 7.7% in the first half and 10.6% in the second half of the 1970s • Since the early 1980s, inflation rate has declined to as low as 3% in the late 1990s
Money and Inflation • Take percentage change from MV = PY %ΔM * %ΔV = %ΔP * %ΔY V = 1/k and Y at full employment are constant • %ΔM = %ΔP : a 1% increase in the money supply causes a 1% increase in the general price level
Sources of Gov’t Revenues • Taxes • Public Debt • Seigniorage or printing money: operates like an inflation tax on money holding as money loses real value
Fisher Effect • Define • i = nominal rate of interest • r = real rate of interest • π = inflation rate i = r + π r = i - π
Money, Inflation, Interest Rate • Quantity Theory of Money: a 1% increase in the money supply causes a 1% increase in inflation • Fisher Effect: a 1% increase in the inflation causes a 1% increase in the nominal interest rate
Real Interest Rate • Ex-ante: real interest rate when loan are made (known) • Ex-post: real interest rate when loans are paid (unknown, but measured by forecasting inflation rate)
Revised Fisher Effect • Define • i = nominal rate of interest • r = real rate of interest • π* = expected inflation rate i = r + π* r = i – π*
Revised Demand for Money • (M/P)d = L(i, Y) where L is for liquidity • (M/P)d = L(r + π*, Y) • Money demand depends on the • real rate of interest (-) • expected inflation rate (-) • personal income (+)
Linkage Among Money, Prices, and Interest Rates • Changes in money demand and supply determine the price level • Changes in the price level determine the inflation rate • The inflation rate affects the interest rate • The nominal interest rate affects the money demand
Linkage Among Money, Prices, and Interest Rates Money Supply Price Level Inflation Rate Nominal Interest Rate Money Demand
Cost of Expected Inflation • Inflation Tax • Menu Cost • Inefficiency due to inflation variability • Increase in tax liability • Consumer inconvenience
Cost of Unexpected Inflation • Loss of returns: • creditors lose if π* > π • borrowers lose if π* < π • Loss of real income when income is fixed
Hyperinflation • Whenπ > 50% per month • All unexpected costs get larger • Delay in tax collection • Inflation psychology • Caused by excessive printing press • Cure required fiscal reform