Chapter 4 Money and Inflation MACROECONOMICS Chapter 4 Money and Inflation

Long Run View Money and inflation are related closely in the long run. Classical economists used Quantity Theory of Money to explain the connection. We start with definitions and go to QTM and proceed to modern adjustments.

What Is Money? Money (=money supply) any vehicle used as a means of exchange to pay for goods, services or debts. In today’s society, any asset that can quickly be transferred into cash is considered money. The more liquid an asset is, the closer it is to money. In economics,money does not mean wealth nor does it mean income.

What Is Money? Functions of Money Medium of exchange Unit of Account Store of Value

What Is Money? Medium of exchange By eliminating barter, this function of money increases efficiency in a society. As human societies started to engage in exchange money had to be invented. Any technological change that reduces transaction costs increases the wealth of the society. Any technological change that allows people to specialize also increases wealth.

What Is Money? Unit of Account We use money to measure the value of goods and services. Suppose we had 4 goods and no money. How do we measure the price of each good? A in terms of B B in terms of C N!/2(N-2)! C in terms of D A in terms of C A in terms of D B in terms of D Money allows to quote prices in terms of currency only.

What Is Money? Store of Value All assets are stored value. Money, although without any return, is still desirable to hold because it allows purchases immediately. Other assets take time (transaction costs) to use as a payment for purchases. The more liquid an asset is, the less transaction cost it carries. Inflation erodes the value of money. Return on money: -π

What Is Money? Commodity money Gold certificates Bank notes Fiat money Checks Electronic Payment E-money

What Is Money? M1: Currency, demand deposits, travelers checks. M2: M1, saving deposits, small time deposits, retail MMMF. M3: M2, large time deposits, repos, Eurodollar deposits, institutional MMMF. MZM: M2, institutional MMMF minus small time deposits. Growth rates of these aggregates do not always go hand in hand, making monetary policy difficult since signals are conflicting. http://research.stlouisfed.org/publications/mt/page16.pdf

Monetary Policy Central Bank is responsible for monetary policy. Open-market operations Changes in required reserve Changes in the discount rate Quantitative easing

Quantity Theory of Money MVT=PT MVY=PY The Classical economists included all transactions in this definition. If one includes only the transactions that create GDP, one gets the second one. %Δ in M + %Δ in V = %Δ in P + %Δ in Y

Quantity Theory of Money In the classical approach, Y is determined by labor, capital, and technology. These resources are fixed in the short run, so Y is fixed. Like every other market, the monetary sector is in equilibrium, i.e. money supply is equal to money demand. Money supply, M, is determined by the central bank.

Quantity Theory of Money In the short run Y is fixed. Velocity was thought to be constant by the Classical economists. Milton Friedman revised it to be “stable” easily forecast. If in the short run both Y and V were fixed, then %Δ in M = %Δ in P

Quantity Theory of Money How to test the hypothesis that %Δ in M is roughly equal to %Δ in P? (%Δ in P is defined as inflation). Longitudinal data Figure 4-1 for USA: On average, %Δ in M = 7%,%Δ in P = 3%. Why not equal? Cross-sectional data Figure 4-2

Money Demand Function Suppose real money balances depend on real income But, by definition, MV=PY. Therefore, It is useful to remember that velocity and money demand are inversely related.

Examples of k Changes Credit card usage increases ATMs introduced People hold less real money balances => k falls => V rises. ATMs introduced Same as above Nominal interest rates rise Same as above. WHY?

Seigniorage How government gets revenue? Taxes Borrowing Printing money = seigniorage M increase leads to P increase but because nominal assets lose value, government transfer that value to itself. http://www.npr.org/blogs/money/2009/01/what_is_seigniorage_1.html http://en.wikipedia.org/wiki/Seigniorage

http://research.stlouisfed.org/publications/usfd/page16.pdf

Inflation and Interest Rates When a borrower and a lender agree on a real return on the loan (r), they still have to agree on the expected inflation (πe) to determine the nominal interest rate (i). (1+r ) (1+πe ) = (1+i) 1 + r + πe + r πe = 1 + i For simplicity, we use the Fisher equation: i = r + πe

Inflation and Interest Rates What happens if the borrower and lender misjudged the expected inflation? Who gains and who loses? See slide 24. What happens when actual inflation (instead of expected) exceeds the nominal interest rate? See Figure 4-3 How do people form expectations, anyway? Static, adaptive, rational

Demand for Money and i What does one give up by holding money? The opportunity to earn r What does one gain from holding money? Deflation makes money more valuable Inflation: -πe What is the net opportunity cost? r – (-πe ) = r + πe = i. Therefore, as i increases, opportunity cost of holding money increases. Money demand should decrease.

Demand for Money The demand for real money balances (liquidity preference) is a negative function of i and a positive function of Y.

Demand Responds to i Increase Money Supply => Y fixed means i has to go down to equate the higher M/P to demand. However, Quantity Theory of Money says money demand is not affected by interest rates. This was Keynes’ objection to Classical Theory. i M/P

Classical Revenge M increase => P increase => π increase => i increase => M/P decrease. In the long run, M increase does not create a lower i. i M/P

The Costs of Expected Inflation Shoe leather costs Menu costs Firms not changing “menus” are not keeping up with inflation. Relative prices change creating inefficiencies. Tax liability increases Uncertainty increases undermining planning

The Costs of Unexpected Inflation Impact on debtors Impact on creditors Impact on fixed incomes Impact on risk taking

Benefit of Inflation Money illusion can adjust real wages and reduce unemployment W/P L