6 1 money and inflation

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  • 6 1 money and inflation

    1. 1. A PowerPoint™Tutorial to Accompany macroeconomics, 5th ed. N. Gregory Mankiw ® Money and Inflation
    2. 2. Chapter Four Stock of assetsStock of assets Used for transactionsUsed for transactions A type of wealthA type of wealth Without Money Self-sufficiencySelf-sufficiency Barter economyBarter economy
    3. 3. Chapter Four  Store of value  Unit of account  Medium of exchange The ease with which money is converted into other things-- goods and services-- is sometimes called money’s liquidity.
    4. 4. Chapter Four Fiat money is money by declaration. It has no intrinsic value. Commodity money is money that has intrinsic value. When people use gold as money, the economy is said to be on a gold standard.
    5. 5. Chapter Four The money supply is the quantity of money available in an economy. The control over the money supply is called Monetary Policy. In the United States, monetary policy is conducted in a partially independent institution called the Federal Reserve, or the Fed.
    6. 6. • To expand the Money Supply: The Federal Reserve buys U.S. Treasury Bonds and pays for them with new money. • To reduce the Money Supply: The Federal Reserve sells U.S. Treasury Bonds and receives the existing dollars and then destroys them. The bearer of the United States Treasury bond is hereby promised the repayment of the principle value plus the interest which it incurs through the terms stated thereof. The United States will justly repay its bearers in its entirety and will not default under any circumstances. Signature of the President ___________________ US. Treasury Bond
    7. 7. The Federal Reserve controls the money supply in three ways. 1) Open Market Operations (buying and selling U.S. Treasury bonds). 2) ∆ Reserve requirements (never really used). 3) ∆ Discount rate which member banks (not meeting the reserve requirements) pay to borrow from the Fed. The bearer of the United States Treasury bond is hereby promised the repayment of the principle value plus the interest which it incurs through the terms stated thereof. The United States will justly repay its bearers in its entirety and will not default under any circumstances. Signature of the President ___________________ US. Treasury Bond
    8. 8. The quantity equation is an identity: the definitions of the four variables make it true. If one variable changes, one or more of the others must also change to maintain the identity. The quantity equation we will use from now on is the money supply (M) times the velocity of money (V) which equals price (P) times output (Y): Money × Velocity = Price × Output M × V = P × Y Because Y is also total income, V in the quantity equations is called the income velocity of money. This tells us the number of times a dollar bill changes hands in a given period of time.
    9. 9. Let’s now express the quantity of money in terms of the quantity of goods and services it can buy. This amount, M/P is called real money balances. Real money balances measure the purchasing power of the stock of money. A money demand function is an equation that shows what determines the quantity of real money balances people wish to hold. Here is a simple money demand function: where k is a constant that tells us how much money people want to hold for every dollar they earn. This equation states that the quantity of real money balances demanded is proportional to real income. (M/P)d = k Y
    10. 10. The money demand function is like the demand function for a particular good. Here the “good” is the convenience of holding real money balances. Higher income leads to a greater demand for real money balances. The money demand equation offers another way to view the quantity equation (MV= PY) where V = 1/k. This shows the link between the demand for money and the velocity of money. When people hold a lot of money for each dollar of income (k is large), money changes hands infrequently (V is small). Conversely, when people want to hold only a little money (k is small), money changes hands frequently (V is large). In other words, the money demand parameter k and the velocity of money V are opposite sides of the same coin.
    11. 11. Copyright © 2004 South-Western Velocity and the 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.
    12. 12. Figure 1 Nominal GDP, the Quantity of Money, and the Velocity of Money Copyright © 2004 South-Western Indexes (1960 = 100) 2,000 1,000 500 0 1,500 1960 1965 1970 1975 1980 1985 1990 1995 2000 Nominal GDP Velocity M2
    13. 13. The Assumption of Constant Velocity The quantity equation can be viewed as a definition: it defines velocity V as the ratio of nominal GDP, PY, to the quantity of money M. But, if we make the assumption that the velocity of money is constant, then the quantity equation MV=PY becomes a useful theory of the effects of money. The quantity equation can be viewed as a definition: it defines velocity V as the ratio of nominal GDP, PY, to the quantity of money M. But, if we make the assumption that the velocity of money is constant, then the quantity equation MV=PY becomes a useful theory of the effects of money. So, let’s hold it constant!MV = PY
    14. 14. Chapter Four Three building blocks that determine the economy’s overall level of prices: 1) The factors of production and the production function determine the level of output Y. 2) The money supply determines the nominal value of output, PY. This follows from the quantity equation and the assumption that the velocity of money is fixed. 3) The price level P is then the ratio of the nominal value of output, PY, to the level of output Y.
    15. 15. In other words, if Y is fixed (from Chapter 3) because it depends on the growth in the factors of production and on technological progress, and we just made the assumption that velocity is constant, or in percentage change form: MV = PY % Change in M + % Change in V = % Change in P + % Change in Y% Change in M + % Change in V = % Change in P + % Change in Y if V is fixed and Y is fixed, then it reveals that % Change in M is what induces % Changes in P. The quantity theory of money states that the central bank, which controls the money supply, has the ultimate control over the inflation rate. If the central bank keeps the money supply stable,the price level will be stable. If the central bank increases the money supply rapidly, the price level will rise rapidly.
    16. 16. The revenue raised through the printing of money is called seigniorage. When the government prints money to finance expenditure, it increases the money supply. The increase in the money supply, in turn, causes inflation. Printing money to raise revenue is like imposing an inflation tax. The revenue raised through the printing of money is called seigniorage. When the government prints money to finance expenditure, it increases the money supply. The increase in the money supply, in turn, causes inflation. Printing money to raise revenue is like imposing an inflation tax.
    17. 17. Economists call the interest rate that the bank pays the nominal interest rate and the increase in your purchasing power the real interest rate. This shows the relationship between the nominal interest rate and the rate of inflation, where r is real interest rate, i is the nominal interest rate and π is the rate of inflation, and remember that π is simply the percentage change of the price level P. Economists call the interest rate that the bank pays the nominal interest rate and the increase in your purchasing power the real interest rate. This shows the relationship between the nominal interest rate and the rate of inflation, where r is real interest rate, i is the nominal interest rate and π is the rate of inflation, and remember that π is simply the percentage change of the price level P. r = i – π
    18. 18. Chapter Four The Fisher Equation illuminates the distinction between the real and nominal rate of interest. Fisher Equation:Fisher Equation: ii == rr ++ ππ Actual (Market)Actual (Market) Nominal rate ofNominal rate of interestinterest Real rateReal rate of interestof interest InflationInflation The one-to-one relationship between the inflation rate and the nominal interest rate is the Fisher Effect. It shows that the nominal interest can change for two reasons: because the real interest rate changes or because the inflation rate changes.
    19. 19. % Change in M + % Change in V = % Change in P + % Change in Y % Change in M + % Change in V = π + % Change in Y i = r + π The quantity theory and the Fisher equation together tell us how money growth affects the nominal interest rate. According to the quantity theory, an increase in the rate of money growth of one percent causes a 1% increase in the rate of inflation. According to the Fisher equation, a 1% increase in the rate of inflation in turn causes a 1% increase in the nominal interest rates. Here is the exact link between our two familiar equations: The quantity equation in percentage change form and the Fisher equation.
    20. 20. Chapter Four Copyright © 2004 South-Western Percent (per year) 1960 1965 1970 1975 1980 1985 1990 1995 2000 0 3 6 9 12 15 Inflation Nominal interest rate
    21. 21. The real interest rate the borrower and lender expect when a loan is made is called the ex ante real interest rate. The real interest rate that is actually realized is called the ex post real interest rate. Although borrowers and lenders cannot predict future inflation with certainty, they do have some expectation of the inflation rate. Let π denote actual future inflation and πe the expectation of future inflation. The ex ante real interest rate is i - πe , and the ex post real interest rate is i - π. The two interest rates differ when actual inflation π differs from expected inflation πe . How does this distinction modify the Fisher effect? Clearly the nominal interest rate cannot adjust to actual inflation, because actual inflation is not known when the nominal interest rate is set. The nominal interest rate can adjust only to expected inflation. The next slide presents a more precise version of the the Fisher effect.
    22. 22. ii == rr ++ ππeeii == rr ++ ππee The ex ante real interest rate r is determined by equilibrium in the market for goods and services, as described by the model in Chapter 3. The nominal interest rate i moves one-for-one with changes in expected inflation πe .
    23. 23. The quantity theory (MV = PY) is based on a simple money demand function: it assumes that the demand for real money balances is proportional to income. But, we need another determinant of the quantity of money demanded– the nominal interest rate. The nominal interest rate is the opportunity cost of holding money: it is what you give up by holding money instead of bonds. So, the new general money demand function can be written as: (M/P)d = L(i, Y) This equation states that the demand for the liquidity of real money balances is a function of income (Y) and the nominal interest rate (i). The higher the level of income Y, the greater the demand for real money balances.
    24. 24. Chapter Four The inconvenience of reducing money holding is metaphorically called the shoe-leather cost of inflation, because walking to the bank more often induces one’s shoes to wear out more quickly. When changes in inflation require printing and distributing new pricing information, then, these costs are called menu costs. Another cost is related to tax laws. Often tax laws do not take into consideration inflationary effects on income.
    25. 25. Unanticipated inflation is unfavorable because it arbitrarily redistributes wealth among individuals. For example, it hurts individuals on fixed pensions. Often these contracts were not created in real terms by being indexed to a particular measure of the price level. There is a benefit of inflation– many economists say that some inflation may make labor markets work better. They say it “greases the wheels” of labor markets.
    26. 26. Hyperinflation is defined as inflation that exceeds 50 percent per month, which is just over 1% a day. Costs such as shoe-leather and menu costs are much worse with hyperinflation– and tax systems are grossly distorted. Eventually, when costs become too great with hyperinflation, the money loses its role as store of value, unit of account and medium of exchange. Bartering or using commodity money becomes prevalent.
    27. 27. Economists call the separation of the determinants of real and nominal variables the classical dichotomy. It suggests that changes in the money supply do not influence real variables. This irrelevance of money for real variables is called monetary neutrality. For the purpose of studying long-run issues-- monetary neutrality is approximately correct.
    28. 28. The Case Study and the Cost of Inflation
    29. 29. Copyright © 2004 South-Western THE CLASSICAL THEORY OF INFLATION • Inflation: Historical Aspects • Over the past 60 years, prices have risen on average about 5 percent per year. • Deflation, meaning decreasing average prices, occurred in the U.S. in the nineteenth century. • Hyperinflation refers to high rates of inflation such as Germany experienced in the 1920s.
    30. 30. Copyright © 2004 South-Western THE CLASSICAL THEORY OF INFLATION • Inflation: Historical Aspects • In the 1970s prices rose by 7 percent per year. • During the 1990s, prices rose at an average rate of 2 percent per year.
    31. 31. Figure 3 Money Supply, Money Demand, and the Equilibrium Price Level Copyright © 2004 South-Western Quantity of Money Value of Money,1/P Price Level, P Quantity fixed by the Fed Money supply 0 1 (Low) (High) (High) (Low) 1 /2 1 /4 3 /4 1 1.33 2 4 Equilibrium value of money Equilibrium price level Money demand A
    32. 32. Figure 4 The Effects of Monetary Injection Copyright © 2004 South-Western Quantity of Money Value of Money,1/P Price Level, P Money demand 0 1 (Low) (High) (High) (Low) 1 /2 1 /4 3 /4 1 1.33 2 4 M1 MS1 M2 MS2 2. . . . decreases the value of money . . . 3. . . . and increases the price level. 1. An increase in the money supply . . . A B
    33. 33. Discussion question • Why is inflation bad?
    34. 34. InflatIon & DeflatIon impact on economy
    35. 35. reflatio n depression Employment thresh hold Trueinflatio n time Price/ output/employment P,O,E P P,O, E Dis inflatio n Deflation Model of trade cycle
    36. 36. Copyright © 2004 South-Western CASE STUDY: Money and Prices during Four Hyperinflations • Hyperinflation is inflation that exceeds 50 percent per month. • Hyperinflation occurs in some countries because the government prints too much money to pay for its spending.
    37. 37. Figure 5 Money and Prices During Four Hyperinflations Copyright © 2004 South-Western (a) Austria (b) Hungary Money supply Price level Index (Jan. 1921 = 100) Index (July 1921 = 100) Price level 100,000 10,000 1,000 100 19251924192319221921 Money supply 100,000 10,000 1,000 100 19251924192319221921
    38. 38. Figure 5 Money and Prices During Four Hyperinflations Copyright © 2004 South-Western (c) Germany 1 Index (Jan. 1921 = 100) (d) Poland 100,000,000,000,000 1,000,000 10,000,000,000 1,000,000,000,000 100,000,000 10,000 100 Money supply Price level 19251924192319221921 Price level Money supply Index (Jan. 1921 = 100) 100 10,000,000 100,000 1,000,000 10,000 1,000 19251924192319221921
    39. 39. Copyright © 2004 South-Western THE COSTS OF INFLATION • A Fall in Purchasing Power? • Inflation does not in itself reduce people’s real purchasing power.
    40. 40. Copyright © 2004 South-Western THE COSTS OF INFLATION • Shoeleather costs • Menu costs • Relative price variability • Tax distortions • Confusion and inconvenience • Arbitrary redistribution of wealth
    41. 41. Copyright © 2004 South-Western 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.
    42. 42. Copyright © 2004 South-Western Shoeleather Costs • 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.
    43. 43. Copyright © 2004 South-Western 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.
    44. 44. Copyright © 2004 South-Western Relative-Price Variability and the Misallocation of Resources • Inflation distorts relative prices. • Consumer decisions are distorted, and markets are less able to allocate resources to their best use.
    45. 45. Copyright © 2004 South-Western Inflation-Induced Tax Distortion • 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.
    46. 46. Copyright © 2004 South-Western Inflation-Induced Tax Distortion • 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.
    47. 47. Table 1 How Inflation Raises the Tax Burden on Saving Copyright©2004 South-Western
    48. 48. Copyright © 2004 South-Western Confusion and 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. 49. Copyright © 2004 South-Western A Special Cost of Unexpected Inflation: 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.
    50. 50. Copyright © 2004 South-Western Summary • The overall level of prices in an economy adjusts to bring money supply and money demand into balance. • When the central bank increases the supply of money, it causes the price level to rise. • Persistent growth in the quantity of money supplied leads to continuing inflation.
    51. 51. Copyright © 2004 South-Western Summary • The principle of money neutrality asserts that changes in the quantity of money influence nominal variables but not real variables. • A government can pay for its spending simply by printing more money. • This can result in an “inflation tax” and hyperinflation.
    52. 52. Copyright © 2004 South-Western Summary • According to the Fisher effect, when the inflation rate rises, the nominal interest rate rises by the same amount, and the real interest rate stays the same. • Many people think that inflation makes them poorer because it raises the cost of what they buy. • This view is a fallacy because inflation also raises nominal incomes.
    53. 53. Copyright © 2004 South-Western Summary • Economists have identified six costs of inflation: • Shoeleather costs • Menu costs • Increased variability of relative prices • Unintended tax liability changes • Confusion and inconvenience • Arbitrary redistributions of wealth
    54. 54. Copyright © 2004 South-Western Summary • When banks loan out their deposits, they increase the quantity of money in the economy. • Because the Fed cannot control the amount bankers choose to lend or the amount households choose to deposit in banks, the Fed’s control of the money supply is imperfect.
    55. 55. Inflation Hyperinflation Money Store of value Unit of account Medium of exchange Fiat money Commodity money Gold Standard Money supply Monetary policy Central Bank Federal Reserve Open-market operations Currency Demand deposits Quantity equation Transactions velocity of money Income velocity of money Real money balances Money demand function Quantity theory of money Seigniorage Nominal and real interest rates Fisher equation Fisher effect Ex ante and ex post real interest rates Shoeleather costs Menu costs Real and nominal variables Classical dichotomy Monetary neutrality

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