Money and Inflation Topic 7: (chapter 4) I’ve included a graph that unfolds over slides 27-31 that tells the same story as Figure 4-1 on p.86 of the text. If you prefer to show Figure 4-1, you can “hide” slides 27-31 and “unhide” slide 26.

In this chapter you will learn The classical theory of inflation causes effects social costs “Classical” -- assumes prices are flexible & markets clear. Applies to the long run.

U.S. inflation & its trend, 1960-2001 In the short run, supply shocks and other factors can push inflation above or below its long-run trend. We study those factors in chapter 13 (on Aggregate Supply and the Phillips Curve). In this chapter, we learn about the long-run trend behavior of prices and inflation.

The connection between money and prices Inflation rate = _____________ _____________. 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 _____ _______________ _______________.

Money: functions _________________ we use it to buy stuff _________________ transfers purchasing power from the present to the future _________________ 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 Greg’s wording is a bit more sophisticated than most other texts.

Money: types ____________ has no intrinsic value example: the paper currency we use has intrinsic value examples: gold coins, cigarettes in P.O.W. camps 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. The textbook (p.78) has a case study on cigarettes being used as money in POW camps during WWII.

Discussion Question Which of these are money? a. Currency b. Checks c. Deposits in checking accounts (called demand deposits) d. Credit cards e. Certificates of deposit (called time deposits) 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 (“Hey, I just bought a $1000 CD, dude!”). They are not readily spendable, though.

The money supply & monetary policy The __________ is the quantity of money available in the economy. ___________ is the control over the money supply. Again, this is mostly review. $$$

The Federal Reserve Building Washington, DC The central bank Monetary policy is conducted by a country’s ___________. The Federal Reserve Building Washington, DC In the U.S., the central bank is called the Federal Reserve (“the Fed”). Again, this is mostly review.

Money supply measures, April 2002 _Symbol Assets included Amount (billions)_ C Currency $598.7 M1 C + ___________, 1174.0 travelers’ checks, other checkable deposits M2 M1 + _____________, 5480.1 savings deposits, money market mutual funds, money market deposit accounts M3 M2 + ____________, 8054.4 repurchase agreements, institutional money market mutual fund balances 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 balances (in M2 but not M1) are less liquid than demand deposits. Large time deposits (those over $100,000 and therefore not Federally insured) are less liquid than small time 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.

The Quantity Theory of Money A simple theory linking the inflation rate to the growth rate of the money supply. Begins with a concept called “velocity”…

Velocity basic concept: the rate at which money circulates definition: ___________________ ____________________________ example: In 2001, $500 billion in transactions money supply = $100 billion The average dollar is used in five transactions in 2001 So, velocity = ___ 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. 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 here on out, we’ll use the income version of velocity.

The quantity equation The quantity equation ____________ 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 = _________________, the purchasing power of the money supply. A simple money demand function: (M/P )d = ____ 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: ________ When people hold lots of money relative to their incomes (k is ________), money changes hands infrequently (V is _______).

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 ____________ (P Y ) ___________ is determined by the economy’s supplies of K and L and the production function (chap 3) The price level is P = ___________________

The Quantity Theory of Money, cont. The quantity equation in growth rates:

The Quantity Theory of Money, cont. Let  (Greek letter “pi”) denote 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. ___________________________________________________.

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 of Money predicts a ______________________________________________________________________________________________________________________________. 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.

International data on inflation and money growth

U.S. data on inflation and money growth

Seigniorage To spend more without raising taxes or selling bonds, the govt can print money. The “revenue” ________________________ _______________________ The __________: Printing money to raise revenue causes inflation. Inflation is like a tax on people who hold money. Introduction of abbreviation “govt” for “government” It’s quicker and easier for students to write “govt” in their notes. In the U.S., seigniorage accounts for only about 3% of total government revenue. In Italy and Greece, seigniorage has often been more than 10% of total revenue. In countries experiencing hyperinflation, seigniorage is often the government’s main source of revenue, and the need to print money to finance government expenditure is a primary cause of hyperinflation. See Case Study on p.88 “Paying for the American Revolution.”

Inflation and interest rates _________ interest rate, i not adjusted for inflation __________ interest rate, r adjusted for inflation: r = i  

The Fisher Effect The Fisher equation: __________ Chap 3: S = I determines r . Hence, an increase in  causes an equal increase in i. This one-for-one relationship is called the ___________.

U.S. inflation and nominal interest rates, 1952-1998 Percent 16 14 12 10 8 Nominal interest rate 6 4 Inflation rate 2 -2 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 Year

Inflation and nominal interest rates across countries

Exercise: Suppose V is constant, M is growing 5% per year, Y is growing 2% per year, and r = 4. Solve for i (the nominal interest rate). If the Fed increases the money growth rate by 2 percentage points per year, find i . Suppose the growth rate of Y falls to 1% per year. What will happen to ? What must the Fed 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: Suppose V is constant, M is growing 5% per year, Y is growing 2% per year, and r = 4. . 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) by 1 point, then  will increase by 1 point; the Fed can prevent this by reducing (M/M) by 1 point.

Two real interest rates  = actual inflation rate (not known until after it has occurred) e = expected inflation rate i – e = ___________ real interest rate: ______________________________________ _____________________ i –  = ____________ real interest rate: ______________________________________ _______________________

Money demand and the nominal interest rate The Quantity Theory of Money assumes that the demand for real money balances depends only on real income Y. We now consider another determinant of money demand: the nominal interest rate. The nominal interest rate i is the ____________________________ (instead of bonds or other interest-earning assets). Hence, ______________________.

The money demand function (M/P )d = real money demand, depends ____________ i is the opp. cost of holding money 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 ________.

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 r Y P

How P responds to M For given values of r, Y, and e, a change in M causes P to ______ _________________________ --- 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 e =  on average. In the short run, e may change when people get new information. EX: Suppose Fed announces it will increase M next year. People will expect next year’s P to be higher, so e rises. This will affect P now, even though M hasn’t changed yet. (continued…)

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

Why is inflation bad? Discussion Question What costs does inflation impose on society? List all the ones you can think of. Focus on the long run. Think like an economist. Many of the social costs of inflation are not hard to figure out, if students “think like an economist.” Suggestion: After you pose the question, don’t immediately ask for students to volunteer their answers. Instead, tell them to think about the question for a moment, jot down their answers, and THEN ask for volunteers. You will get more participation (quantity & quality) this way, especially from students who don’t consider themselves fast thinkers. After presenting the following slides (which describe the costs), see if you can map students’ responses to this slide into the different costs listed on the following ones.

A common misperception Common misperception: inflation reduces real wages This is true only in the short run, when nominal wages are fixed by contracts. (Chap 3) 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. Consider the data…

The classical view of inflation The classical view: A change in the price level is merely a change in the units of measurement. So why, then, is inflation a social problem?

The social costs of inflation …fall into two categories: 1. costs when inflation is expected 2. additional costs when inflation is different than people had expected.

The costs of expected inflation: 1. __________________ def: the costs and inconveniences of reducing money balances to avoid the inflation tax.   i   real money balances Remember: In long run, inflation doesn’t 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. ___________ def: __________________________. Examples: print new menus print & mail new catalogs The higher is inflation, the more frequently firms must change their prices and incur these costs.

The costs of expected inflation: 3. __________________ Firms facing menu costs change prices infrequently. Example: Suppose 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… …which cause microeconomic inefficiencies in the allocation of resources.

The costs of expected inflation: 4. _________________ Some taxes are not adjusted to account for inflation, such as the capital gains tax. Example: 1/1/2001: you bought $10,000 worth of Starbucks stock 12/31/2001: you sold the stock for $11,000, so your nominal capital gain was $1000 (10%). Suppose  = 10% in 2001. Your real capital gain is $0. But the govt requires you to pay taxes on your $1000 nominal gain!! 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.

The costs of expected inflation: 5. __________________ Inflation makes it harder to compare nominal values from different time periods. This complicates long-range financial planning. 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. :)

Additional cost of unexpected inflation: _________________________________ Many long-term contracts not indexed, but based on e. If  turns out different from e, then some gain at others’ expense. Example: borrowers & lenders If  > e, then _______________ and purchasing power is transferred from ___________________. If  < e, then purchasing power is transferred from ______________. 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 nice example on p.99 (at the top of the page). (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.)

Additional cost of high inflation: _________________________ When inflation is high, it’s more variable and unpredictable:  turns out different from 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, which makes risk averse people worse off.

One benefit of inflation Nominal wages are rarely reduced, even when the equilibrium real wage falls. Inflation allows the real wages to reach equilibrium levels without nominal wage cuts. Therefore, moderate inflation improves the functioning of labor markets.

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. The bottom half of p.102 has two excellent examples of life during a hyperinflation, both involving beer, a commodity with which some of your students may be somewhat familiar. See also the excellent case study on pp.103-104.

What causes hyperinflation? Hyperinflation is caused by ____________________________: When the central bank prints money, the price level rises. If it prints money rapidly enough, the result is hyperinflation.

Recent episodes of hyperinflation slide 56

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: _______________. In the real world, ___________________________________________________.

The Classical Dichotomy Real variables are ________________________: quantities and relative prices, e.g. quantity of output produced ________: output earned per hour of work _________: output earned in the future by lending one unit of output today Nominal variables: ___________________, e.g. _________: dollars per hour of work ________________: dollars earned in future by lending one dollar today _____________: the amount of dollars needed to buy a representative basket of goods slide 58

The Classical Dichotomy Note: Real variables were explained in Chap 3, nominal ones in Chap 4. Classical Dichotomy : the theoretical separation of real and nominal variables in the classical model, which implies _______________________________________________________________________. _________________ : Changes in the money supply do not affect real variables. In the real world, money is approximately neutral in the long run.

Chapter summary 1. Quantity theory of money 2. Money demand assumption: velocity is stable conclusion: the money growth rate determines the inflation rate. 2. Money demand depends on income in the Quantity Theory more generally, it also depends on the nominal interest rate;

Chapter summary 3. Nominal interest rate 4. Hyperinflation equals real interest rate + inflation. Fisher effect: it moves one-for-one with expected inflation. 4. Hyperinflation caused by rapid money supply growth when money printed to finance government budget deficits stopping it requires fiscal reforms to eliminate govt’s need for printing money

Chapter summary 5. Classical dichotomy In classical theory, money is neutral--does not affect real variables. So, we can study how real variables are determined w/o reference to nominal ones. Then, eq’m in money market determines price level and all nominal variables.