Presentation on theme: "Discussion Question Last year, the Federal Reserve engaged in open-market operations to the tune of 600 billion dollars. The discount rate and federal."— Presentation transcript:
1Discussion QuestionLast year, the Federal Reserve engaged in open-market operations to the tune of 600 billion dollars. The discount rate and federal funds rates are at all time lows. Based on the quantity theory of money, this is sure to cause inflation. In 2009, we experienced the atypical scenario of deflation. With a group of 4, create a consensus for the following:How can deflation seem good for the consumer but harmful to the economy as a whole?How can inflation seem harmful to the consumer while at the same time be good for the economy as a whole?
2Chapter 30 - Money Growth and Inflation Inflation indicators:Consumer Price Index (CPI)GDP DeflatorHow do we analyze the price level?Inflation, disinflation, deflation, hyperinflation,3 Theories:Quantity Theory, Demand-Pull, Cost-PushChapter 30 - Money Growth and Inflation
4Chapter 30 - Money Growth and Inflation Readdress the effects of Inflation:Inflation lowers value of moneyEach dollar buys a smaller quantity of goods and servicesNegatively affects people:On a fixed incomeWithout a COLA in their contractBanks that have offered fixed rates of interestPeople that are unaffected/helped:On a flexible incomeWith a COLA in their contractBorrowers that have borrowed at fixed rates of interestChapter 30 - Money Growth and Inflation
5What does a Lack of Inflation Indicate? GrowthBorrowingSpendingExpansion
6What Can The Fed Do To Boost The Economy? Expansionary Monetary Policy:Buy BondsLower interest ratesIncrease borrowingCreate inflation (increase in price levels)
7Effects of Low Interest Rates Generally, low interest rates stimulate the economy because the cost of credit is low.Consumers buy cars and houses.Businesses expand, invest in capital, etc.Impact of Lowering Rates:The cost of borrowing money goes down.Induced consumer spending increases economic activity.Low interest rates cut the cost of capital for businesses and improve profit margins and encourages expansion.
8What does Too Much Inflation Indicate? Large Money SupplySpeculative BubblesOver Zealous GrowthIrrationality in the MarketToo much borrowing and spending
9How can the fed slow the economy? The Fed raises interest rates as an effective way to fight inflation.Consumers pay more to borrow money, dampening spending.Businesses have difficulty borrowing; unemployment rises.The Fed generally raises rates as an effective way to quell inflation (a sustained rise in the general price level).Inflation means that your money is worth lessImpact of Raising Rates:Businesses have difficulty in obtaining loans for expansion; unemployment risesConsumers will pay higher interest rates on credit cards and mortgages, which can cool spending.
10Money Market GraphNominal Interest RateInterest Rates are high, qd of money is low because people prefer to have their money in a financial assett (bonds, cds, savings,etc.)Interest rates are low, there is little incentive to save; people prefer to have their money on hand for spending20%5%1%D (Demand for Money)Quantity of Money
11Money Market Graph Who controls the money supply? The FED! Nominal Interest RateS (Supply of Money)Who controls the money supply?The FED!The supply curve is perfectly inelastic because the supply of money is not controlled by the interest rate20%5%1%4 TrillionQuantity of Money
12Money Market GraphNominal Interest RateS2S of MoneyS1Increase money supply, decrease interest rates (easy money policy, expansionary monetary policy, ramp up borrowing and spending, price levels rise, S1)Decrease money supply, increase interest rates (tight money policy, contractionary monetary policy, slow down borrowing and increase saving, price levels fall, s2)How do they do this?OMOsRRRDR/FFR20%5%1%Quantity of Money4 Trillion
20The Effects of a Monetary Injection What happens if the Fed doubles the supply of money by through open-market operations?Quantity Theory of Money – the quantity of money available in the economy determines the value of money and inflationNew equilibriumSupply curve shifts rightInterest Rates will fallPrice levels increase
21a brief look at the adjustment process Immediate effect of a monetary injectionCreates an excess supply of moneyQS>QD of moneyPeople will want to spend excess moneyIncrease in demand for goods and servicesUltimately, price of goods and services increases as a result of too much money chasing too little amount of goodsIncrease in price level (CPI/GDP Deflator)
24The classical dichotomy & monetary neutrality Classical dichotomy – division into two groups; division between the real side of the economy and the monetary side.Theoretical separation of nominal & real variablesNominal variables – variables measured in monetary units (not accounting for inflation)Real variables – variables measured in physical units (accounting for inflation)GDP, Interest Rates, Income, etc.
25Nominal and Real Variables ==How does this affect consumers?Reduced purchasing powerInterest rates on money in the bank must keep up with the 100% increase in price levels
26The classical dichotomy & monetary neutrality Monetary neutrality – changes in money supply don’t affect real variables in the long run, only nominal variables in the long runLong run, nominal variables adjust to match expected inflationShort run – less than 2 yearsLong run – greater than 2 years
27Velocity and the quantity equation Velocity of money (V)Average number of times a dollar is used to purchase a final product during a yearSpeed at which a dollar bill travels from wallet to walletHow many times is a dollar bill used to pay for a newly produced good or service?Used to determine the growth of the economy and bank lendingSlow velocity means slow spending, slow lending
28Velocity and the quantity equation Quantity Equation – shows that money supply has a direct, proportional relationship with the price level.Quantity equation: M × V = P × YQuantity of money (M)Velocity of money (V)Price Level (P)GDP (Y)Classical economists believed that velocity (V) of money was constant, virtually unchangingReal GDP (Y) was unchanged by increases in quantity of moneyIncreases in money supply (m) would lead to proportional increases in price level (P)
29Velocity of MoneyEconomy has $+$500+$700.00+$200.00+$300.00+$300$ $300 + $700 + $200 + $300 = $2000
30$ $300 + $700 + $200 + $300 = $2000V = Price x GDP(Nominal)/MSV = $400 x 5/1000V = $2000/1000V = 2Quantity EquationM x V = P x Y1000 x 2 = $400 x 52000 = 2000Monetary Neutrality$10,000 x 2 = $2000 x 5
31The Inflation TaxHow does government cause countries experience inflation?Government RevenueTaxation – levying taxes, income, sales, excise, property, etc.Borrowing – selling of bondsPrinting of moneyInflation tax – the revenue the government raises by creating moneyNo one receives a bill for this taxIncrease in price levels, dollars are less valuableTax burden is on everyone that holds moneyU.S. – 3% inflationNovember 2008 estimated Zimbabwe's annual inflation rate at 89.7 sextillion (1021) percent. By December 2008, annual inflation was estimated at 6.5 quindecillion novemdecillion percent (6.5 x 10108%, the equivalent of 6 quinquatrigintillion 500 quattuortrigintillion percent, or 65 followed by 107 zeros – one googol 65 million percent).
32Fisher EffectReal interest rate = Nominal interest rate – Inflation rateBank posts nominal interest rate of 7% per year and inflation is 3%, real interest rate is 4% per yearNominal interest rate = Real interest rate + Inflation rateFisher effect – developed by Irving Fisher, one-for-one long-run adjustment of nominal interest rate to inflation rateNominal interest rate adjusts to expected inflation
33Nominal Interest rate is 8% Fisher EffectNominal Interest rate is 8%Inflation is 3%Real Interest Rate = 8% - 3%r = 5%Inflation is 8%Real Interest Rate = 8%-8%r = 0
34Unanticipated Inflation Problems arise when there is unanticipated inflation:Creditors (lenders) lose and borrowers gain if the lender does not anticipate inflation correctly.For those who borrow, this is similar to getting an interest-free loan.When the Fed increases the rate of money growthHigher inflation rateHigher price levels
35Is Inflation a Problem? Costs of Inflation (real variables) Shoeleather costsResources wasted when inflation encourages people to reduce their money holdingsMore frequent trips to the bank cause your shoes to wear out
36Is Inflation a Problem? Menu costs Costs of changing prices Inflation – increases input costs that firms must bear
37Is Inflation a Problem?Relative-price variability & misallocation of resourcesInflation distorts relative prices, consumer and firms decisions become distortedMarkets are not as efficient when they can’t predict inflation
38Is Inflation a Problem? Inflation induced tax distortion Consumer decisions – stop savingMarkets – less able to set contracts/loans, to their best use
39Why Is Inflation a Problem? Confusion and inconvenienceMoney is the yardstick with which we measure economic transactionsThe Fed’s job is to ensure the reliability of moneyWhen the Fed increases the money supply, creates inflationErodes the real value of the unit of account, which can cause confusion
40Why Is Inflation a Problem Costs of Inflation:Unexpected inflationRedistributes wealth among the populationRedistribute wealth among borrowers and lenders
42Flow Chart – Costs of Inflation, pgs. 677 - 682 Shoeleather CostsMenu CostsRelative-Price Variability and the Missallocation of ResourcesInflation-Induced Tax DistortionsConfusion and InconvenienceA Special Cost of Unexpected Inflation: Arbitrary Redistributions of WealthDescription - Avoiding inflation- Definition - Bolivia Example (briefly describe)Description - Firm price changes- Definition- Effect of InflationDescription - Eatabit Eatery example- Relative prices and Consumption decisionsDescription - Discourage saving (capital gains)- Microsoft example- Tax treatment of nominal interest- Solution to the problemDescription- Yardstick Metaphor- Increase in Money Supply- Confusion as a result of inflationDescription- Unexpected inflation- Sam Student example- Predictable vs. unpredictable inflation- Cost of unexpected inflation
43Mankiw Practice Chapter 29 Mankiw Practice Chapter 30 Free Responses Due WednesdayChapter 30 Mankiw Practice Chapter 29Mankiw Practice Chapter 30Free ResponsesDaily TensNotes Chapter 30Terms
44Formulas V = (P × Y)/M Quantity equation: M × V = P × Y Real Interest Rate = Nominal interest rate – Inflation rateNominal interest rate = Real interest rate + Inflation ratePolitical Cartoon:What do you think the event(s) or issue(s) are that inspired the cartoon? What is the cartoonist trying to portray in the cartoon?Are there any real people/places in the cartoon? Who are these people?Are there symbols in the cartoon? What are they and what do they represent?What is your opinion of the cartoon, do you agree or disagree? Why?
45FormulasLast year, the Federal Reserve engaged in open-market operations to the tune of 600 billion dollars. As a result, the federal funds rate are at all time lows. Based on the quantity theory of money, this is sure to cause inflation. Why would the Fed want to create inflation in the economy?What should the FED do if the economy begins to expand beyond what is normal inflation? What type of monetary policy is this referred to as?Describe the three theories of inflation.Political Cartoon:What do you think the event(s) or issue(s) are that inspired the cartoon? What is the cartoonist trying to portray in the cartoon?Are there any real people/places in the cartoon? Who are these people?Are there symbols in the cartoon? What are they and what do they represent?
46Chapter 30 – Application Questions Why do people hold money?How will an increase in the interest rate on bonds influence the amount of money that people will want to hold?How would each of the following influence the quantity of money you would like to hold?An increase in the interest rate on checking depositsAn increase in the expected rate of inflationAn increase in incomeUse the quantity equation for this problem. Suppose the money supply is $200, real output is 1,000 units, and the price per unit of output is $1.What is the value of velocity?If velocity is fixed at the value you solved for in part (a), what does the quantity theory of money suggest will happen if the money supply is increased to $400?Is your answer in part (b) consistent with the classical dichotomy? Explain.When inflation gets very high, people do not like to hold money because it is losing value quickly. Therefore, they spend it faster. If, when the money supply is doubled, people spend money more quickly, what happens to prices? Do prices more than double, less than double, or exactly double? Why?Suppose the money supply at the beginning of this problem refers to M1. That is, the M1 money supply is $200. What would the M2 quantity equation look like if the M2 money supply were $500 (and all other values were as stated at the beginning of the problem)?
47Chapter 30 - Daily Assignment Questions Why do people hold money? People - buy things, groceries, house payment, gas, prepare for accidents or medical emergencys, etc. Businesses – pay their workers, buy supplies.How will an increase in the interest rate on bonds influence the amount of money that people will want to hold? Interest rates make it more costly to hold money. $1000, 10% interest, it would cost you $100 a year. If it is 1%, the cost of holding your money is only $10.How would each of the following influence the quantity of money you would like to hold?An increase in the interest rate on checking deposits - Increase incentive to hold your money depositsAn increase in the expected rate of inflation - Reduce your incentive to hold moneyAn increase in income - Increase your incentive to hold money for consumption purposes
48Chapter 30 - Daily Assignment Questions Use the quantity equation for this problem. Suppose the money supply is $200, real output is 1,000 units, and the price per unit of output is $1.What is the value of velocity? V = (1,000 x $1)/$200 = 5If velocity is fixed at the value you solved for in part (a), what does the quantity theory of money suggest will happen if the money supply is increased to $400? $400 x 5 = $2 x 1,000, prices will double from $1 to $2Is your answer in part (b) consistent with the classical dichotomy? Explain. Yes. The classical dichotomy divides economic variables into real and nominal. According to classical economists money affects nominal variables proportionately and has no impact on real variables. In part (b), prices double, but real output remains constant.When inflation gets very high, people do not like to hold money because it is losing value quickly. Therefore, they spend it faster. If, when the money supply is doubled, people spend money more quickly, what happens to prices? Do prices more than double, less than double, or exactly double? Why? Money has a proportional impact on nominal output if V is constant If V grows, a doubling of M will cause P to more than double.Suppose the money supply at the beginning of this problem refers to M1. That is, the M1 money supply is $200. What would the M2 quantity equation look like if the M2 money supply were $500 (and all other values were as stated at the beginning of the problem)?$500 x 2 = $1 x 1,000, M2 velocity is 2.
49Money Market Graph The FED Reserve buys government securities The FED sells government securitiesThe FED lowers the RRRThe FED Raises the RRRGroup 5 – Velocity and the Quantity Equation Velocity of money, formula, math example, quantity equationGroup 6 – Five Steps of the Quantity Theory of Money List five steps (pg. 672)