Lecture 18 Money What is money? Anything people will accept in place of the goods they seek to obtain. Trust is critical. Examples from history: salt in Egypt; rice in Japan; dried fish in Iceland; cotton cloth in Africa; cigarettes in Romania in the 1970s; liquor in Germany after World War II; QQ coin in China; rocks such as gold and silver

Roles of Money Account keeping Store of Value Medium of Exchange More efficient than barter If people do not trust official money, they use other things

Money Creation Governments create money Role of central banks Independence from politics important Many views on how the banks should manage money creation — fixed rules versus flexibility

Inflation What is inflation? It is a general rise in prices — not an increase in one price, such as higher price for wheat one year due to bad crops causing a short supply. Usually it is caused by more money in the hands of people who are trying to buy the same quantity of goods in an economy.

Inflation Is Not an Increase in One Price If the price of one good rises, it does not cause inflation. It is a change in relative prices. People have no more money to spend than before, they change spending mix. Example: Price of gasoline up in U.S. 2006: 4.6% of personal expenditures on gas; in 1997: 2.6% Where does the extra money spent on gas (2% of personal income) come from? Less spending on other goods.

MV = PT The quantity theory of money is: MV = PT M = money in circulation V = velocity (number of times money spent per year) P = average price level T = number of transactions Note: this is national income.

Price of Gas Rises MV = PT Assume M and V constant. P of gasoline rises; T constant If Demand for gasoline constant (T not changing), since more spent on gas, other transactions must fall (and their prices may too as a result).

Gas Goes Up — What Goes Down? Consumers do not make money, so M constant. Velocity rarely changes in stable economies. Price of gas goes up; but Demand constant, so something gives—in U.S. the drop occurred in spending at higher class stores and nicer restaurants. Spending on luxury goods dropped (boat sales and jewelry). Lower income people cut spending at Wal-Mart. Same thing from increase in mortgage rates—consumers must cut back in other areas. It hurts, but it is not inflation.

So What Causes Inflation? In general, inflation is caused by more money (M) chasing the same quantity of goods. If M rises and V constant then PT must rise to balance equation. People have more money so make more purchases (T rises) increase in T means more demand for same level of goods, so prices (P) bid higher.

Origins of Inflation So why do we get inflation? The government creates more money. Why? Not stupidity. It is deficit spending. 1. Print money. 2. Borrow money from Central Bank or from foreigners.

Destructive Effects When inflation rising (and is expected to continue to rise): ▲ spending and borrowing ▼ savings and investment ▲ incentive to inflate currency even more, depending on political forces

Real vs. Nominal Interest Rate Suppose inflation averages 10% per year (the value of the currency falls by 10% each year). If interest rate paid is 12%, that is the nominal interest rate. What is real (after inflation) interest rate? 12% – 10% = 2%

Inflation Hurts People, Business, and Society Businesses have a difficult time planning for future — which means less investment. How do you time payments? Do you accept currency? There are winners and losers in every transaction just due to changes in the value of the currency — up or down.

Real World Example Assume a person in the U.S. invested $10,000 in 1971 for their retirement in 1991 when the investment is worth $35,000 — a normal rate of return. What is the gain? Due to inflation, $10,000 in 1971 = $34,000 in So gain is only $1,000. But the entire “gain” of $25,000 is subject to taxes of about $7,000, leaving $28,000 in 1991 — less than the original investment in real spending power. So if people think there will be inflation—what actions do they rationally take?

Rational Decision Makers People try to avoid losses imposed by inflation: ● invest in hard assets ● invest in other countries ● avoid currency of own country Due to international flows of currency, inflation is punished in the market. Local people with few options suffer the most. Political instability more likely if currency unstable.