Lecture 2 Money and inflation

In this lecture, you will learn… The classical theory of inflation causes effects “Classical” – assumes prices are flexible & markets clear Applies to the long run

The connection between money 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 defined in terms of money, we need to consider the nature of money, the supply of money, and how it is controlled.

Money: Definition Money is the stock of assets that can be readily used to make transactions.

Money: Functions medium of exchange we use it to buy stuff store of value transfers purchasing power from the present to the future unit of account the common unit by which everyone measures prices and values 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.

The money supply and monetary policy definitions The money supply is the quantity of money available in the economy. Monetary policy is the control over the money supply. Again, this is mostly review.

The central bank Monetary policy is conducted by a country’s central bank. In Poland, the central bank is called the Narodowy Bank Polski (“NBP”). Again, this is mostly review.

Money supply measures, April 2006 symbol assets included amount ($ billions) $739 Currency C $1391 C + demand deposits, travelers’ checks, other checkable deposits M1 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. $6799 M1 + small time deposits, savings deposits, money market mutual funds, money market deposit accounts M2

Plot – money supply

Prices How to measure prices? Nominal vs real … GDP deflator Consumption expenditure … CPI Firms expenditure … PPI

Nominal GDP Suppose that we produce apples and oranges. 2000 2002 Apples (value) 5*2=10 5*3=15 Quantity 5 Price 2 3 Oranges (value) 2*2=4 3*1=3 1 Nominal GDP 10+4=14 15+3=18

Nominal GDP So, the nominal GDP was 14 in the year 2000 and 18 in the year 2002. The nominal GDP rises by 18 14 −1=28,4%

Real GDP Real GDP is computed with prices from a base year, let say 2000. 2000 2002 Apples (value) 5*2=10 Quantity 5 Price 2 Oranges (value) 2*2=4 3*2=6 3 Nominal GDP 10+4=14 15+3=16

Real DGP So, the real GDP increases by 16 14 −1=14,3% Real and nominal values differ and changes by different amount.

GDP deflator The GDP deflator reflects what’s happening to the overall level of prices in the economy. 𝑮𝑫𝑷 𝒅𝒆𝒇𝒍𝒂𝒕𝒐𝒓 = 𝒏𝒐𝒎𝒊𝒏𝒂𝒍 𝑮𝑫𝑷 𝒓𝒆𝒂𝒍 𝑮𝑫𝑷 ×𝟏𝟎𝟎 So 𝐺𝐷𝑃 𝑑𝑒𝑓𝑙𝑎𝑡𝑜𝑟 = 18 16 ×100=112,5

Consumer price index The most commonly used measure of the level of prices is the consumer price index (CPI). Based on value of a typical “basket” 𝑪𝑷𝑰= 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝒂 𝒃𝒂𝒔𝒌𝒆𝒕 𝟐𝟎𝟎𝟐 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝒂 𝒃𝒂𝒔𝒌𝒆𝒕 𝟐𝟎𝟎𝟎 ×𝟏𝟎𝟎 CPI turns the prices of many goods and services into a single index measuring the overall level of prices.

CPI Suppose, that a typical household buys 5 apples and 2 oranges. What is the CPI in the year 2002, if we choose the year 2000 as a base? 𝐶𝑃𝐼= 5∙3+2∙1 5∙2+2∙2 ×100= 17 14 ×100=121

CPI vs GDP deflator GDP deflator CPI Type of goods in the baskey All goods (consumer, firms, government) Only consumer goods Place of produciton Domestic Domestic and international Weights in the basket Changing Constant

Inflation Inflation is the percentage increase in the average level of prices. 𝜋 𝑡 = 𝑃 𝑡 − 𝑃 𝑡−1 𝑃 𝑡−1 Loss of money value Used for updating pensions etc.

U.S. inflation and its trend, 1960-2006 0% 3% 6% 9% 12% 15% 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 % change in CPI from 12 months earlier long-run trend

CPI vs. GDP deflator (inflation), US

Polish inflation: 1995-2014

Why inflation meter? Inflation changes the value of money in time. Suppose, you have 100zl today. How much money you should have to buy the same amount of goods next year, if the inflation is 𝜋=4%? Suppose, you will get 100zl next year, how much it is worth today? Present value is the today value of future money flow. 104 100/1,04 = 96,15

Exercise Inflation rate 01.01.2017 (PV) 01.01.2018 (FV) 0% 100 1% 5% 10% 20%

What are the inflation costs? Costs of expected inflation „Shoe-leather costs” new menu costs, inefficient allocation of resources, higher taxes higher risk

Quantity theory of money Velocity and money demand

The Quantity Theory of Money A simple theory linking the inflation rate to the growth rate of the money supply. 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 zl billion in transactions money supply = 100 zl billion The average zloty is used in five transactions in 2007 So, velocity = 5 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.

Velocity, cont. where V = velocity T = value of all transactions This suggests the following definition: where V = velocity T = value of all transactions M = money supply

Velocity, cont. Use nominal GDP as a proxy for total transactions. Then, where P = price of output (GDP deflator) Y = quantity of output (real GDP) P Y = value of output (nominal GDP) 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.

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 quantity equation 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 quantity equation 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 of money starts with quantity equation assumes V is constant & exogenous: With this assumption, the quantity equation can be written as

The quantity theory of money, cont. How 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). 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 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:

The quantity theory of money, cont.  (Greek letter “pi”) denotes the inflation rate: The result from the preceding slide was: Solve this result for  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 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.

The quantity theory of money, cont. Y/Y depends on growth in the factors of production and on technological progress (all of which we take as given, for now). Hence, the Quantity Theory predicts a one-for-one relation between changes in the money growth rate and changes in the inflation rate. 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.

Confronting the quantity theory with data The quantity theory of money implies 1. countries with higher money growth rates should have higher inflation rates. 2. the long-run trend behavior of a country’s inflation should be similar to the long-run trend in the country’s money growth rate. Are the data consistent with these implications?

International data on inflation and money growth Turkey Ecuador Indonesia Belarus Argentina U.S. Switzerland Singapore

U.S. inflation and money growth, 1960-2006 0% 3% 6% 9% 12% 15% 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 M2 growth rate Over the long run, the inflation and money growth rates move together, as the quantity theory predicts. inflation rate

Poland, inflation and money growth, 1995-2013

Inflation and the interest rate Fisher effect

Inflation and interest rates Nominal interest rate, i not adjusted for inflation Real interest rate, r adjusted for inflation: r = i   This is probably review, if your students have taken an introductory course in economics.

The Fisher effect The Fisher equation: i = r +  Previous lecture: S = I determines r . Hence, an increase in  causes an equal increase in i. This one-for-one relationship is called the Fisher effect. 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.)

Inflation and nominal interest rates in the U.S., 1955-2006 percent per year 15 nominal interest rate 10 5 inflation rate -5 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Inflation and nominal interest rates across countries Romania Zimbabwe Brazil Bulgaria Israel Germany U.S. Switzerland

Exercise: Suppose V is constant, M is growing 5% per year, Y is growing 2% per year, and r = 4. a. Solve for i. b. If the NBP increases the money growth rate by 2 percentage points per year, find i. c. Suppose the growth rate of Y falls to 1% per year. What will happen to  ? What must the NBP do if it wishes to keep  constant? This exercise gives students an immediate application of the Quantity Theory of Money and the Fisher effect. The math is not difficult.

Answers---the details: V is constant, M grows 5% per year, Y grows 2% per year, r = 4. a. First, find  = 5  2 = 3. Then, find i = r +  = 4 + 3 = 7. b. i = 2, same as the increase in the money growth rate. c. If the NBP does nothing,  = 1. To prevent inflation from rising, Fed must reduce the money growth rate by 1 percentage point per year. Answers---the details: a. First, we need to find . Constant velocity implies  = (M/M) - (Y/Y) = 5 - 2 = 3. Then, i = r +  = 4 + 3 = 7. b. Changes in the money growth rate do not affect real GDP or its growth rate. So, a two-point increase in money growth causes a two-point increase in inflation. According to the Fisher effect, the nominal interest rate should rise by the increase in inflation: two points (from i=7 to i=9). c.  = (M/M) - (Y/Y). If (Y/Y) falls by 1 point, then  will increase by 1 point; the Fed can prevent this by reducing (M/M) by 1 point. Intuition: With slower growth in the economy, the volume of transactions will be growing more slowly, which means that the need for new money will grow more slowly.

Two real interest rates  = actual inflation rate (not known until after it has occurred)  e = expected inflation rate i –  e = ex ante real interest rate: the real interest rate people expect at the time they buy a bond or take out a loan i –  = ex post real interest rate: the real interest rate actually realized

Money demand and the 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. 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).

Money demand Money demand function

The money demand function (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 function because money is the most liquid asset.)

The money demand function When people are deciding whether to hold money or bonds, they don’t know what inflation will turn out to be. Hence, the nominal interest rate relevant for money demand is r +  e.

The supply of real money balances Equilibrium The supply of real money balances Real money demand

What determines what variable how determined (in the long run) M exogenous (the NBP) r adjusts to make S = I Y P adjusts to make

How P responds to M For given values of r, Y, and  e, a change in M causes P to change by the same percentage – just like in the quantity theory of money. This slide shows the connection between the money market equilibrium condition and the (simpler) Quantity Theory of Money, presented earlier in this chapter.

What about expected inflation? Over the long run, people don’t consistently over- or under-forecast inflation, so  e =  on average. In the short run,  e may change when people get new information. EX: NBP announces it will increase M next year. People will expect next year’s P to be higher, ….so  e rises. This affects P now, even though M hasn’t changed yet…. This slide and the next correspond to the subsection of Chapter 4 entitled “Future Money and Current Prices,” appearing on pp.96-97.

How P responds to  e For given values of r, Y, and M ,

Questions How do the money demand respond to the rise of inflation? How do the money demand respond to the expected fall of income? The higher the nominal interest rate, the more costly is to keep cash and the lower is the money demand. The higher the income, the bigger the money demand.

Questions Lets assume a constant money supply M and constant prices P. How an interest rate will change if the income increases? What happens, when the central banks announces that it will increase the money supply but it will not? Q1 Money demand is increasing in the income Y and decreasing in the interest rate i. An increase in the income causes a rise of the money demand. In order to adjust the money demand to the real value of money M/P , the interest rate i must increase. Q2 The announcement causes the rise of expected inflation. The nominal interest rate will rise and the demand for money will fall. Smaller demand for money combined with a constant money stock M causes a rise of prices P. There is an inflation.

Hyperinflation Challenge for a central bank

Hyperinflation def:   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. 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.

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.

A few examples of hyperinflation money growth (%) inflation (%) 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

Why governments create hyperinflation When a government cannot raise taxes or sell bonds, it must finance spending increases by printing money. In theory, the solution to hyperinflation is simple: stop printing money. In the real world, this requires drastic and painful fiscal restraint. Before revealing the contents of this slide, you might consider asking students the following question: “Solving the problem of hyperinflation is easy. Why, then, do governments allow hyperinflation to occur?”

Summary Money and inflation

The Classical Dichotomy Real variables: Measured in physical units – quantities and relative 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 today Nominal variables: Measured in money units, 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.

The Classical Dichotomy Note: Real variables were explained in last lecture, nominal ones here. Classical dichotomy: the theoretical separation of real and nominal variables in the classical model, which implies nominal variables do not affect real variables. Neutrality of money: Changes in the money supply do not affect real variables. In the real world, money is approximately neutral in the long run.

Summary Money the stock of assets used for transactions serves as a medium of exchange, store of value, and unit of account. Commodity money has intrinsic value, fiat money does not. Central bank controls the money supply. Quantity theory of money assumes velocity is stable, concludes that the money growth rate determines the inflation rate.

Summary Nominal interest rate equals real interest rate + inflation rate the opp. cost of holding money Fisher effect: Nominal interest rate moves one-for-one w/ expected inflation. Money demand depends only on income in the Quantity Theory also depends on the nominal interest rate if so, then changes in expected inflation affect the current price level.

Summary Hyperinflation caused by rapid money supply growth when money printed to finance govt budget deficits stopping it requires fiscal reforms to eliminate govt’s need for printing money