ECON 366 Lecture 1 - Money and Inflation.pdf

Kwame Nkrumah University of
Science & Technology, Kumasi, Ghana
Daniel Sakyi (PhD)
Department of Economics
Faculty of Social Sciences
College of Humanities and Social Sciences
Money and Inflation
June 2022

Money and Inflation: The Plan
• What is money? What is inflation?
• What functions does money have?
• What determines demand and supply of money?
• What determines inflation in the long run?
• Can we finance government expenditure by ’printing
money’?
• How high should inflation be?

Money and inflation: Money
What is money? And what functions does money have?
• By “money” we do not mean wealth in general but money
that is used to make payments
• It is not obvious in the real world which asset should count
as money
• The most obvious is bills (notes) and coins, but there are
other assets that may be used to make payments
1. Medium of exchange (means of payment) - Payment of
goods and services and wage payments are made with money
2. Unit of account (unit of measurement) - Prices and wages
are set in terms of money
3. Store of value that does not yield interest - So the interest
rate is the opportunity cost of holding money

In the theoretical model developed here we assume that:
1. Money is used as a means of payment so the demand for
money depends upon the volume of transactions
2. Money is used as a unit of measurement: prices and
wages are set in terms of money
3. Money is a store of value (a form of savings) that
generates no interest so the interest rate is opportunity
cost of holding money
4. The central bank controls the money supply (i.e. the
quantity of money in circulation is controlled by the CB)
• NB: Money also serve as standard for deferred payment

In practice there are several ways to measure money:
• Monetary base (High-powered money): bills (paper
money) and coins in circulation plus deposits that banks
have in the central bank – MB = C + R
– The CB can control the monetary base – through
• Open Market Operations (OMO) where the CB buys/sells
government securities (mainly treasury bills or bonds) –
– If the CB buys government bonds from a bank, it pays by
transferring the money to the bank’s account thus
increasing the monetary base
• Overnight lending to banks
– This increases the monetary base
• NB – Monetary base and M1 are the empirical measures of the
stock of money

• M1: bills (paper money) and coins among the general
public plus demand deposits (‘immediately available
funds’)
– Demand deposits are accounts from which money can be
withdrawn at any time without notice.
– A problem with M1 definition is that it is not directly
controlled by the central bank.
– Individuals can easily transfer money between different
accounts, thereby changing M1
• M2: M1 plus deposits that cannot be immediately
withdrawn (deposits tied for a certain time etc.)
• M3: M2 plus money market fund shares and certain debt
securities

Monetary base is closest to our theoretical concept:
1. All payments take place using monetary base.
This is true also when we use a credit or debit card:
monetary base is transferred between banks.
2. Money is the unit of measurement for wages and prices.
3. Paper money (bills) and coins generate no interest and
bank funds kept overnight at the central bank generate
lower interest than the market interest rate.
4. The CB can perfectly control the monetary base using
‘outright’ open market operations, repurchase
agreements and overnight lending.

• Wider (broader) definitions of money (M2, M3 etc.)
correspond less closely to our theoretical concept:
• Savings/Time deposits and other financial assets may be
liquid (easy to sell) but they cannot be used to make
payments directly.
– These assets yield interest and costly to withdraw at
short notice
• Various deposits and financial assets yield interest which
is not the case with “money” in our model.
• In many countries there is no clear distinction between
‘demand deposits’ and ‘time deposits’.
• The CB cannot directly control the volumes of deposits and
other financial assets.

Money and inflation: Inflation
• A general increase in the price level from one year to the
next is called inflation
• Very high inflation causes economic costs because the
price system works less efficiently
• High inflation makes it hard to keep track of and to
compare prices
• Fluctuations in inflation lead to random gains and losses
for borrowers and lenders
• Maintaining low and stable rate of inflation is the primary
goal of most central banks

Money and inflation: Inflation
• So which factors determine inflation?
• We will show in this lecture that the CB can control the
long-run rate of inflation because
– It control the quantity of money in circulation (the
money supply)
• Money is the unit of account, so prices of goods and
services are expressed in terms of money
– If there is more money ‘chasing’ available goods and
services, the price level will increase
– We would expect that, if the quantity of money in
circulation increases, prices will also increase
• The relation b/n money growth and inflation is far from
stable, but, all else being equal,
– The CB can reduce or increase the rate of inflation by
reducing or increasing the rate of money growth

Money and inflation: Demand for money
Money and Inflation in the long run
What determines the demand for money?
𝑀 ⋅ 𝑉 = 𝑃 ⋅ 𝑌
• Mis the supply of money in circulation
• V is the turnover speed of money
• P is the price level
• Y is production
NB: We assume that money has an exogenous fixed velocity
of circulation
Example: Suppose that households are paid each month and
they use the money to buy goods from firms during the
month, then V=12.

Alternative 1: Constant V
• Demand for money
𝑀𝑑 =
1
𝑉
𝑃𝑌
If V=12 demand for money is 1/12 of GDP
• Real demand for money is proportional to real production
(income):
𝑀𝑑
𝑃
=
1
𝑉
𝑌

Alternative 2: V is an increasing function of the nominal
interest rate, V=V(i)
• One of the factors that affect velocity is the interest rate
• If interest rate is high, it is plausible that people will be less
willing to hold money
• This means that money will circulate at a faster rate
– so, the velocity of money is an increasing function of the
interest rate
• From MV=PY, 𝑀 =
1
𝑉 𝑖
𝑃𝑌

• Real demand for money
𝑀
𝑃
=
𝑌
𝑉 𝑖
• The equations says that the available supply of money,
measured in real terms, equals the real demand for money
• The right side is therefore the amount of money that
households, firms, and banks want to have to carry out their
transactions
Real demand for money
𝑀
𝑃
=
𝑀𝑑
𝑃
=
𝑌
𝑉 𝑖
• increases with Y (level of real production)
• decreases with i (nominal interest rate)
• NB: The interest rate is the opportunity cost of holding
money so if the interest rate increases, demand for money
will decrease

Money and inflation: Money and inflation in the
long run
Equilibrium (supply of money = demand for money):
• Real supply of money:
𝑀
𝑃
Demand for money:
𝑌
)
𝑉(𝑖
• In equilibrium:
𝑀
𝑃
=
𝑌
𝑉 𝑖
What happens if the CB increases the money supply M? Three
alternatives:
o Y increases?
o i decreases?
o P increases?
The analysis depends on what time perspective we consider.
Short run: prices are rigid. Long run: prices adjust.

long run
Here we consider the long run:
• Production is given by 𝑌𝑛
• Real interest is given by 𝑟 = 𝑟𝑛
• Nominal interest is given by 𝑖 = 𝑟𝑛 + 𝜋
Equilibrium condition
𝑀
𝑃
=
𝑌𝑛
𝑉 𝑟𝑛+𝜋
So we get the price level: 𝑃 =
𝑀𝑉 𝑟𝑛+𝜋
𝑌𝑛

long run
Price level: 𝑃 =
𝑀𝑉 𝑟𝑛+𝜋
𝑌𝑛
Assume that 𝑟𝑛
,𝜋 and V are constant
Inflation when 𝑌 = 𝑌𝑛: 𝜋 =
𝛥𝑃
𝑃
=
𝛥𝑀
𝑀
−
𝛥𝑌𝑛
𝑌𝑛
Conclusion: If the money supply grows faster than
equilibrium production, the result is inflation

long run
• In the long run, inflation does not affect real variables (the
classical dichotomy)
• Higher money supply growth brings higher inflation
ceteris paribus
• Milton Friedman: ‘Inflation is always and everywhere a
monetary phenomenon’
• Yes, in the long run!

long run

long run
• Very high money supply growth leads to high inflation –
support for the theory
• No correlation when money supply growth is low:
V is far from constant
• A theory that assumes that V is constant in the short run is
not useful for predicting inflation
• But our theory says that ceteris paribus increased money
supply growth leads to increased inflation.
• Hence the CB can control long run (average) inflation if
they want to.

Money and inflation: Seignorage and inflation tax
• Can we finance governement expenditure by "printing
money” (increasing the monetary base)?
• Yes, but only to a small extent
• The CB can control the monetary base. It can create as
much monetary base as it wants
• The monetary base needs to increase if the volume of
transactions increases over time
• In order to increase the monetary base the CB lends money
– to the government (when it buys government bonds, it
is effectively lending to the government)
– to the private sector
• To sell bonds to the CB is one way in which a government
can finance a deficit

• The revenue from money created in this way is called
Seinorage
• Seinorage can be seen as profit made by a government by
issuing currency
– especially the difference between the face value of coins
and their production costs
• If we use M to represent monetary base and ∆M is the
increase of the monetary base, then Seinorage as a
proportion of GDP is ∆M/PY
• Lets assume that real GDP increases (𝑔𝑦) at the rate g+n
where g is technological progress and n is the population
growth rate

• From M=PY/V if we use the rule of thum for growth rates
and we assume that velocity is constant then
∆𝑀
𝑀
= 𝜋 + 𝑔 + 𝑛
∆𝑀
𝑃𝑌
= 𝜋 + 𝑔 + 𝑛
𝑀
𝑃𝑌
=
𝜋 + 𝑔 + 𝑛
𝑉
• Assume that velocity is constant at V=12, real GDP
increases 3 percent per year and inflation is 3 percent
𝑀 =
𝑃𝑌
𝑉
⇒
𝛥𝑀
𝑀
= 𝜋 + 𝑦𝑔 = 0,03 + 0,03 = 0,06
𝛥𝑀
𝑃𝑌
=
𝛥 Τ
𝑀 𝑀
𝑃 Τ
𝑌 𝑀
=
0.06
12
= 0.005 = 1/2 percent of GDP
- Seinorage is ½ percent of GDP
• If you try to finance a more substantial share of
expenditure you will create hyperinflation

• Seignorage arise for two reasons
– Real growth increases the demand for monetary base
– Inflation reduces the real value of the monetary base so
the monetary base must increase in nominal terms –
this part is seen as an inflation tax
• Inflation tax – expressed as a fraction of GDP it is the
inflation rate divided by the velocity of the monetary base,
Τ
𝜋
𝑉

Money and inflation: How high should inflation
be?
Problems with too high inflation:
• ‘Menu costs’
• More difficult to compare prices when price observations
quickly become out of date
• Inefficient changes of relative prices when prices change at
different times
• Unintended redistribution via on tax and transfer systems
which remain fixed in nominal terms
• Unexpected inflation: wealth redistribution associated
with long-term contracts (wages, loans)

be?
Problems with low inflation:
• Obstructs real wage adjustment if nominal wages are
sluggish downwards
• Monetary policy may be constrained because the interest
rate cannot be lower than zero

be?
Conclusions:
• Very high inflation leads to substantial losses
• Zero inflation can cause problems
• Some positive rate of inflation is optimal but hard to say
exactly what rate
• Many central banks have an inflation targets in range 2-3
per cent and manage to keep inflation close to this
• In the short run they decide about the interest rate rather
than the money supply – see Chapter 10

www.knust.edu.gh
The End
Next Lecture: Interest Rate
and Inflation in the Short Run

ECON 366 Lecture 1 - Money and Inflation.pdf

Recommended

Recommended

More Related Content

Similar to ECON 366 Lecture 1 - Money and Inflation.pdf

Similar to ECON 366 Lecture 1 - Money and Inflation.pdf (20)

Recently uploaded

Recently uploaded (20)

ECON 366 Lecture 1 - Money and Inflation.pdf