Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 8-1 CHAPTER 8 Money, Prices, and Inflation

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 8-2 Questions What do economists mean by “money”? Why is money useful? What do economists mean when they say that money is a unit of account? What determines the price level and the inflation rate?

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 8-3 Questions Why would a government ever generate “hyperinflation”? What determines the level of money demand? What determines the level of the money supply? Why is inflation seen as something to be avoided?

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 8-4 Inflation In the 1970s, the United States experienced an episode of relatively mild inflation –prices rose between five and ten percent per year –caused significant economic and political trauma avoiding a repeat of the inflation of the 1970s remains a major goal of economic policy

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 8-5 Figure Post-World War II Inflation in the United States,

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 8-6 The Flexible-Price Model The Classical dichotomy implies that real variables (real GDP, real investment spending, or the real exchange rate) can be analyzed and calculated without considering nominal variables (price level) –money is “neutral” This is a special feature of the full- employment flexible-price model

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 8-7 Money is wealth that is held in a readily- spendable form is made up of –coin and currency –checking account balances –other assets that can be turned into cash or demand deposits nearly instantaneously, without risk or cost

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 8-8 The Usefulness of Money Without money, market transactions would have to be performed through barter In a barter economy, market exchange would require the coincidence of wants –you would have to have some good or service that someone wants and he or she would have to have some good or service that you want

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 8-9 Figure Coincidence of Wants

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Usefulness of Money Money also serves as a unit of account –money is used as a yardstick to measure value or quote prices Anything that alters the real value of money in terms of its purchasing power will also alter the real terms of existing contracts that use the money as a unit of account

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Demand for Money Businesses and households have a demand for money –they want to hold a certain amount of wealth in the form of readily-spendable purchasing power to carry out transactions a higher level of spending means a larger money demand There is a cost of holding money –cash and checking deposits earn little or no interest

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure Reasons for and Opportunity Cost of Holding Money

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Quantity Theory of Money assumes that the only important determinant of the demand for money is the flow of spending can be summarized using –the Cambridge money-demand function –the quantity equation

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Quantity Theory of Money (P  Y) represents the total nominal flow of spending M is the quantity of money V is a measure of how fast money moves through the economy –how many times the average unit of money is used to buy a final good or service

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure The Velocity of Money

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Determining the Price Level In the flexible-price model of the macroeconomy –real GDP (Y) is equal to potential GDP (Y*) –the velocity of money is determined by the sophistication of the banking system –the money supply is determined by the central bank

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Determining the Price Level If the price level is higher than the quantity equation predicts –households and businesses will have less wealth in the form of money than they wish they will cut back on purchases –sellers will note demand is weak and lower prices

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Determining the Price Level If the price level is lower than the quantity equation predicts –households and businesses will have more wealth in the form of money than they wish they will increase purchases –sellers will note demand is strong and raise prices

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Determining the Price Level Example (third quarter of 1998) –real GDP = $7,566 billion –money stock = $1,072 billion –velocity = In the third quarter of 1998, the price level was equal to % of its 1992 level

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Money Stock The Federal Reserve determines the money stock in the U.S. –the determination of the money stock is the basic task of monetary policy The Federal Reserve can directly impact the monetary base –the sum of currency in circulation and deposits at the Federal Reserve’s twelve branches

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Money Stock To reduce the monetary base, the Federal Reserve sells short-term government securities To increase the monetary base, the Federal Reserve buys short-term government securities These transactions are called open market operations

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure Open Market Operations

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Money Stock The Federal Reserve directly controls the monetary base The other measures of the money stock are determined by the interaction of the monetary base with the banking sector –regulatory requirements –the incentive of financial institutions to have enough funds on hand to satisfy depositors’ demands

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Money Stock Besides the monetary base (H), there are other definitions of the money stock such as –M1 (currency, checking accounts, travelers checks) –M2 (M1 plus savings accounts, small term deposits, money held in money market accounts) –M3 (M2 plus large term deposits and institutional money market balances)

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Table Measures of the Money Stock

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Inflation The inflation rate is the proportional rate of change in the price level Since the inflation rate () will be –v=growth rate of velocity –m=growth rate of the money stock –y=growth rate of real GDP

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Inflation Example –growth rate of real GDP=4% per year –growth rate of velocity=2% per year –growth rate of the money stock=5% per year

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Inflation The bulk of changes in the rate of inflation are due to changes in the growth rate of the money stock –the growth rate of the money stock (m) can change quickly and substantially –changes in the growth rates of real GDP (y) and velocity (v) are generally smaller

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Inflation In the real world, inflation is not always proportional to money growth –in the 1980s, both inflation and velocity fell sharply but the money stock grew –in the first half of the 1990s, velocity fell meant that high growth of the money stock did not lead to high inflation –in the second half of the 1990s, velocity grew money supply growth was negative to keep inflation from rising

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure Money Growth and Inflation Are Not Always Parallel

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Money Demand Economic theory implies that money demand should be inversely related to the nominal interest rate –cash and checking account balances earn little or no interest –the purchasing power of money erodes at the rate of inflation –the expected real return on money is - e

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Money Demand The opportunity cost of holding money is the difference between the rate of return on other assets (r) and the rate of return on money (- e ) –the opportunity cost of holding money is the nominal interest rate [i=r+ e ] As the opportunity cost of holding money (i) rises, the quantity of money balances demanded falls

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure Money Demand and the Inflation Rate

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Money Demand The velocity of money can be represented by –V L represents the financial technology- driven trend in velocity –V 0 +V i (r+ e ) represents the dependence of the demand for money on the nominal interest rate

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Money Demand The demand for nominal money balances is

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Money, Prices, and Inflation Suppose that the rate of growth of the money stock permanently increases –the inflation rate will rise –if the real interest rate is stable, the opportunity cost of holding money will rise –the velocity of money will increase –if the money stock and real GDP remain fixed, the price level will jump suddenly and discontinuously

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure Effects of a Rise in Money Growth

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Costs of Inflation The costs of expected inflation are small –requires you to make more trips to the bank –firms must spend resources changing their prices –households find it difficult to determine a good deal from a bad one –our tax laws are not designed to deal well with inflation

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Costs of Inflation The costs of unexpected inflation are more significant –redistributes wealth from creditors to debtors creditors receive less purchasing power than they had anticipated debtors find the payments they must make less burdensome than they had expected

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Hyperinflation occurs when inflation rises to more than 20 percent per month arises when governments attempt to obtain extra revenue by printing money –financing its spending by levying a tax on holdings of cash –known as an inflation tax

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure The Inflation Tax

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Hyperinflation Eventually prices rise so rapidly that the monetary system breaks down –people would rather deal in barter terms Real GDP begins to fall –the economy loses the benefits of the division of labor In the end, the currency becomes worthless

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Chapter Summary By “money” economists mean something special: wealth in the form of readily-spendable purchasing power Without money it is hard to imagine how our economy could successfully function –the fact that everyone will accept money as payment for goods and services is necessary for the market economy to function

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Chapter Summary Money is not only a medium of exchange, it is also a unit of account: a yardstick that we use to measure values and to specify contracts

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Chapter Summary Money demand is determined by –businesses’ and households’ desire to hold wealth in the form of readily- spendable purchasing power to carry out transactions –businesses’ and households’ recognition that there is a cost to holding money wealth in the form of readily-spendable purchasing power pays little or no interest

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Chapter Summary The velocity of money is how many transactions a given piece of money manages to facilitate in a year –the principal determinant of velocity is the economy’s “transactions technology” The stock of money is determined by the central bank –the Federal Reserve in the U.S.

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Chapter Summary The price level is equal to the money stock times the velocity of money divided by the level of real GDP The inflation rate is equal to the proportional growth rate of the money stock plus the proportional growth rate of velocity minus the proportional growth rate of real GDP

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Chapter Summary Governments cause hyperinflation because printing money is a way of taxing the public, and a government that cannot tax any other way will be strongly tempted to resort to it