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CHAPTER 4Money and Inflation

A PowerPointTutorialTo Accompany

MACROECONOMICS,6th. ed.N. Gregory Mankiw

By

Mannig J. Simidian

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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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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 services--is sometimes called moneys liquidity.

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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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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 gold-certificates 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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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.

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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.

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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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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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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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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 one-to-one 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 one-for-one with

changes in expected inflation e.

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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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The inconvenience of reducing moneyholding is metaphorically called the

shoe-leather 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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Hyperinflation is defined as inflation that exceeds

50 percent per month, which is just over 1percent aday.

Costs such as shoe-leather 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 long-run

issues--monetary neutrality is approximately correct.

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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

Open-market 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