#### Transcript Mankiw 5/e Chapter 4: Money and Inflation

macro CHAPTER FOUR Money and Inflation macroeconomics fifth edition N. Gregory Mankiw PowerPoint® Slides by Ron Cronovich © 2004 Worth Publishers, all rights reserved Money: definition Money is the stock of assets that can be readily used to make transactions. CHAPTER 4 Money and Inflation slide 1 Money: functions 1. medium of exchange we use it to buy stuff 2. store of value transfers purchasing power from the present to the future 3. unit of account the common unit by which everyone measures prices and values CHAPTER 4 Money and Inflation slide 2 Money: types 1. fiat money • has no intrinsic value • example: the paper currency we use 2. commodity money • has intrinsic value • examples: gold coins, cigarettes in P.O.W. camps, stone wheels up to 12 feet (3.6 meters) in diameter (Yap) CHAPTER 4 Money and Inflation slide 3 Money Supply Government control over supply of money is called monetary policy. In Ukraine, National Bank of Ukraine carries out monetary policy The primary way of controlling the supply of money is through the open-market operations: Purchase of government bonds from public increase money supply – Sale of government bonds to public reduce money supply – CHAPTER 4 Money and Inflation slide 4 Measurement of Money C or M0 currency M1 currency and demand deposits M2 M1+saving deposits M3 M2+large time deposits Table Structure of money supply in Ukraine Symbol * Currency outside banks (M0) * Money (M1) * Money (M2) * Money (M3) Unit UAH, million UAH, million UAH, million UAH, million Date Amount 07/06/06 66241.8 07/06/06 108585.9 07/06/06 220560.8 07/06/06 221535.8 % 29.9 49.0 99.6 100.0 Source: National Bank of Ukraine and my calculations CHAPTER 4 Money and Inflation slide 5 The Quantity Theory of Money A simple theory linking the inflation rate to the growth rate of the money supply. Begins with a concept called “velocity”… CHAPTER 4 Money and Inflation slide 6 Velocity basic concept: the rate at which money circulates definition: the number of times the average dollar bill changes hands in a given time period example: In 2003, • $500 billion in transactions • money supply = $100 billion • The average dollar is used in five transactions in 2003 • So, velocity = 5 CHAPTER 4 Money and Inflation slide 7 Velocity, cont. This suggests the following definition: V T M where V = velocity T = value of all transactions M = money supply CHAPTER 4 Money and Inflation slide 8 Velocity, cont. Use nominal GDP as a proxy for total transactions. Then, V P Y M where P = price of output (GDP deflator) Y = quantity of output (real GDP) P Y = value of output (nominal GDP) CHAPTER 4 Money and Inflation slide 9 The quantity equation The quantity equation M V = P Y follows from the preceding definition of velocity. It is an identity: it holds by definition of the variables. CHAPTER 4 Money and Inflation slide 10 Money demand and the quantity equation M/P = real money balances, the purchasing power of the money supply. A simple money demand function: (M/P )d = k Y where k = how much money people wish to hold for each dollar of income. (k is exogenous) CHAPTER 4 Money and Inflation slide 11 Money demand and the quantity equation money demand: (M/P )d = k Y quantity equation: M V = P Y The connection between them: k = 1/V When people hold lots of money relative to their incomes (k is high), money changes hands infrequently (V is low). CHAPTER 4 Money and Inflation slide 12 back to the Quantity Theory of Money starts with quantity equation assumes V is constant & exogenous: V V With this assumption, the quantity equation can be written as M V P Y CHAPTER 4 Money and Inflation slide 13 The Quantity Theory of Money, cont. M V P Y How the price level is determined: With V constant, the money supply determines nominal GDP (P Y ) Real GDP is determined by the economy’s supplies of K and L and the production function (chap 3) The price level is P = (nominal GDP)/(real GDP) CHAPTER 4 Money and Inflation slide 14 The Quantity Theory of Money, cont. The quantity equation in growth rates: M M V V P P Y Y T h e qu a n tity th e o ry o f m o n e y a ssu m e s V is co n sta n t, so CHAPTER 4 Money and Inflation V V = 0. slide 15 The Quantity Theory of Money, cont. Let (Greek letter “pi”) denote the inflation rate: The result from the preceding slide was: Solve this result for to get CHAPTER 4 P M M Money and Inflation M M P P P Y Y Y Y slide 16 The Quantity Theory of Money, cont. M M Y Y Normal economic growth requires a certain amount of money supply growth to facilitate the growth in transactions. Money growth in excess of this amount leads to inflation. CHAPTER 4 Money and Inflation slide 17 The Quantity Theory of Money, cont. M M Y Y Y/Y depends on growth in the factors of production and on technological progress (all of which we take as given, for now). Hence, the Quantity Theory of Money predicts a one-for-one relation between changes in the money growth rate and changes in the inflation rate. CHAPTER 4 Money and Inflation slide 18 International data on inflation and money growth Inflation rat e (percent, logarit hmic scale) 10,000 Democr atic Republic of Congo Nicaragua 1,000 Angola Br azil Georgia 100 Bulgaria 10 Germany Kuwait 1 USA Oman 0.1 0.1 1 Japan Canada 10 100 1,000 10,000 M oney supply growth (p ercent, logarit hmic scale) CHAPTER 4 Money and Inflation slide 19 U.S. Inflation & Money Growth, 1960-2003 14% 12% 10% 8% 6% 4% 2% 0% 1960 1965 1970 1975 Inflation rate CHAPTER 4 1980 1985 1990 1995 2000 Inflation rate trend Money and Inflation slide 21 Inflation and interest rates Nominal interest rate, i not adjusted for inflation Real interest rate, r adjusted for inflation: r = i CHAPTER 4 Money and Inflation slide 22 The Fisher Effect The Fisher equation: i =r + S = I determines r . Hence, an increase in causes an equal increase in i. This one-for-one relationship is called the Fisher effect. CHAPTER 4 Money and Inflation slide 23 U.S. inflation and nominal interest rates, since 1954 Percent 18 16 14 12 10 8 Nominal interest rate 6 4 2 0 Inflation rate -2 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 CHAPTER 4 Money and Inflation slide 24 Inflation and nominal interest rates across countries 100 Nominal interest rat e (percent, logarit hmic scale) Kazakhstan Kenya Ar menia Uruguay Italy Fr ance 10 Nigeria United Kingdom United States Japan Germany Singapore 1 1 10 100 1000 Inflation rat e (p ercent, logarit hmic scale) CHAPTER 4 Money and Inflation slide 25 Ex ante and ex post inflation Ex ante variable: e = expected inflation rate Ex post variable: = actual inflation rate (not known until after it has occurred) When lender and borrower agree on a nominal interest rate, they do not know what the rate of inflation is going to be, hence… Modified Fisher Effect: i=r+ e CHAPTER 4 Money and Inflation slide 26 Nominal interest rate and the demand for money i is opportunity cost of holding money: you can deposit it in a savings account which earn the nominal interest rate rather then keep it under the mattress e d (M P ) L ( i , Y ) L ( r , Y ) CHAPTER 4 Money and Inflation slide 27 Equilibrium M P L (r , Y ) The supply of real money balances CHAPTER 4 e Money and Inflation Real money demand slide 28 What determines what M P variable e L (r , Y ) how determined (in the long run) M exogenous (the Central Bank) r adjusts to make S = I Y Y F (K , L ) P adjusts to make CHAPTER 4 Money and Inflation M P L (i ,Y ) slide 29 How P responds to M M P e L (r , Y ) For given values of r, Y, and e, a change in M causes P to change by the same percentage --- just like in the Quantity Theory of Money. CHAPTER 4 Money and Inflation slide 30 How P responds to e M e L (r , Y ) P For given values of r, Y, and M , e i (the Fisher effect) M P P d to m ake M P fall to re-establish eq'm CHAPTER 4 Money and Inflation slide 31 Discussion Question Why is inflation bad? CHAPTER 4 Money and Inflation slide 32 A common misperception Common misperception: inflation reduces real wages This is true only in the short run, when nominal wages are fixed by contracts. In the long run, the real wage is determined by labor supply and the marginal product of labor, not the price level or inflation rate. Consider the data… CHAPTER 4 Money and Inflation slide 33 Average hourly earnings & the CPI Average hourly earnings & the CPI, 1964-2004 250 Hourly earnings in 2004 dollars Wage ($ per hour) 18 16 200 14 12 10 150 Average hourly earnings (nominal) 100 8 6 Consumer Price Index 4 2 CPI (1982-84=100) 20 50 0 0 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 CHAPTER 4 Money and Inflation slide 34 The classical view of inflation The classical view: A change in the price level is merely a change in the units of measurement. So why, then, is inflation a social problem? CHAPTER 4 Money and Inflation slide 35 Homework Assignment Read Section 4-6 of the textbook. Answer the following questions: – Do economists and other people differ in their view on costs of inflation? – What are the costs of expected inflation? – What are the costs of unexpected inflation? – Is there anything good about inflation anyway? CHAPTER 4 Money and Inflation slide 36 The Classical Dichotomy Real variables are measured in physical units: quantities and relative prices, e.g. quantity of output produced real wage: output earned per hour of work real interest rate: output earned in the future by lending one unit of output today Nominal variables: measured in money units, e.g. nominal wage: dollars per hour of work nominal interest rate: dollars earned in future by lending one dollar today the price level: the amount of dollars needed to buy a representative basket of goods slide 37 The Classical Dichotomy Classical Dichotomy : the theoretical separation of real and nominal variables in the classical model, which implies nominal variables do not affect real variables. Neutrality of Money : Changes in the money supply do not affect real variables. In the real world, money is approximately neutral in the long run. CHAPTER 4 Money and Inflation slide 38 Chapter summary 1. Money the stock of assets used for transactions serves as a medium of exchange, store of value, and unit of account. Commodity money has intrinsic value, fiat money does not. Central bank controls money supply. 2. Quantity theory of money assumption: velocity is stable conclusion: the money growth rate determines the inflation rate. CHAPTER 4 Money and Inflation slide 39 Chapter summary 3. Nominal interest rate equals real interest rate + inflation rate. Fisher effect: nominal interest rate moves one-for-one w/ expected inflation. is the opp. cost of holding money 4. Money demand depends on income in the Quantity Theory more generally, it also depends on the nominal interest rate; if so, then changes in expected inflation affect the current price level. CHAPTER 4 Money and Inflation slide 40 Chapter summary 5. Classical dichotomy In classical theory, money is neutral--does not affect real variables. So, we can study how real variables are determined w/o reference to nominal ones. Then, eq’m in money market determines price level and all nominal variables. Most economists believe the economy works this way in the long run. CHAPTER 4 Money and Inflation slide 41