This document discusses money, inflation, and their relationship. It defines money as an asset used to purchase goods and services that serves as a medium of exchange, unit of account, and store of value. The document outlines different monetary aggregates (M0, M1, M2) and explains how too much money growth can lead to inflation according to the quantity theory of money. While money and inflation are linked in the long run, the relationship breaks down in the short run, allowing monetary policy to influence output.

1. Money and Inflation
Ryan Herzog, Ph.D.
Associate Professor Economics

2. Key Questions
• What is money?
• How do we measure money?
• What is the link between inflation and
money?
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3. Readings
• The Plodding Dollar (FRED Blog)
• What Does Money Velocity Tell Us about Low
Inflation in the U.S.?
• The Disconnect Between Inflation and
Employment
• The New Normal and What it Means for
Monetary Policy
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4. The Use of Money
• Money is an asset that is generally accepted as payment for goods and
services or repayment of debt.
• Income is a flow of earnings over time, where wealth is the value of
assets minus liabilities.
• Functions of money:
– Medium of exchange: Money must serve as a medium of exchange. It needs
to be commonly accepted for the purchase of goods and services.
– Unit of account: Money must be able to measure the value of a good or
service. It serves as a yardstick for comparison.
– Store of value: Money must be able to hold value over time.
• Liquidity: is a measure of the ease with which an asset can be turned into
a means of payment.
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5. Credit and Debit Cards
• Are credit/debit cards money?
• A debit card works like a check only faster.
Funds are immediately removed from your
account.
• A credit card makes a deferred payment.
– If not paid on time, there is a late fee.
– If not paid fully, there is interest on the debt.
– It is an interest free loan for a period of time.
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6. Evolution of the Payments
System
• Commodity Money:
– valuable, easily standardized and divisible
commodities (e.g. precious metals, cigarettes)
• Fiat Money:
– paper money decreed by governments as legal
tender

7. Evolution of the Payments
System
• Checks:
– an instruction to your bank to transfer money
from your account
• Electronic Payment (e.g. online bill pay).
• E-Money (electronic money):
– Debit card
– Stored-value card (smart card)
– E-cash

8. Are We Headed for a Cashless
Society?
• Predictions of a cashless society have been
around for decades, but they have not come to
fruition.
• Although e-money might be more convenient and
efficient than a payments system based on paper,
several factors work against the disappearance of
the paper system.
• However, the use of e-money will likely still
increase in the future.

9. Will Bitcoin Become the
Money of the Future?
• Bitcoin is type of electronic money created in
2009.
• By “mining,” Bitcoin is created by decentralized
users when they use their computing power to
verify and process transactions.
• Although Bitcoin functions as a medium of
exchange it is unlikely to become the money of
the future because it performs less well as a unit
of account and a store of value.

10. Bitcoin
• Bitcoin is “a decentralized peer-to-peer
network that allows for the proof and transfer
of ownership with the need for a trusted third
party.”
– The technology used to record Bitcoin ownership
is the block chain
• The block chain is an ever-growing public
ledger of transactions that is encrypted and
distributed over a network of computers.
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11. Bitcoin
• Advocates view Bitcoin as a new form of digital
money with two advantages
– 1. Its value cannot be undermined by government
fiat
– 2. Its users can remain anonymous
• Bitcoin lacks the key characteristics of money
• Can private currency—digital or otherwise—do a
job better as money than what we currently
have?
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12. Commodity and Fiat Monies
• Commodity monies are things with intrinsic
value.
– Usable by most people
• Able to be made into standardized quantities, durable,
easily transportable, and divisible into smaller units.
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13. History of Commodity and
Fiat Money
• Gold has been the most common as it meets these requirements.
• In 1656, Stockholm Banco issued Europe’s first paper money King
of Sweden printed too many to try to finance a war and the bank
failed.
• In 1775, the Continental Congress of the United States of America
issues continentals to finance the Revolutionary War.
• Because of huge quantities issued, people became suspicious of
government-issued paper money.
• In 1862, the Confederate and the Union governments printed
money with no backing. After the Civil War, the US reverted to
using gold as money.
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14. Fiat Money
• Gold coins and notes, backed by gold, were used
into the 20th century.
• Todays paper money is called fiat money, because
its value comes from government decree, or
fiat.
• We are willing to accept these bills as payment
because the US government stands behind its
paper money.
• In the end, money is about trust. (Discuss more in
monetary policy goals and objectives)
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15. Money and Inflation
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16. Monetary Aggregates
• M0 or Monetary Base includes currency and
bank reserves
• M1 includes currency, checkable deposits and
travelers checks.
• M2 includes M1 plus savings accounts, money
market accounts, short term time deposits,
other stuff.
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17. Monetary Aggregates
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Value (billions)
M1 = Currency $1,598.6
(+) Traveler’s checks $.....
(+) Demand deposits $1,433.9
(+) Other checkable deposits $621.8
Equals Total M1 $3,656.1
M2 = M1
(+) Small-denomination time deposits $491.3
(+) Savings deposits and money market deposit accounts $9,275.4
(+) Money market mutual fund shares (retail) $767.9
Equals: Total M2 $14,190.6

18. Components of M1
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19. Components of M2
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20. Money, Inflation, and Interest
• With inflation, you need more money to buy
the same basket of goods.
– The primary cause of inflation is too much money.
– How do we define money?
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21. Growth of M1 and M2
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22. Money and Inflation
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23. Q-Theory of Money
• The quantity theory of money states that the
price level is proportional to the level of money:
– Mt x Vt P t x Yt
– where M is the supply of money, V is the velocity of
money which equals the average number of times per
period that each unit of money is spent, P is the price
index of the items traded, and Y is real GDP.
• The right hand side is nominal GDP
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24. Q-Theory of Money
• Two key assumptions:
– The velocity (V) of money is constant in the short
run
– Changes to P do not affect Y, Y is considered
constant in the short run.
• These assumptions imply:
• 𝑀 × 𝑉 = 𝑃 × 𝑌
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25. Velocity of Money
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26. Velocity of Money
• We can also use the equation of exchange to show the
relationship between money and inflation:
• %∆M + %∆V = %∆P + %∆Y
• Subtract %∆Y from both sides then:
• π = %∆P = %∆M + %∆V − %∆Y
• If we assume velocity is held constant then:
• π = %∆M − %∆Y
• Inflation will increase as money growth exceeds output
growth.
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27. Predicting Velocity
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28. Predicting Velocity
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29. Money and Inflation
• How robust is the relationship between money and
inflation?
• The relationship between money growth and inflation does
hold in the long run but not in the short run.
• This suggests that money is not neutral in the short run. We
can use money to change output.
• Since money is not neutral we can use monetary policy in
the short run (and perhaps long run).
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