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N. Gregory Mankiw N. Gregory Mankiw

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Modified by the instructor

MACROECONOMICS MACROECONOMICS

Topic 5

Money and Inflation

(Chapter 4) ICU, Winter Term 2011

Principles of Macroeconomics

Learning objectives

Learning objectives

In this chapter, we will learn:

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The concept of money

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The classical theory of inflation

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^causes

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^effects

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social costs

※Note that the word “classical” here means prices are flexible & markets clear. And thus the classical theory we study here applies to the long run.

I nflation and its trend in the U.S.,

1960- 2009

3% 6% 9% 12% 15%

long-run trend

% change in CPI from 12 months earlier

The connection betw een

money and prices

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Inflation rate = the percentage increase in the average level of prices.

...as observed from data, the inflation rate varies greatly time and across countries. Question: Why is so?

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Price = the rate at which money is exchanged for a good.

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Because prices are defined in terms of money, we need to consider the nature of money,

the supply of money, and how it is controlled.

Money: Definition

Money

Money is the stock is the stock of assets that can be of assets that can be readily used to make readily used to make

transactions. transactions.

Money: Functions

Money has the following three functions:

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unit of account: money is used as the common unit by which everyone measures prices and values.

E.g.: The price of a 500 ml-bottle of orange juice is ¥150. The debt of a company is ¥10 million. _Æ All of these are denominated in yen.

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store of value: money is used to store income or wealth to transfer purchasing power from the

present to the future.

E.g.: A person works and earns ¥500,000 a month. He can store this income in the form of cash (i.e. money). Can you think of other

Money: Functions

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medium of exchange: money is used to exchange a good for another.

ƒ When we use money to buy stuff we actually use this function of it. Why?

Consider the following example:

(i) You work for a restaurant and earn ¥200,000.

(ii) Then you use this amount of money to buy a PC. Æ Your exchange is actually labor force for the PC.

Money: Functions

ƒ

medium of exchange:...

Question: Why don’t you conduct the exchange directly?

ƒ An economy in which exchanges of goods and services are conducted this way is called a barter economy.

ƒ But it is often very inefficient because it requires the double coincidence of wants.

ƒ The good you have is the good that your partner wants.

ƒ The good your partner has is the good that you want. This is unlikely to happen, and you need to spend a lot of time and efforts to search for your exchange partner.

Money: Functions

ƒ

medium of exchange:...

ƒ With money, the double coincidence of wants is no more necessary, and the exchange is much more easier.

Æ Money contributes greatly to reduce the transaction cost.

ƒ Liquidity: the ease with which an asset can be converted into a medium of exchange of goods and services.

ƒ Can you rank the liquidity of the following

Money is most widely accepted in transactions

⇒ it has the highest liquidity (or it is the most liquid asset).

Money: Types

1. Commodity money

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has intrinsic value

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examples: tea leaves, animal bones, gold coins, cigarettes in P.O.W. camps

2. Fiat money

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has no intrinsic value

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example: the paper currency we use

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established as money by government decree

(i.e. fiat)

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used in most economies today

e.g. tea leaves: if not used as money, can be used to make tea to drink.

e.g. a bank note: if not used as money, can be used for nothing.

NOW YOU TRY:

Discussion Question

Which of these are money?

a. Currency

b. Checks

c. Deposits in checking accounts (“demand deposits”)

d. Credit cards

The money supply and

monetary policy definitions

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The money supply is the quantity of money available in the economy.

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Monetary policy is the control over the money supply.

The central bank

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Monetary policy is conducted by a country’s central bank.

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How the central bank controls money supply?

Æ (one way is) open-market operations.

E.g.: The central bank buys government bonds in the market from the public ^⇒ the public’s holding of money^↑⇒ money in circulation^{↑ ⇒} money supply^↑.

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In the U.S., the central bank is called the

Money supply measures,

May 2009

$8328 M1 + small time deposits,

savings deposits,

money market mutual funds, money market deposit accounts M2

$1596 C + demand deposits,

travelers’ checks,

other checkable deposits M1

$850 Currency

C

amount ($ billions) assets included

symbol

The Quantity Theory of Money

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A simple theory linking the inflation rate to the growth rate of the money supply.

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Begins with the concept of velocity…

Velocity

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basic concept:

the rate at which money circulates

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definition: the number of times the average

dollar bill changes hands in a given time period

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example: In 2009,

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$500 billion in transactions

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money supply = $100 billion

ÆThe average dollar is used in 5 transactions in 2009

ÆSo, velocity =...

Velocity, cont.

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This suggests the following definition:

where

V = velocity

T = value of all transactions M = money supply

Velocity, cont.

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Use nominal GDP as a proxy for total transactions.

Then,

where

P = price of output (GDP deflator) Y = quantity of output (real GDP) P ^×Y = value of output (nominal GDP)

The quantity equation

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The quantity equation

M ^×V = P ^×Y

follows from the preceding definition of velocity.

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It is an identity:

it holds by definition of the variables.

Recall: an identity is

something that always holds.

Money demand and the quantity

equation

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M/P = real money balances, the

purchasing power of the money supply.

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A simple money demand function: (M/P)^d = kY

where

k = how much money people wish to hold for each dollar of income (k is exogenous).

shows how many units of goods and services we can buy

shows that the money demand depends on real income.

※NOTE: when we say “money demand” we mean real money demand, not nominal.

Money demand and the quantity

equation

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money demand: (M/P)^d = kY

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quantity equation: M ^×V = P ^×Y

ÎThe connection between them: k = 1/V

Interpretation: When people hold lots of money relative to their incomes (k is large), money

changes hands infrequently (V is small).

Back to the quantity theory of money

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starts with quantity equation

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assumes V is constant & exogenous: Then, quantity equation becomes:

The quantity theory of money

^{, cont.}

How the price level is determined:

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With V constant, the money supply determines nominal GDP (P ^×Y ).

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Real GDP is determined by the economy’s supplies of K and L and the production

function (Chap 3). Recall: GDP deflator is a

The quantity theory of money

^{, cont.}

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Recall from Chapter 2:

The growth rate of a product equals the sum of the growth rates.

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The quantity equation in growth rates:

The quantity theory of money

^{, cont.}

π (Greek letter “pi”)

denotes the inflation rate: The result from the

preceding slide:

Combine the two

The quantity theory of money

^{, cont.}

This is the key equation, the one that we seek for, that shows how inflation is determined

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Normal economic growth requires a certain

amount of money supply growth to facilitate the growth in transactions.

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Money growth in excess of this amount leads to inflation.

The quantity theory of money

^{, cont.}

ΔY/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 predicts Hence, the Quantity Theory predicts

Confronting the quantity theory w ith

data

The quantity theory of money implies:

1. Countries with higher money growth rates should have higher inflation rates.

2. The long-run trend behavior of a country’s

inflation should be similar to the long-run trend in the country’s money growth rate.

Are the data consistent with these implications?

I nternational data on inflation and

money grow th

Singapore Ecuador

Turkey

Belarus

Argentina Indonesia

The line showing the average

U.S. inflation and money grow th,

1960- 2009

-3% 0% 3% 6% 9% 12% 15%

inflation rate

M2 growth rate

Over the long run, the rates of inflation and money growth move together, as the Quantity Theory predicts.

Over the long run, the rates of inflation and money growth move together, as the Quantity Theory predicts.

Seigniorage

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To spend more without raising taxes or selling bonds, the government can print money.

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The “revenue” raised from printing money is called seigniorage.

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The inflation tax: Printing money to

raise revenue causes inflation. Inflation

I nflation and interest rates

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Nominal interest rate, i not adjusted for inflation

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Real interest rate, r adjusted for inflation:

r = i ^{− π}

The Fisher effect

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The Fisher equation: i = r + ^π

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Chap 3: S = I determines r.

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Hence, an increase in ^π

causes an equal increase in i.

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This one-for-one relationship is called the Fisher effect.

Shows the relationship bwt the nominal interest rate and real interest rate &inflation rate.

So r is determined from the real side, and does not depend on the nominal side. Or simply r is fixed.

U.S. inflation and nominal interest rates,

1960- 2009

inflation rate nominal

interest rate

M2 growth rate

Over the long run, the two move very closely with each other, as predicted by the Fisher equation.

Over the long run, the two move very closely with each other, as predicted by the Fisher equation.

I nflation and nominal interest rates across

countries

Nominal interest rate

(percent, logarithmic scale)

Zimbabwe Romania

Turkey Brazil

Israel

Kenya Georgia

The line showing the average relationship btw π and i: its slope is

approximately 1, as predicted by the Fisher equation.

NOW YOU TRY:

Applying the theory

Suppose V is constant, M is growing 5% per year, Y is growing 2% per year, and r = 4.

a. Solve for i.

b. If the Fed increases the money growth rate by 2 percentage points per year, find ^Δi.

c. Suppose the growth rate of Y falls to 1% per year.

ƒ What will happen to ^π ?

ƒ What must the Fed do if it wishes to keep constant?

Tw o real interest rates

Notation:

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^π = actual inflation rate

(not known until after it has occurred)

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^Eπ = expected inflation rate Two real interest rates:

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^{i – Eπ = ex ante} real interest rate: the real interest rate people expect

Money demand and

the nominal interest rate

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In the quantity theory of money,

the demand for real money balances depends only on real income Y.

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Another determinant of money demand: the nominal interest rate, i. Why?

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... because i is the opportunity cost of holding money (instead of bonds or other interest-earning assets)_.

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^{Hence, i↑ ⇒} money demand^↓.

The money demand function

(M/P )^d = real money demand, depends

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^{negatively on i}

i is the opp. cost of holding money

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^{positively on Y}

higher Y ^⇒ more spending

so, need more money

The money demand function

When people are deciding whether to hold

money or bonds, they don’t know what inflation will turn out to be.

Hence, the nominal interest rate relevant for money demand is r + E^π.

41

E q u il ib ri u m

Real money demand

What determines w hat

variable how determined (in the long run) M exogenous (the Fed)

r adjusts to ensure S = I Y

P adjusts to ensure

How P responds to ^Δ M

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For given values of r, Y, and E^π,

a change in M causes P to change by the same percentage – just like in the quantity theory of money.

What about expected inflation?

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Over the long run, people don’t consistently over- or under-forecast inflation,

so E^π = ^π on average.

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In the short run, E^π may change when people get new information.

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EX: Fed announces it will increase M next year. People will expect next year’s P to be higher,

so E^π rises.

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This affects P now, even though M hasn’t changed yet.

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P re s p o n d s t o Δ E π

r, Y, and M,

NOW YOU TRY:

Discussion Question

Why is inflation bad?

ƒ What costs does inflation impose on society?

List all the ones you can think of.

…….

A common misperception

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Common misperception:

inflation reduces real wages

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This is true only in the short run, when nominal wages are fixed by contracts.

ƒ ^{(Chap. 3)} 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.

The CPI and Average Hourly Earnings,

1965- 2009

Hourly wage in May 2009 dollars

$5

$10

$15

$20

100 200 300 400 500 600 700 800 900

CPI

(1965 = 100)

Nominal average hourly earnings,

(1965 = 100) Real average

hourly earnings in 2009 dollars,

right scale

Doesn’t change much, although CPI rises over time (as a result of inflation).

1965 = 100

The classical view of inflation

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The classical view:

A change in the price level is merely a change in the units of measurement.

Then, why is inflation

a social problem?

The social costs of inflation

…fall into two categories:

1. costs when inflation is expected

2. costs when inflation is different than people had expected

The costs of expected inflation:

1. Shoeleather cost

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def: The costs and inconveniences of reducing money balances to avoid the inflation tax.

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^{↑π ⇒ ↑i ⇒ ↓} real money balances

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Remember: In long run, inflation does not affect real income or real spending.

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So, same monthly spending but lower average money holdings means more frequent trips to the bank to withdraw smaller amounts of cash.

The costs of expected inflation:

2. Menu costs

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def: The costs of changing prices.

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^Examples:

ƒ cost of printing new menus

ƒ cost of printing & mailing new catalogs

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The higher is inflation, the more frequently firms must change their prices and incur these costs.

The costs of expected inflation:

3. Relative price distortions

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Firms facing menu costs change prices infrequently.

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^Example:

A firm issues new catalog each January.

As the general price level rises throughout the year, the firm’s relative price will fall.

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Different firms change their prices at different times, leading to relative price distortions…

The costs of expected inflation:

4. Unfair tax treatment

Some taxes are not adjusted to account for inflation, such as the capital gains tax.

Example:

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Jan 1: you buy $10,000 worth of IBM stock

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Dec 31: you sell the stock for $11,000,

so your nominal capital gain is $1000 (10%).

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^{Suppose π} = 10% during the year. Your real capital gain is $0.

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But the govt requires you to pay taxes on your

$1000 nominal gain!!

The costs of expected inflation:

5. General inconvenience

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Inflation makes it harder to compare nominal values from different time periods.

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This complicates long-range financial planning.

Additional cost of unexpected inflation:

Arbitrary redistribution of purchasing pow er

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Many long-term contracts not indexed, but based on E^π.

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^{If π} turns out different from E^π, then some gain at others’ expense. Example: borrowers & lenders

ƒ ^{If π > Eπ, then (i − π) < (i − Eπ)}

and purchasing power is transferred from lenders to borrowers.

ƒ ^{If π < Eπ}, then purchasing power is transferred from borrowers to lenders.

Additional cost of high inflation: I ncreased uncertainty

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When inflation is high, it’s more variable and unpredictable:

π turns out different from E^π more often, and the differences tend to be larger

(though not systematically positive or negative)

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Arbitrary redistributions of wealth become more likely.

One benefit of inflation

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Nominal wages are rarely reduced, even when the equilibrium real wage falls.

This hinders labor market clearing.

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Inflation allows the real wages to reach

equilibrium levels without nominal wage cuts.

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Therefore, moderate inflation improves the functioning of labor markets.

Market equilibrium is a desirable state.

Hyperinflation

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Common definition: ^{π ≥} 50% per month

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All the costs of moderate inflation described above become ^HUGE under hyperinflation.

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Money ceases to function as a store of value, and may not serve its other functions (unit of account, medium of exchange).

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What causes hyperinflation?

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Hyperinflation is caused by excessive money supply growth:

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When the central bank prints money, the price level rises.

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If it prints money rapidly enough, the result is hyperinflation.

A few examples of hyperinflation

country period CPI Inflation

% per year

M2 Growth

% per year

Israel 1983-85 338% 305%

Brazil 1987-94 1256% 1451%

Bolivia 1983-86 1818% 1727%

Ukraine 1992-94 2089% 1029%

Argentina 1988-90 2671% 1583%

Dem. Republic

of Congo / Zaire ^{1990-96 3039% 2373%}

Why governments create hyperinflation

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When a government cannot raise taxes or sell bonds, it must finance spending increases by printing money.

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In theory, the solution to hyperinflation is simple: stop printing money.

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In the real world, this requires drastic and painful fiscal restraint.

The Classical Dichotomy

Nominal variables: Measured in money units, e.g.:

ƒnominal wage: Dollars per hour of work.

ƒnominal interest rate: Dollars earned in future by lending one dollar today.

ƒthe price level: The amount of dollars needed to buy a representative basket of goods.

Real variables: Measured in physical units – quantities and relative prices, e.g.:

ƒquantity of output produced

The Classical Dichotomy

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Note: Real variables were explained in Chap 3, nominal ones in Chapter 4.

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Classical dichotomy:

the theoretical separation of real and nominal variables in the classical model, which implies nominal variables do not affect real variables.

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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 Summary

Chapter Summary

Money

ƒ def: the stock of assets used for transactions

ƒ functions: medium of exchange, store of value, unit of account

ƒ types: commodity money (has intrinsic value), fiat money (no intrinsic value)

ƒ money supply controlled by central bank

Quantity theory of money assumes velocity is stable,

Chapter Summary

Chapter Summary

Nominal interest rate

ƒ equals real interest rate + inflation rate

ƒ the opp. cost of holding money

ƒ Fisher effect: Nominal interest rate moves one-for-one w/ expected inflation.

Money demand

ƒ depends only on income in the Quantity Theory

ƒ also depends on the nominal interest rate

ƒ if so, then changes in expected inflation affect the current price level.

Chapter Summary

Chapter Summary

Costs of inflation

ƒ Expected inflation

shoeleather costs, menu costs, tax & relative price distortions,

inconvenience of correcting figures for inflation

ƒ Unexpected inflation

all of the above plus arbitrary redistributions of wealth between debtors and creditors

Chapter Summary

Chapter Summary

Hyperinflation

ƒ caused by rapid money supply growth when money printed to finance govt budget deficits

ƒ stopping it requires fiscal reforms to eliminate govt’s need for printing money

Chapter Summary

Chapter Summary

Classical dichotomy

ƒ In classical theory, money is neutral--does not affect real variables.

ƒ So, we can study how real variables are determined w/o reference to nominal ones.

ƒ Then, money market eq’m determines price level and all nominal variables.

ƒ Most economists believe the economy works this