The money supply and inflation ppt @ bec doms
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Transcript

  • 1. THE MONEY SUPPLY AND INFLATION
  • 2. QUESTION
    • China is experiencing a serious inflation Problem. How can we explain this phenomenon?
  • 3. WHAT IS MONEY?
    • Money is the set of assets in an economy that people regularly use to buy goods and services from other people.
  • 4. FUNCTIONS OF MONEY
    • Money has three functions in the economy:
    • Medium of exchange
    • Unit of account
    • Store of value
  • 5. LIQUIDITY
    • Liquidity
    • Liquidity is the ease with which an asset can be converted into the economy ’ s medium of exchange.
  • 6. KINDS OF MONEY
    • Commodity money takes the form of a commodity with intrinsic value.
    • Examples: Gold, silver, cigarettes.
    • Fiat money is used as money because of government decree.
    • It does not have intrinsic value.
    • Examples: Coins, currency, check deposits.
  • 7. MONEY IN THE ECONOMY
    • Currency is the paper bills and coins in the hands of the public.
    • Demand deposits are balances in bank accounts that depositors can access on demand by writing a check.
  • 8. MONEY SUPPLY
    • M1
    • _ M1A
    • _ M1B
    • M2
  • 9. MONEY IN THE U.S. ECONOMY Copyright©2003 Southwestern/Thomson Learning Billions of Dollars 0 • Currency ($580 billion) • Demand deposits • Traveler ’ s checks • Other checkable deposits ($599 billion) • Everything in M1 ($1,179 billion) • Savings deposits • Small time deposits • Money market mutual funds • A few minor categories ($4,276 billion) M1 $1,179 M2 $5,455
  • 10. FEDERAL RESERVE
    • The Federal Reserve (Fed) serves as the nation ’ s central bank.
    • It is designed to oversee the banking system.
    • It regulates the quantity of money in the economy.
  • 11. FEDERAL OPEN MARKET COMMITTEE
    • The Federal Open Market Committee (FOMC)
    • Serves as the main policy-making organ of the Federal Reserve System.
    • Meets approximately every six weeks to review the economy.
  • 12. MONETARY POLICY
    • Monetary policy is conducted by the Federal Open Market Committee.
    • Monetary policy is the setting of the money supply by policymakers in the central bank
    • The money supply refers to the quantity of money available in the economy.
  • 13. OPEN-MARKET OPERATIONS
    • Open-Market Operations
    • The money supply is the quantity of money available in the economy.
    • The primary way in which the Fed changes the money supply is through open-market operations .
    • The Fed purchases and sells U.S. government bonds.
  • 14. OPEN-MARKET OPERATIONS: CONTINUED
    • Open-Market Operations
    • To increase the money supply, the Fed buys government bonds from the public.
    • To decrease the money supply, the Fed sells government bonds to the public.
  • 15. BANKS AND MONEY SUPPLY
    • Banks can influence the quantity of demand deposits in the economy and the money supply.
    • Reserves are deposits that banks have received but have not loaned out.
    • In a fractional-reserve banking system, banks hold a fraction of the money deposited as reserves and lend out the rest.
    • Reserve Ratio
    • The reserve ratio is the fraction of deposits that banks hold as reserves.
  • 16. MONEY CREATION
    • When a bank makes a loan from its reserves, the money supply increases.
    • The money supply is affected by the amount deposited in banks and the amount that banks loan.
    • Deposits into a bank are recorded as both assets and liabilities.
    • The fraction of total deposits that a bank has to keep as reserves is called the reserve ratio.
    • Loans become an asset to the bank.
  • 17. T-ACCOUNT
    • T-Account shows a bank that …
    • accepts deposits,
    • keeps a portion as reserves,
    • and lends out the rest.
    • It assumes a reserve ratio of 10%.
  • 18. T-ACCOUNT: FIRST NATIONAL BANK Assets Liabilities First National Bank Reserves $10.00 Loans $90.00 Deposits $100.00 Total Assets $100.00 Total Liabilities $100.00
  • 19. MONEY CREATION: CONTINUED
    • When one bank loans money, that money is generally deposited into another bank.
    • This creates more deposits and more reserves to be lent out.
    • When a bank makes a loan from its reserves, the money supply increases.
  • 20. MONEY MULTIPLIER
    • How much money is eventually created in this economy?
    • The money multiplier is the amount of money the banking system generates with each dollar of reserves.
  • 21. THE MONEY MULTIPLIER Assets Liabilities Second National Bank Reserves $9.00 Loans $81.00 Deposits $90.00 Total Assets $90.00 Total Liabilities $90.00 Money Supply = $190.00! Assets Liabilities First National Bank Reserves $10.00 Loans $90.00 Deposits $100.00 Total Assets $100.00 Total Liabilities $100.00
  • 22. MONEY MULTIPLIER:CONTINUED
    • The money multiplier is the reciprocal of the reserve ratio:
    • M = 1/R
    • With a reserve requirement, R = 20% or 1/5,
    • The multiplier is 5.
  • 23. TOOLS OF MONEY CONTROL
    • The Fed has three tools in its monetary toolbox:
    • Open-market operations
    • Changing the reserve requirement
    • Changing the discount rate
  • 24. OPEN-MARKET OPERATIONS
    • Open-Market Operations
    • The Fed conducts open-market operations when it buys government bonds from or sells government bonds to the public:
    • When the Fed buys government bonds, the money supply increases.
    • The money supply decreases when the Fed sells government bonds.
  • 25. RESERVE REQUIREMENTS
    • Reserve Requirements
    • The Fed also influences the money supply with reserve requirements .
    • Reserve requirements are regulations on the minimum amount of reserves that banks must hold against deposits.
  • 26. CHANGE THE RESERVE REQUIREMENT
    • Changing the Reserve Requirement
    • The reserve requirement is the amount (%) of a bank ’ s total reserves that may not be loaned out.
    • Increasing the reserve requirement decreases the money supply.
    • Decreasing the reserve requirement increases the money supply.
  • 27. CHANGE DISCOUNT RATE
    • Changing the Discount Rate
    • The discount rate is the interest rate the Fed charges banks for loans.
    • Increasing the discount rate decreases the money supply.
    • Decreasing the discount rate increases the money supply.
  • 28. PROBLEMS IN CONTROLLING MONEY SUPPLY
    • The Fed ’ s control of the money supply is not precise.
    • The Fed must wrestle with two problems that arise due to fractional-reserve banking.
    • The Fed does not control the amount of money that households choose to hold as deposits in banks.
    • The Fed does not control the amount of money that bankers choose to lend.
  • 29. MONEY SUPPLY
    • The money supply is a policy variable that is controlled by the Fed.
    • Through instruments such as open-market operations, the Fed directly controls the quantity of money supplied.
  • 30. MOTIVES OF MONEY DEMAND
    • Transaction motive
    • Precautionary motive
    • Speculative motive
  • 31. MONEY DEMAND
    • Money demand has several determinants, including interest rates and the average level of prices in the economy
    • People hold money because it is the medium of exchange.
    • The amount of money people choose to hold depends on the prices of goods and services.
  • 32. Quantity of Money Value of Money, 1 / P Price Level, P 0 1 (Low) (High) (High) (Low) 1 / 2 1 / 4 3 / 4 1 1.33 2 4 Quantity fixed by the Fed Money supply Equilibrium value of money Equilibrium price level Money demand A
  • 33. Quantity of Money Value of Money, 1 / P Price Level, P 0 1 (Low) (High) (High) (Low) 1 / 2 1 / 4 3 / 4 1 1.33 2 4 Money demand M 1 MS 1 M 2 MS 2 2. . . . decreases the value of mone y . . . 3. . . . and increases the price level. 1. An increase in the money supply . . . A B
  • 34. SPECULATIVE MOTIVE
    • The interest rate and quantity demanded of money are negatively related. Therefore, the money demand curve is downward sloping.
    • The quantity supplied of money is controlled by Fed. Therefore, the money supply curve is vertical.
    • As money demand increases, the interest rate is higher.
    • As money supply increases, the interest rate is lower.
  • 35. LIQUIDITY TRAP
    • When the money demand is perfectly elastic at a low interest rate, the increase in money supply would not have any impact on the interest rate.
  • 36. QUANTITY THEORY OF MONEY
    • The Quantity Theory of Money
    • How the price level is determined and why it might change over time is called the quantity theory of money.
    • The quantity of money available in the economy determines the value of money.
    • The primary cause of inflation is the growth in the quantity of money .
  • 37. VELOCITY OF MONEY
    • The velocity of money refers to the speed at which the typical dollar bill travels around the economy from wallet to wallet.
    • V = (P  Y)/M
    • Where: V = velocity
    • P = the price level
    • Y = the quantity of output
    • M = the quantity of money
  • 38. QUANTITY EQUATION
    • Rewriting the equation gives the quantity equation:
    • M  V = P  Y
    • The quantity equation relates the quantity of money ( M ) to the nominal value of output ( P  Y ).
  • 39. QUANTITY EQUATION
    • The quantity equation shows that an increase in the quantity of money in an economy must be reflected in one of three other variables:
    • the price level must rise,
    • the quantity of output must rise, or
    • the velocity of money must fall.
  • 40. INFLATION TAX
    • When the government raises revenue by printing money, it is said to levy an inflation tax.
    • An inflation tax is like a tax on everyone who holds money.
    • The inflation ends when the government institutes fiscal reforms such as cuts in government spending.
  • 41. FISHER EFFECT
    • The Fisher effect refers to a one-to-one adjustment of the nominal interest rate to the inflation rate.
    • According to the Fisher effect, when the rate of inflation rises, the nominal interest rate rises by the same amount.
    • The real interest rate stays the same.
  • 42. COSTS OF INFLATION
    • Shoeleather costs
    • Menu costs
    • Relative price variability
    • Tax distortions
    • Confusion and inconvenience
    • Arbitrary redistribution of wealth
  • 43. SHOELEATHER COSTS
    • Shoeleather costs are the resources wasted when inflation encourages people to reduce their money holdings.
    • Inflation reduces the real value of money, so people have an incentive to minimize their cash holdings.
    • Less cash requires more frequent trips to the bank to withdraw money from interest-bearing accounts.
    • The actual cost of reducing your money holdings is the time and convenience you must sacrifice to keep less money on hand.
    • Also, extra trips to the bank take time away from productive activities.
  • 44. MENU COSTS
    • Menu costs are the costs of adjusting prices.
    • During inflationary times, it is necessary to update price lists and other posted prices.
    • This is a resource-consuming process that takes away from other productive activities.
  • 45. DISTORTIONS OF RELATIVE PRICES
    • Inflation distorts relative prices.
    • Consumer decisions are distorted, and markets are less able to allocate resources to their best use.
  • 46. TAX DISTORTIONS
    • Inflation exaggerates the size of capital gains and increases the tax burden on this type of income.
    • With progressive taxation, capital gains are taxed more heavily.
  • 47. TAX DISTORTIONS
    • The income tax treats the nominal interest earned on savings as income, even though part of the nominal interest rate merely compensates for inflation.
    • The after-tax real interest rate falls, making saving less attractive.
  • 48. CONFUSION & INCONVENIENCE
    • When the Fed increases the money supply and creates inflation, it erodes the real value of the unit of account.
    • Inflation causes dollars at different times to have different real values.
    • Therefore, with rising prices, it is more difficult to compare real revenues, costs, and profits over time.
  • 49. ARBITRARY REDISTRIBUTION OF WEALTH
    • Unexpected inflation redistributes wealth among the population in a way that has nothing to do with either merit or need.
    • These redistributions occur because many loans in the economy are specified in terms of the unit of account—money.