Week 2b money and inflation
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Week 2b money and inflation

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  • If your students have taken principles of economics, they will probably be familiar with the material on this slide. It might be worthwhile, though, to take an extra moment to be sure that students understand that the definition of store of value (an item that transfers purchasing power from the present to the future) simply means that money retains its value over time, so you need not spend all your money as soon as you receive it. The idea should be familiar, even though Mankiw’s wording is a bit more sophisticated than most other texts.
  • Again, this material should be review for most students. Note: Many students have seen the film The Shawshank Redemption starring Tim Robbins and Morgan Freeman. Most of this film takes place in a prison. The prisoners have an informal “underground economy” in which cigarettes are used as money, even by prisoners who don’t smoke. Students who have seen the film will better understand “commodity money” if you mention this example. Also, the textbook (p.79) has a case study on cigarettes being used as money in POW camps during WWII.
  • You might want to ask students to determine, for each item listed, which of the functions of money it serves. Answers: a - yes b - no, not the checks themselves, but the funds in checking accounts are money. c - yes (see b) d - no, credit cards are a means of deferring payment. e - CDs are a store of value, and they are measured in money units. They are not readily spendable, though.
  • Again, this is mostly review.
  • This table is an updated version of Table 4-1 on p.82 of the textbook, with one change: This slide excludes M3, which the Federal Reserve discontinued in March 2006. For more info, see http://www.federalreserve.gov/releases/h6/discm3.htm The most important thing that students should get from this slide is the following: Each successive measure of the money supply is BIGGER and LESS LIQUID than the one it follows. I.e., checking account deposits (in M1 but not C) are less liquid than currency. Money market deposit account and savings account balances (in M2 but not M1) are less liquid than demand deposits. Whether you require your students to learn the definitions of every component of each monetary aggregate is up to you. Most professors agree that students should learn the definitions of M1, M2, demand deposits, and time deposits. Some professors feel that, since the quantity of information students can learn in a semester is finite, it is not worthwhile to require students to learn such terms as “repurchase agreements.” However, you might verbally state the definitions of such terms to help students better understand the nature of the monetary aggregates.
  • In order for $500 billion in transactions to occur when the money supply is only $100b, each dollar must be used, on average, in five transactions.
  • You might ask students if they know the difference between nominal GDP and the value of transactions. Answer: nominal GDP includes the value of purchases of final goods; total transactions also includes the value of intermediate goods. Even though they are different, they are highly correlated. Also, our models focus on GDP, and there’s lots of great data on GDP. So from this point on, we’ll use the income version of velocity.
  • It’s worthwhile to underscore the order (logical order, though not necessarily chronological order) in which variables are determined in this model (as well as the other models students will learn in this course). First, real GDP is already determined outside this model (real GDP is determined by the model from chapter 3, which was completely independent of the money supply or velocity or other nominal variables). Second, the Quantity Theory of money determines nominal GDP. Third, the values of nominal GDP (PY) and real GDP (Y) together determine P (as a ratio of PY to Y). If, on an exam or homework problem, students forget the logical order in which endogenous variables are determined --- or on a more fundamental level, forget which variables are endogenous and which are exogenous --- then they are much less likely to earn the high grades that most of them desire. [Note the similarity between the way P is determined and the definition of the GDP deflator from chapter 2.]
  • The text on this slide is an intuitive way to understand the equation. For students that are more comfortable with concrete numerical examples, you could offer the following: Suppose real GDP is growing by 3% per year over the long run. Thus, production, income, and spending are all growing by 3%. This means that the volume of transactions will be growing as well. The central bank can achieve zero inflation (on average over the long run) simply by setting the growth rate of the money supply at 3%, in which case exactly enough new money is being supplied to facilitate the growth in transactions.
  • Note: the theory doesn’t predict that the inflation rate will equal the money growth rate. It *does* predict that a change in the money growth rate will cause an equal change in the inflation rate.
  • This is probably review, if your students have taken an introductory course in economics.
  • Note that S and I are real variables. In chapter 3, we learned about the factors that determine S and I. These factors did not include the money supply, velocity, inflation, or other nominal variables. Hence, in the classical (long-run) theory we are learning, changes in money growth or inflation do not affect the real interest rate. This is why there’s a one-for-one relationship between changes in the inflation rate and changes in the nominal interest rate. (Again, the Fisher effect does not imply that the nominal interest rate EQUALS the inflation rate. It implies that CHANGES in the nominal interest rate equal CHANGES in the inflation rate, given a constant value of the real interest rate.)
  • The concept of “money demand” can be a bit awkward for students the first time they learn it. A good way to explain it is to imagine that a consumer has a certain amount of wealth, which is divided between money and other assets. The other assets typically generate some type of income (e.g. interest income in the case of bonds), but are much less liquid than money. There is therefore a trade-off: the more money the consumer holds in his portfolio, the more interest income he foregoes; the less money he holds, the more interest income he makes, but the less liquid is his portfolio. With this for background, a consumer’s “money demand” refers to the fraction of his wealth he would like to hold in the form of money (as opposed to less-liquid income-generating assets like bonds).
  • An increase in the nominal interest rate represents the increase in the opportunity cost of holding money rather than bonds, and would motivate the typical consumer to hold less of his wealth in the form of money, and more in the form of bonds (or other interest-earning assets). An increase in real income (other things equal) causes an increase in the consumer’s consumption and therefore spending. To facilitate this extra spending, the consumer will require more money. Thus, the consumer would like a larger fraction of his wealth to be in the form of money (rather than bonds, etc). This might involve redeeming some of his bonds. Or it might simply involve holding the additional income in the form of money rather than putting it into bonds.
  • Again, it is very important for students to learn the logical order in which variables are determined. I.e., you do NOT need to know P in order to determine Y. You DO need to know Y in order to determine L, and you need to know L and M in order to determine P.
  • This slide shows the connection between the money market equilibrium condition and the (simpler) Quantity Theory of Money, presented earlier in this chapter.
  • This slide and the next correspond to the subsection of Chapter 4 entitled “Future Money and Current Prices,” appearing on pp.96-97.
  • In the 1970s, the income tax was not adjusted for inflation. There were a lot of people who received nominal salary increases large enough to push them into a higher tax bracket, but not large enough to prevent their real salaries from falling in the face of high inflation. This led to political pressure to index the income tax brackets. If inflation had been higher during 1995-2000, when lots of people were earning high capital gains, then there might have been more political pressure to index the capital gains tax.
  • Examples: Parents trying to decide how much to save for the future college expenses of their (now) young child. Thirty-somethings trying to decide how much to save for retirement. The CEO of a big corporation trying to decide whether to build a new factory, which will yield a revenue stream for 20 years or more. Your grandmother claiming that things were so much cheaper when she was your age. A silly digression: My grandmother often has these conversations with me, concluding that the dollar just isn’t worth what it was when she was young. I ask her “well, how much is a dollar worth today?”. She considers the question, and then offers her estimate: “About 60 cents.” I then offer her 60 cents for every dollar she has. She doesn’t accept the offer. :)
  • Ask students this rhetorical question: Would it upset you off if somebody arbitrarily took wealth away from some people and gave it to others? Well, this in effect is what’s happening when inflation turns out different than expected. Furthermore, it’s impossible to predict when inflation will turn out higher than expected, when it will be lower, and how big the difference will be. So, these redistributions of purchasing power are arbitrary and random. The text gives a simple numerical example starting on the bottom of p.100. (In the short run, when many nominal wages are fixed by contracts, there are transfers of purchasing power between firms and their employees whenever inflation is different than expected when the contract was written and signed.)
  • Students will better appreciate this point when they learn chapter 6 (the natural rate of unemployment). In this chapter, we will see how the failure of wages to adjust contributes to a long-term unemployment problem.
  • Page 104 has an excellent example of life during a hyperinflation, which involves beer, a commodity with which your students may be somewhat familiar. See also the excellent case study on pp.104-105. Note: On p.103, the text states “Hyperinflation is often defined as inflation that exceeds 50 percent per month.” I’ve included this definition at the top of this slide, to be consistent with the textbook. However, some professors are a bit uncomfortable assigning a specific number (such as 50% per month) to the definition of hyperinflation, because, for example, most would agree that 49% per month inflation is high enough to be considered hyperinflation. The definition I like to use in my own teaching is this: hyperinflation : a really, really, really high rate of inflation Feel free to edit the definition of “hyperinflation” on this slide if you wish.
  • Examples of hyperinflation from the textbook: 1. interwar Germany (data and discussion) 2. Bolivia in 1985 (Case Study) This table provides data on Bolivia’s hyperinflation, and some additional examples.

Week 2b money and inflation Week 2b money and inflation Presentation Transcript

  • MONEY ANDINFLATIONWeek-2
  • In this chapter, you will learn… The classical theory of inflation  Its causes  Its effects  Its macroeconomic costs It applies in the long run
  • The connection betweenmoney 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 measured in units of money, we need to consider the nature of money, the supply of money, and how it is controlled.
  • Money: DefinitionMoney is the stockof assets that can bereadily used to make transactions.
  • The money supply andmonetary policy definitions The money supply is the quantity of money available in the economy. Monetary policy is the control over the money supply.
  • Money supply measures symbol assets included C Currency C + demand deposits, M1 travelers’ checks, other checkable deposits M1 + small time deposits, savings deposits, M2 money market mutual funds, money market deposit accounts
  • The Quantity Theory of Money Its a simple theory linking the inflation rate to the growth rate of the money supply. It begins with the concept of velocity…
  • 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 2007,  $500 billion in transactions  money supply = $100 billion  The average dollar is used in five transactions in 2007  So, velocity = 5
  • 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.
  • Money demand and the quantityequation M/P = real money balances, the purchasing power of the money supply. A simple money demand function: (M/P )d = k Y where k = how much money people wish to hold for each dollar of income. (k is exogenous)
  • Money demand and the quantityequation money demand: (M/P )d = k Y quantity equation: M ×V = P ×Y The connection between them: k = 1/V When people hold lots of money relative to their incomes (k is high), money changes hands infrequently (V is low).
  • Back to the quantity theory ofmoney starts with quantity equation assumes V is constant & exogenous: V = V With this assumption, the quantity equation can be written as M ×V = P ×Y
  • The quantity theory of money, cont. M ×V = P ×YHow the price level is determined: With V constant, the money supply determines nominal GDP (P ×Y ). Real GDP is determined by the economy’s supplies of K and L and the production function The price level is P = (nominal GDP)/(real GDP).
  • 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
  • The quantity theory of money, cont.π (Greek letter “pi”) ∆Pdenotes the inflation rate: π = PThe result from the ∆M ∆P ∆Y = +preceding slide was: M P YSolve this resultfor π to get
  • The quantity theory of money, cont. 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.
  • The quantity theory of money, cont.∆Y/Y depends on growth in the factors ofproduction and on technological progress(all of which we take as given, for now). Hence, the Quantity Theory Hence, the Quantity Theory predicts predicts a one-for-one relation between a one-for-one relation between changes in the money growth rate changes in the money growth rate
  • Inflation and interest rates Nominal interest rate, i not adjusted for inflation Real interest rate, r adjusted for inflation: r = i −π
  • The Fisher effect The Fisher equation: i = r + π In the previous section: S = I determines r . Hence, an increase in π causes an equal increase in i. This one-for-one relationship is called the Fisher effect.
  • Money demand andthe 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.
  • Money Demand d M = L(i ) × Y P (M/P )d = real money demand, depends  negatively on i. (Because i is the opportunity cost of holding money)  positively on Y higher Y ⇒ more spending ⇒ so, need more money
  • Money Equilibrium Money Demand (Md) = Money Supply (M) in equilibrium. Therefore, M = L(i ) × Y P
  • Money Equilibrium Recall that i = r + πe. In the long run, expectations are fulfilled on average: πe = π. Therefore, i = r + π. M M = L(i ) × Y = L(r + π ) × Y P P
  • Money EquilibriumM = L(r + π ) × YP From page 25 of the textbook … Growth rate of M – Growth rate of P = Growth rate of L + Growth rate of Y. Recall that r was determined in Ch. 3. Also, assume that inflation, π, is constant in the long run. Then i = r + π is constant. Therefore, L is constant. Therefore, π = Growth rate of M – Growth rate of Y, a constant.
  • Price Level Therefore, the long run price level (P) is: MP= L(r + Growth rate of M − Growth rate of Y ) × Y Note that if M increases—without any change in the growth rate of M—then P increases by the same proportion.  Keep in mind that Y and its growth rate are determined by non-monetary factors discussed in chapter 3.
  • Price Level MP= L(r + Growth rate of M − Growth rate of Y ) × Y If the growth rate of M increases, then so does P. If either Y or its growth rate increases, then P decreases. If the real interest rate, r, increases, then so does P.
  • Inflation Recall that π = Growth rate of M – Growth rate of Y in the long run. Therefore, if either the growth rate of the money supply (M) increases by, say, 2 percentage points, or if the growth rate of total output (Y) decreases by the same amount, then the rate of inflation (π) will increase by the same 2 percentage points.
  • Monetary Neutrality Note that unless there is a change in the real parameters of chapter 3, the real endogenous variables of that chapter will not change. In particular, changes in M or the growth rate of M cannot affect the real variables that were determined in chapter 3, for obvious reasons.
  • Monetary Neutrality However, although M/P is a real variable, it is affected by changes in the growth rate of M. Also, changes in real variables such as Y and the growth rate of Y do have an effect on P, although it is a nominal variable.
  • The money demand function (M P ) = L (i , Y ) d(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 functionbecause money is the most liquid asset.)
  • The money demand function (M P ) = L (i , Y ) d = L (r + π , Y ) eWhen people are deciding whether to holdmoney or bonds, they don’t know what inflationwill turn out to be.Hence, the nominal interest rate relevant formoney demand is r + π e.
  • Equilibrium M = L (r + π e , Y ) PThe supply of real money balances Real money demand
  • What determines what M = L (r + π , Y ) e P variable how determined (in the long run) M exogenous (the Fed) r adjusts to make S = I Y Y = F (K , L ) P adjusts to make M = L ( i ,Y ) P
  • How P responds to ∆M M = L (r + π , Y ) e P For given values of r, Y, and π e, a change in M causes P to change by the same percentage – just like in the quantity theory of money.
  • What about expected inflation? Over the long run, people don’t consistently over- or under-forecast inflation, so π e = π on average. In the short run, π e may change when people get new information. EX: Fed announces it will increase M next year. People will expect next year’s P to be higher, so π e rises. This affects P now, even though M hasn’t changed yet….
  • How P responds to ∆π e M = L (r + π e , Y ) P For given values of r, Y, and M , ↑ π e ⇒ ↑ i (the Fisher effect) ⇒ ↓ (M P ) d ⇒ ↑ P to make ( M P ) fall to re-establish eqm
  • A common misperception Common misperception: inflation reduces real wages This is true only in the short run, when nominal wages are fixed by contracts. In the long run, the real wage is determined by labor supply and the marginal product of labor, not the price level or inflation rate.
  • The social costs of inflation…fall into two categories:1. costs when inflation is expected2. costs when inflation is different than people had expected
  • The costs of expected inflation:1. Shoeleather cost def: the costs and inconveniences of reducing money balances to avoid the inflation tax. ↑π ⇒ ↑i ⇒ ↓ real money balances Remember: In long run, inflation does not affect real income or real spending. So, same monthly spending but lower average money holdings means more frequent trips to the bank to withdraw smaller amounts of cash.
  • The costs of expected inflation:2. Menu costs def: The costs of changing prices. Examples:  cost of printing new menus  cost of printing & mailing new catalogs The higher is inflation, the more frequently firms must change their prices and incur these costs.
  • The costs of expected inflation:3. Relative price distortions Firms facing menu costs change prices infrequently. Example: A firm issues new catalog each January. As the general price level rises throughout the year, the firm’s relative price will fall. Different firms change their prices at different times, leading to relative price distortions… …causing microeconomic inefficiencies in the allocation of resources.
  • The costs of expected inflation:4. Unfair tax treatmentSome taxes are not adjusted to account forinflation, such as the capital gains tax.Example:  Jan 1: you buy $10,000 worth of IBM stock  Dec 31: you sell the stock for $11,000, so your nominal capital gain is $1000 (10%).  Suppose π = 10% during the year. Your real capital gain is $0.  But the govt requires you to pay taxes on your $1000 nominal gain!!
  • The costs of expected inflation:5. General inconvenience Inflation makes it harder to compare nominal values from different time periods. This complicates long-range financial planning.
  • Additional cost of unexpected inflation:Arbitrary redistribution of purchasing power Many long-term contracts not indexed, but based on π e. If π turns out different from π e, then some gain at others’ expense. Example: borrowers & lenders  If π > π e, then (i − π ) < (i − π e) and purchasing power is transferred from lenders to borrowers.  If π < π e, then purchasing power is transferred from borrowers to lenders.
  • Additional cost of high inflation:Increased uncertainty When inflation is high, it’s more variable and unpredictable: π turns out different from π e more often, and the differences tend to be larger (though not systematically positive or negative) Arbitrary redistributions of wealth become more likely. This creates higher uncertainty, making risk averse people worse off.
  • One benefit of inflation Nominal wages are rarely reduced, even when the equilibrium real wage falls. This hinders labor market clearing. Inflation allows the real wages to reach equilibrium levels without nominal wage cuts. Therefore, moderate inflation improves the functioning of labor markets.
  • Hyperinflation def: π ≥ 50% per month All the costs of moderate inflation described above become HUGE under hyperinflation. Money ceases to function as a store of value, and may not serve its other functions (unit of account, medium of exchange). People may conduct transactions with barter or a stable foreign currency.
  • What causes hyperinflation? Hyperinflation is caused by excessive money supply growth: When the central bank prints money, the price level rises. If it prints money rapidly enough, the result is hyperinflation. CHAPTER 4 Money and Inflation
  • A few examples of hyperinflation money inflation growth (%) (%) Israel, 1983-85 295 275 Poland, 1989-90 344 400 Brazil, 1987-94 1350 1323 Argentina, 1988-90 1264 1912 Peru, 1988-90 2974 3849 Nicaragua, 1987-91 4991 5261 Bolivia, 1984-85 4208 6515
  • The Classical DichotomyReal variables: Measured in physical units – quantities andrelative prices, for example:  quantity of output produced  real wage: output earned per hour of work  real interest rate: output earned in the future by lending one unit of output todayNominal variables: Measured in money units, e.g.,  nominal wage: Dollars per hour of work.  nominal interest rate: Dollars earned in future by lending one dollar today.  the price level: The amount of dollars needed to buy a representative basket of goods.