Lecture 4 Money and inflation

Example: Zimbabwe hyperinflation

What happened?  A dramatic increase in government expenditure.  For example, in 2006:  Soldiers salary was raised by 300%  Police’ salary was raised by 200%  Government had no money to do that – they print money.

Right now  Since April 2009, all transactions are done in foreign currencies, such as the US dollar or South Africa’s Rand.

Price of a daily newspaper  Jan 1921: 0.30 mark  May 1922: 1 mark  Oct 1922: 8 marks  Feb 1923: 100 marks  Sep 1923: 1,000 marks  Oct 1, 1923: 2,000 marks  Oct 15, 1923: 1 million marks  Nov 17, 1923: 17 million marks

This lecture  Quantity theory of money  how inflation is determined.  Demand for money  a link between output and money  Fisher equation

Why could this happen?  What is money?  A store of value  A medium of exchange  A unit of account

Money supply measure  CCurrency $715.4 billion  M1Currency + demand deposits + Checking accounts $ billion  M2M1 + retail money market mutual fund + Saving deposits $ billion  M3M2 + repurchase agreements $ billion  Note: US GDP is trillion

Money supply in US  Open market operations Sell bond  decrease money supply Buy bond  increase money supply  Reserve requirement  The discount rate

Money supply in US

Banks borrowing from Fed

US money supply

Velocity  Basic concept: the rate at which money circulates.  Example: In 2009, US GDP: $14000 billion Money supply = $700 billion (M1) The average dollar is used 20 times. So velocity = 20

Quantity theory of money  V = velocity  T = value of all transactions (T = PY)  M = money supply. Money * Velocity = Price * Output M * V = P * Y

Quantity theory of money  Take the log of previous equation: (1)  Since it works for time t, it also works for time t-1: (2)  Equations (1) – (2), we have: (3)

Quantity theory of money  Equation (3) says: % change in M + % change in V = % change in P + % change in Y

Inflation and money supply

Demand for money  Consider the “trip to the bank” story:  People would have some of their income in their pocket, and the rest in a bank.  When the money in his pocket is lower than some number, he would take a trip to the bank to “refill” his pocket.  Therefore, factors that affect the number of the trips would affect his demand for money.

Demand for money  Income effect: When a person has a higher income, it is more costly for him to go to the bank (opportunity cost is high). When a person has a higher income, he would typically consume more – therefore he needs more money in his pocket.

Demand for money  Interest effect: When the nominal interest rate is higher, putting money in the bank would earn more interests  less money in his pocket.  Price effect: Higher price would require more money in the pocket.

Demand for money  Money demand equation  α and β are two positive numbers: α represents the relationship between money demand and the income β represents the relationship between money demand and nominal interest rate.

Discussion:  If, because of increasing popularity of credit use, people carry almost no cash in their pockets, regardless of their income. What would happen to the money demand equation?  The value of α would be reduced to almost zero -- people’s income levels would no longer have any effects on their demand for money in their pockets.

Fisher equation  At the beginning of a year, Bill has 1 million dollars. Two options:  Option #1: Deposit into a bank to earn a preset nominal interest. At the end of the year, he would have: $ (1 + i) million

Fisher equation  Option #2: Invest.  At the current price p, he would buy 1/p million units machines.  Each unit of machine would produce (1+r) units of output. At the end of the year, he would produce total output: 1/p x (1+r)

Fisher equation:  Option #2 (continued):  At the end of the year, the new price is px(1+π )  He would sell the output at the new price to get money: 1/p x (1 + r) x px(1+π) = (1+r) x(1+π)

Fisher equation:  Two options should generate exact same amount of money: (1 + i) = (1+r) x(1+π)  1 + i = 1 + r + π + r x π Since r x π is generally very small, we have the Fisher equation: i ≈ r + π

Fisher equation  Since at the beginning of the year we do not know the inflation, so we use expected inflation:

Discussions:  Since real interest rate does not vary much across time, nominal interest rate and the inflation should be highly correlated. See graphs next.

The Fisher equation: time series evidence

The Fisher equation: cross country evidence

Cost of expected inflation  Cost of expected inflation  Menu cost: first may have to change their posted prices more often.  Tax laws: many provision of the tax code do not account for the inflation.

Cost of unexpected inflation  Unexpected redistribution.

Summary  Quantity theory suggests that inflation is almost entirely due to the money supply.  Demand for money depends on income, price level, and nominal interest rate.  Fisher equation suggests that nominal interest = real interest + expected inflation