Download Chapter 17

Chapter 17
Money,
Inflation, and
Banking
Copyright © 2014 Pearson Education, Inc.
Chapter 17 Topics
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Alternative forms of money.
Money and the absence of double coincidence of wants.
The causes and effects of long-run inflation.
Financial intermediation and banking.
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Alternative Forms of Money
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Commodity money
Circulating private bank notes
Commodity-backed paper currency
Fiat money
Transactions deposits at banks
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The Double-Coincidence Problem
and the Role of Money
•  Barter exchange is difficult in highly-developed,
specialized economies.
•  Economic exchange requires search costs, and these
costs are high when economic agents are specialized in
consumption and production, and can only trade a good
or service for another good or service.
•  Search costs are reduced dramatically if everyone
accepts money in exchange for goods and services.
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Figure 17.1
An Absence-of-Double-Coincidence Economy
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Figure 17.2
Good 1 as a Commodity Money in the
Absence-of-Double-Coincidence Economy
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Figure 17.3
Fiat Money in the Absence-of-DoubleCoincidence Economy
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The Effects of Long-Run Inflation
•  Use the monetary intertemporal model from Chapter
12.
•  Show that money is not superneutral – higher money
growth causes higher inflation, which affects real
economic variables.
•  An increase in the money growth rate increases the
inflation rate and the nominal interest rate, and reduces
employment and output.
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Figure 17.4
Inflation vs. Money Growth: 1960-2007
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Figure 17.5
Inflation vs. Money Growth: 2008-2012
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Money Growth
•  Assume that the central bank causes the money
supply to grow at a constant rate.
M ' = (1 + x) M
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Equilibrium
In equilibrium, money supply equals money demand.
M = PL(Y , r + i )
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In the Future
•  Money supply also equals money demand in the future
period.
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Then,
Combine the previous two equations.
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Consumer Optimization
The consumer’s intertemporal marginal condition.
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Another Marginal Condition
•  Marginal condition reflecting the consumer’s tradeoff
between current leisure and future consumption:
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And Another One
•  Marginal condition reflecting the consumer’s tradeoff
between current leisure and current consumption:
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Figure 17.6
The Long-Run Effects of an Increase in the
Money Growth Rate
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The Friedman Rule
•  Inflation causes an inefficiency, in that it distorts
intertemporal decisions.
•  The Friedman rule is a prescription for monetary growth
that eliminates the inefficiency caused by inflation.
•  The Friedman rule specifies that the money stock grow
at a rate that makes the nominal interest rate zero.
•  In practice, no central bank appears to have adopted a
Friedman rule to guide monetary policy.
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Pareto Optimality
Pareto optimality requires that
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Competitive Equilibrium
In a competitive equilibrium,
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Competitive Equilibrium
Also, in a competitive equilibrium,
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Friedman Rule
•  Therefore, for efficiency, R = 0 and x = -r. That is,
the money supply should shrink over time to
produce a long-run deflation. This gives money the
same rate of return as on other safe assets, and
removes the inefficiency.
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Properties of Assets
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Rate of return
Risk
Maturity
Liquidity
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Defining Characteristics of Financial
Intermediaries
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Borrow from one group of economic agents and lend
to another.
Well-diversified with respect to both assets and
liabilities.
Transform assets.
Process information.
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The Diamond-Dybvig Banking Model
•  Three periods, 0, 1, and 2.
•  Two types of consumers: early (consume in period 1)
and late (consume in period 2)
•  Efficient economic arrangement is for consumers to set
up a bank in order to share risk.
•  Given the bank’s deposit contract, the bank is open to
a run, which is a bad equilibrium.
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Figure 17.7
The Utility Function for a Consumer in the
Diamond–Dybvig Model
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The Preferences of a Diamond–Dybvig Consumer
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Marginal Rate of Substitution
•  The marginal rate of substitution of early
consumption for late consumption is
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Figure 17.8
The Preferences of a Diamond–Dybvig Consumer
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Constraints on Deposit Contract
Combine the two constraints to get one:
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Rewrite the Constraint
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Figure 17.9
The Equilibrium Deposit Contract Offered by the
Diamond–Dybvig Bank
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