D ISCUSSION Q UESTION Last year, the Federal Reserve engaged in open-market operations to the tune...
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DISCUSSION QUESTION Last year, the Federal Reserve engaged in open-market operations to the tune of 600 billion dollars. The discount rate and federal funds rates are at all time lows. Based on the quantity theory of money, this is sure to cause inflation. In 2009, we experienced the atypical scenario of deflation. With a group of 4, create a consensus for the following: How can deflation seem good for the consumer but harmful to the economy as a whole? How can inflation seem harmful to the consumer while at the same time be good for the economy as a whole?
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Transcript of D ISCUSSION Q UESTION Last year, the Federal Reserve engaged in open-market operations to the tune...
DISCUSSION QUESTION Last year, the Federal Reserve engaged in
open-market operations to the tune of 600 billion dollars. The discount rate and federal funds rates are at all time lows. Based on the quantity theory of money, this is sure to cause inflation. In 2009, we experienced the atypical scenario of deflation. With a group of 4, create a consensus for the following: How can deflation seem good for the consumer but harmful to
the economy as a whole? How can inflation seem harmful to the consumer while at the
same time be good for the economy as a whole?
CHAPTER 30 - MONEY GROWTH AND INFLATION Inflation indicators: Consumer Price Index (CPI) GDP Deflator
How do we analyze the price level? Inflation, disinflation, deflation, hyperinflation,
3 Theories: Quantity Theory, Demand-Pull, Cost-Push
CHAPTER 30 - MONEY GROWTH AND INFLATION Readdress the effects of Inflation: Inflation lowers value of money Each dollar buys a smaller quantity
of goods and services Negatively affects people:
On a fixed income Without a COLA in their contract Banks that have offered fixed
rates of interest People that are unaffected/helped:
On a flexible income With a COLA in their contract Borrowers that have borrowed at
fixed rates of interest
WHAT DOES A LACK OF INFLATION INDICATE?
Lack of:GrowthBorrowingSpendingExpansion
WHAT CAN THE FED DO TO BOOST THE ECONOMY?
Expansionary Monetary Policy: Buy Bonds Lower interest rates Increase borrowing Create inflation (increase in price
levels)
EFFECTS OF LOW INTEREST RATES
Generally, low interest rates stimulate the economy because the cost of credit is low. Consumers buy cars and houses. Businesses expand, invest in capital,
etc.
WHAT DOES TOO MUCH INFLATION INDICATE?
Large Money Supply Speculative Bubbles Over Zealous Growth Irrationality in the Market Too much borrowing and spending
HOW CAN THE FED SLOW THE ECONOMY?
The Fed raises interest rates as an effective way to fight inflation.
Consumers pay more to borrow money, dampening spending.
Businesses have difficulty borrowing; unemployment rises.
MONEY MARKET GRAPHNominal Interest Rate
Quantity of Money
20%
5%
1%
• Interest Rates are high, qd of money is low because people prefer to have their money in a financial assett (bonds, cds, savings,etc.)
• Interest rates are low, there is little incentive to save; people prefer to have their money on hand for spending
D (Demand for Money)
MONEY MARKET GRAPHNominal Interest Rate
Quantity of Money
20%
5%
1%
• Who controls the money supply?• The FED!• The supply curve is perfectly inelastic
because the supply of money is not controlled by the interest rate
4 Trillion
S (Supply of Money)
MONEY MARKET GRAPHNominal Interest Rate
Quantity of Money
20%
5%
1%
4 Trillion
S of MoneyS2 S1 • Increase money supply, decrease interest rates (easy money policy, expansionary monetary policy, ramp up borrowing and spending, price levels rise, S1)
• Decrease money supply, increase interest rates (tight money policy, contractionary monetary policy, slow down borrowing and increase saving, price levels fall, s2)
• How do they do this?• OMOs• RRR• DR/FFR
MONETARY POLICY3 FED Tools Increase Money Supply Decrease Money Supply
Open Market Operations
Reserve Requirements
Discount Rate/Fed Funds Rate
Buy(Easy
Money)
Sell(Tight
Money)
Contractionary Monetary Policy
+$50 Million
-$50 Million
MM = 1/RRR1/.10 = 10
10 x 50 = 500 Million
Fixed Income1 year
contract
THE EFFECTS OF A MONETARY INJECTION What happens if the Fed doubles the supply of money by through open-market operations?
Quantity Theory of Money – the quantity of money available in the economy determines the value of money and inflation New equilibrium
Supply curve shifts right Interest Rates will fall Price levels increase
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A BRIEF LOOK AT THE ADJUSTMENT PROCESS Immediate effect of a monetary
injection Creates an excess supply of money
QS>QD of money People will want to spend excess
money Increase in demand for goods and
services Ultimately, price of goods and
services increases as a result of too much money chasing too little amount of goods Increase in price level (CPI/GDP
Deflator)
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TOO MUCH MONEY VIDEO
THE CLASSICAL DICHOTOMY & MONETARY NEUTRALITY Classical dichotomy – division into two groups; division between the real side
of the economy and the monetary side. Theoretical separation of nominal & real variables
Nominal variables – variables measured in monetary units (not accounting for inflation)
Real variables – variables measured in physical units (accounting for inflation) GDP, Interest Rates, Income, etc.
NOMINAL AND REAL VARIABLES
=
=
How does this affect consumers?• Reduced purchasing power• Interest rates on money in the bank must keep up with the 100% increase in price levels
THE CLASSICAL DICHOTOMY & MONETARY NEUTRALITY Monetary neutrality – changes in money supply don’t affect real variables in
the long run, only nominal variables in the long run Long run, nominal variables adjust to match expected inflation
Short run – less than 2 yearsLong run – greater than 2 years
VELOCITY AND THE QUANTITY EQUATION Velocity of money (V)
Average number of times a dollar is used to purchase a final product during a year
Speed at which a dollar bill travels from wallet to wallet How many times is a dollar bill used to pay for a newly produced good or
service? Used to determine the growth of the economy and bank lending
Slow velocity means slow spending, slow lending
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VELOCITY AND THE QUANTITY EQUATION Quantity Equation – shows that money supply has a direct, proportional relationship with the price level.
Quantity equation: M × V = P × Y Quantity of money (M) Velocity of money (V) Price Level (P) GDP (Y)
Classical economists believed that velocity (V) of money was constant, virtually unchanging
Real GDP (Y) was unchanged by increases in quantity of money
Increases in money supply (m) would lead to proportional increases in price level (P) 28
+$700.00+$500 +$200.00 +$300.00
$500.00 + $300 + $700 + $200 + $300 = $2000
Velocity of Money
Economy has $1000.00
+$300
$500.00 + $300 + $700 + $200 + $300 = $2000
V = Price x GDP(Nominal)/MSV = $400 x 5/1000V = $2000/1000V = 2
Quantity Equation M x V = P x Y1000 x 2 = $400 x 52000 = 2000
Monetary Neutrality$10,000 x 2 = $2000 x 5
THE INFLATION TAX How does government cause countries experience inflation? Government Revenue
Taxation – levying taxes, income, sales, excise, property, etc. Borrowing – selling of bonds
Printing of money Inflation tax – the revenue the government raises by creating money No one receives a bill for this tax Increase in price levels, dollars are less valuable Tax burden is on everyone that holds money U.S. – 3% inflation November 2008 estimated Zimbabwe's annual inflation rate at 89.7 sextillion (1021)
percent. By December 2008, annual inflation was estimated at 6.5 quindecillion novemdecillion percent (6.5 x 10108%, the equivalent of 6 quinquatrigintillion 500 quattuortrigintillion percent, or 65 followed by 107 zeros – one googol 65 million percent).
FISHER EFFECT Real interest rate = Nominal interest rate – Inflation rate Bank posts nominal interest rate of 7% per year and inflation is 3%,
real interest rate is 4% per year Nominal interest rate = Real interest rate + Inflation rate Fisher effect – developed by Irving Fisher, one-for-one long-run
adjustment of nominal interest rate to inflation rate Nominal interest rate adjusts to expected inflation
FISHER EFFECT
Nominal Interest rate is 8% Inflation is 3%Real Interest Rate = 8% - 3%r = 5%
Nominal Interest rate is 8% Inflation is 8%Real Interest Rate = 8%-8%r = 0
UNANTICIPATED INFLATION Problems arise when there is unanticipated inflation:
Creditors (lenders) lose and borrowers gain if the lender does not anticipate inflation correctly.
For those who borrow, this is similar to getting an interest-free loan. When the Fed increases the rate of money growth
Higher inflation rate Higher price levels
IS INFLATION A PROBLEM? Costs of Inflation (real variables) Shoeleather costs
Resources wasted when inflation encourages people to reduce their money holdings
More frequent trips to the bank cause your shoes to wear out
IS INFLATION A PROBLEM? Menu costs
Costs of changing prices Inflation – increases input costs that
firms must bear
IS INFLATION A PROBLEM?
Relative-price variability & misallocation of resources Inflation distorts relative prices, consumer and
firms decisions become distorted Markets are not as efficient when they can’t
predict inflation
IS INFLATION A PROBLEM? Inflation induced tax distortion
Consumer decisions – stop savingMarkets – less able to set
contracts/loans, to their best use
WHY IS INFLATION A PROBLEM? Confusion and inconvenience
Money is the yardstick with which we measure economic transactions The Fed’s job is to ensure the reliability of money When the Fed increases the money supply, creates inflation Erodes the real value of the unit of account, which can cause
confusion
WHY IS INFLATION A PROBLEM Costs of Inflation: Unexpected inflation
Redistributes wealth among the population
Redistribute wealth among borrowers and lenders
FLOW CHART – COSTS OF INFLATION, PGS. 677 - 682
Shoeleather Costs
Menu Costs
Relative-Price Variability and
the Missallocation of Resources
Inflation-Induced
Tax Distortions
Description
- Avoiding inflation
- Definition
- Bolivia Example (briefly describe)
Description
- Firm price changes
- Definition
- Effect of Inflation
Description
- Eatabit Eatery example
- Relative prices and Consumption decisions
Description
- Discourage saving (capital gains)
- Microsoft example
- Tax treatment of nominal interest
- Solution to the problem
Costs of Inflation
Confusion and Inconvenience
Description
- Yardstick Metaphor
- Increase in Money Supply
- Confusion as a result of inflation
A Special Cost of Unexpected
Inflation: Arbitrary
Redistributions of Wealth
Description
- Unexpected inflation
- Sam Student example
- Predictable vs. unpredictable inflation
- Cost of unexpected inflation
DUE WEDNESDAY
Chapter 30 1. Mankiw Practice Chapter 29 2. Mankiw Practice Chapter 303. Free Responses 4. Daily Tens 5. Notes Chapter 30 6. Terms
FORMULAS V = (P × Y)/M Quantity equation: M × V = P × Y Real Interest Rate = Nominal interest rate – Inflation
rate Nominal interest rate = Real interest rate + Inflation
rate
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Political Cartoon:1. What do you think the
event(s) or issue(s) are that inspired the cartoon? What is the cartoonist trying to portray in the cartoon?
2. Are there any real people/places in the cartoon? Who are these people?
3. Are there symbols in the cartoon? What are they and what do they represent?
4. What is your opinion of the cartoon, do you agree or disagree? Why?
FORMULAS 1. Last year, the Federal Reserve engaged in open-market operations to the tune
of 600 billion dollars. As a result, the federal funds rate are at all time lows. Based on the quantity theory of money, this is sure to cause inflation. Why would the Fed want to create inflation in the economy?
2. What should the FED do if the economy begins to expand beyond what is normal inflation? What type of monetary policy is this referred to as?
3. Describe the three theories of inflation.
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Political Cartoon:4. What do you think the event(s) or
issue(s) are that inspired the cartoon? What is the cartoonist trying to portray in the cartoon?
Are there any real people/places in the cartoon? Who are these people?
Are there symbols in the cartoon? What are they and what do they represent?
CHAPTER 30 – APPLICATION QUESTIONS1. Why do people hold money?
2. How will an increase in the interest rate on bonds influence the amount of money that people will want to hold?
3. How would each of the following influence the quantity of money you would like to hold?
a. An increase in the interest rate on checking depositsb. An increase in the expected rate of inflationc. An increase in income
4. Use the quantity equation for this problem. Suppose the money supply is $200, real output is 1,000 units, and the price per unit of output is $1. a. What is the value of velocity?b. If velocity is fixed at the value you solved for in part (a), what does the
quantity theory of money suggest will happen if the money supply is increased to $400?
c. Is your answer in part (b) consistent with the classical dichotomy? Explain.d. When inflation gets very high, people do not like to hold money because it
is losing value quickly. Therefore, they spend it faster. If, when the money supply is doubled, people spend money more quickly, what happens to prices? Do prices more than double, less than double, or exactly double? Why?
e. Suppose the money supply at the beginning of this problem refers to M1. That is, the M1 money supply is $200. What would the M2 quantity equation look like if the M2 money supply were $500 (and all other values were as stated at the beginning of the problem)?
CHAPTER 30 - DAILY ASSIGNMENT QUESTIONS1. Why do people hold money?
People - buy things, groceries, house payment, gas, prepare for accidents or medical emergencys, etc. Businesses – pay their workers, buy supplies.
2. How will an increase in the interest rate on bonds influence the amount of money that people will want to hold?Interest rates make it more costly to hold money. $1000, 10% interest, it would cost you $100 a year. If it is 1%, the cost of holding your money is only $10.
3. How would each of the following influence the quantity of money you would like to hold?
a. An increase in the interest rate on checking deposits - Increase incentive to hold your money deposits
b. An increase in the expected rate of inflation - Reduce your incentive to hold money
c. An increase in income - Increase your incentive to hold money for consumption purposes
CHAPTER 30 - DAILY ASSIGNMENT QUESTIONS4. Use the quantity equation for this problem. Suppose the money supply is $200, real
output is 1,000 units, and the price per unit of output is $1.
a. What is the value of velocity? V = (1,000 x $1)/$200 = 5
b. If velocity is fixed at the value you solved for in part (a), what does the quantity theory of money suggest will happen if the money supply is increased to $400? $400 x 5 = $2 x 1,000, prices will double from $1 to $2
c. Is your answer in part (b) consistent with the classical dichotomy? Explain. Yes. The classical dichotomy divides economic variables into real and nominal. According to classical economists money affects nominal variables proportionately and has no impact on real variables. In part (b), prices double, but real output remains constant.
When inflation gets very high, people do not like to hold money because it is losing value quickly. Therefore, they spend it faster. If, when the money supply is doubled, people spend money more quickly, what happens to prices? Do prices more than double, less than double, or exactly double? Why? Money has a proportional impact on nominal output if V is constant. If V grows, a doubling of M will cause P to more than double.
a. Suppose the money supply at the beginning of this problem refers to M1. That is, the M1 money supply is $200. What would the M2 quantity equation look like if the M2 money supply were $500 (and all other values were as stated at the beginning of the problem)?
$500 x 2 = $1 x 1,000, M2 velocity is 2.
MONEY MARKET GRAPH The FED Reserve buys government securities The FED sells government securities The FED lowers the RRR The FED Raises the RRR Group 5 – Velocity and the Quantity Equation
Velocity of money, formula, math example, quantity equation Group 6 – Five Steps of the Quantity Theory of Money
List five steps (pg. 672)
