Understanding the World Economy Master in Economics and Business Money and inflation Lecture 5 Nicolas Coeurdacier nicolas.coeurdacier@sciencespo.fr
Lecture 5 : Money and inflation 1. History and measurement of inflation 2. Money 3. Long-run inflation and quantity theory 4. Hyperinflation
14 12 10 8 6 4 2 0 U.K. Consumer Price Index, 1271-1960 1271 1291 1311 1331 1351 1371 1391 1411 1431 1451 1471 1491 1511 1531 1551 1571 1591 1611 1631 1651 1671 1691 1711 1731 1751 1771 1791 1811 1831 1851 1871 1891 1911 1931 1951 Source: Office of National Statistics, UK
200 180 160 140 120 100 80 60 40 20 0 U.K. Consumer Price Index, 1271-2011 1271 1291 1311 1331 1351 1371 1391 1411 1431 1451 1471 1491 1511 1531 1551 1571 1591 1611 1631 1651 1671 1691 1711 1731 1751 1771 1791 1811 1831 1851 1871 1891 1911 1931 1951 1971 1991 Source: Office of National Statistics, UK
Consumer Price Index and Inflation Consider the consumer price index at date. is a weighted sum of the different goods in the consumption basket where weights correspond to the share of each good in consumption expenditure. Issue with new goods and quality changes. Normalized to a given value at a given date. Inflation at date,, is the % change of the price index between 1and. = ( )/ Example: if CPI is the U.S. is 100 in 2000 and 110 in 2005, inflation has been 10% over 5 years.
40 30 20 10 0-10 -20-30 U.K Consumer price inflation since 1265 (in %) 40 30 20 10 0-10 -20-30 -40 1265 1285 1305 1325 1345 1365 1385 1405 1425 1445 40 30 20 10-40 1465 1485 1505 1525 1545 1565 1585 1605 1625 1645 40 NOTE: Red lines denote change of monarch 30 20 10 0-10 -20-30 0-10 -20-30 Source: Allen: Robert Allen, Wages, Prices & Living Standards: The World- Historical Perspective and ONS -40 1665 1685 1705 1725 1745 1765 1785 1805 1825 1845-40 1865 1885 1905 1925 1945 1965 1985 2005 2025 2045 Prior to 1900s saw periods of positive and negative inflation - only since 1945 seen sustained positive inflation
30% 25% 20% 15% 10% 5% 0% -5% U.K. inflation rate Inflation rate (%) 1950 1952 1954 1956 1958 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
Source: Fred data -4% -2% 0% 2% 4% 6% 8% 10% 12% 14% 16% 1952-01-01 1954-01-01 1956-01-01 1958-01-01 1960-01-01 1962-01-01 1964-01-01 1966-01-01 1968-01-01 1970-01-01 1972-01-01 1974-01-01 1976-01-01 1978-01-01 1980-01-01 1982-01-01 1984-01-01 1986-01-01 1988-01-01 1990-01-01 1992-01-01 1994-01-01 1996-01-01 1998-01-01 2000-01-01 2002-01-01 2004-01-01 2006-01-01 2008-01-01 2010-01-01 2012-01-01 2014-01-01 2016-01-01 U.S. Inflation Rate
Quick history of world inflation since 1970 1. 1973. OPEC I Oil prices rise from $3 to $10 per barrel at end of boom and as result of Yom Kippur war. Surging world inflation, governments raise interest rates to lower inflation but trigger recession. 1979. OPEC II After inflation subsides the world is hit by another massive increase in oil prices from $10 to $30. Again inflation rises. The economy slows and inflation subsides (stagflation). 2. Early 1980s. Recession leads to weaker oil prices and breakdown in OPEC cartel reinforces this. Disinflation policies leading to weak inflation. 3. Late 1980s. Strong synchronised world boom no global spare capacity so inflation rises strongly leading once again to higher interest rates and growth slowdown. 4. 1990s to 2008. Period of unusually low inflation due to combination of improvements in monetary policy (independent central banks and inflation targeting), globalisation and technology led productivity breakthroughs. 5. 2009-2010 (or later). Great Recession and deflation risk.
The costs of inflation Obvious inflation is disliked, but for economists not obvious why? Why have governments effectively decided that stabilising inflation at low levels is the primary aim of stabilisation policy?
Survey Evidence on Costs of Inflation Do you agree with the following statement? 'The control of inflation is one of the most important missions of economic policy' 100% 75% 50% 25% 0% US Born <1940 US Born > 1950 Germany Born < 1940 Germany Born > 1950 Brazil Fully Agree Agree Undecided Disagree Completely Disagree Source : Why do people dislike inflation? Shiller
Survey Evidence on Costs of Inflation Asked to choose two options A) Over next ten years an inflation rate of 2% and unemployment of 9% B) Over next ten years an inflation rate of 10% but unemployment of 3% 100 90 80 25 21 28 28 46 70 60 50 40 30 75 79 72 72 54 20 10 0 US US Born <1940 US Born > 1950 Germany Brazil Source : Why do people dislike inflation? Shiller
The costs of inflation If prices and wages are flexible, why should inflation matter at all? Only real variables matter, unit of account does not. = Monetary Neutrality. If prices and wages are (partially) rigid, an economy does adapt to inflation when expected: - Financial contracts are indexed : Fisher relation: = + ( ), where = nominal interest rate between and +1, = real interest rate and =expected future inflation. - When prices and wages are not flexible, contracts become indexed (wages, pensions, prices).
The costs of inflation Consequently: important to draw a distinction between expected and unexpected inflation. Expected inflation: shoe leather costs and menu costs : with higher expected inflation, the demand for cash falls (why?) and firms need to change their prices more often. Encourages barter or dollarization. Inefficient. Interaction with the tax system often not perfectly indexed (collection lags) Distributional consequences: a regressive tax. Inconvenience of change in value over time (like changing the meter or the kilogram).
The costs of inflation Unexpected Inflation: a surprise increase in prices so that realized inflation > expected inflation: > ( ). Redistribute wealth from lenders to borrowers with fixed rates. Taxes people with fixed income (retirees) or firms with long term contracts because most indexation contracts are backward looking. Volatile unexpected component generates uncertainty in relative prices. Nominal long term contracts break down. People only enter short term contracts. Countries with higher expected inflation also have higher volatility of (unexpected) inflation.
Real GDP growth and inflation across countries, 1960-1990 Source: Motley, Fed SF, 1998
Lecture 5 : Money and inflation 1. History and measurement of inflation 2. Money 3. Long-run inflation and quantity theory 4. Hyperinflation
Functions and types of money Functions: Medium of exchange Unit of Account Store of value Types: - Commodity money - money is worth a specified amount of a given commodity e.g. gold, silver - Fiat or paper money - bits of paper become valuable because someone with legal authority decrees it so
Money supply Money supply can be measured in either narrow or broad terms, depending on the type of bank deposits included. Types of money: BaseMoney: Cash held by public and banks (M0) Narrow Money: Cash and non-interest bearing domestic currency bank deposits held by public (M1) Broad Money: Cash and all domestic currency deposits held by public (M2 or M3) The types differ in (a) which types of money are included, and (b) the central bank s control of the money supply. The broader the definition the larger the money stock and the less the power of the central bank to control it.
The U.S. Money Supply (1984-2016, billions of USD) 12000 10000 MONETARY BASE M2 8000 6000 4000 2000 0 1984-02-01 1985-05-01 1986-08-01 1987-11-01 1989-02-01 1990-05-01 1991-08-01 1992-11-01 1994-02-01 1995-05-01 1996-08-01 1997-11-01 1999-02-01 2000-05-01 2001-08-01 2002-11-01 2004-02-01 2005-05-01 2006-08-01 2007-11-01 2009-02-01 2010-05-01 2011-08-01 2012-11-01 2014-02-01 2015-05-01 USD, Billions Source : Fred Data
The money multiplier Suppose the government prints an extra $ which is then received by someone as salary. This money is then deposited in a bank account What will the bank do? Will want to lend out as much of this$ as possible as makes money on the loan But cannot lend out the whole$ - some funds must be kept in reserve in case the depositor wants to withdraw funds Assume keeps x% in reserve - loans out$(1 x) and keeps $x as reserves
The money multiplier Deposit Reserves Loans 1 st Round x (1 x) 2 nd Round (1 x) x(1 x) (1 x) 3 rd Round (1 x) x(1 x) (1 x) 4 th Round (1 x) x(1 x) (1 x) Total /x (1 )/x Multiplier = (1 x) = 1/x
The money multiplier The extra money supply $ provided by the government is converted by the profit maximising behaviour of the banks into $/x in new deposits with x the reserve requirement ratio. Multiplier is 1/x. In this example x is fixed but in reality it varies depending on interest rates and the uncertainty attached to future events. Think of the last financial crisis as generating a rise inx. x can also be modified by Central Banks to change credit conditions. Not standard instrument though. The end result is that most of the money supply reflects the private decisions of the banking sector.
Illiquidity and Insolvency A bank is illiquid if it cannot readily convert assets into cash, particularly against short term debt that it cannot immediately realise if called upon to do so. A bank is insolvent when is unable to pay off its debts when they fall due. Illiquidity and insolvency are distinct concepts associated with different financial positions, though they can both cause bank runs. When a bank run occurs the Central Bank has the option to act as lender of last resort. However, it will choose to do so only if the bank is illiquid but solvent.
Bank runs Banks cannot provide full cash value of accounts if all depositors demand funds at same time. This is so because banks economic function is to transform maturity: they collect on sight and short term deposits and extend longer term loans. Hence, banks are vulnerable to bank runs and multiple equilibria: -if you hear your bank is in financial troubles you want your cash. -if everyone does this, then the bank is in financial distress and likely to go bankrupt. -if no one does then the bank is fine. These multiple equilibria are the result of strategic complementarities: my payoffs and optimal actions depend on the actions of others.
Bank runs Bank Run in New York during the Great Depression(1931)
Bank runs --- not only something from the past Northern Rock Bank Run, Sept. 2007.
Deposit insurance and moral hazard To overcome these problems and rule out the bad equilibrium, many countries have set-up deposit insurance: if the deposits are guaranteed, there is less reason to rush to the bank, hence fewer bank runs. But deposit insurance can also induce banks to behave less prudently. Might create moral hazard, i.e. the tendency for banks to act in socially suboptimal ways. Too big to fail syndrome.
Lecture 5 : Money and inflation 1. History and measurement of inflation 2. Money 3. Long-run inflation and quantity theory 4. Hyperinflation
Inflation and the supply of money Inflation represents changes in value of money -- 10 euros buy fewer goods after period of inflation. Friedman: Inflation is always and everywhere a monetary phenomenon. Is this a profound comment or a statement of the obvious? Turn to examining interaction of money and inflation.
The quantity theory of money Quantity Theory of Money = Monetary view of inflation The following relationship must hold at date :! " = # where! = quantity of money " = velocity of circulation = price level # = output (GDP) Since" is not observed, this is just an accounting identity.
The quantity theory of money Quantity Theory can be rewritten also as follows:! = (1/" ) # Think of (1/" ) as the proportion of transactions which individuals pay for in cash. (1/" ) depends on nominal interest rates (cost of holding money), transaction costs Example: assume! / = 0.2 # " = 5 People want to hold money balances equal to around 20% of their purchases.
The quantity theory of money Can turn this into atheoryofinflationandthepricelevel. To do this, we need to specify what are theexogenous and the endogenous variables. Endogenous variables (the variables of interest to us, determined by the model):. Exogenous variables (variables given to us, or controlled by policymakers):!,# and". In other words, if I know!, # and ", then I also know the price level = Quantity Theory of Money: = "! /#
The quantity theory of money What can we say about the exogenous variables:! is controlled by the central bank, directly (!0 ) and indirectly (!2) via the money multiplier. Assume" = " is stable over time. This means people want to use cash for a stable fraction of their transactions. What about#? In the long run (or when prices are flexible)# will be determined by real factors (technology, physical and human capital, labor etc.). Monetary neutrality holds. Under these assumptions, prices are proportional to the money supply: =("/# )!
Prices and money in the long run M M S M S P Increasing the money supply increases prices in the LR P P
Long run output and aggregate demand Prices Potential Output: # Long-Run Supply Curve Shifts in Money supply only change the price level! Aggregate Demand Output # In long run, output is exogenous (fixed in that case) - tied down by the production function. Therefore in the long run higher money supply leads only to higher prices
The quantity theory of money Express in logs and take time difference: log ( / ) = log (! /! ) log (# /# ) =. /. 0 With =inflation rate,. / = growth rate of money supply and. 0 = growth rate of output (all in log-terms) Inflation should move one for one with change in money supply. Regression across countries or time: = 1. / +2 Should give 1 = 1. If output growth is exogenous (=long-run).
The quantity theory of money =. /. 0 Quantity Theory implies that inflation is a monetary phenomena (at least in thelongrun). This underpins Friedman s famous quotation Remind that it depends on two key assumptions: a)" constant b) money neutrality (equivalently, potential output does not depend on money supply) Under these assumptions, prices are proportional to the money supply and inflation tied by the growth rate of money supply.
The quantity theory of money across countries (very long-run) 1950 s to 1990s ; sampleof 79 countries; Source: Telesand Uhlig, 2010
In long-run, money supply and inflation move one for one In long-run, money neutral for output Source IMF. Inflation is measured as the average yearly change of CPI over 1960-1990. Real output growth is the average change in real output over 1960-1990.
Cross country correlation of inflation and money supply growth 1980-2002 70 The quantity theory of money across countries (long-run) Inflation (%, 1980-2002, annual) 60 50 40 30 20 10 0 Rest of the World G7 member economies 0 10 20 30 40 50 60 70 Money Supply Growth (%, 1980-2002, annual) Source : OECD economic outlook
50 The quantity theory of money across countries (short-run) 40 Inflation (%, 2001-2002) 30 20 10 0-10 Rest of the World G7 member economies -20 0 20 40 60 80 100 Money Supply Growth (%, 2001-2002) In short run (1 year), money and inflation not so connected Source : OECD economic outlook
The quantity theory of money in the U.S over time Source : Federal Reserve.
The quantity theory of money in Latin America over time Average Money Growth and Inflation in Latin America, 1987 2006 Source: IMF, World Economic Outlook, Regional aggregates are weighted by shares of dollar GDP in total regional dollar GDP.
Quantity theory an interim assessment Long run data strongly supportive of quantity theory both time series and cross-country. However, short run data offers no support, no correlation between inflation and money supply growth. Monetary policy needs to take a more sophisticated approach to controlling inflation than simply quantity theory suggests. In particular, in the short-run, we will see that output is not exogenous (as prices are not fully flexible).
Problems with quantity theory 1. Velocity " is not a constant, changes in interest rates and in financial institutions all lead to variations in". 2. Can the government control!? - most of money supply is endogenous and can only be affected by central bank - not fully controlled. 3. In short run many non-monetary factors which lead to changes in and inflation. 4. Monetary policy not neutral in the short run. Increases in! lead to increases in and in#in the short-run.
Lecture 5 : Money and inflation 1. History and measurement of inflation 2. Money 3. Long-run inflation and quantity theory 4. Hyperinflation
Seigniorage Seigniorage 3 is the goods that governments can buy with the new money they print. Denote change in money supply:! =!!. Then:3 =! / =! /!! / A little bit of algebra, introducing inflation = 4 5 4 567 4 567 : 3 = / 5 4 5 / 567 4 567 + ( / 567 4 5 ) 3 = Real Balance Effect + Inflation Tax
Seigniorage 3 = / 5 4 5 = / 5 4 5 / 567 4 567 + ( / 567 4 5 ) Real Balance Effect + Inflation Tax Inflation has two effects on seigniorage: a) Increases inflation tax. b) Reduces money demand and so real money supply. Thus, reduces tax base and seigniorage. Remark: Seignoriage and inflation tax coincide when! /! =
Hyperinflation Commonly used definition: more than 50% monthly inflation. Hyperinflations tend to be produced in response to chronic failure of governments to raise revenues. Therefore source of hyperinflation are fiscal problems not monetary. Government resorts to printing money as face value exceeds cost. However eventually reduces value of money so becomes necessary to print even more money to raise same revenue - hyperinflationary spiral
Seigniorage and hyperinflation Seigniorage Seigniorage declines as money demand collapses Hyperinflationary spiral Inflation The inflationary Laffer curve
Seven Hyperinflations of the 1920s and 1940s Beginning End End Price/ Initial Price Avg. Monthly Inflation Avg. Monthly Money Austria 01/10/21 01/08/22 70 47 31 Germany 01/08/22 01/11/23 1 x 10 + 10 322 314 Greece 01/11/43 01/11/44 4.7 x 10 + 6 365 220 Hungary I 01/03/23 01/02/24 44 46 33 Hungary II 01/08/45 01/07/46 3.8 x 10 + 27 19,800 12,200 Poland 01/01/23 01/01/24 699 82 72 Russia 01/12/21 01/01/24 1.2 x 10 + 5 57 49
The German hyperinflation 1922-23 (January 1922 =1) Currency Prices Real Money Inflation (% per month) Jan 1922 1 1 1.00 5 Jan 1923 16 75 0.21 189 July 1923 354 2021 0.18 386 Sept 1923 227777 645946 0.35 2532 Oct 1923 20201256 191891890 0.11 29720 A 1920 bill and a 1923 bill
Hyperinflation in Central and Eastern Europe Inflation (except Romania) 5000 4500 4000 3500 3000 2500 2000 1500 1000 500 Inflation (Romania) 300 Belarus Bulgaria 250 Kazakhstan Russia 200 Ukraine 150 Romania 100 50 0 1992 1993 1994 1995 1996 1997 1998 1999 2000 0 Source : Annual rate. IMF, 2000
Which country is this? 1000000% 100000% Inflation Rate (annual) 10000% 1000% 100% 10% 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Source : IMF, 2008
Hyperinflation Hyperinflations are monetary in character, resulting from very rapid increases in the money supply. But these always result from the printing of money to finance a budget deficit. Once hyperinflation gets going, it becomes self-fuelling because: rapid inflation increases the budget deficit and adds to monetary growth rapid inflation lowers the demand for money Thus at 100% inflation per month, a one month lag in collection of tax halves the real value of taxes.
Cumbersome
Summary Persistent high levels of inflation a twentieth century phenomena as countries switched to entirely fiat money. Inflation widely disliked but is a nominal variable. Understanding the costs of inflation requires explaining how nominal variables affect real ones. Crucial distinction between expected and unexpected inflation. Most of the broad measures of money supply are created by commercial rather than central banks = money multiplier. Monetarist views based around the quantity theory of money: a 10% increase in money supply translates into a 10% increase in prices in the long-run. This statement presumes that velocity and output are exogenous, which does not hold in the short-run. Hyperinflations are mostly a fiscal problem where a government finances a budget deficit by money printing.