Macroeconomics & The global economy Ace Institute of Management Chapter 4: Money and Inflation Instructor Sandeep Basnyat

Stock of assets Used for transactions A type of wealth Money

Store of value: You can postpone your purchase for next period. Store of value: You can postpone your purchase for next period. Unit of account: units in which prices are quoted and debts recorded Unit of account: units in which prices are quoted and debts recorded A medium of exchange.: used to buy goods and services A medium of exchange.: used to buy goods and services The ease with which money is converted into other things such as goods and services--is sometimes called money’s liquidity.

Measures economic transactions like yardsticks. Without it, we would be forced to barter. Problem with barter: requires the double coincidence of wants.

Fiat money is money by declaration. It has no intrinsic value. Commodity money is money that has intrinsic value. Eg. Gold or cigarettes in P.O.W. camps When people use gold as money, the economy is said to be on a gold standard.

The money supply: quantity of money available in an economy. Monetary policy: The control over the money supply (increasing or decreasing). Central Bank: Institution that conduct monetary policy. Open Market Operation: Primary way of controlling Money Supply To expand the money supply: Central banks buys government bonds and pays for them with new money. To reduce the money supply: Central banks sells government bonds and receives the existing money and then destroys them.

Other instrument of Monetary Policy Changing the Reserve requirements. Minimum reserves each Commercial bank must hold Changing the Discount rate (which member banks (not meeting the reserve requirements) pay to borrow from the Central Banks.) The bearer of the United States Treasury bond is hereby promised the repayment of the principle value plus the interest which it incurs through the terms stated thereof. The United States will justly repay its bearers in its entirety and will not default under any circumstances. Signature of the President ___________________ US. Treasury Bond

Currency Demand Deposits M1, M2, M3 For Nepal: Broad Money (M2) and Narrow Money (M1)

Monetary Statistics for US and Nepal for 2008/2009 NepalUS Monetary Base (M1) Rs million or Approx. $250 million $1.99 trillion M2 Rs million or Approx. $926 million $8.36 trillion Reserve Requirements 5.50%10% FYI: Prepare a list of countries with their Money Supply, Reserve Requirements and Central Banks monetary instruments in monetary policy operations.

Equilibrium in Money Market Quantity of Money Value of Money, 1/ P Price Level, P Quantity fixed by the Central Bank Money supply 0 1 (Low) (High) (Low) 1 / 2 1 / 4 3 / Equilibrium value of money Equilibrium price level Money demand A

Quantity Theory of Money The Quantity Theory of Money states that there is a direct relationship between the quantity of money in an economy and the level of prices of goods and services sold. – If the amount of money in an economy doubles, price levels also double, causing Inflation (the percentage rate at which the level of prices is rising in an economy). – The consumer therefore pays twice as much for the same amount of the good or service. – Money is like any other commodity: increases in its supply decrease marginal value (the buying capacity of one unit of currency). – So an increase in money supply causes prices to rise (inflation) as they compensate for the decrease in money’s marginal value.

Quantity Theory of Money-Derivation Md = T x P – T = Number of transactions in an economy – P = General price Level. It is the nominal GDP Ms = M x V – M = Amount of Money in circulation – V = Velocity of money (the number of times money changes hands) From Equilibrium condition, M d = M s T x P = M x V

Transactions calculation not easy Replaces with Total Output (Transactions and output are related as the more the economy produces, the more goods are bought and sold). Money  Velocity = Price  Output M  V = P  Y The Quantity Theory of Money MV = PY M α P Fixed Y = as K, L are fixed, and Fixed V : supposed constant over time Price Level is directly proportional to the Quantity of Money in the Economy.

or in percentage change form: MV = PY % Change in M + % Change in V = % Change in P + % Change in Y If V is fixed and Y is fixed, then it reveals that % Change in M is what induces % Changes in P. M α P The Quantity Theory of Money The quantity theory of money states that the central bank, which controls the money supply, has the ultimate control over the inflation rate. If the central bank keeps the money supply stable, the price level will be stable. If the central bank increases the money supply rapidly, the price level will rise rapidly.

The revenue raised through the printing of money is called seigniorage. When the government prints money to finance expenditure, it increases the money supply. The increase in the money supply, in turn, causes inflation. Printing money to raise revenue is like imposing an inflation tax. The revenue raised through the printing of money is called seigniorage. When the government prints money to finance expenditure, it increases the money supply. The increase in the money supply, in turn, causes inflation. Printing money to raise revenue is like imposing an inflation tax.

The Effects of Monetary Injection Quantity of Money Value of Money, 1/ P Price Level, P Money demand 0 1 (Low) (High) (Low) 1 / 2 1 / 4 3 / M1M1 MS 1 M2M2 MS decreases the value of money and increases the price level. 1. An increase in the money supply... A B

Money and Prices During Four Hyperinflations (a) Austria(b) Hungary Money supply Price level Index (Jan = 100) Index (July 1921 = 100) Price level 100,000 10,000 1, Money supply 100,000 10,000 1,

Money and Prices During Four Hyperinflations (c) Germany 1 Index (Jan = 100) (d) Poland 100,000,000,000,000 1,000,000 10,000,000,000 1,000,000,000, ,000,000 10, Money supply Price level Price level Money supply Index (Jan = 100) ,000, ,000 1,000,000 10,000 1,

Nominal interest rate: interest rate that the bank pays Real interest rate: increase in purchasing power The relationship between the nominal interest rate and the rate of inflation: r = real interest rate; I = nominal interest rate; and,  = inflation rate of inflation Nominal interest rate: interest rate that the bank pays Real interest rate: increase in purchasing power The relationship between the nominal interest rate and the rate of inflation: r = real interest rate; I = nominal interest rate; and,  = inflation rate of inflation r =i- r = i - π

Fisher Equation: i = r +  Actual (Market) nominal rate of interest Real rate of interest Inflation The one-to-one relationship between the inflation rate and the nominal interest rate is the Fisher effect. because the real interest rate changes because the inflation rate changes. It shows that the nominal interest can change for two reasons: because the real interest rate changes or because the inflation rate changes.

i = r +  According to the quantity theory, a 1% increase in the money supply causes a 1% increase in inflation. According to the quantity theory, a 1% increase in the money supply causes a 1% increase in inflation. According to the Fisher equation, a 1% increase in the rate of inflation in turn causes a 1% increase in the nominal interest rates. According to the Fisher equation, a 1% increase in the rate of inflation in turn causes a 1% increase in the nominal interest rates. Simplified: Simplified: r = i - 

People have expectation of the inflation rate. Let  = actual future inflation and  e = expectation of future inflation. Adjustment to Fisher Effects i = r +  e i = r +  e Actual inflation is not known when the nominal interest rate is set. But people can adjust to expected inflation. The nominal interest rate i moves one-for-one with changes in expected inflation  e.

Shoe-leather cost of inflation: walking to the bank more often induces one’s shoes to wear out more quickly. Menu costs: When changes in inflation require printing and distributing new pricing information. Tax Laws: Often tax laws do not take into consideration inflationary effects on income.

Unanticipated inflation is unfavorable because it arbitrarily redistributes wealth among individuals. For example, it hurts individuals on fixed pensions. There is a benefit of inflation—many economists say that some inflation may make labor markets work better. They say it “greases the wheels” of labor markets.

Hyperinflation: inflation that exceeds 50 percent per month, which is just over 1percent a day. Costs such as shoe-leather and menu costs are much worse with hyperinflation—and tax systems are grossly distorted. Eventually, when costs become too great with hyperinflation, the money loses its role as store of value, unit of account and medium of exchange. Bartering or using commodity money becomes prevalent.

Separation of the determinants of real and nominal variables: changes in the money supply do not influence real variables. This irrelevance of money for real variables is called monetary neutrality. For the purpose of studying long-run issues--monetary neutrality is approximately correct.

The Classical dichotomy N N W/P Y Y P P W Increase in Wage Level No Change in Output No Change in Level of Employment There is a dichotomy between real and monetary sector. Increase in Price

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