chapter 4_money & inflation

7/17/2019 Chapter 4_Money & Inflation

1/74

C H A P T ER

Money and Infation

4


2/74

slide 2CHAPTER 4 Money and Inflation

In this chapter, you will

learn

The classical theory of inflation

causes

effects

social costs

Classical assumes prices are flexible &

markets clear

Applies to the lon run


3/74

slide !CHAPTER 4 Money and Inflation


4/74

U.. infation and its trend, !"#$%&$$#

slide "

#$

!$

%$

$

'2$

'($

'%# '%( ')# ')( '*# '*( '# '( 2### 2##(

long-run trend

% change in CPI from12 months earlier


5/74

slide (CHAPTER 4 Money and Inflation

The connection 'etween

(oney and prices

Inflation rate + the percentae increase

in the a,erae le,el of prices-

.rice + amount of money re/uired to

buy a ood-

0ecause prices are defined in terms of money1

e need to consider the nature of money1

the supply of money1 and ho it is controlled-


6/74

slide %CHAPTER 4 Money and Inflation

Money) *e+nition

MoneyMoneyis the stockis the stock

of assets that can be readilyof assets that can be readily

used to make transactions-used to make transactions-


7/74slide )CHAPTER 4 Money and Inflation

Money) unctions

medium of exchane

we use it to buy stuff

store of ,alue

transfers purchasing power from the present to

the future

unit of account

the common unit by which everyone measures

prices and values


8/74slide *CHAPTER 4 Money and Inflation

Money) Types

1. fiat money

has no intrinsic ,alue

example3 the paper currency e use

2. commodity money

has intrinsic ,alue

examples3

old coins1ciarettes in .-4-5- camps


9/74

slide CHAPTER 4 Money and Inflation

*iscussion -uestion

5hich of these are money6

a. Currency

b. Checksc. 7eposits in checkin accounts

8demand deposits9

d. Credit cardse. Certificates of deposit

8time deposits9


10/74

slide '#CHAPTER 4 Money and Inflation

The (oney supply and

(onetary policy de+nitions

The money supplyis the /uantity of money

a,ailable in the economy-

Monetary policyis the control o,er the money

supply-


11/74

slide ''CHAPTER 4 Money and Inflation

The central 'an

Monetary policy

is conducted by

a country:s

central bank-

In India1

the central bank

is called theReserve ank

o! "ndia-


12/74

slide '2

Measures o! Monetary and #i$uidity A%%re%ates

&R"' Au% 1' 2(()*

M# 8;eser,e Money93Currency in Circulation< 0anker:s

7eposits ith the ;0I< 4ther 7eposits ith the ;0I-

M'3 Currency ith the .ublic< 7emand 7eposits ith the0ankin =ystem< 4ther deposits ith the ;0I-

M23M'< =a,ins 7eposits of .ost 4ffice =a,ins 0anks-

M!3M'< Time 7eposits ith the 0ankin =ystem-

M"3 M!< All 7eposits ith .ost 4ffice =a,ins 0anks

8>xcludin ?ational =a,ins Certificates9-


13/74

slide '!+ata ,ource-@and 0ook of =tatistics1 ;0I


14/74

slide '"

8`0illion9

Components o! Money ,tockMeasures

utstandin% as on Marc/ 01

2(1014

1

' Currency ith the .ublic 8'-' < '-2< '-! '-"9 '21"*!-"

'-' ?otes in Circulation '21*!)-"

'-2 Circulation of ;upee Coin '%%-#

'-! Circulation of =mall Coins )-"

'-" Cash on @and ith 0anks (2)-!

2 7eposit Money of the .ublic *1#%!-(

2-' 7emand 7eposits ith 0anks *1#"!-2-2 4ther: 7eposits ith ;eser,e0ank

'-)

! M'8' < 29 2#1(")-#

" .ost 4ffice =a,in 0ank 7eposits "2!-%

( M2 8! < "9 2#1)#-%

% Time 7eposits ith 0anks )"1"2%-!) M!8! < %9 "1)!-!

* Total .ost 4ffice 7eposits '1()2-#

M"8) < *9 %1("(-!

http3BB-rbi-or-inBscriptsB0=Die0ulletin-aspx
http://www.rbi.org.in/scripts/BS_ViewBulletin.aspxhttp://www.rbi.org.in/scripts/BS_ViewBulletin.aspx


15/74

slide '(,ource- .rbi.or%.in

Components of Reserve Money in India (` Billion)

Ite(

/utstandin0 as onMarch 1!

&$!1%!2!

Reserve Money (1.1 + 1.2 + 1.3 =2.1 + 2.2 + 2.3 + 2.4 + 2. !

2.")1#$32#.4

1 Components

1.1 C&rren'y in Cir'&lation 13$1.#1.2 Baners* eposits ,it- RBI 4$2#.1.3 /0t-er eposits ,it- RBI 1.#2 o&r'es

2.1 et Reserve Ban Credit toovernment

"$5#.1

2.2 Reserve Ban Credit to Bans 45".2.3 Reserve Ban Credit to Commer'iale'tor

55.4

2.4 et 6orei7n 89'-an7e :ssets of RBI 15$2.3

2. overnment*s C&rren'y ;ia


16/74

slide '%+ata ,ource-@and 0ook of =tatistics1 ;0I


17/74

slide ')CHAPTER 4 Money and Inflation

The -uantity Theory o3 Money

A simple theory linkin the inflation rate

to the roth rate of the money supply-

0eins ith the concept of velocityE


18/74

slide '*CHAPTER 4 Money and Inflation

4elocity

basic concept3 the rate at hich money circulates

definition3 the number of times the a,erae rupee

chanes hands in a i,en time period

example3 In 2#'!F'"1 G7. nominal price +

;s-''1!(### billion 8G7. + ''!-( lakh crore9

money supply + ;s- 4#3.3billion

The a,erae rupee is used in tel,etransactions in 2#'!F'"

=o1 ,elocity + ''1!(###B")!-!+ '2


19/74

slide '

Money and ?&asi money (M2) as @of

Co&ntry ame15

1

2

21

213

:&stralia 41 4 "5 11 1":&stria 13 155 1"BraAil 12 3 4# " 5,itAerland 1 13 11" 14" 152C-ina 3# # 13# 151 18&ropean nion 1 1" 1456ran'e 5 14" 11nited in7dom 31 5# 11 1" 11Don7 on7 :R$ C-ina 224 32 33India 12 2! 52 6# 66

Iran$ Islami' Rep. "2 5 3" 2 13Ira? 35 33orea$ Rep. 3 34 " 131 134

;east developed 'o&ntriesE 'lassiF'ation 15 23 24 3# 3

ri ;ana 32 25 35 3# 34Middle 8ast G ort- :fri'a (allin'ome levels) 3 " 5 "2 5i7eria 2 2 22 21 22Di7- in'omeE 08C #" " 114 13# 1308C mem


20/74

slide 2#CHAPTER 4 Money and Inflation

4elocity, cont.

This suests the folloin definition3

TV

M=

hereV+ ,elocity

T+ ,alue of all transactions

M+ money supply


21/74

slide 2'CHAPTER 4 Money and Inflation

4elocity, cont.

Hse nominal G7. as a proxy for totaltransactions-

Then1 P YV

M

=

here

P + price of output 8G7. deflator9

Y + /uantity of output 8real G7.9

P

Y + ,alue of output 8nominal G7.9


22/74


The 7uantity e7uation

The $uantity e$uation

M

V+ P

Y

follos from the precedin definition of ,elocity-

It is an identity:

it holds by definition of the ,ariables-


23/74

slide 2!CHAPTER 4 Money and Inflation

Money de(and and the

7uantity e7uation

MBP+ real money balances1 the purchasin

poer of the money supply-

A simple money demand function3

8MBP9d+ kY

here

k+ ho much money people ish to hold for

each rupee of income-8kis exoenous9


24/74

slide 2"CHAPTER 4 Money and Inflation

Money de(and and the

7uantity e7uation

money demand3 8MBP9d+ kY

/uantity e/uation3 M V+ P Y

The connection beteen them3 k+ 'BV

5hen people hold lots of money relati,e

to their incomes 8kis hih91

money chanes hands infre/uently 8Vis lo9-


25/74

slide 2(CHAPTER 4 Money and Inflation

8ac to the 7uantity theory o3

(oney

starts ith /uantity e/uation

assumes V is constant & exoenous3

5ith this assumption1 the /uantity e/uation canbe ritten as

=V V

= M V P Y


26/74

slide 2%CHAPTER 4 Money and Inflation

The 7uantity theory o3 (oney,cont.

@o the price le,el is determined3

5ith V constant1 the money supply determines

nominal G7. 8P Y 9-

;eal G7. is determined by the economy:s

supplies of K and L and the production

function 8Chap !9- The price le,el is

P+ 8nominal G7.9B8real G7.9-

= M V P Y


27/74

slide 2)CHAPTER 4 Money and Inflation


The /uantity e/uation in roth rates3

M V P Y

M V P Y

+ = +

The /uantity theory of money assumes

is constant1 so + #-V

VV


28/74

slide 2*CHAPTER 4 Money and Inflation


8Greek letter pi9

denotes the inflation rate3

M P YM P Y

= +

P

P

=

The result from theprecedin slide as3

=ol,e this result

for to et


29/74



?ormal economic roth re/uires a certain

amount of money supply roth to facilitate the

roth in transactions-

Money roth in excess of this amount leads

to inflation-


30/74

slide !#CHAPTER 4 Money and Inflation


Y/Y depends on roth in the factors of

production and on technoloical proress

8all of hich e take as i,en1 for no9-

Hence, the Quantity Theory predicts

a one-for-one relation between

chanes in the !oney rowth rate and

chanes in the inflation rate"


31/74

slide !'CHAPTER 4 Money and Inflation

Con3rontin0 the 7uantity

theory with data

The /uantity theory of money implies

'- countries ith hiher money roth rates

should ha,e hiher inflation rates-

2- the lonFrun trend beha,ior of a country:s

inflation should be similar to the lonFrun trend

in the country:s money roth rate-

re the data consistent with these implications!


32/74

slide !2CHAPTER 4 Money and Inflation

International data on infation and

(oney 0rowth

"ingapore

#$"$

"witerland

rgentina

Indonesia

&ur'ey

(elarus)cuador


33/74

slide !!+ata ,ource-@and 0ook of =tatistics1 ;0I


34/74

U.. infation and (oney 0rowth,!"#$%&$$#

slide !"

#$

!$

%$

$

'2$

'($

'%# '%( ')# ')( '*# '*( '# '( 2### 2##(

*2 growth rate

inflation

rate

+ver the long run, the inflation andmoney growth rates move together,

as the uantity theory predicts$


35/74

slide !(CHAPTER 4 Money and Inflation

ei0niora0e

To spend more ithout raisin taxes or sellin

bonds1 the o,t can print money-

The re,enue raised from printin money

is called sei%niora%e

8pronounced =>>?FyourFide9-

The in!lation ta33

.rintin money to raise re,enue causes inflation-Inflation is like a tax on people ho hold

money-


36/74

slide !%CHAPTER 4 Money and Inflation

Infation and interest rates

?ominal interest rate1 i

not adusted for inflation

;eal interest rate1 radusted for inflation3

r + i


37/74

slide !)CHAPTER 4 Money and Inflation

The isher e9ect

The Jisher e/uation3 i + r L3 Jed announces it ill increase Mnext year-

.eople ill expect next year:s P to be hiher1

so erises-

This affects Pno1 e,en thouh M hasn:t chaned

yetE-


50/74

slide (#CHAPTER 4 Money and Inflation

How P responds to e

( , )eM

L r YP

= +

8the Jisher effect9 e i

( )d

M P

( ) to make fall to reFestablish e/Mm P M P

Jor i,en ,alues of r1 Y1 and M1


51/74

slide ('CHAPTER 4 Money and Inflation

*iscussion 7uestion

$hy is inflation bad%

5hat costs does inflation impose on society6

Nist all the ones you can think of-

Jocus on the lon run-

Think like an economist-


52/74

slide (2CHAPTER 4 Money and Inflation

A co((on (isperception

Common misperception3inflation reduces real wages

This is true only in the short run1 hen nominal

aes are fixed by contracts-

In the lon run1 the real ae is determined by

labor supply and the marinal product of labor1

not the price le,el or inflation rate- Consider the dataE


53/74

slide (!CHAPTER 4 Money and Inflation

A:era0e hourly earnin0s and the

CPI, !"#2%&$$#

O#

O2

O"

O%

O*

O'#

O'2

O'"

O'%

O'*O2#

'%" ')# ')% '*2 '** '" 2### 2##%

/ourlya%

e

#

(#

'##

'(#

2##

2(#

C

P"&1562647

1((*

C.I 8riht scale9

ae in current dollars

ae in 2##% dollars


54/74

slide ("CHAPTER 4 Money and Inflation

The classical :iew o3 infation

&he classical view:

A chane in the price le,el is merely a chane

in the units of measurement-

"o why, then, is inflation a

social problem!


55/74

slide ((CHAPTER 4 Money and Inflation

The social costs o3 infation

Efall into to cateories3

1. costs hen inflation is expected

2. costs hen inflation is different than

people had expected


56/74

slide (%CHAPTER 4 Money and Inflation

The costs o3 e;pected infation)!.hoeleather cost

def3 the costs and incon,eniences of reducinmoney balances to a,oid the inflation tax-

i

real money balances

;emember3 In lon run1 inflation does not

affect real income or real spendin-

=o1 same monthly spendin but loer a,eraemoney holdins means more fre/uent trips to

the bank to ithdra smaller amounts of cash-


57/74

slide ()CHAPTER 4 Money and Inflation

The costs o3 e;pected infation)&.Menu costs

def3 The costs of chanin prices-

>xamples3

cost of printin ne menus

cost of printin & mailin ne catalos

The hiher is inflation1 the more fre/uently

firms must chane their prices and incur

these costs-


58/74

slide (*CHAPTER 4 Money and Inflation

The costs o3 e;pected infation)1.Relati:e price distortions

Jirms facin menu costs chane prices infre/uently-

>xample3

A firm issues ne catalo each Panuary-

As the eneral price le,el rises throuhout the year1

the firm:s relati,e price ill fall-

7ifferent firms chane their prices at different times1

leadin to relati,e price distortionsE

Ecausin microeconomic inefficiencies

in the allocation of resources-

h 3 d i f i


59/74

slide (CHAPTER 4 Money and Inflation

The costs o3 e;pected infation)2.Un3air ta; treat(ent

=ome taxes are not adusted to account forinflation1 such as the capital ains tax-

>xample3

Pan '3 you buy O'#1### orth of I0M stock

7ec !'3 you sell the stock for O''1###1

so your nominal capital ain is O'### 8'#$9-

=uppose + '#$ durin the year-

Qour real capital ain is O#-

0ut the o,t re/uires you to pay taxes on your

O'### nominal ainRR

Th 3 d i f i


60/74

slide %#CHAPTER 4 Money and Inflation

The costs o3 e;pected infation)5.


61/74

slide %'CHAPTER 4 Money and Inflation

Additional cost o3 nex!ectedinfation)

Ar'itrary redistri'ution o3 purchasin0

power

Many lonFterm contracts not indexed1but based on e-

If turns out different from e1

then some ain at others: expense-

>xample3 borroers & lenders

If S e1 then 8i 9 8i e9

and purchasin poer is transferred from

lenders to borroers- If e1 then purchasin poer is transferred

from borroers to lenders-

Additi l t 3 hi h i f ti


62/74

slide %2CHAPTER 4 Money and Inflation

Additional cost o3 hi0h infation)

Increased uncertainty

5hen inflation is hih1 it:s more ,ariable andunpredictable3

turns out different from emore often1

and the differences tend to be larerthough not systematically positive or negative

Arbitrary redistributions of ealth

become more likely-

This creates hiher uncertainty1

makin risk a,erse people orse off-


63/74

slide %!CHAPTER 4 Money and Inflation

/ne 'ene+t o3 infation

?ominal aes are rarely reduced1 e,en hen

the e/uilibrium real ae falls-

This hinders labor market clearin-

Inflation allos the real aes to reache/uilibrium le,els ithout nominal ae cuts-

Therefore1 moderate inflation impro,es the

functionin of labor markets-


64/74

slide %"CHAPTER 4 Money and Inflation

Hyperinfation

def3 (#$ per month

All the costs of moderate inflation described

abo,e become HUGEunder hyperinflation-

Money ceases to function as a store of ,alue1

and may not ser,e its other functions 8unit of

account1 medium of exchane9- .eople may conduct transactions ith barter

or a stable forein currency-


65/74

slide %(CHAPTER 4 Money and Inflation

=hat causes hyperinfation>

@yperinflation is caused by excessi,e moneysupply roth3

5hen the central bank prints money1 the price

le,el rises-

If it prints money rapidly enouh1 the result is

hyperinflation-

A 3ew e;a(ples o3


66/74

slide %%CHAPTER 4 Money and Inflation

A 3ew e;a(ples o3

hyperinfation

moneygrowth %

inflation%

Israel1 '*!F*( 2( 2)(

.oland1 '*F# !"" "##0raKil1 '*)F" '!(# '!2!

Arentina1 '**F# '2%" ''2

.eru1 '**F# 2)" !*"?icaraua1 '*)F' "' (2%'

0oli,ia1 '*"F*( "2#* %('(

=hy 0o:ern(ents create


67/74

slide %)CHAPTER 4 Money and Inflation

=hy 0o:ern(ents create

hyperinfation

5hen a o,ernment cannot raise taxes or sellbonds1

it must finance spendin increases by printin

money-

In theory1 the solution to hyperinflation is simple3

stop printin money-

In the real orld1 this re/uires drastic and painful

fiscal restraint-


68/74

slide %*CHAPTER 4 Money and Inflation

The Classical *ichoto(y

&eal 'ariables3Measured in physical units /uantities and relati,e prices1 for e3ample:

/uantity of output produced

real ae3 output earned per hour of ork

real interest rate3 output earned in the futureby lendin one unit of output today

(o!inal 'ariables: Measured in money units1 e$g$,

nominal ae3 rupees per hour of ork- nominal interest rate3 ;upees earned in future

by lendin one dollar today-

the price le,el3 The amount of 3 ;upees needed


69/74

slide %CHAPTER 4 Money and Inflation

The Classical *ichoto(y

?ote3 ;eal ,ariables ere explained in Chap !1nominal ones in Chapter "-

)lassical dichoto!y3

the theoretical separation of real and nominal,ariables in the classical model1 hich implies

nominal ,ariables do not affect real ,ariables-

(eutrality of !oney3 Chanes in the money

supply do not affect real ,ariables-

In the real orld1 money is approximately neutral

in the lon run-


70/74

Chapter u((aryChapter u((ary

Money the stock of assets used for transactions

ser,es as a medium of exchane1 store of ,alue1 and

unit of account-

Commodity money has intrinsic ,alue1 fiat money

does not-

Central bank controls the money supply-

Uuantity theory of money assumes ,elocity is stable1concludes that the money roth rate determines the

inflation rate-

CHAPTER 4 Money and Inflation slide )#


71/74


?ominal interest rate e/uals real interest rate < inflation rate

the opp- cost of holdin money

Jisher effect3 ?ominal interest rate mo,esoneFforFone B expected inflation-

Money demand

depends only on income in the Uuantity Theory

also depends on the nominal interest rate

if so1 then chanes in expected inflation affect thecurrent price le,el-

CHAPTER 4 Money and Inflation slide )'


72/74


Costs of inflation

)3pected inflation

shoeleather costs1 menu costs1

tax & relati,e price distortions1incon,enience of correctin fiures for inflation

#ne3pected inflation

all of the abo,e plus arbitrary redistributions of

ealth beteen debtors and creditors

CHAPTER 4 Money and Inflation slide )2


73/74


@yperinflation

caused by rapid money supply roth hen money

printed to finance o,t budet deficits

stoppin it re/uires fiscal reforms to eliminateo,t:s need for printin money

CHAPTER 4 Money and Inflation slide )!


74/74


Classical dichotomy In classical theory1 money is neutralFFdoes not affect

real ,ariables-

=o1 e can study ho real ,ariables are determinedBo reference to nominal ones-

Then1 money market e/:m determines price le,el

and all nominal ,ariables-

Most economists belie,e the economy orks thisay in the lon run-

chapter 4_money & inflation

Documents