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**Money and Inflation CHAPTER FOUR**

I’ve included a graph that unfolds over slides that tells the same story as Figure 4-1 on p.86 of the text. If you prefer to show Figure 4-1, you can “hide” slides and “unhide” slide 26.

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Money: definition Money is the stock of assets that can be readily used to make transactions.

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**Money: functions medium of exchange we use it to buy stuff**

store of value transfers purchasing power from the present to the future unit of account the common unit by which everyone measures prices and values If your students have taken principles of economics, they will probably be familiar with the material on this slide. It might be worthwhile, though, to take an extra moment to be sure that students understand that the definition of store of value (an item that transfers purchasing power from the present to the future) simply means that money retains its value over time, so you need not spend all your money as soon as you receive it. The idea should be familiar, even though Greg’s wording is a bit more sophisticated than most other texts.

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**Money: types fiat money commodity money has no intrinsic value**

example: the paper currency we use commodity money has intrinsic value examples: gold coins, cigarettes in P.O.W. camps, stone wheels up to 12 feet (3.6 meters) in diameter (Yap) Again, this material should be review for most students. Note: Many students have seen the film The Shawshank Redemption starring Tim Robbins and Morgan Freeman. Most of this film takes place in a prison. The prisoners have an informal “underground economy” in which cigarettes are used as money, even by prisoners who don’t smoke. Students who have seen the film will better understand “commodity money” if you mention this example. Also, the textbook (p.78) has a case study on cigarettes being used as money in POW camps during WWII.

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Money Supply Government control over supply of money is called monetary policy. In Ukraine, National Bank of Ukraine carries out monetary policy The primary way of controlling the supply of money is through the open-market operations: Purchase of government bonds from public increase money supply Sale of government bonds to public reduce money supply

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Measurement of Money

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**The Quantity Theory of Money**

A simple theory linking the inflation rate to the growth rate of the money supply. Begins with a concept called “velocity”…

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**Velocity basic concept: the rate at which money circulates**

definition: the number of times the average dollar bill changes hands in a given time period example: In 2003, $500 billion in transactions money supply = $100 billion The average dollar is used in five transactions in 2003 So, velocity = 5 In order for $500 billion in transactions to occur when the money supply is only $100b, each dollar must be used, on average, in five transactions.

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**Velocity, cont. This suggests the following definition: where**

V = velocity T = value of all transactions M = money supply

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**Velocity, cont. Use nominal GDP as a proxy for total transactions.**

Then, where P = price of output (GDP deflator) Y = quantity of output (real GDP) P Y = value of output (nominal GDP) You might ask students if they know the difference between nominal GDP and the value of transactions. Answer: nominal GDP includes the value of purchases of final goods; total transactions also includes the value of intermediate goods. Even though they are different, they are highly correlated. Also, our models focus on GDP, and there’s lots of great data on GDP. So from here on out, we’ll use the income version of velocity.

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The quantity equation The quantity equation M V = P Y follows from the preceding definition of velocity. It is an identity: it holds by definition of the variables.

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**Money demand and the quantity equation**

M/P = real money balances, the purchasing power of the money supply. A simple money demand function: (M/P )d = k Y where k = how much money people wish to hold for each dollar of income (k is exogenous)

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**Money demand and the quantity equation**

money demand: (M/P )d = k Y quantity equation: M V = P Y The connection between them: k = 1/V When people hold lots of money relative to their incomes (k is high), money changes hands infrequently (V is low).

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**back to the Quantity Theory of Money**

starts with quantity equation assumes V is constant & exogenous: With this assumption, the quantity equation can be written as

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**The Quantity Theory of Money, cont.**

How the price level is determined: With V constant, the money supply determines nominal GDP (P Y ) Real GDP is determined by the economy’s supplies of K and L and the production function (chap 3) The price level is P = (nominal GDP)/(real GDP) It’s worthwhile to underscore the order (logical, though not necessarily chronological order) in which variables are determined in this model (as well as the other models students will learn in this course). First, real GDP is already determined outside this model (real GDP is determined by the model from chapter 3, which was completely independent of the money supply or velocity or other nominal variables). Second, the Quantity Theory of money determines nominal GDP. Third, the values of nominal GDP (PY) and real GDP (Y) together determine P (as a ratio of PY to Y). If, on an exam or homework problem, students forget the logical order in which endogenous variables are determined --- or on a more fundamental level, forget which variables are endogenous and which are exogenous --- then they are much less likely to earn the high grades that most of them desire. [Note the similarity between the way P is determined and the definition of the GDP deflator from chapter 2.]

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**The Quantity Theory of Money, cont.**

The quantity equation in growth rates:

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**The Quantity Theory of Money, cont.**

Let (Greek letter “pi”) denote the inflation rate: The result from the preceding slide was: Solve this result for to get

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**The Quantity Theory of Money, cont.**

Normal economic growth requires a certain amount of money supply growth to facilitate the growth in transactions. Money growth in excess of this amount leads to inflation. The text on this slide is an intuitive way to understand the equation. For students that are more comfortable with concrete numerical examples, you could offer the following: Suppose real GDP is growing by 3% per year over the long run. Thus, production, income, and spending are all growing by 3%. This means that the volume of transactions will be growing as well. The central bank can achieve zero inflation (on average over the long run) simply by setting the growth rate of the money supply at 3%, in which case exactly enough new money is being supplied to facilitate the growth in transactions.

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**The Quantity Theory of Money, cont.**

Y/Y depends on growth in the factors of production and on technological progress (all of which we take as given, for now). Hence, the Quantity Theory of Money predicts a one-for-one relation between changes in the money growth rate and changes in the inflation rate. Note: the theory doesn’t predict that the inflation rate will equal the money growth rate. It *does* predict that a change in the money growth rate will cause an equal change in the inflation rate. Next: If the Quantity Theory of Money is correct, then we would expect that countries with high inflation have high money growth rates, and countries with low inflation have low money growth rates. Let’s look at the data to see whether this implication is consistent with real-world experience….

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**International data on inflation and money growth**

Figure 4-2 from p.87 of the text.

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**U.S. data on inflation and money growth**

Figure 4-1 from p.86. We see here that the positive relationship between money growth and inflation implied by the Quantity Theory holds up over time as well as across countries.

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**U.S. Inflation & Money Growth, 1960-2003**

This graph unfolds over this and the next three slides. Its purpose is to show that the long-run trends in inflation and money growth are highly correlated, even though the short-run movements aren’t.

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**Inflation and interest rates**

Nominal interest rate, i not adjusted for inflation Real interest rate, r adjusted for inflation: r = i

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**The Fisher Effect The Fisher equation: i = r + S = I determines r .**

Hence, an increase in causes an equal increase in i. This one-for-one relationship is called the Fisher effect. Note that S and I are real variables. In chapter 3, we learned about the factors that determine S and I. These factors did not include the money supply, velocity, inflation, or other nominal variables. Hence, in the classical (long-run) theory we are learning, changes in money growth or inflation do not affect the real interest rate. This is why there’s a one-for-one relationship between changes in the inflation rate and changes in the nominal interest rate. (Again, the Fisher effect does not imply that the nominal interest rate EQUALS the inflation rate. It implies that CHANGES in the nominal interest rate equal CHANGES in the inflation rate, given a constant value of the real interest rate.)

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**U.S. inflation and nominal interest rates, since 1954**

Inflation rate An updated replica of Figure 4-3 on p.90 of the text.

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**Inflation and nominal interest rates across countries**

Figure 4-4 on p.91

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**Ex ante and ex post inflation**

Ex ante variable: e = expected inflation rate Ex post variable: = actual inflation rate (not known until after it has occurred) When lender and borrower agree on a nominal interest rate, they do not know what the rate of inflation is going to be, hence… Modified Fisher Effect: i=r+ e

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**Nominal interest rate and the demand for money**

i is opportunity cost of holding money: you can deposit it in a savings account which earn the nominal interest rate rather then keep it under the mattress An increase in the nominal interest rate represents the increase in the opportunity cost of holding money rather than bonds, and would motivate the typical consumer to hold less of his wealth in the form of money, and more in the form of bonds (or other interest-earning assets). An increase in real income (other things equal) causes an increase in the consumer’s consumption and therefore spending. To facilitate this extra spending, the consumer will require more money. Thus, the consumer would like a larger fraction of his wealth to be in the form of money (rather than bonds, etc). This might involve redeeming some of his bonds. Or it might simply involve holding the additional income in the form of money rather than putting it into bonds.

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**The supply of real money balances**

Equilibrium The supply of real money balances Real money demand

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**What determines what variable how determined (in the long run)**

M exogenous (the Central Bank) r adjusts to make S = I Y Again, it is very important for students to learn the logical order in which variables are determined. I.e., you do NOT need to know P in order to determine Y. You DO need to know Y in order to determine L, and you need to know L and M in order to determine P. P adjusts to make

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**How P responds to M For given values of r, Y, and e,**

a change in M causes P to change by the same percentage --- just like in the Quantity Theory of Money. This slide shows the connection between the money market equilibrium condition and the (simpler) Quantity Theory of Money, presented earlier in this chapter.

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How P responds to e For given values of r, Y, and M ,

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**Why is inflation bad? Discussion Question**

Many of the social costs of inflation are not hard to figure out, if students “think like an economist.” Suggestion: After you pose the question, don’t immediately ask for students to volunteer their answers. Instead, tell them to think about the question for a moment, jot down their answers, and THEN ask for volunteers. You will get more participation (quantity & quality) this way, especially from students who don’t consider themselves fast thinkers. After presenting the following slides (which describe the costs), see how many of the costs presented here were anticipated by the students’ responses to the question on this slide.

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**A common misperception**

Common misperception: inflation reduces real wages This is true only in the short run, when nominal wages are fixed by contracts. In the long run, the real wage is determined by labor supply and the marginal product of labor, not the price level or inflation rate. Consider the data…

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**Average hourly earnings & the CPI**

Hourly earnings in 2004 dollars Average hourly earnings (nominal) First, point out the CPI (the dark blue line, right-hand scale): It’s risen tremendously over the past 40 years. If the common misperception were true, then the real wage should show exactly the opposite behavior. It doesn’t. Average hourly earnings (the red line) have increased roughly in tandem with the cost of living. As a result, inflation has not caused a downward trend in the real wage (hourly earnings in today’s dollars, green). The real wage isn’t constant - it varies within the $15 to $18 range - but there is no downward trend in the real wage over the long term. (The movements in the real wage are due to movements in the labor supply and MPL curves.) Original source: BLS: Form 790, obtained from - Consumer Price Index

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**The classical view of inflation**

The classical view: A change in the price level is merely a change in the units of measurement. So why, then, is inflation a social problem?

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Homework Assignment Read Section 4-6 of the textbook. Answer the following questions: Do economists and other people differ in their view on costs of inflation? What are the costs of expected inflation? What are the costs of unexpected inflation? Is there anything good about inflation anyway?

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**The Classical Dichotomy**

Real variables are measured in physical units: quantities and relative prices, e.g. quantity of output produced real wage: output earned per hour of work real interest rate: output earned in the future by lending one unit of output today Nominal variables: measured in money units, e.g. nominal wage: dollars per hour of work nominal interest rate: dollars earned in future by lending one dollar today the price level: the amount of dollars needed to buy a representative basket of goods slide 37

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**The Classical Dichotomy**

Classical Dichotomy : the theoretical separation of real and nominal variables in the classical model, which implies nominal variables do not affect real variables. Neutrality of Money : Changes in the money supply do not affect real variables. In the real world, money is approximately neutral in the long run.

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**Chapter summary Money Quantity theory of money**

the stock of assets used for transactions serves as a medium of exchange, store of value, and unit of account. Commodity money has intrinsic value, fiat money does not. Central bank controls money supply. Quantity theory of money assumption: velocity is stable conclusion: the money growth rate determines the inflation rate.

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**Chapter summary Nominal interest rate Money demand**

equals real interest rate + inflation rate. Fisher effect: nominal interest rate moves one-for-one w/ expected inflation. is the opp. cost of holding money Money demand depends on income in the Quantity Theory more generally, it also depends on the nominal interest rate; if so, then changes in expected inflation affect the current price level.

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**Chapter summary Classical dichotomy**

In classical theory, money is neutral--does not affect real variables. So, we can study how real variables are determined w/o reference to nominal ones. Then, eq’m in money market determines price level and all nominal variables. Most economists believe the economy works this way in the long run.

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Money. Money: Definition Money Money is the stock of assets that can be readily used to make transactions.

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