Chapter 4 Money and Inflation

Transcription

1 Chapter 4 Money and Inflation Zhengyu Cai Ph.D. Institute of Development Southwestern University of Finance and Economics All rights reserved

2 Refresh your mind Economy in long run: Goods and services market production factor market Financial market Real interest rate Fiscal policy Zhengyu Cai Spring Macroeconomics Chapter 4 2/25

3 What are we going to do today? What is money? Money supply Who and how to create money? Monetary policy Money demand Quantity theory of money Inflation and interest rate Interest rate and money demand Inflation Zhengyu Cai Spring Macroeconomics Chapter 4 3/25

4 Reality: What is money? What do you use money for? Three main functions of money: Store of value Unit of account Medium of exchange Other functions? Can we use money to produce goods and services? Types of money Fiat money: no intrinsic value Commodity money: with intrinsic value Example: gold standard Zhengyu Cai Spring Macroeconomics Chapter 4 4/25

5 Reality: What is money? Liquidity Measuring the quantity of money C: currency outstanding paper money and coins M1: C + demand deposits + checks M2: M1 + retail money market mutual funds; saving deposits; small time deposits Why categorize? Some theorists want to explain money demand. Zhengyu Cai Spring Macroeconomics Chapter 4 5/25

6 Money supply Reality: we are using money, and we roughly know money is printed by the government. But exactly who and how? WHO? Money supply is controlled by the central banks The US: Federal Reserve China: People s Bank of China Monetary policy: control of money supply Zhengyu Cai Spring Macroeconomics Chapter 4 6/25

7 Money supply How? Does government need to print exactly the quantity of money we demand? No. We invented banks! How do banks create money? Zhengyu Cai Spring Macroeconomics Chapter 4 7/25

8 Money supply How do banks create money? An example: M = C + D Firstly, consider a world without bank M = C Assuming Dr. Cai owns $1000, thus M = C = $1000 Now, let s have some bankers Reserve (R): the deposits that banks have received but have not lent out. 100% reserve banking Fractional-reserve banking. Assume the reserve-deposit ratio (rr=r/d) is 20% Zhengyu Cai Spring Macroeconomics Chapter 4 8/25

9 Money supply Although the creation of money can keep going on, but it cannot create unlimited amount of money. See how: Original deposit by Dr. Cai = H Creation of money by 1 st bank: Creation of money by 2 nd bank: Creation of money by 3 rd bank: Total money supply = H + In our case, H = $1000, rr = 0.2, M? Zhengyu Cai Spring Macroeconomics Chapter 4 9/25

10 Money supply Banks create money. Do they also create wealth? Banking system only increases the economy s liquidity, not its wealth. Bank capital requirement Bankers need to invest some financial resources to open a bank. LLLLLLLLLLLLLLLL LLLLrrrrrr = Assets AAAAAAAAAAAA BBBBBBBB ccccccccaabbcc Liabilities & Owner s Equity R $200 D $750 Loans $500 Debt $200 Securities $300 Capital (owner s equity) $50 Bank capital Zhengyu Cai Spring Macroeconomics Chapter 4 10/25

11 Money supply Banker contributes $1 in bank, the bank has $20 of assets. But when the economy goes down, bank will lose capital very quickly with leverage. E.g. value of assets 5%, depositors & debt holders have the legal right to be paid first. So, if leverage ratio is 20, assets 5%, bank capital 100% Fear of depositors Bank runs Capital requirements: ensure banks are able to pay off debt. Zhengyu Cai Spring Macroeconomics Chapter 4 11/25

12 Money supply: a model Exogenous variables: Monetary base (or high-powered money): H H = C + R controlled by central banks Reserve-deposit ratio: rr determinted by law Currency-deposit ratio: cr = C/D it reflects the preferences of households about the form of money they wish to hold. The model: M = C + D H = C + R (1) (2) Zhengyu Cai Spring Macroeconomics Chapter 4 12/25

13 Money supply: a model (1) (2): E.g. The factors affect money supply: H rr? cr? = cccc + 1 cccc + LLLL HH rr less loans can be made less money created m: money (creation) multiplier cr people save more banks have more money to lend out create more money According to this analysis, central banks can affect money supply by using several instruments Zhengyu Cai Spring Macroeconomics Chapter 4 13/25

14 Money supply: a model Open-market operations: central bank buys & sells government bonds Buy bonds from public: H M Sell bonds to public: H M Most frequently used (every trading day) Reserve requirements: a minimum reserve-deposit ratio set by central bank rr M rr M Least frequently used Discount rate: the interest rate of banks borrow money from the central bank when they need money to meet the reserve requirement (U.S. Fed Funds Rate) Discount rate H M Zhengyu Cai Spring Macroeconomics Chapter 4 14/25

15 Money supply: a model However, central bank cannot control M completely. If banks hold excess reserve - reserves above the reserve requirement: rr M Discount rate, but banks do not increase borrowing, M does not change. Zhengyu Cai Spring Macroeconomics Chapter 4 15/25

16 Money demand How much money we need? Recall one of the functions of money: medium of exchange Suppose we use $P averagely in a typical transaction, and we make T times of transactions a year. Thus, we need P T of money a year. Do we need to print P T of money? The quantity equation PPPP M: quantity of money V: transactions velocity of money P: price T: the number of transactions E.g. M = $10, P = $0.5, T = 60, V =? Zhengyu Cai Spring Macroeconomics Chapter 4 16/25

17 Money demand In real life, T is hard to count. We use real GDP instead of T. PPPP P: GDP deflator PY: nominal GDP V: income velocity of money Alternative perspective of quantity equation: A simplified money demand function: dd = kkkk PP : real money balances PP Y: real income k: average propensity to hold money how much money you want to hold facing every $1 of income (What is the difference between k and MPS?) Zhengyu Cai Spring Macroeconomics Chapter 4 17/25

18 Money market equilibrium At equilibrium, money demanded = money supplied: Money supply is given by the government: ss = PP PP PP dd = PP ss kkkk = PP 1 kk = PPPP Compare this equation with the quantity equation: PPPP kk VV VV = 1 kk Zhengyu Cai Spring Macroeconomics Chapter 4 18/25

19 Money market equilibrium and inflation Quantity theory of money Assumption: V is fixed for simplicity the preference of holding money is changeless. VV = PPPP If the velocity of money is fixed, quantity of money determines nominal GDP. log VV = log PPPP log + log VV = log PP + log YY dd + dd VV VV = dddd PP + dddd YY dddd dddd PP by central bank 0 constant inflation rate : central bank can control inflation rate by controlling M Zhengyu Cai Spring Macroeconomics Chapter 4 19/25

20 Money market equilibrium and inflation Why does central bank increase money supply even if it will cause inflation? Revenue of government Collect taxes Sell bonds Print money Seigniorage (inflation tax) revenue of government from printing money Print money Money supply Inflation rate Real value of money Thus, inflation is like a kind of tax collected from the money holders. Zhengyu Cai Spring Macroeconomics Chapter 4 20/25

21 Inflation and interest rate Fisher equation: Nominal interest rate: i Real interest rate: r Inflation rate: π ii = rr + ππ Fisher equation indicates that r and π determine i together. This one-for-one relationship between π and i is called Fisher effect. Why π and i? r is determined by general equilibrium. Zhengyu Cai Spring Macroeconomics Chapter 4 21/25

22 Inflation and interest rate Borrowers and lenders will have an expectation on the future inflation rate when they set the nominal interest rate: Eπ Ex ante real interest rate: i - Eπ Ex post real interest rate: i π They are different if ππ EEEE A more accurate version of Fisher equation (effect): ii = rr + EEEE i can only be adjusted to Eπ. Zhengyu Cai Spring Macroeconomics Chapter 4 22/25

23 Interest rate and money demand Money demand is related to the cost of holding money Opportunity cost: lend out the money and earn the nominal interest rate i cost of holding money money demand dd = LL(ii) PP Recall the quantity theory Money demand also depends on Y. Generally, we write the money demand function as: dd PP PP dd = kkkk = LL( ii Plug the Fisher equation into the money demand function: PP dd, YY ) + = LL rr + EEEE, YY This function tells us current price level can be influenced by more than one channel. Zhengyu Cai Spring Macroeconomics Chapter 4 23/25

24 Money demand and inflation Money supply PP ss = PP Money demand PP PP dd dd = kkkk Price level dd + dd VV VV = dddd PP + dddd YY = LL(ii, YY) Price level = LL(ii, YY) PP Inflation rate dddd PP ππ Nominal interest rate ii = rr + EEEE Current price level is not only determined by current money supply, but also by expected future money supply. Zhengyu Cai Spring Macroeconomics Chapter 4 24/25

25 Cost of inflation Cost of expected inflation < Cost of unexpected inflation < Cost of hyperinflation Cause and end of hyperinflation: fiscal policies and reform Benefit of inflation: greases the wheels of labor markets Zhengyu Cai Spring Macroeconomics Chapter 4 25/25