1. MONEY AND INFLATION

2. In this chapter you will learn :
Money: Definition and functions
The quantity theory of money
The classical theory of inflation

3. Money and Inflation: Evidence
«Inflation is always and everywhere a monetary phenomenon»
Milton Friedman
Whenever a country’s inflation rate is extremely high for a sustained period of time,
its rate of money supply growth is also extremely high.
Reduced-form evidence.

4. The connection between money and prices :
amount of money required to buy a good.
Inflation rate
the percentage increase in the average level of prices.

5. is the stock of assets that can be readily used to make transactions.
Money : definition
Money
is the stock of assets that can be readily used to make transactions.

6. Money : functions The three basic functions of money are:
medium of exchange
What sellers generally accept and buyers generally use to pay for goods and services.
store of value
An asset that can be used to transport purchasing power from one time period to another.
unit of account
A standard unit that provides a consistent way of quoting prices.
Barter - the direct exchange of goods and services for other goods and services.

7. Money : types Fiat, or token, money
Items designated as money that are intrinsically worthless.
Commodity monies
Items used as money that also have intrinsic value in some other use.

8. Discussion question: Which of these are money? Currency Checks
Deposits in checking accounts (called demand deposits)
Credit cards

9. The money supply & monetary policy
the total stock of money circulating in an economy.
The circulating money involves the currency, printed notes, money in the deposit accounts and in the form of other liquid assets.
Monetary policy
is the control over the money supply.
It involves management of money supply and interest rate and is used by the government of a country to achieve macroeconomic objectives like inflation, consumption, growth and liquidity.

10. Open-Market Operations The purchase and sale of Government Bonds
To reduce the money supply:
The Central bank sells Treasury Bonds and receives the existing dollars and then destroys them.
To expand the money supply:
The Central bank buys Treasury Bonds and pays for them with new money.

11. Quantitative Easing :
Quantitative easing is the monetary policy of central banks that prints large amounts of money and then buying financial assets to inject additional liquidity into the national economy.

12. Money Supply measures :
The two most common measures of money are :
transactions money, also called M1, and
broad money, also called M2.
Exact classifications of M1 and M2 depend on the country.
M1 - Money that can be directly used for transactions.
M2 - M1 plus savings accounts, money market accounts, and other near monies.
near monies
Close substitutes for transactions money, such as savings accounts and money market accounts.

13. Money Supply measures :

14. Money Supply and the role of the banking system :
Monetary Base:
The total amount of a currency that is either circulated
in the hands of the public or in the commercial bank deposits
held in the central bank's reserves.
This measure of the money supply typically only includes
the most liquid currencies.
The central bank controls directly only the monetary base
that is defined as:
B = C + R
C – currency, R - reserves.

15. Money Supply and the role of the banking system :
The money stock in the economy :
M = C + D
C - currency.
D - deposits (all deposits: demand deposits, saving deposits, etc. etc.)
The main assets of a bank are Loans and the Reserves it needs to keep in an account at the central bank.

16. Money Supply and the role of the banking system :
If the Central Bank wants to increase the money supply by 100$. They do is to buy government bonds for 100 $. Bond dealer now has a cheque of 100 $. Bond dealer deposit this cheque in a Firstbank. By law a bank must keep 10% of its deposits as Reserves and can lend all the rest.
Now we have 90 $ that are lent to someone .
This person get this 90 $ and will deposit them in Secondbank.
Now there are 81 $ that are lent to someone and that will be deposited in some other bank.

18. The Quantity Theory of Money

19. Velocity basic concept: the rate at which money circulates
definition: the number of times the average dollar bill changes hands in a given time period
example: In 2013,
$500 billion in transactions
money supply = $100 billion
The average dollar is used in five transactions in 2013
So, velocity = 5

20. The Quantity Theory of Money, cont. Money  Velocity = Price  Output
Transactions and output are related, because the more the
economy produces, the more goods are bought and sold.
If Y denotes the amount of output and P denotes the price of one
unit of output, then the dollar value of output is PY.
We encountered measures for these variables when we discussed the national income accounts.
This version of the quantity equation is called the income
velocity of money, which tells us the number of times a dollar
bill enters someone’s income in a given time.
Money  Velocity = Price  Output
M  V = P  Y

21. The quantity equation The quantity equation
M V = P Y
follows from the preceding definition of velocity.
It is an identity: it holds by definition of the variables.
Starts with quantity equation and assumes V is constant & exogenous:
With this assumption, the quantity equation can be written as

22. The Quantity Theory of Money, cont. P = (nominal GDP)/(real GDP)
How the price level is determined:
With V constant, the money supply determines nominal GDP (P Y )
Real GDP is determined by the economy’s supplies
of K (capital) and L (labour) and the production function
The price level is
P = (nominal GDP)/(real GDP)

23. The Quantity Theory of Money:
what determines inflation in the long-run

24. The Quantity Theory of Money, cont.
Normal economic growth requires a certain amount of money supply growth to facilitate the growth in transactions.
Money growth in excess of this amount leads to inflation.

25. The Quantity Theory of Money, cont.
Y/Y depends on growth in the factors of production
and on technological progress
(all of which we take as given, for now).
Hence, the Quantity Theory of Money predicts a
one-for-one relation between changes
in the money growth rate and changes in the inflation rate.

26. a monetary phenomenon”
INFLATION
“Inflation is always and everywhere
a monetary phenomenon”
A continuous rise of the general price level.
General price level is measured by the CPI or GDP Deflator.
Percentage change of the general price level over the previous period.

27. International Data On Inflation And Money Growth

28. U.S. Inflation & Money Growth
The trends of the two series tend to move together.

29. Is the Velocity of Money Constant?
Velocity is not fixed in reality. Velocity rises with
financial innovation and with the nominal interest rate.

30. Real and Nominal Interest Rates
Economists call the interest rate that the bank pays the
nominal interest rate and the increase in your purchasing power the real interest rate.
This shows the relationship between the nominal interest rate
and the rate of inflation, where :
r is real interest rate,
i is the nominal interest rate and
is the rate of inflation.
Remember that  is simply the percentage change of the price level P.
r = i - π

31. (unknown, but measured by forecasting inflation rate)
Real Interest Rate
Nominal interest rate, i not adjusted for inflation
Real interest rate, r adjusted for inflation : r = i  
 = actual inflation rate (not known until after it has occurred)
e = expected inflation rate
i – e = ex ante real interest rate: real interest rate when loan are made (known)
i –  = ex post real interest rate: real interest rate when loans are paid
(unknown, but measured by forecasting inflation rate)

32. The Fisher Effect

33. Money, Inflation, Interest Rate
The quantity theory and the Fisher equation together tell us how money growth affects the nominal interest rate.
Quantity Theory of Money:
a 1% increase in the money supply causes a 1% increase in inflation
Fisher Effect:
a 1% increase in the inflation causes a 1% increase in the nominal interest rate

34. U.S. Inflation And Nominal Interest Rates
Inflation and the nominal interest rate are very highly correlated.

35. Homework: (due to next week)
Use the Internet to identify a country that has had high inflation over the past year and another country that has had low inflation. For these two countries, find the rate of money growth and the current level of the nominal interest rate. Relate your findings to the theories presented in this chapter.