Econ 219 Spring Lecture #11

Transcription

1 Econ 219 Spring 2006 Lecture #11

2 Money What is money? Who controls it? Does it matter? When does it matter? 2

3 Money Functions of money: Medium of exchange Store of value Unit of account Measuring money: M0 (monetary base, outside money, high-powered money): US currency outside the Fed Bank deposits at the Fed M1: M0+ Currency in circulation Travelers checks Demand deposits Other checkable accounts M2: M1+: Savings deposits Small time deposits Retail money market mutual funds 3

4 Monetary intertemporal model Why do we use money? Transactions possible with single coincidence of wants In case credit transactions are not trusted How do we implement money in economic models? Develop complicated theories that explain the existence of money Problem: Difficult to calibrate the models to fit the data Simply assume money is valued! Easy way to match the data We are going to take the second approach! 4

5 Cash in advance model Two period model Two assets: Money Bonds No financial intermediation Price is measured in terms of money: Price this period: P Price next period: P Nominal bond: Costs 1 unit of money now and pays 1+R units next period R is the nominal interest rate Inflation: rate of change in the price level: 5

6 Cash in advance model Fisher relation: Nominal interest rate on money is 0 Real interest rate on money is: If the interest rate and inflation are small: There is a problem in measuring real interest rate: We observe nominal interest rates We do not know the current inflation rate We have to use expected inflation rate, but we do not observe it either For the practical purposes we use realized inflation 6

7 Representative consumer To account for the presence of money in economy we introduce money/credit/asset market: Consumers need money to buy goods (thus demand for money) Central bank supplies money to the market All other decisions of consumer are the same (e.g. labor/leisure, consumption/savings decisions) Problem of the representative consumer: Starts the current period with amount of nominal money and amount of nominal bonds (all from the previous period) Consumer has to pay the tax of T apples or PT in terms of money Then consumer decides on the asset portfolio: How much bonds versus cash should he/she hold In the asset market consumer collects interest on the bonds from previous period, and decides how much bonds to purchase -. Note that can be positive or negative! 7

8 Representative consumer Consumer can not be at two places at the same time: After leaving the credit market consumer goes to work at the firm Consumer supplies hours of work for the wage of w (apples!) or Pw units of money. Representative firm will pay consumer only after the goods have been sold though. After the work, consumer goes to the goods market, where goods can only be purchased with cash. Maximum value of goods purchased PC is: This is what we call cash-in-advance constraint Finally, representative firm pays representative consumer (wage and dividend income) in cash. Budget constraint of representative consumer: 8

9 Representative consumer Consumer chooses: Current consumption, leisure, holding of bonds and money, subject to budget and cash-in-advance constraints. Note: Consumer can not spend current earnings and must hold them as cash until the next period This implies that CIA constraint is binding Money demand (real money): Increasing in lifetime wealth of consumer Decreasing in nominal interest rate In the long run we can ignore inflation, thus: 9

10 Figure 10.2 The Sequence of Transactions During a Period in the Monetary Intertemporal Model 10

11 Figure 10.4 The Effect of an Increase in Current Real Income on the Nominal Money Demand Curve 11

12 Government Government in this model collects taxes and issues money Government budget constraint: Note: Government can finance expenditures through three channels: Taxation Borrowing (bond issue) Issuing money 12

13 Figure 10.5 The Current Money Market in the Monetary Intertemporal Model 13

14 Figure 10.6 The Complete Monetary Intertemporal Model 14

15 Increase in money supply (level) Increase in M alters government budget constraint: Government can reduce taxes (helicopter drop of money) Reduce borrowing (buy back bonds with open market operations) Increase government spending (impose inflation tax) Let s assume the helicopter dump scenario: Since labor market and goods market is independent of money, nothing changes there. Same equilibrium real wage and interest rate are obtained. The only effect is an increase in the price level! This is what is called classical dichotomy: Determination of real variables is separate from the determination of nominal variables We can say that in this model money is neutral in the long run Although it may be the case that money is not neutral in the short run 15

16 Figure 10.8 The Effects of a Level Increase in M The Neutrality of Money 16

17 Decrease in total factor productivity Decrease in z: Decreases MP L labor demand shifts left Output supply decreases decreasing equilibrium output In equilibrium real interest rate increases This shift output supply to the right So that in equilibrium wage rate decreases In the money market: Increasing interest rates and decreasing income decrease money demand This increases equilibrium price level This finding is consistent with the stylized facts (countercyclical price level) 17

18 Figure 10.9 Short-Run Analysis of a Temporary Decrease in Total Factor Productivity 18

19 Why money demand may change? Change in the cost of using alternatives to currency: Use of credit/debit cards Change in the cost of converting assets into money: Introduction of ATM machine reduced average money holdings Change in government regulation: Starting 1980 banks can pay interest on demand deposits. This had a positive effect on money balances. Change in inflation risk: Increase in inflation makes returns on money holding uncertain Change in the riskiness of other assets If riskiness of other assets increases, money demand goes up 19

20 Quantity Theory of Money Defining velocity of money: Or expressed as money demand: Monetarists: Argue that money demand function is stable over time If that is true, money supply is key to aggregate economic activity It is also the key indicator of monetary policy 20