Transcript MACROECONOMICS

MACROECONOMICS
Chapter 4
Money and Inflation
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Long Run View
Money and inflation are related closely in
the long run.
 Classical economists used Quantity
Theory of Money to explain the
connection.
 We start with definitions and go to QTM
and proceed to modern adjustments.
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What Is Money?
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Money (=money supply) any vehicle used as a
means of exchange to pay for goods, services
or debts.
In today’s society, any asset that can quickly be
transferred into cash is considered money.
The more liquid an asset is, the closer it is to
money.
In economics,money does not mean wealth nor
does it mean income.
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What Is Money?
 Functions
of Money
 Medium
of exchange
 Unit of Account
 Store of Value
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What Is Money?

Medium of exchange
By eliminating barter, this function of money
increases efficiency in a society.
 As human societies started to engage in
exchange money had to be invented.
 Any technological change that reduces
transaction costs increases the wealth of
the society.
 Any technological change that allows
people to specialize also increases wealth.
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What Is Money?

Unit of Account
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We use money to measure the value of goods and
services.
Suppose we had 4 goods and no money. How do we
measure the price of each good?
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A in terms of B
B in terms of C
C in terms of D
A in terms of C
A in terms of D
B in terms of D
N!/2(N-2)!
Money allows to quote prices in terms of currency only.
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What Is Money?
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Store of Value
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All assets are stored value.
Money, although without any return, is still desirable to
hold because it allows purchases immediately.
Other assets take time (transaction costs) to use as a
payment for purchases.
The more liquid an asset is, the less transaction cost it
carries.
Inflation erodes the value of money.

Return on money: -π
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What Is Money?
Commodity money
 Gold certificates
 Bank notes
 Fiat money
 Checks
 Electronic Payment
 E-money
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What Is Money?
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M1: Currency, demand deposits, travelers checks.
M2: M1, saving deposits, small time deposits, retail
MMMF.
M3: M2, large time deposits, repos, Eurodollar
deposits, institutional MMMF.
MZM: M2, institutional MMMF minus small time
deposits.
Growth rates of these aggregates do not always go
hand in hand, making monetary policy difficult since
signals are conflicting.
http://research.stlouisfed.org/publications/mt/page16.pdf
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Monetary Policy
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Central Bank is responsible for monetary
policy.
Open-market operations
 Changes in required reserve
 Changes in the discount rate
 Quantitative easing
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Quantity Theory of Money
MVT=PT
MVY=PY
The Classical economists included all
transactions in this definition. If one
includes only the transactions that
create GDP, one gets the second one.
%Δ in M + %Δ in V = %Δ in P + %Δ in Y
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Quantity Theory of Money
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In the classical approach, Y is determined by
labor, capital, and technology.
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These resources are fixed in the short run, so Y is
fixed.
Like every other market, the monetary sector is in
equilibrium, i.e. money supply is equal to money
demand.
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Money supply, M, is determined by the central bank.
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Quantity Theory of Money
In the short run Y is fixed.
 Velocity was thought to be constant by the
Classical economists. Milton Friedman
revised it to be “stable” easily forecast.
 If in the short run both Y and V were fixed,
then %Δ in M = %Δ in P
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Quantity Theory of Money
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How to test the hypothesis that %Δ in M is
roughly equal to %Δ in P? (%Δ in P is
defined as inflation).
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Longitudinal data
 Figure
4-1 for USA: On average, %Δ in M =
7%,%Δ in P = 3%. Why not equal?
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Cross-sectional data
 Figure
4-2
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Money Demand Function
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Suppose real money balances
depend on real income
{M
}  kY
P
d
But, by definition, MV=PY.
Therefore,
1
k
V
It is useful to remember that
velocity and money demand
are inversely related.
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Examples of k Changes
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Credit card usage increases
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ATMs introduced
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People hold less real money balances => k
falls => V rises.
Same as above
Nominal interest rates rise
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Same as above. WHY?
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Seigniorage
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How government gets revenue?
1.
2.
3.
Taxes
Borrowing
Printing money = seigniorage
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M increase leads to P increase but because
nominal assets lose value, government transfer
that value to itself.
http://www.npr.org/blogs/money/2009/01/what_is
_seigniorage_1.html
http://en.wikipedia.org/wiki/Seigniorage
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http://research.stlouisfed.org/publications/usfd/page16.pdf
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Inflation and Interest Rates
When a borrower and a lender agree on a
real return on the loan (r), they still have to
agree on the expected inflation (πe) to
determine the nominal interest rate (i).
(1+r ) (1+πe ) = (1+i)
1 + r + πe + r πe = 1 + i
For simplicity, we use the Fisher equation:
i = r + πe
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Inflation and Interest Rates
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What happens if the borrower and lender
misjudged the expected inflation? Who gains
and who loses?
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What happens when actual inflation (instead of
expected) exceeds the nominal interest rate?
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See slide 24.
See Figure 4-3
How do people form expectations, anyway?
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Static, adaptive, rational
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Demand for Money and i
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What does one give up by holding money?
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What does one gain from holding money?
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Deflation makes money more valuable
Inflation: -πe
What is the net opportunity cost?
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The opportunity to earn r
r – (-πe ) = r + πe = i.
Therefore, as i increases, opportunity cost of
holding money increases.
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Money demand should decrease.
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Demand for Money
M
P
 L(i, Y )
The demand for real money balances (liquidity
preference) is a negative function of i and a positive
function of Y.
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Demand Responds to i
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Increase Money Supply => Y fixed means i has
to go down to equate the higher M/P to demand.
However, Quantity Theory of Money says money
demand is not affected by interest rates.
This was Keynes’ objection to Classical Theory.
i
M/P
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Classical Revenge
M increase => P increase => π increase
=> i increase => M/P decrease.
 In the long run, M increase does not
create a lower i.
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i
M/P
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The Costs of Expected Inflation
Shoe leather costs
 Menu costs
 Firms not changing “menus” are not
keeping up with inflation. Relative prices
change creating inefficiencies.
 Tax liability increases
 Uncertainty increases undermining
planning
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The Costs of Unexpected Inflation
Impact on debtors
 Impact on creditors
 Impact on fixed incomes
 Impact on risk taking
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Benefit of Inflation
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Money illusion can adjust real wages and
reduce unemployment
W/P
L
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