Download Macroeconomy in the Long Run

Macroeconomy in the Long
Run
Money and Inflation
Source: Mankiw (2000) Macroeconomics, Worth Publishers, Fourth edition chapter 7.
Fifth edition: chapter4
1
Money and Inflation
•
What is money?
– Money = stock of assets that can be readily
used to make transactions
•
Functions of money:
1. Store of value: way of transferring
purchasing power to the future (holding
money and spending it in the future)
2. Unit of account: terms in which prices are
quoted and debts are recorded e.g. car
costs €12,000 not 400 shirts
Source: Mankiw (2000) Macroeconomics, Worth Publishers, Fourth edition chapter 7.
Fifth edition: chapter4
2
Money and Inflation
• Functions of money
3. Medium of exchange – money is what we
use to buy goods and services. Money
liquidity = the ease of converting money into
goods and services
• Types of money
– Fiat money: money that has no intrinsic value,
established as money by the government. The
norm in most economies
– Commodity money: using a commodity with
some intrinsic value as money e.g. gold
Source: Mankiw (2000) Macroeconomics, Worth Publishers, Fourth edition chapter 7.
Fifth edition: chapter4
3
Money and Inflation
• How the quantity of money is controlled:
– Money supply = Quantity of money available
– Government controls the supply of money =
monetary policy
– Monetary policy is delegated to a central bank
• European Central Bank
• Central Bank of Ireland
Source: Mankiw (2000) Macroeconomics, Worth Publishers, Fourth edition chapter 7.
Fifth edition: chapter4
4
Money and Inflation
• How the quantity of money is measured:
– Money is the stock of assets used for
transactions
– Assets: cash, cheques etc.
– Measures of the quantity of money:
• Currency: paper money and coins
• Demand deposits: funds people hold in their
cheque accounts
• Etc.
Source: Mankiw (2000) Macroeconomics, Worth Publishers, Fourth edition chapter 7.
Fifth edition: chapter4
5
Source: Mankiw (2000) Macroeconomics, Worth Publishers, Fourth edition chapter 7.
Fifth edition: chapter4
6
The Quantity theory of Money
Transactions and the quantity equation
• Quantity equation:
M x V
= P x T
Money x Velocity = Price x Transactions
• T = transactions: number of times in a year
that goods or services are exchanged for
money
• P = price: the price of a typical transaction
Source: Mankiw (2000) Macroeconomics, Worth Publishers, Fourth edition chapter 7.
Fifth edition: chapter4
7
The Quantity Theory of Money
Quantity equation:
• P x T = the number of euros exchanged in
a year
• M = quantity of money
• V = transactions velocity of money:
measures the rate at which money
circulates in the economy i.e. the number
of times a euro changes hands in a year
Source: Mankiw (2000) Macroeconomics, Worth Publishers, Fourth edition chapter 7.
Fifth edition: chapter4
8
The Quantity Theory of Money
Quantity equation:
• Example:
– Suppose 60 loaves of bread are sold in year 1
at €0.50 per loaf
T = 60
P = €0.50
P x T = €0.50 x 60 = €30
– Suppose quantity of money in economy = €10
Source: Mankiw (2000) Macroeconomics, Worth Publishers, Fourth edition chapter 7.
Fifth edition: chapter4
9
Quantity Theory of Money
– Suppose quantity of money in economy = €10
MxV =PxT
Rearrange:
V = PT/M
=€30/€10
=3 times per year: For €30 of transactions per
year to take place with €10 of money, each
euro must change hands 3 times
Source: Mankiw (2000) Macroeconomics, Worth Publishers, Fourth edition chapter 7.
Fifth edition: chapter4
10
Quantity Theory of Money
• From Transactions to Income:
– Number of transactions is difficult to measure
– So T is replaced by total output in economy
(Y)
Money x Velocity = Price x Output
M
x
V
= P x Y
– Y = total output or total income
– V= income velocity of money
– This is the equation most commonly used
Source: Mankiw (2000) Macroeconomics, Worth Publishers, Fourth edition chapter 7.
Fifth edition: chapter4
11
Quantity Theory of Money
The money demand function and the quantity
equation:
– M/P = real money balances (how much you can buy
with a quantity of money)
– Money demand function:
(M/P)d = kY,
where k = a constant (how much money people want to
hold for every euro of income)
the quantity of real money balances demanded is
proportional to income. Higher income leads to a
higher demand of real money balances
Source: Mankiw (2000) Macroeconomics, Worth Publishers, Fourth edition chapter 7.
Fifth edition: chapter4
12
Quantity Theory of Money
• (M/P)d = kY is another way to view the
quantity equation
• To see why this is so:
Add condition that real money demand =
real money supply
(M/P) = real money supply
(M/P)d = real money demand
Source: Mankiw (2000) Macroeconomics, Worth Publishers, Fourth edition chapter 7.
Fifth edition: chapter4
13
Quantity theory of money
Therefore:
(M/P) = kY
Rearrange:
M(1/k) = PY
MV = PY
Where 1/k = V
k = how much money people want to hold for
every euro of income. If k is large, money
changes hands infrequently so V is small
Source: Mankiw (2000) Macroeconomics, Worth Publishers, Fourth edition chapter 7.
Fifth edition: chapter4
14
Quantity Theory of Money
• Constant velocity:
Assumption: velocity of money is constant –
an approximation to reality
Quantity equation theory:
MV = PY
• The quantity of money determines the
value of the economy’s output
Source: Mankiw (2000) Macroeconomics, Worth Publishers, Fourth edition chapter 7.
Fifth edition: chapter4
15
Quantity Theory of Money
• Money, Prices and Inflation:
– What happens when the quantity of money in
the economy changes? i.e. when money
supply changes
– Quantity equation written in percentage form:
% Δ in M + % Δ in V = % Δ in P + % Δ in Y
• V is constant, so % change in V = 0
Source: Mankiw (2000) Macroeconomics, Worth Publishers, Fourth edition chapter 7.
Fifth edition: chapter4
16
Quantity Theory of Money
% Δ in M + % Δ in V = % Δ in P + % Δ in Y
– % change in money (M) is under control of the
central bank
– Velocity is constant, so % change in V = 0
– % change in prices (P) = inflation
– % change in output (Y) depends on
production function and factors of production,
which are fixed
– So growth in money supply determines the
rate of inflation
Source: Mankiw (2000) Macroeconomics, Worth Publishers, Fourth edition chapter 7.
Fifth edition: chapter4
17
Quantity Theory of Money
• Quantity theory of money states that:
– The central bank, which controls money
supply, has ultimate control over the rate of
inflation
– If money supply is stable, price level will be
stable
Source: Mankiw (2000) Macroeconomics, Worth Publishers, Fourth edition chapter 7.
Fifth edition: chapter4
18
Seigniorage
• Seigniorage = revenue raised by the
government by printing money
• Government printing money raises money
supply and thus inflation
• Independency of Central Bank
Source: Mankiw (2000) Macroeconomics, Worth Publishers, Fourth edition chapter 7.
Fifth edition: chapter4
19
Inflation and Interest rates
• Two interest rates: real and nominal
• Nominal interest rate: what they bank pays
• Real interest rate: takes prices into
account
• Notation:
i = nominal interest rate
r = real interest rate
π = rate of inflation
Source: Mankiw (2000) Macroeconomics, Worth Publishers, Fourth edition chapter 7.
Fifth edition: chapter4
20
Inflation and interest rate
r=i–π
• The real interest rate is the difference
between the nominal interest rate and
inflation
The Fisher Effect:
• Rearranging:
i=r+π
The Fisher equation
Source: Mankiw (2000) Macroeconomics, Worth Publishers, Fourth edition chapter 7.
Fifth edition: chapter4
21
Inflation and Interest Rates
• The nominal interest rate can change because:
– The real interest rate changes
– The inflation rate changes
• Fisher effect:
– There is a one-for-one relation between the inflation
rate and the nominal interest rate
– i.e. a 1% increase in the rate of inflation in turn
causes a 1% increase in the nominal interest rate
• Quantity theory:
– An increase in the rate of money growth by 1%
causes an increase in the rate of inflation by 1%
Source: Mankiw (2000) Macroeconomics, Worth Publishers, Fourth edition chapter 7.
Fifth edition: chapter4
22
Inflation and Interest rates
• Expected inflation:
– When a borrower and lender agree a nominal
interest rate – inflation rate over term of loan
is not known
– But there is an expectation of future inflation
rate: expected inflation rate
πe = expected inflation rate
π = actual inflation rate
Source: Mankiw (2000) Macroeconomics, Worth Publishers, Fourth edition chapter 7.
Fifth edition: chapter4
23
Inflation and Interest Rates
• Fisher effect is more precisely written as:
i = r + πe
Because actual inflation is not known when
the nominal interest rate is set
Source: Mankiw (2000) Macroeconomics, Worth Publishers, Fourth edition chapter 7.
Fifth edition: chapter4
24
Nominal Interest Rate and the
Demand for Money
• Quantity theory stated that the demand for
real money balances is proportional to
income
• But the nominal interest rate can also be
added as a determinant of the quantity of
money demanded
• Nominal interest rate = opportunity cost of
holding money
Source: Mankiw (2000) Macroeconomics, Worth Publishers, Fourth edition chapter 7.
Fifth edition: chapter4
25
Nominal Interest Rate and Money
Demand
• Therefore, the demand for real money
balances depends on:
– The level of income and
– The nominal interest rate
• General money demand function:
(M/P)d = L(i, Y)
• L: denotes money demand because money is the
most liquid asset in an economy
– The demand for the liquidity of real money
balances is a function of income and the
interest rate
Source: nominal
Mankiw (2000) Macroeconomics,
Worth Publishers, Fourth edition chapter 7.
Fifth edition: chapter4
26
Nominal Interest Rate and the
Demand for Money
• The higher the nominal interest rate – the
lower the demand for real money balances
• The higher the level of income – the higher
the demand for real money balances
Future money and current prices:
– M/P = supply of real money balances
– (M/P)d = demand for real money balances =
L(i, Y)
Source: Mankiw (2000) Macroeconomics, Worth Publishers, Fourth edition chapter 7.
Fifth edition: chapter4
27
Nominal Interest Rate and the
Demand for Money
• Future Money and Current Prices (cont’d):
Let supply = demand:
M/P = L(i, Y)
Use Fisher equation i = r + πe
M/P = L(r + πe, Y)
The level of real money balances depends
on the expected rate of inflation
Source: Mankiw (2000) Macroeconomics, Worth Publishers, Fourth edition chapter 7.
Fifth edition: chapter4
28
Nominal Interest Rate and the
Demand for Money
• Quantity theory of money: price level
moves proportionately with money supply
• General money demand equation: the
nominal interest rate depends on
expected inflation, which in turn depends
on the growth of money supply
Source: Mankiw (2000) Macroeconomics, Worth Publishers, Fourth edition chapter 7.
Fifth edition: chapter4
29
Costs of Inflation
• Main costs of expected inflation:
– Shoeleather costs
– Menu costs
• Hyperinflation:
– Often defined as inflation that exceeds 50% per
month
– Extreme inflation
– Caused by excessive growth in the supply of money –
when the central bank prints money rapidly
Source: Mankiw (2000) Macroeconomics, Worth Publishers, Fourth edition chapter 7.
Fifth edition: chapter4
30
The Classical Dichotomy
• When we studied income and unemployment,
we studied real variables e.g. the variables
measured a physical (rather than a monetary)
quantity e.g. real GDP, real wage
• Money and inflation: we studied nominal
variables – variables expressed in terms of
money
• We explained real variables without the
existence of money
• The theoretical separation of real and nominal
variables is called the classical dichotomy
Source: Mankiw (2000) Macroeconomics, Worth Publishers, Fourth edition chapter 7.
Fifth edition: chapter4
31