EC 205 Lecture 11 23/03/15 Announcement: Makeup exam will be held this week! Second Half of the Course: Short Run Macroeconomics - Focus on: SR fluctuations in output and how to stabilize them Inflation Unemployment We start with Chapter 4 & 5 Money Quantity Theory of Money Money Demand NOTE: In the new edition, we skip most of Chp 4. Follow the slides. 0
The connection between money and prices Inflation rate = the percentage increase in the average level of prices. Price = amount of money required to buy a good. 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. 1
Money: Definition Money is the stock of assets that can be readily used to make transactions. Money stock Income flow 2
Money: Functions medium of exchange we use it to buy stuff store of value transfers purchasing power from the present to the future unit of account the common unit by which everyone measures prices and values 3
Money: Types 1. Fiat money has no intrinsic value example: the paper currency we use 2. Commodity money has intrinsic value examples: gold coins, cigarettes in P.O.W. camps 4
The money supply and monetary policy definitions The money supply is the quantity of money available in the economy. Monetary policy is the control over the money supply. Monetary policy is conducted by a country s central bank Through Open market operations The purchase and sale of government bonds by the central bank Purchases of bonds and FX to increase M Sale of bonds and FX to decrease M 5
Money supply measures, Turkey, end-of- 2008 symbol C M1 M2 assets included Currency C + demand deposits, travelers checks, other checkable deposits M1 + small time deposits, savings deposits, money market mutual funds, money market deposit accounts amount ($ billions) $20 $40 $195 6
Money supply measures, USA, May 2009 symbol C M1 M2 assets included Currency C + demand deposits, travelers checks, other checkable deposits M1 + small time deposits, savings deposits, money market mutual funds, money market deposit accounts amount ($ billions) $850 $1596 $8328 7
The Quantity Theory of Money A simple theory linking the inflation rate to the growth rate of the money supply. A classical theory in essence since prices are assumed to be flexible. It is agreed that it holds relatively well in the long-run. Begins with the concept of velocity 8
Velocity basic concept: the rate at which money circulates definition: the number of times the average dollar bill changes hands in a given time period example: In 2009, $500 billion in transactions money supply = $100 billion The average dollar is used in five transactions in 2009 So, velocity = 5 9
Velocity, cont. This suggests the following definition: V = P T M where V = velocity P = price of a typical transaction T = number of transactions M = money supply 10
Velocity, cont. Use nominal GDP as a proxy for total transactions. Then, P Y V = M where P = price of output (GDP deflator) Y = quantity of output (real GDP) P Y = value of output (nominal GDP) 11
The quantity equation The quantity equation M V = P Y follows from the preceding definition of velocity. It is an identity: it holds by definition of the variables. 12
Money demand and the quantity equation M/P = real money balances, the purchasing power of the money supply. 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) 13
Money demand and the quantity equation Simple money demand: (M/P) d = ky quantity equation: M V = P Y Money Demand equation offers another way to view the quantity equation: k = 1/V When people hold lots of money relative to their incomes (k is large), money changes hands infrequently (V is small). 14
Back to the quantity theory of money starts with quantity equation assumes V is constant & exogenous: Then, quantity equation becomes: V = V M V = P Y 15
The quantity theory of money, cont. M V = P Y How the price level is determined: With V constant, the money supply (M) determines nominal GDP (P Y ). Real GDP is determined by the economy s supplies of K and L and the production function (Chp. 3). The price level is P = (nominal GDP)/(real GDP). 16
The quantity theory of money, cont. Recall: The growth rate of a product equals the sum of the growth rates. The quantity equation in growth rates: M V P Y + = + M V P Y The quantity theory of money assumes V V is constant, so = 0. V 17
The quantity theory of money, cont. π (Greek letter pi ) denotes the inflation rate: π = P P The result from the preceding slide: M P Y = + M P Y Solve this result for π: π M = M Y Y 18
The quantity theory of money, cont. π M = M Y Y Normal economic growth requires a certain amount of money supply growth to facilitate the growth in transactions. Money growth in excess of this amount leads to inflation. 19
The quantity theory of money, cont. π M = M Y Y Y/Y depends on growth in the factors of production and on technological progress (all of which we take as given, for this model). Hence, the Quantity Theory predicts a one-for-one relation between changes in the money growth rate and changes in the inflation rate. 20
Confronting the quantity theory with 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? 21
International data on inflation and money growth, 2000-2010 40 35 Belarus Inflation rate (percent) 30 25 20 15 10 Malta Mexico U.S. Serbia Zambia Iraq Turkey Suriname Russia 5 0 Cyprus China -5-10 0 10 20 30 40 50 Money supply growth (percent) 22
% change from 12 mos. earlier U.S. inflation and money growth, 1960 2014 14% 12% 10% 8% 6% 4% 2% inflation rate 0% 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 23 M2 growth rate
% change from 12 mos. earlier U.S. inflation and money growth, 1960 2014 14% 12% 10% 8% 6% 4% 2% Inflation and money growth have the same long-run trends, as the quantity theory predicts. 0% 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 24
Seigniorage To spend more without raising taxes or selling bonds, the govt can print money. The revenue raised from printing money is called seigniorage The inflation tax: Printing money to raise revenue causes inflation. Inflation is like a tax on people who hold money. Q: What is the potential problem that you can see about this type of revenue raising? 25
Inflation and interest rates Nominal interest rate, i not adjusted for inflation Real interest rate, r adjusted for inflation: The Fisher equation: r i π i r π e + π e where : π : ex ante (before inflation happens, expected) also denoted as Eπ ex post (realized/actual inflation) 26
The Fisher effect The Fisher equation: Chap 3: S = I determines r. Hence, a 1% increase in π e increase in i. i r π e + causes an equal This one-for-one relationship is called the Fisher effect. 27
U.S. inflation and nominal interest rates, 1960 2014 18% 14% nominal interest rate 10% 6% 2% inflation rate -2% 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 28
Inflation and nominal interest rates across countries, 1999-2007 Nominal interest rate (percent, logarithmic scale) 100 Georgia Brazil Romania Turkey Zimbabwe 10 Israel Kenya 1 U.S. Germany Ethiopia 1 10 100 1000 Inflation rate (percent, logarithmic scale) 29
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 i. c. Suppose the growth rate of Y falls to 1% per year. What will happen to π? What must the Fed do if it wishes to keep π constant? 30
NOW YOU TRY: Answers V is constant, M grows 5% per year, Y grows 2% per year, r = 4. a. First, find π = 5 2 = 3. Then, find i = r + π = 4 + 3 = 7. b. i = 2, same as the increase in the money growth rate. c. If the Fed does nothing, π = 1. To prevent inflation from rising, Fed must reduce the money growth rate by 1 percentage point per year. 31
Money demand and the nominal interest rate In the quantity theory of money, the demand for real money balances depends only on real income Y. Another determinant of money demand: the nominal interest rate, i. the opportunity cost of holding money (instead of bonds or other interest-earning assets). Hence, i in money demand. 32
The money demand function General money demand function: d ( M P) = LiY (, ) (M/P ) d = real money demand, depends negatively on i i is the opp. cost of holding money positively on Y higher Y more spending so, need more money ( L is used for the money demand function because money is the most liquid asset.) 33
The money demand function ( M P) = LiY (, ) 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 + Eπ. d = L( r + E π, Y ) 34
Equilibrium (Money demand=money supply) M P = Lr ( + E π, Y) The supply of real money balances Real money demand 35
What determines what variable M r M = Lr ( + E π, Y) P how determined (in the long run) exogenous (the Central Bank) adjusts to ensure S = I Y P Y = F ( K, L ) adjusts to ensure M L ( i, Y ) P = 36