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In this chapter, we learn: what inflation is, and how costly it can be .

In this chapter, we learn: what inflation is, and how costly it can be . Freshwater bias: didn’t bewail cost of unemployment--ch7 how the quantity theory of money and the classical dichotomy allow us to understand source of inflation

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In this chapter, we learn: what inflation is, and how costly it can be .

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  1. In this chapter, we learn: • what inflation is, and how costly it can be. • Freshwater bias: didn’t bewail cost of unemployment--ch7 • how the quantity theory of money and the classical dichotomy allow us to understand source of inflation • Nominal variables, e.g., money, have only nominal effects, e.g., on prices and nominal interest rates, no real effects. • Money cannot call forth goods. David Ricardo, Works, volume III. • Freshwater bias: classical dichotomy holds in long-run • how the nominal interest rate, the real interest rate, and inflation are related through the Fisher equation. • Irving Fisher: Chained price indexes, Fisher equation … and debt deflation  debt burden  vicious circle • the important link between fiscal policy and high inflation. • Freshwater bias: blame government

  2. Inflationis the percentage change in an economy’s overall price level: πt = Pt/Pt-1 – 1 = (Pt - Pt-1 )/ Pt-1 • Hyperinflation is an episode of extremely high inflation, usually greater than 500 percent per year…a 6-fold increase • From 1919 to 1923, prices in Germany rose by over a factor of a trillion and were rising 300-fold each month toward the end of 1923. • Excess of claims on reduced German output capacity • Reparations claims • Labor claims…the 8-hour day • Bondholder claims • Passive resistance claims • Printing money to meet claims • Money to meet bloated government payrolls • Assassination of minister who tried to raise taxes • Declining real value of tax collections • Money for the Reichbank’s friends

  3. ~1.4% • The Consumer Price Index (CPI) is a price index for a bundle of • consumer goods. • Conceptually, the “market basket” is held constant • In practice, the market basket is adjusted as consumption patterns change. • Core CPI: exclude food and energy prices, which are volatile

  4. 2010 111.69

  5. Measures of the Money Supply • Think of Money as Currency in your wallet and Deposits in your checking account • The balance on your RebelCard should also be thought of as “money,” but it’s not yet counted • The monetary base (MB) includes currency(C) and reserves(R) held by private banks • Banks a hold a fraction of the deposits (D) they owe you as reserves R = fD • Reserves include Vault Cash and deposits banks themselves hold at their Central Banks • Our Central Bank is the Federal Reserve Bank

  6. CHAPTER 8 Inflation

  7. The Federal Reserve’s Balance Sheet Owns (Assets) Owes (Liabilities) Gold Foreign Exchange Federal Reserve Notes Currency in circulation = C Vault cash = R Bank IOUs on Discount Loans Bank deposits at Fed Bank A deposits @ fed Bank B deposits @ fed Bank C deposits @ fed Government Bonds Mortgage Backed Securities Government deposits @ Fed Fixed Assets Total Assets = Monetary Base = MB = H = High Powered Money = Total Liabilities

  8. The Functions of a Modern Central Bank

  9. The Federal Reserve’s Balance Sheet Owns (Assets) Owes (Liabilities) Gold Foreign Exchange Federal Reserve Notes Currency in circulation = C Vault cash = R Bank IOUs on Discount Loans Bank deposits at Fed Bank A deposits @ fed Bank B deposits @ fed Bank C deposits @ fed Government Bonds Mortgage Backed Securities Government deposits @ Fed Fixed Assets Total Assets = Monetary Base = MB = H = High Powered Money = Total Liabilities

  10. Functions of Federal Reserve District Banks • Clear checks • Issue new currency/withdraw damaged currency • Make discount loans to banks in district • Evaluate mergers/expansions of bank activities • Liaison between business community and the Fed • Examine bank holding companies and state-chartered member banks • Collect data on local business conditions • Research Money, Banking and the Financial System FRBNY’s special roles • Bond and currency open market operations • Supervise bank holding companies in NY district • Member of Bank for International Settlements

  11. Measures of the Money Supply • Think of Money as Currency in your wallet and Deposits in your checking account • The balance on your RebelCard should also be thought of as “money,” but it’s not yet counted • The monetary base (MB) includes currency(C) and reserves(R) held by private banks • Banks a hold a fraction of the deposits (D) they owe you as reserves R = fD • Reserves include Vault Cash and deposits banks themselves hold at their Central Banks • Our Central Bank is the Federal Reserve Bank • Banks receive no interest on Vault Cash (mostly held in ATM machines) • They now receive some interest on their deposits at the Fed • Currency (Federal Reserve Notes in circulation) and bank Reserves are liabilities of the Central Bank. Think of them as High Powered Money (=Monetary Base) • Central Bank Liabilities (the Monetary Base) are necessarily matched by its Assets • When the Fed buys something, say a government bond (T-bill or T-bond) or a mortgage backed security (MBS), its assets increase by the amount of the purchase. • The Fed pays for what it buys by “writing a check” to whoever sells it the asset. The check ends up deposited in a bank which then deposits it in its reserve account. • The Fed’s Assets (the T-bill) and its Liabilities (bank Reserves) increase by the same amount. • An increase in the Monetary Base (high powered money) usually multiplies through a fractional reserve banking system to a greater increase in Money Supply. • The Fed buys something and pays with a check; the check is deposited in a bank; the bank holds a fraction of the deposit in reserve and loans out the rest; the borrower buys something; some of what he pays is held in Currency while the rest is Deposited in another bank which holds a fraction in Reserve and loans out the rest…

  12. In general Money Supply = Money multiplier xMonetary Base M = m x MB • Flavors of money: • M1 = Currency + Demand Deposits +Travelers Checks • M1 is most liquid = means of payment • M2 = M1 + Savings Accounts + Money Market Accounts + Small CDs • M2 = M1 + “Near monies” • M3 = M2 + Large CDs + Short term repos + …

  13. The Quantity Equation • Let Mt = money supply in year t; Vt = velocity of money turnover in t; Pt = price level in t; Yt= real GDP in t MtVt = PtYt • MtVt = Money held ($) x Turns/year = $ spent in year = $GDP ($/year) • PtYt = Stuff bought (units/year) x Price paid ($/unit) = $ purchases in year = $GDP ($/year) • Thus, $ Purchases/year = $ Spent/year The Quantity Theory of Money: P = (V/Y) M

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