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ChapterFour
1
CHAPTER 4Money and Inflation
A PowerPointTutorialTo Accompany
MACROECONOMICS,6th. ed.N. Gregory Mankiw
By
Mannig J. Simidian

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ChapterFour
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Stock of assetsStock of assets
Used for transactionsUsed for transactions
A type of wealthA type of wealth
Money
Inflation is an increase in the average level of prices, and a price
is the rate at which money is exchanged for a good or service.

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ChapterFour
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It serves as a store of value, unit of account, and a medium of
exchange. The ease with which money is converted into other things
such as goods and servicesis sometimes called moneys liquidity.

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ChapterFour
5
Fiat money is money by declaration.
It has no intrinsic value.
Commodity money is money that
has intrinsic value.
When people use gold as money, the
economy is said to be on agold standard.

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ChapterFour
6
The government may get involved in
the monetary system to help people
reduce transaction costs. Using gold as
a currency is costly because the purityand weight has to be verified. Also,
coins are more widely recognized than
gold bullion.
The government then accepts gold from the publicin exchange for goldcertificates pieces of paper
that can be redeemed for actual gold. If people trust
that the government will give them the gold upon
request, then the currency will be just as valuable as
the gold itselfplus, it is easier to carry around the
paper than the gold. The end result is that because
no one redeems the gold anymore and everyone
accepts the paper, they will have value and serve as
money.

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ChapterFour
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The money supply is the quantity of money available in an economy.
The control over the money supply is called monetary policy.In the United States, monetary policy is conducted in a partially
independent institution called the central bank. The central bank in the
U.S. is called the Federal Reserve, or the Fed.

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To expandthe money supply:
The Federal Reserve buys U.S. Treasury Bondsand pays for them with new money.
To reduce the money supply:
The Federal Reserve sells U.S. Treasury Bondsand receives the existing dollars and then destroys
them.
Thebearerofth
eUnitedStates
Treasurybond
isherebyprom
ised
therepaymento
ftheprinciple
valueplusthe
interestwhich
it
incursthrough
thetermsstated
thereof.
TheUnitedSta
teswilljustlyr
epay
itsbearersinits
entiretyand
willnotdefaul
tunderany
circumstances.
Signatureofth
ePresident
____________
_______
US.TreasuryBond

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ChapterFour
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The Federal Reserve controls
the money supply in 3 ways:
Conducting Open Market Operations
(buying and selling U.S. Treasury bonds).
Changing the Reserve requirements
(never really used).
Changing the Discount rate which
member banks (not meeting the reserve
requirements) pay to borrow from the
Fed.
Thebearer
oftheUn
itedState
s
Treasuryb
ondisher
ebypromis
ed
therepaym
entofthe
principle
valueplus
theinter
estwhich
it
incursthr
oughthet
ermsstate
d
thereof.
TheUnited
Stateswi
lljustly
repay
itsbearer
sinitse
ntiretyan
d
willnotd
efaultund
erany
circumstan
ces.
Signature
ofthePresident
__________
_________
US.TreasuryBo
nd

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ChapterFour
10
The quantity equation is an identity: the definitions of the four
variables make it true. If one variable changes, one or more of the
others must also change to maintain the identity. The quantity
equation we will use from now on is the money supply (M) times the
velocity of money (V) which equals price (P) times the number of
transactions (T):Money Velocity = Price Transactions M V = P T
Vin the quantity equation is called the transactions velocity of money.This tells us the number of times a dollar bill changes hands in a given
period of time.

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Transactions and output are related, because the more the
economy produces, the more goods are bought and sold.
IfYdenotes the amount of output andPdenotes the price of one
unit of output, then the dollar value of output isPY. We
encountered measures for these variables when we discussed
the national income accounts.
Money Velocity = Price Output M V = P Y
This version of the quantity equation is called the incomevelocity of money, which tells us the number of times a dollar
bill enters someones income in a given time.

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Lets now express the quantity of money in terms of the quantity of
goods and services it can buy. This amount, M/Pis called real money
balances. Real money balances measure the purchasing power of the
stock of money.
A money demand function is an equation that shows the determinantsof real money balances people wish to hold. Here is a simple money
demand function:
where k is a constant that tells us how much money people want to holdfor every dollar they earn. This equation states that the quantity of real
money balances demanded is proportional to real income.
(M/P)d= kY

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ChapterFour
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The money demand function is like the demand function for a
particular good. Here the good is the convenience of holding real
money balances. Higher income leads to a greater demand for real
money balances. The money demand equation offers another way
to view the quantity equation (MV= PY) where V= 1/k.
This shows the link between the demand for money and the
velocity
of money. When people hold a lot of money for each dollar of
income (k is large), money changes hands infrequently (Vis small).
Conversely, when people want to hold only a little money (k is
small), money changes hands frequently (Vis large). In other
words, the money demand parameterkand the velocity of money V
are opposite sides of the same coin.

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ChapterFour
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The quantity equation can be viewed as a definition:
it defines velocity Vas the ratio of nominal GDP, PY,
to the quantity of money M. But, if we make theassumption that the velocity of money is constant,
then the quantity equation MV = PYbecomes a useful
theory of the effects of money. The bar over the V
means that velocity is fixed.
The quantity equation can be viewed as a definition:
it defines velocity Vas the ratio of nominal GDP, PY,
to the quantity of money M. But, if we make theassumption that the velocity of money is constant,
then the quantity equation MV = PYbecomes a useful
theory of the effects of money. The bar over the V
means that velocity is fixed.
So, lets hold it constant! Remember
a change in the quantity of money causes
a proportional change in nominal GDP.
MV = PY

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Three building blocks that determine the economys overall level
of prices:
The factors of production and the production function determine
the level of output Y.
The money supply determines the nominal value of output,PY.
This follows from the quantity equation and the assumption that
the velocity of money is fixed.The price levelPis then the ratio of the nominal value of output,
PY, to the level of output Y.

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In other words, if Y is fixed (from Chapter 3) because it depends
on the growth in the factors of production and on technological
progress, and we just made the assumption that velocity is constant,
or in percentage change form:
MV = PY
% Change in M + % Change in V = % Change in P + % Change in Y% 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.
The quantity theory of money states that the central bank, whichcontrols 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.

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The revenue raised through the printing of money is calledseigniorage. 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.

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ChapterFour
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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 thenominal interest rate and is the rate of inflation, and remember
that is simply the percentage change of the price levelP.
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, and remember
that is simply the percentage change of the price levelP.
rr==ii

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The Fisher Equation illuminates the distinction betweenthe real and nominal rate of interest.
Fisher Equation:Fisher Equation: ii == rr++
Actual (Market)Actual (Market)
nominal rate ofnominal rate ofinterestinterest
Real rateReal rateof interestof interest
InflationInflation
The onetoone relationship
between the inflation rate and
the nominal interest rate is
the Fisher effect.
It shows that the nominal interest can change for two reasons: because
the real interest rate changes or because the inflation rate changes.

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% Change in M+ % Change in V= % Change inP+ % Change in Y
% Change in M+ % Change in V= + % Change in Y
i =r+
The quantity theory and the Fisher equation together tell us how money
growth affects the nominal interest rate. According to the quantity
theory, an increase in the rate of money growth of one percent causes a
1% increase in the rate of 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.
Here is the exact link between our two familiar equations: The quantityequation in percentage change form and the Fisher equation.

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The real interest rate the borrower and lender expect when a loan is
made is called the ex ante real interest rate. The real interestrate that is actually realized is called the ex post real interest rate.
Although borrowers and lenders cannot predict future inflation with
certainty, they do have some expectation of the inflation rate. Let
denote actual future inflation and
e
the expectation of future inflation.The ex ante real interest rate is i  e, and the ex postreal interest rate is
i  . The two interest rates differ when actual inflation differs from
expected inflation e.
How does this distinction modify the Fisher effect? Clearly the nominal
interest rate cannot adjust to actual inflation, because actual inflation
is not known when the nominal interest rate is set. The nominal interest
rate can adjust only to expected inflation. The next slide presents a
more precise version of the the Fisher effect.

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ii == rr++ eeii == rr++ ee
The ex ante real interest rate r is determined by equilibrium in the
market for goods and services, as described by the model in
Chapter 3. The nominal interest rate i moves oneforone with
changes in expected inflation e.

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ChapterFour 24
The quantity theory (MV = PY) is based on a simple money demand
function: it assumes that the demand for real money balances is
proportional to income. But, we need another determinant of the
quantity of money demandedthe nominal interest rate.
The nominal interest rate is the opportunity cost of holding money:
it is what you give up by holding money instead of bonds. So, the newgeneral money demand function can be written as:
(M/P)d= L(i, Y)
This equation states that the demand for the liquidity of real money
balances is a function of income (Y) and the nominal interest rate (i).
The higher the level of income Y, the greater the demand for real
money balances.

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As the quantity theory of money explains, money supply and money
demand together determine the equilibriumprice level. Changes in
theprice level are, by definition, the rate of inflation. Inflation, in
turn, affects the nominal interest rate through the Fisher effect.
But now, because the nominal interest rate is the cost of holding
money, the nominal interest rate feeds back into the demand for money.
MoneyS
upply&MoneyD e
mand
Inflation&theFis
herEf
fect

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ChapterFour 26
The inconvenience of reducing moneyholding is metaphorically called the
shoeleather costof inflation, because
walking to the bank more often induces
ones shoes to wear out more quickly.
When changes in inflation require printing
and distributing new pricing information,
then, these costs are called menu costs.
Another cost is related to tax laws. Often
tax laws do not take into consideration
inflationary effects on income.

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Unanticipated inflation is unfavorable because it arbitrarily
redistributes wealth among individuals.
For example, it hurts individuals on fixed pensions. Often these
contracts were not created in real terms by being indexed to a
particular measure of the price level.
There is a benefit of inflationmany economists say that some
inflation may make labor markets work better. They say it
greases the wheels of labor markets.

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ChapterFour 28
Hyperinflation is defined as inflation that exceeds
50 percent per month, which is just over 1percent aday.
Costs such as shoeleather and menu costs are much
worse with hyperinflationand tax systems are
grossly distorted. Eventually, when costs become toogreat 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.

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Economists call the separation of the determinants of real
and nominal variables the classical dichotomy. A
simplification of economic theory, it suggests that 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 longrun
issuesmonetary neutrality is approximately correct.

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ChapterFour 30
Inflation
Hyperinflation
Money
Store of value
Unit of account
Medium of exchangeFiat money
Commodity money
Gold Standard
Money supply
Monetary policy
Central bank
Federal Reserve
Openmarket operations
Currency
Demand deposits
Quantity equationTransactions velocity
of money
Income velocity
of money
Real money balances
Money demand function
Quantity theory of money
Seigniorage
Nominal and
real interest rates
Fisher equation
Fisher effect
Ex ante and ex postreal interest rates
Shoeleather costs
Menu costs
Real and nominalvariables
Classical dichotomy
Monetary neutrality