ECN 2003 MACROECONOMICS 1 CHAPTER 4 MONEY and INFLATION Assoc. Prof. Yeşim Kuştepeli1

2 The rate of inflation is the percentage change in the overall prices, it varies substantially over time and across countries. In Germany in 1932, prices rose an average of 500 % per month. Such an episode of extra ordinary high inflation is called hyperinflation. We ignore short run price stickiness for this chapter. The classical theory of inflation not only provides a good description of the long run, it also provides a useful foundation for short run analysis. Inflation is an increase in average level of prices and a price is the rate at which money is exchanged for a good or a service.

Assoc. Prof. Yeşim Kuştepeli3 To understand inflation, we must understand money; what it is, its supply and demand and its effects on the economy. 1. Concept of money 2. Determination of price and inflation 3. Inflation tax 4. Effect of inflation on interest rate 5. Effect of interest rate on money demand 6. Inflation, a major problem ? 7. hyperinflation

WHAT IS MONEY? Assoc. Prof. Yeşim Kuştepeli4 Money is the stock of assets that can be readily used to make transactions. Functions of money 1) Store of value : money is a way to transfer purchasing power from present to future. 2) Unit of account: terms in which prices are quoted and debts are recorded. 3) Medium of exchange: what is used to buy goods and services (liquidity) Barter economy-double coincidence of wants

WHAT IS MONEY? Assoc. Prof. Yeşim Kuştepeli5  Types of money a. Fiat money-no intrinsic value b. Commodity money - intrinsic value – ex. Gold standard  How fiat money evolves:  People are willing to accept a commodity currency such as gold due to its intrinsic value.  Using raw gold as money is costly as it takes time to verify the purity of gold and to measure the correct quantity.  Government can mint gold coins to reduce these costs.  Government accepts gold from public in exchange for gold certificates  Gold backing becomes irrelevant.

WHAT IS MONEY? Assoc. Prof. Yeşim Kuştepeli6 How the quantity of money is controlled?  The quantity of money available is called the money supply.  The control over money supply by the government is monetary policy.  The Central Bank is the partially independent institution that decides on the monetary policy.  Open market operations  Discount rate  Required reserve ratio

WHAT IS MONEY? Assoc. Prof. Yeşim Kuştepeli7  The measurement of quantity of money: 1. Currency: sum of outstanding paper money and coins. 2. Demand deposits: the funds people hold in their checking accounts. M1= currency +demand deposits+traveler’s checks+other checkable deposits M2= M1+money market mutual fund balances+saving deposits+small time deposits M3= M2+large time deposits+eurodollars L= M3+other liquid assets (saving bonds, short term Treasury securities)

THE QUANTITY THEORY OF MONEY Assoc. Prof. Yeşim Kuştepeli8 The quantity equation: Money*velocity = price*transactions; M*V = P*T T is number of times in a period that goods and services are exchanged for money. P is the price of a typical transaction. V is transactions velocity of money and measures the rate at which money circulates in the economy. Ex: 60 loaves of bread = T ; 0,50 per loaf = P; M=10 P*T=60*0,5= 30/year = value of transactions; then, 10*V=30 V=3

THE QUANTITY THEORY OF MONEY Assoc. Prof. Yeşim Kuştepeli9  Transactions and output are closely related as the more the economy produces the more goods are bought and sold. The value of transactions is roughly proportional to the value of output.  M*V=P*Y where Y= output  V=(P*Y)/M  V is income velocity of money, the number of times 1 TL enters someone’s income in a given time.  M/P= real money balances=purchasing power of the stock of money

THE QUANTITY THEORY OF MONEY Assoc. Prof. Yeşim Kuştepeli10  Money demand function shows the determinants of the quantity of real money balances people wish to hold.  Ex: (M/P) d = k*Y where k is a constant that tells how much money people want to hold for every 1 TL.  Equilibrium in the money market : (M/P) d = (M/P) s ; M/P = k*Y ; M*V=P*Y M(1/k)=P*Y ; V= 1/k  When people want to hold a lot of money for 1 TL of income (k is high), money changes hands infrequently (V is small).

THE QUANTITY THEORY OF MONEY Assoc. Prof. Yeşim Kuştepeli11  Constant velocity of money :  M*V=P*Y  Change in M +change in V =Chang in (P*Y)  Change in V = 0; thus  The quantity of money determines the value of output.

Assoc. Prof. Yeşim Kuştepeli12 The determination of the economy’s overall level of prices depend on three assumptions: 1. Y =f(K, L) ; productive capacity determines real GDP 2. M*V=P*Y; money determines nominal GDP 3. P=PY/Y ; GDP Deflator = nominal GDP/Real GDP As velocity is constant, any change in the money supply leads to a proportionate change in nominal GDP. Because inputs and production function have already determines real GDP, change in nominal GDP must present a change in P. Hence the quantity theory implies that the price level is proportional to the money supply.

SEIGNIORAGE Assoc. Prof. Yeşim Kuştepeli13 Why does government increase the money supply? A government can finance its spending in three ways: a) Through taxes b) Borrowing from public by selling bonds c) Printing money The revenue raised through printing money is called seigniorage. When the government prints money to finance expenditures, it increases the money supply, this in turn causes inflation. Printing money to raise revenue is like imposing an inflation tax.

INFLATION and INTEREST RATES Assoc. Prof. Yeşim Kuştepeli14 The interest rate that the bank pays is the nominal interest rate and the increase in the purchasing power is the real interest rate. Fisher effect : nominal interest rate can change either because the real interest rate changes or because inflation changes. According to Fisher equation, an increase in inflation rate causes an increase in the nominal interest rate. This one-to-one relationship between inflation and nominal interest rate is called the Fisher effect.

INFLATION and INTEREST RATES Assoc. Prof. Yeşim Kuştepeli15  When a borrower and a lender agree on a nominal interest rate, they do not know what the inflation rate over the term of the loan will be.  The real interest rate that the borrower and the lender expect when the loan is made is called the ex ante real interest rate.  The real interest rate actually realized is called ex post interest rate.  Ex ante interest rate = i –expected inflation  Ex post interest rate = i – actual inflation.

Assoc. Prof. Yeşim Kuştepeli16  The costs of holding money :  The nominal interest rate is the opportunity cost of holding money.  Assets other than money such as gıovernment bonds earn th real return r.  Money earns an expected real return of (–expected inflation).  The cost of holding money is r-(-exp.inf.) = i  As interest rate goes up, the quantity of money demanded goes down.

SOCIAL COSTS OF INFLATION Assoc. Prof. Yeşim Kuştepeli17  The Layman’s view: If the governmnet reduced inflation by slowing the rate of money growth, workers would not see their real wager increasing more rapidly. Instead when inflation slows, firms would increase the prices of their products less each year and would give their workers less raises each year.  According to the classical theory of money, a change in the overall price level is like a change in the unit of measurement.  Then why is inflation a social problem?

THE COSTS OF EXPECTED INFLATION Assoc. Prof. Yeşim Kuştepeli18 1. Distortion of inflation tax on money held: shoe-leather cost 2. Menu costs 3. İ nefficient allocation of resources due to variablity in relative prices 4. Changes in tax liability (taxes are due nominal income) 5. Inconvenience of changing living standards

THE COSTS OF UNEXPECTED INFLATION Assoc. Prof. Yeşim Kuştepeli19 1. Redistribution of wealth 2. People on fixed income are worse off 3. Uncertainty 4. Unstable currency-less contracts 5. Varaible inflation leads to high varaible inflation

THE CLASSICAL DICHOTOMY Assoc. Prof. Yeşim Kuştepeli20  Seperation of real and nominal variables is crucial.  Real variables can be explained without introducing nominal variables or money.  In classical theory, cahnges in money supply do not influence real variables. This irrelevance of money for real variables is called monetary neutrality.