Chapter 5. Money and Inflation

Transcription

1 Chapter 5 Money and Inflation

2 What Is Money? Economists define money as an asset that is generally accepted in payment for goods and services or in the repayment of debts When people talk about money, they usually refer to currency Money is not the same as: Wealth: the total collection of property that serves as a store of value Income: a flow of earnings per unit of time (money is a stock) Copyright 2015 Pearson Education, Inc. All rights reserved. 5-2

3 Box: Unusual Forms of Money Beads (wampum) used by American Indians Tobacco and whisky used by early American colonists Big stone wheels used by residents on the island of Yap Cigarettes used by prisoners of war in a POW camp during World War II Copyright 2015 Pearson Education, Inc. All rights reserved. 5-3

4 Functions of Money Money has three primary functions: Medium of exchange Unit of account Store of value Copyright 2015 Pearson Education, Inc. All rights reserved. 5-4

5 Functions of Money (cont d) Money as a medium of exchange: Without money, people would barter, which requires a double coincidence of wants Money promotes economic efficiency by minimizing transaction costs Copyright 2015 Pearson Education, Inc. All rights reserved. 5-5

6 Functions of Money (cont d) Money as a unit of account: we measure the value of goods and services in terms of money as we measure weight in pounds and distance in miles Copyright 2015 Pearson Education, Inc. All rights reserved. 5-6

7 Functions of Money (cont d) Money as a store of value: Money saves purchasing power from the time income is received until the time it is spent Money as a medium of exchange makes money the most liquid of all assets: It does not have to be converted into a medium of exchange to immediately make purchases Copyright 2015 Pearson Education, Inc. All rights reserved. 5-7

8 Control of the Money Supply Central Bank controls the money supply through open market operations, which are purchases or sales of government bonds When the central bank buys government bonds, the money supply increases When the central bank sells government bonds, the money supply decreases Copyright 2015 Pearson Education, Inc. All rights reserved. 5-8

9 Source: Federal Reserve Economic Database (FRED). Federal Reserve Bank of St. Louis. Copyright 2015 Pearson Education, Inc. All rights reserved. 5-9

10 Quantity Theory of Money The quantity theory of money is the product of the classical economists, also known as classicals, who assumed that wages and prices were completely flexible American economist Irving Fisher gave a clear exposition of this theory in his influential book, The Purchasing Power of Money, published in 1911 Copyright 2015 Pearson Education, Inc. All rights reserved. 5-10

11 Velocity of Money and the Equation of Exchange The link between the total quantity of money (M) and the total amount of spending on goods and services produced (P x Y) is the velocity of money (V): V = P Y M Copyright 2015 Pearson Education, Inc. All rights reserved. 5-11

12 Velocity of Money and the Equation of Exchange (cont d) The equation of exchange relates nominal income to the quantity of money and velocity: M V = P Y Copyright 2015 Pearson Education, Inc. All rights reserved. 5-12

13 Velocity of Money and the Equation of Exchange (cont d) The demand for money (M d ) is the quantity of money that people want to hold M d can be obtained from dividing the equation of exchange by V: M 1 = PY V Copyright 2015 Pearson Education, Inc. All rights reserved. 5-13

14 Velocity of Money and the Equation of Exchange (cont d) Assuming V is constant, the demand for real money balances: where k=1/v d M k Y P = Copyright 2015 Pearson Education, Inc. All rights reserved. 5-14

15 From the Equation of Exchange to the Quantity Theory of Money According to Fisher, V is fairly constant at short run in the This transforms the equation of exchange into the quantity theory of money nominal income is determined solely by movements in the quantity of money: V P Y = M V Copyright 2015 Pearson Education, Inc. All rights reserved. 5-15

16 The Classical Dichotomy Classical economists viewed wages and prices as flexible, so that prices of goods and service and factor prices would fully adjust to the level that equates the supply and demand for a particular good or service in the long run Copyright 2015 Pearson Education, Inc. All rights reserved. 5-16

17 The Classical Dichotomy (cont d) Classical dichotomy: In the long run there is a complete separation between the real side of the economy and the nominal side The amounts of goods and services produced in an economy in the long run is not affected by the price level Copyright 2015 Pearson Education, Inc. All rights reserved. 5-17

18 Quantity Theory and the Price Level Assuming that Y is fixed at Y so that in the price level in the quantity theory of money becomes: P = M V Y This implies that, in the long run, changes in the quantity of money lead to proportional changes in the price level This view is also known as the neutrality of money the money supply has no impact on real variables Copyright 2015 Pearson Education, Inc. All rights reserved. 5-18

19 Quantity Theory and Inflation A theory of inflation can be obtained by rewriting the equation of exchange as: %DM + %DV = %DP + %DY If V is constant, the inflation rate ( ) becomes: The quantity theory of inflation indicates that the inflation rate equals the growth rate of the money supply minus the growth rate of aggregate output p p = %DP = %DM - %DY Copyright 2015 Pearson Education, Inc. All rights reserved. 5-19

20 Application: Testing the Quantity Theory of Money Because the quantity theory of money provides a long-run theory of inflation, it explains differing long-run inflation rates across countries However, the relationship between inflation and money growth on an annual basis is not strong at all The conclusion: Milton Friedman s statement that inflation is always and everywhere a monetary phenomenon is accurate in the long run, but is not supported by the data for the short run Copyright 2015 Pearson Education, Inc. All rights reserved. 5-20

21 FIGURE 5.3 Relationship Between Inflation and Money Growth (a) Sources: For panel (a), Milton Friedman and Anna Schwartz, Monetary trends in the United States and the United Kingdom: Their relation to income, prices, and interest rate, , Federal Reserve Economic Database (FRED), Federal Reserve Bank of St. Louis For panel (b), International Financial Statistics. International Monetary Fund. Copyright 2015 Pearson Education, Inc. All rights reserved. 5-21

22 FIGURE 5.3 Relationship Between Inflation and Money Growth (b) Sources: For panel (a), Milton Friedman and Anna Schwartz, Monetary trends in the United States and the United Kingdom: Their relation to income, prices, and interest rate, , Federal Reserve Economic Database (FRED), Federal Reserve Bank of St. Louis For panel (b), International Financial Statistics. International Monetary Fund. Copyright 2015 Pearson Education, Inc. All rights reserved. 5-22

23 FIGURE 5.4 Annual U.S. Inflation and Money Growth Rates, Sources: FRED, Federal Reserve Economic Data, Federal Reserve Bank of St. Louis; Bureau of Labor Statistics, Copyright 2015 Pearson Education, Inc. All rights reserved. 5-23

24 Hyperinflation Hyperinflation occurs when a country experiences extremely rapid price increases of more than 50 percent per month (over 1000 percent per year) Except for the United States, many economies both poor and developed have experienced hyperinflation over the last century Copyright 2015 Pearson Education, Inc. All rights reserved. 5-24

25 Policy and Practice: The Zimbabwean Hyperinflation In 2000s, the Zimbabwean government paid for its excessive spending by raising its money supply rapidly As predicted by the quantity theory, the surge in the money supply led to a rapidly rising price level: The inflation rate hit over 1,500 percent in March 2007, over 2 million percent by 2008 Copyright 2015 Pearson Education, Inc. All rights reserved. 5-25

26 Inflation and Interest Rates The Fisher equation in Chapter 2 states that the nominal interest rate i equals the real interest rate e r plus the expected rate of inflation : π e i = r + π The Fisher effect occurs at a result of the Fisher equation and the classical dichotomy: When expected inflation rises, interest rates will rise Copyright 2015 Pearson Education, Inc. All rights reserved. 5-26

27 Application: Testing the Fisher Effect The U.S. evidence demonstrates that the Fisher effect prediction that nominal rates rise along with expected inflation is accurate in the long run, but over shorter time periods, expected inflation and nominal interest rates do not always move together Copyright 2015 Pearson Education, Inc. All rights reserved. 5-27

28 Copyright 2015 Pearson Education, Inc. All rights reserved. 5-28

29 FIGURE 5.5 Expected Inflation and the Nominal Interest Rate (b) Sources: For panel (a), FRED, Federal Reserve Economic Data, Federal Reserve Bank of St. Louis; Board of Governors of the Federal Reserve System; the estimated expected inflation rate is estimated using the procedure outlined in Mishkin, Frederic S The real interest rate: An empirical investigation. Carnegie-Rochester Conference Series on Public Policy 15: pp This procedure involves estimating expected inflation as a function of past interest rates, inflation, and time trends. For panel (b), International Monetary Fund. International Financial Statistics. Copyright 2015 Pearson Education, Inc. All rights reserved. 5-29

30 Chapter 5 Appendix The Money Supply Process

31 Control of the Monetary Base The monetary base equals currency in circulation (C) plus the total reserves in banking system (R): MB = C + R MB is also called high-powered money because the central bank exercises control over it through open market operations, and through its extension of discount loans to banks. Copyright 2015 Pearson Education, Inc. All rights reserved. 5-31

32 Open Market Operations An open market purchase is a purchase of bonds by the central bank An open market sale is a sale of bonds by the central bank Suppose that the central bank purchases $100 of bonds from a bank and pays for them with a $100 check. Copyright 2015 Pearson Education, Inc. All rights reserved. 5-32

33 Control the Monetary Base The monetary base has two components: 1. Nonborrowed monetary base Created through open market operations The central bank can control completely 2. Borrowed reserves Created through banks borrowings from the central bank (discount loans) The central bank has less control over Copyright 2015 Pearson Education, Inc. All rights reserved. 5-33

34 Factors that Determine the Money Supply Changes in the nonborrowed monetary base The money supply is positively related to the non-borrowed monetary base MB n Changes in borrowed reserves from the central bank The money supply is positively related to the level of borrowed reserves, BR, from the central bank Copyright 2015 Pearson Education, Inc. All rights reserved. 5-34

35 Factors that Determine the Money Supply (cont d) Changes in the required reserves ratio The money supply is negatively related to the required reserve ratio rr Changes in currency holdings The money supply is negatively related to currency holdings Changes in excess reserves The money supply is negatively related to the amount of excess reserves Copyright 2015 Pearson Education, Inc. All rights reserved. 5-35

36 The Money Multiplier Define money as currency plus checkable deposits: M1 The money multiplier (m) tells us how much the money supply (M) changes for a given change in the monetary base (MB): M = m MB Copyright 2015 Pearson Education, Inc. All rights reserved. 5-36

37 Deriving the Money Multiplier Assume that the desired holdings of currency (C) and excess reserves (ER) grow proportionally with checkable deposits (D), then: c = {C/D} = currency ratio e = {ER/D} = excess reserves ratio Copyright 2015 Pearson Education, Inc. All rights reserved. 5-37

38 Deriving the Money Multiplier (cont d) The total amount of reserves ( R) equals the sum of required reserves ( RR) and excess reserves ( ER). R = RR + ER The total amount of required reserves equals the required reserve ratio times the amount of checkable deposits RR = rr D Subsituting for RR in the first equation R = (rr D) + ER The Fed sets rr to less than 1 Copyright 2015 Pearson Education, Inc. All rights reserved. 5-38

39 Deriving the Money Multiplier (cont d) Because the monetary base MB equals currency (C) plus reserves (R): MB = R + C= (rr x D) + ER + C This equation reveals the amount of the monetary base needed to support the existing amounts of checkable deposits, currency and excess reserves. Copyright 2015 Pearson Education, Inc. All rights reserved. 5-39

40 Deriving the Money Multiplier (cont d) c = {C / D} Þ C = c D e = { ER / D} Þ ER = e D Substituting in the previous equation: MB = ( rr D) + ( e D) + ( c D) = ( r + e + c) D Divide both sides by the term in parentheses: 1 D= MB r+ e+ c Because M = D+ C and C = c D: M = D+ ( c D) = (1 + c) D Substituting again: 1+ c M = MB r+ e+ c The money multiplier is therefore: 1+ c m = r+ e+ c Copyright 2015 Pearson Education, Inc. All rights reserved. 5-40

41 Intuition Behind the Money Multiplier What is the value of the money multiplier given the following information? rr = required reserve ratio = 0.10 C = currency in circulation = $400 billion D = checkable deposits = $800 billion ER = excess reserves = $0.8 billion M = money supply (M1) = C + D = $1,200 billion Copyright 2015 Pearson Education, Inc. All rights reserved. 5-41

42 Intuition Behind the Money Multiplier (cont d) m $400 billion c = = 0.5 $800 billion $0.8 billion e = = $800 billion = = = The money multiplier is less than the multiple deposit expansion of 10 in the simple model. Although there is multiple expansion of deposits, there is no such expansion for currency Copyright 2015 Pearson Education, Inc. All rights reserved. 5-42

43 Money Supply Response to Changes in the Factors Because the monetary base (MB) is the sum of nonborrowed base (MB n ) and borrowed reserves (BR): MB=MB n +BR A rise in MB n or BR raises the money supply by m Copyright 2015 Pearson Education, Inc. All rights reserved. 5-43

44 Money Supply Response to Changes in the Factors (cont d) If rr increases from 10% to 15%, then m falls to: m = = = If c rises from 0.5 to 0.75, then m falls to: m = = = If e rises from to 0.005, then m falls to: m = = = Copyright 2015 Pearson Education, Inc. All rights reserved. 5-44