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Economics THIRD EDITION By John B. Taylor Stanford University Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 1 Chapter 22 (Macro 9) Money and Inflation Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 2 Chapter Overview This chapter completes the long-run part of macroeconomics with an introduction to money and inflation. The discussion of the money creation and control process involves a description of banks and the Federal Reserve System. Money growth and inflation are related through the quantity equation of money. The inflationunemployment tradeoff and natural rate proposition of Phelps and Friedman are presented in their historical context, including a discussion of the original Phillips curve. The chapter concludes with a brief discussion of why inflation is not zero and the bias in measuring inflation. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 3 Teaching Objectives 1. Introduce money into the macroeconomy and discuss its creation and control. 2. Describe the structure of the Federal Reserve System. 3. Relate money to inflation through the quantity equation of money. 4. Discuss the inflation-unemployment tradeoff and the natural rate proposition. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 4 1. What Is Money? • 1a. Commodity money has taken a variety of forms. Since commodity money is a commodity, it is susceptible to changes in supply, and so its relative price is altered, leading to inflation or deflation. • 1b. Money has three functions. • It is a medium of exchange, a quid pro quo process that replaced barter. • It is a convenient store of value from one period to the next. • It is a unit of account in order to represent the relative values of goods. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 5 1. What Is Money? • 1c. The evolution from commodity money to coins to paper money reflects a movement to more efficient forms of money. The potential for over issue of paper fiat money has at times led to requirements that currency be convertible into some commodity like gold that is in relatively fixed supply. Governments now serve as the sole issuer of currency, but checking deposits are also a part of money. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 6 1. What Is Money? • 1d. Narrowly defined, money is M1, or, roughly, currency plus checking deposits.Less liquid forms of money such as a savings deposit are included in M2. These forms of money and their magnitudes for 1996 are given in Table 22.1. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 7 Figure 22.1 (Macro 9) Channeling Funds from Savers to Investors Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 8 2. The Fed and the Banks: Creators of Money • 2a. Banks and other financial intermediaries are involved in the translation of the funds of savers into an asset sold to investors or borrowers. Bank liabilities, such as deposits are loaned to borrowers, creating assets, such as loans. The basic balance sheet of a commercial bank is given in Table 22.2. • For example, a deposit account is an asset for the customer but a liability for the bank, while a customer's auto loan is a liability for the customer but an asset for the bank. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 9 2. The Fed and the Banks: Creators of Money • 2b. The Federal Reserve System is structured under the Federal Reserve Act of1913. • 2b.1 Under this act, the overall supervision of the Fed rests with a seven-person Board of Governors, appointed for fourteen-year terms. A chairman is appointed by the president for a four-year term that is renewable; most chairmen serve more than four years. The board is responsible for monetary policy as well as the regulation and supervision of certain aspects of banking. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 10 2. The Fed and the Banks: Creators of Money • 2b.2 The twelve district banks carry out a number of tasks related to the money supply process, banking regulation and supervision, and the analysis of economic conditions in their region. In addition the presidents of the district banks participate in the formulation of monetary policy. The geographical distribution of Fed districts is given in Figure 22.2. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 11 Figure 22.2 (Macro 9) The Twelve Districts of the Fed Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 12 2. The Fed and the Banks: Creators of Money • 2b.3 The Federal Open Market Committee (FOMC) consists of the seven governors and twelve district bank presidents, five of whom have votes on the committee.The chairman is the most powerful member of the FOMC, and his influence is so extensive that he is viewed by many as the second most powerful person in America. The relationship among the board, the district banks, and the FOMC is summarized in Figure 22.3. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 13 Figure 22.3 (Macro 9) The Structure of the Fed Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 14 2. The Fed and the Banks: Creators of Money • 2c. Banks are an integral part of the moneycreation process due to the fractional value of the reserve requirement. • 2c.1 Deposit expansion occurs as a bank-by-bank process and is treated in detail in Tables 24.3, 24.4, and 24.5. 2c.2 The simple reserve multiplier in a system with only deposits as money is given by: Deposits= (1/reserve ratio) x reserves. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 15 3. How the Fed Controls the Money Supply: Currency Plus Deposits 3a. The money supply and bank reserves are related through the usual set of definitions: M =CU +D , where is the money stock,CU is currency, and is deposits BR =rD ,where BR is bank reserves and r the reserve ratio Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 16 3. How the Fed Controls the Money Supply CU =k D , where k is the currency to deposit ratio MB =CU +BR , where MB is the monetary base Substitution yields M = (k + 1)D and MB =(k +r )D so that the money multiplier is: M /Mb = (k + 1)/(r +k ) Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 17 3. How the Fed Controls the Money Supply • The currency to deposit ratio (k ) reflects the decisions of the public in terms of transaction habits, the state of the economic environment, and the like and is ordinarily not subject to large changes. The reserve ratio r is a Fed decision variable that remains fairly fixed. The implication for control is clear: The Fed can alter M by changes in the base,MB .However,r and especially k will change as conditions change, as in the early years of the Great Depression and again with the onset of World War II. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 18 3. How the Fed Controls the Money Supply Some values of k for this period are: April 1928: k = .091 (prior to financial crisis) March 1933: k = .225 (bank holiday declared) May 1941: k = .251 (World War II) Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 19 4. Money Growth and Inflation • 4a. The relationship between money and nominal GDP that reflects the transactions of the economy is the quantity equation of money, MV = PY or, in terms of velocity, V = PY / M . So for V, a constant, the growth in M is reflected in the growth in nominal GDP, PY . In growth form, g P + g Y = g M +gV. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 20 4. Money Growth and Inflation • 4b. Figure 22. 4 plots inflation and money growth for the G-7 economies. Persistent inflation is a post-World War II phenomenon, especially since 1965. 4c. Hyperinflation occurs when the government prints money to finance spending, as in Germany in 1923 or Argentina in the early 1990s. See Figure 22.5 Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 21 Figure 22.4 (Macro 9) The Relation Between Money Growth and Inflation Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 22 Figure 22.5 (Macro 9) German Hyperinflation of 1923 Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 23 5. Inflation: Effects on Unemployment and Productivity Growth • The effect of inflation on long-run growth in the economy is potentially felt through its effects on unemployment and on capital accumulation and technology. • 5a. The Phillips curve, Figure 22.8, was the first attempt to quantitatively link inflation and unemployment. The apparent negative relationship between inflation and unemployment implied a tradeoff in the long run. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 24 5. Inflation: Effects on Unemployment and Productivity Growth • 5b. The Friedman-Phelps natural rate argument showed that the Phillips curve was a short-run relation. In the long run, the Phillips curve is vertical at the natural rate, as indicated by Figure 22.9. 5c. Inflation affects investment and technological change because it affects the level of uncertainty about relative prices, in particular, uncertainty about future real returns. A similar argument holds for technological change. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 25 5. Inflation: Effects on Unemployment and Productivity Growth 5d. In many countries governments resort to printing money to finance expenditures, resulting in an inflation tax. This is not true for the United States, so some other reason for persistent inflation must be found. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 26 5. Inflation: Effects on Unemployment and Productivity Growth 5e. One explanation is that the measures of inflation are biased due to the method used to compute price indexes. This is true for the CPI because it relies on a base-year quantity to construct the index. When the price of a good rises, substitution occurs so that the quantity of the higher-priced good falls. But the quantity of the good is fixed at the base-year value, lending a bias to the index. This bias is about 2 percentage points. So at 2 percent inflation based on the index, actual inflation is close to zero. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 27 5. Inflation: Effects on Unemployment and Productivity Growth • 5f. Concerns about disinflations needed to reduce high inflation reflect the short-run costs associated with the policy, namely, high unemployment. So even if low inflation is a good long-run policy, if policymakers place emphasis on the shortrun costs, they will not pursue disinflation. Copyright © 2001 by Houghton Mifflin Company. 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