Macroeconomics fifth edition N. Gregory Mankiw PowerPoint ® Slides by Ron Cronovich macro © 2004...
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Transcript of Macroeconomics fifth edition N. Gregory Mankiw PowerPoint ® Slides by Ron Cronovich macro © 2004...
macroeconomics fifth edition
N. Gregory Mankiw
PowerPoint® Slides by Ron Cronovichm
acro
© 2004 Worth Publishers, all rights reserved
CHAPTER FOUR
Money and Inflation
CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 2
Money: definitionMoney: definition
MoneyMoney is the stock is the stock of assets that can of assets that can be readily used to be readily used to make transactions.make transactions.
CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 3
Money: functionsMoney: functions
1. medium of exchangewe use it to buy stuff
2. store of valuetransfers purchasing power from the present to the future
3. unit of accountthe common unit by which everyone measures prices and values
CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 4
Money: typesMoney: types
1. fiat money• has no intrinsic value• example: the paper currency we use
2. commodity money• has intrinsic value• examples: gold coins,
cigarettes in P.O.W. camps, stone wheels up to 12 feet (3.6 meters) in diameter (Yap)
CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 5
Money SupplyMoney Supply
Government control over supply of money is called monetary policy.
In Ukraine, National Bank of Ukraine carries out monetary policy
The primary way of controlling the supply of money is through the open-market operations:– Purchase of government bonds from
public increase money supply– Sale of government bonds to public
reduce money supply
CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 6
Measurement of MoneyMeasurement of MoneyC or M0 currency
M1 currency and demand deposits
M2 M1+saving deposits
M3 M2+large time deposits
Table Structure of money supply in Ukraine
Symbol Unit Date Amount %* Currency outside banks (M0) UAH, million 07/06/06 66241.8 29.9* Money (M1) UAH, million 07/06/06 108585.9 49.0* Money (M2) UAH, million 07/06/06 220560.8 99.6* Money (M3) UAH, million 07/06/06 221535.8 100.0
Source: National Bank of Ukraine and my calculations
CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 7
The Quantity Theory of MoneyThe Quantity Theory of Money
A simple theory linking the inflation rate to the growth rate of the money supply.
Begins with a concept called “velocity”…
CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 8
VelocityVelocity
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 2003, • $500 billion in transactions• money supply = $100 billion• The average dollar is used in five
transactions in 2003• So, velocity = 5
CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 9
Velocity, Velocity, cont.cont.
This suggests the following definition:
T
VM
where
V = velocity
T = value of all transactions
M = money supply
CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 10
Velocity, Velocity, cont.cont.
Use nominal GDP as a proxy for total transactions.
Then, P YV
M
where
P = price of output (GDP deflator)
Y = quantity of output (real GDP)
P Y = value of output (nominal GDP)
CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 11
The quantity equationThe quantity equation
The quantity equationM V = P Y
follows from the preceding definition of velocity.
It is an identity: it holds by definition of the variables.
CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 12
Money demand and the quantity equationMoney demand and the quantity equation
M/P = real money balances, the purchasing power of the money supply.
A simple money demand function: (M/P )d = k Y
wherek = how much money people wish to hold for each dollar of income. (k is exogenous)
CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 13
Money demand and the quantity equationMoney demand and the quantity equation
money demand: (M/P )d = k Y
quantity equation: M V = P Y
The connection between them: k = 1/V
When people hold lots of money relative to their incomes (k is high), money changes hands infrequently (V is low).
CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 14
back to the Quantity Theory of Moneyback to the Quantity Theory of Money
starts with quantity equation
assumes V is constant & exogenous:
V V
With this assumption, the quantity equation can be written as
M V P Y
CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 15
The Quantity Theory of MoneyThe Quantity Theory of Money, cont., cont.
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 and L and the production function (chap 3)
The price level is P = (nominal GDP)/(real GDP)
M V P Y
CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 16
The Quantity Theory of MoneyThe Quantity Theory of Money, cont., cont.
The quantity equation in growth rates:
M V P YM V P Y
The quantity theory of money assumes
is constant, so = 0.V
VV
CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 17
The Quantity Theory of MoneyThe Quantity Theory of Money, cont., cont.
Let (Greek letter “pi”) denote the inflation rate:
M P YM P Y
PP
The result from the preceding slide was:
Solve this result
for to get
CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 18
The Quantity Theory of MoneyThe Quantity Theory of Money, cont., 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.
CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 19
The Quantity Theory of MoneyThe Quantity Theory of Money, cont., 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.
CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 20
International data on International data on inflation and money growthinflation and money growth
Inflation rate(percent, logarithmicscale)
1,000
10,000
100
10
1
0.1
Money supply growth (percent, logarithmic scale)0.1 1 10 100 1,000 10,000
Nicaragua
AngolaBrazil
Bulgaria
Georgia
Kuwait
USA
Japan Canada
Germany
Oman
Democratic Republicof Congo
CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 22
U.S. Inflation & Money Growth, 1960-2003U.S. Inflation & Money Growth, 1960-2003
0%
2%
4%
6%
8%
10%
12%
14%
1960 1965 1970 1975 1980 1985 1990 1995 2000
Inflation rate Inflation rate trend
CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 23
Inflation and interest ratesInflation and interest rates
Nominal interest rate, inot adjusted for inflation
Real interest rate, radjusted for inflation:
r = i
CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 24
The Fisher EffectThe Fisher Effect
The Fisher equation: i = r +
S = I determines r .
Hence, an increase in causes an equal increase in i.
This one-for-one relationship is called the Fisher effect.
CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 25
U.S. inflation and nominal interest rates, U.S. inflation and nominal interest rates, since 1954since 1954
-2
0
2
4
6
8
10
12
14
16
18
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
Percent
Nominal interest rate
Inflation rate
CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 26
Inflation and nominal interest rates Inflation and nominal interest rates across countriesacross countries
Inflation rate (percent, logarithmic scale)
Nominal interest rate(percent, logarithmicscale)
100
10
11 10 100 1000
KenyaKazakhstan
Armenia
Nigeria
Uruguay
United Kingdom
United States
Singapore
GermanyJapan
France
Italy
CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 27
Ex ante and ex post inflationEx ante and ex post inflation
Ex ante variable: e = expected inflation rate
Ex post variable: = actual inflation rate (not known until after it has occurred)
When lender and borrower agree on a nominal interest rate, they do not know what the rate of inflation is going to be, hence…
Modified Fisher Effect:
i=r+ e
CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 28
Nominal interest rate and the demand Nominal interest rate and the demand for moneyfor money
i is opportunity cost of holding money:
you can deposit it in a savings account which earn the nominal interest rate rather then keep it under the mattress
( ) ( , )dM P L i Y ( , )eL r Y
CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 29
EquilibriumEquilibrium
( , )eML r Y
P
The supply of real money balances
Real money demand
CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 30
What determines whatWhat determines what
variable how determined (in the long run)
M exogenous (the Central Bank)
r adjusts to make S = I
Y
( , )eML r Y
P
( , )Y F K L
P adjusts to make ( , )M
L i YP
CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 31
How How PP responds to responds to MM
For given values of r, Y, and e,
a change in M causes P to change by the same percentage --- just like in the Quantity Theory of Money.
( , )eML r Y
P
CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 32
How How PP responds to responds to ee
( , )eML r Y
P
(the Fisher effect)e i
d M P
to make fall
to re-establish eq'm
P M P
For given values of r, Y, and M ,
CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 33
Discussion Question Discussion Question
Why is inflation bad?
CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 34
A common misperceptionA common misperception
Common misperception: inflation reduces real wages
This is true only in the short run, when nominal wages are fixed by contracts.
In the long run, the real wage is determined by labor supply and the marginal product of labor, not the price level or inflation rate.
Consider the data…
CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 35
Average hourly earnings & the CPIAverage hourly earnings & the CPIAverage hourly earnings & the CPI, 1964-2004
0
2
4
6
8
10
12
14
16
18
20
1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004
Wag
e ($
per
hou
r)
0
50
100
150
200
250
CP
I (1
982-
84=
100)
Hourly earnings
in 2004 dollars
Consumer Price Index
Average hourly earnings (nominal)
CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 36
The classical view of inflationThe classical view of inflation
The classical view: A change in the price level is merely a change in the units of measurement.
So why, then, is inflation So why, then, is inflation a social problem?a social problem?
CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 37
Homework Assignment Homework Assignment
Read Section 4-6 of the textbook. Answer the following questions:
– Do economists and other people differ in their view on costs of inflation?
– What are the costs of expected inflation?
– What are the costs of unexpected inflation?
– Is there anything good about inflation anyway?
The Classical DichotomyThe Classical DichotomyReal variables are measured in physical units: quantities and relative prices, e.g.
quantity of output produced real wage: output earned per hour of work real interest rate: output earned in the future
by lending one unit of output today
Nominal variables: measured in money units, e.g. nominal wage: dollars per hour of work nominal interest rate: dollars earned in future
by lending one dollar today the price level: the amount of dollars needed
to buy a representative basket of goods
slide 38
CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 39
The Classical DichotomyThe Classical Dichotomy
Classical Dichotomy : the theoretical separation of real and nominal variables in the classical model, which implies nominal variables do not affect real variables.
Neutrality of Money : Changes in the money supply do not affect real variables. In the real world, money is approximately neutral in the long run.
CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 40
Chapter summaryChapter summary
1. Money the stock of assets used for transactions
serves as a medium of exchange, store
of value, and unit of account. Commodity money has intrinsic value,
fiat money does not. Central bank controls money supply.
2. Quantity theory of money assumption: velocity is stable conclusion: the money growth rate
determines the inflation rate.
CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 41
Chapter summaryChapter summary
3. Nominal interest rate equals real interest rate + inflation rate. Fisher effect: nominal interest rate
moves one-for-one w/ expected inflation. is the opp. cost of holding money
4. Money demand depends on income in the Quantity
Theory more generally, it also depends on the
nominal interest rate; if so, then changes in expected inflation affect the current price level.
CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 42
Chapter summaryChapter summary
5. Classical dichotomy In classical theory, money is neutral--
does not affect real variables. So, we can study how real variables are
determined w/o reference to nominal ones.
Then, eq’m in money market determines price level and all nominal variables.
Most economists believe the economy works this way in the long run.