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Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 15 Money, Inflation and Banking.

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Presentation on theme: "Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 15 Money, Inflation and Banking."— Presentation transcript:

1 Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 15 Money, Inflation and Banking

2 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Chapter 15 Topics Alternative forms of money. Money and the absence of double coincidence of wants. The causes and effects of long-run inflation. Financial intermediation and banking.

3 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Alternative Forms of Money Commodity money (made of precious metal) Circulating private bank notes (local currency) Commodity-backed paper currency (entitled to gold, save cost of carrying goods) Fiat money (valueless, believe to be accepted in future transaction) Transactions deposits at banks (purchase by check or debit card)

4 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Role of Money Barter trade: exchange of goods for goods. Money trade: exchange of goods for money. Why do people need to use money as medium of exchange (existence of money trade) ? Barter exchange is difficult in highly-developed, specialized economies. For example, lack of double coincidence of wants problem happens all the time. Money trade helps to fix this problem, and therefore, promote transactions and welfare.

5 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Lack of Double-Coincidence of Wants and the Role of Money An economy with many goods and people are specialize in what they produce and consume. Ex: Person I produces good 1, but need to consume good 2. Trade between person I and II without money can be performed if person II produces good 2 and consumes good 1. That is, double-coincidence of wants occurs. In a economy with many goods, a successful trade is hard to perform due to lack of double-coincidence of wants problem. To pursue a successful trade, people have to search hard, which is costly. This hurts welfare (transactions are low). Search costs are reduced dramatically if everyone accepts money.

6 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 15.1 An Absence-of-Double- Coincidence Economy

7 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 15.2 Good 1 as a Commodity Money in the Absence-of-Double- Coincidence Economy Good 1 is served as commodity money. More transactions happen with commodity money.

8 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 15.3 Fiat Money in the Absence- of-Double-Coincidence Economy With money as medium of exchange, successful transactions increase greatly.

9 Copyright © 2008 Pearson Addison-Wesley. All rights reserved The Effects of Long-Run Inflation Money may not be neutral in SR (sticky nominal wage models in Ch. 12). Money is neutral in LR (a change in level of M s has no long-run effect when prices can adjust freely). However, a change in growth rate of M s has LR effect on real variables (not superneutral). Why: an increase in the money growth rate increases the inflation rate and the nominal interest rate, and reduces employment and output.

10 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 15.4 Scatter plot of the Inflation Rate vs. the Growth Rate in M0 for the United States, 1960–2006 The best fit to the set of points is the positively sloped straight line in the figure. So the two variables are positively correlated, though not strongly so. Conventional Wise: the sustained inflations are usually the result of sustained growth in M s.

11 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Equation 15.1 Assume that the central bank causes the money supply to grow at a constant rate x. M’: money supply in future period. M: money supply in current period. x: growth rate of money supply from current period to future period.

12 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Equation 15.2 In equilibrium, nominal money supply equals nominal money demand.

13 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Equation 15.3 Nominal money supply also equals nominal money demand in the future period.

14 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Equation 15.4 Combine the previous two equations.

15 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Implication of Equation 15.4 With constant growth rate in M s, all real variables stay constant, and the growth in M s is reflected by growth in price level. Money growth rate = inflation rate That is, x = i Q: if x increases, what happens to real variables?

16 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Equation 15.5 The consumer’s intertemporal marginal condition (recall two-period model in Ch.8).

17 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Equation 15.6 Marginal condition reflecting the consumer’s tradeoff between current leisure and future consumption: Wage income cannot be spent on consumption goods until next period, The effective real wage is, therefore, P w / P’. Recall from Ch.4, the MRS l, C = w (real wage)

18 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Equation 15.7 Marginal condition reflecting the consumer’s tradeoff between current leisure and current consumption: R: nominal interest rate. The RHS is the relative price of leisure to consumption. When R increases, leisure becomes cheaper, so consumer trades C for l.

19 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 15.5 The Long-Run Effects of an Increase in the Money Growth Rate N s curve shifts as a result of substitution effect.

20 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Conclusion A change in the growth rate of money supply has real effects in that higher growth in money leads to higher inflation, which changes consumer’s decision on leisure and consumption, which affects equilibrium output and employment. Moreover, higher inflation increases the nominal interest rate, which is opportunity cost of carrying money. As a result, consumers tend to hold less money balances.

21 Copyright © 2008 Pearson Addison-Wesley. All rights reserved The Friedman Rule Inflation causes an inefficiency, in that it distorts intertemporal decisions (more leisure, less consumption goods). The Friedman rule is a prescription for monetary growth that eliminates the inefficiency caused by inflation. The Friedman rule specifies that the money stock grow at a rate that makes the nominal interest rate zero.

22 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Equation 15.9 Pareto optimality requires that (recall from Ch.5)

23 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Equation In a competitive equilibrium (recall from Ch.4),

24 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Equation Also, in a competitive equilibrium, Compared with Equation 15.9, the CE is not PO if R>0. Inefficiency arises due to the positive nominal interest rate. Particularly, with R>0, too much leisure is consumed, which leads to lower labor supply, lower outputs and lower consumption in economy.

25 Copyright © 2008 Pearson Addison-Wesley. All rights reserved How to Restore Efficiency? Optimal Monetary Policy - Friedman Rule To restore efficiency, one needs to set R = 0. This implies x = -r < 0. That is, the money supply decreases over time. So the optimal policy to for CB to generate a deflation that continues forever. By doing so, because of zero opportunity cost of carrying money, all transactions are carried out by money. Efficiency is restored since consumers do not consumer leisure too much, which increases labor supply, and therefore, output.

26 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Why not Popular in Practice In practice, no central bank appears to have adopted a Friedman rule to guide monetary policy. Friedman rule is not followed by CB. Reason 1: Welfare losses from moderate inflation is quite small. Reason 2: Liquidity trap: monetary policy does not function any more with zero nominal interest rate. –With R = 0, money and bond are identical assets. So the open market operation would have no real effect in SR.

27 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Properties of Assets Rate of return: payoff on the asset over some specified period of time divided by the initial investment in the asset, minus one. Risk: the risk that matters is the one that an asset contributes to the whole portfolio. Maturity: the time it takes for an asset to pay off. Liquidity: a measure of how long it takes to sell an asset for its market value and of how high the costs are of selling the asset.

28 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Defining Characteristics of Financial Intermediaries 1.Borrow from one group of economic agents and lend to another. 2.Well-diversified with respect to both assets and liabilities. 3.Transform assets. 4.Process information.

29 Copyright © 2008 Pearson Addison-Wesley. All rights reserved The Diamond-Dybvig Banking Model Capture key features of banks. Explain why bank run (bankruptcy) may happen. What should government do to prevent bank run.

30 Copyright © 2008 Pearson Addison-Wesley. All rights reserved The Diamond-Dybvig Banking Model Three periods, T = 0, 1, 2. N consumers with endowment of one unit of good at T=0. Production function: convert one unit of good at T=0 to (1+r) unit of good at T=2. If production is interrupted at T=1, receive one unit of good at T=1. And production stops with nothing produced at T=2. Two types of consumers: early (consume in period 1) and late (consume in period 2). Information on type is unknown at T=0, but reveal at T=1. At T=1, with prob. t to be early type and (1-t) to be late type.

31 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 15.6 The Utility Function For a Consumer in the Diamond–Dybvig Model

32 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Equation The marginal rate of substitution of early consumption for late consumption is

33 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 15.7 The Preferences of a Diamond–Dybvig Consumer

34 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Optimal Arrangement without Bank At T=0, the optimal arrangement for consumers is c 1 = 1, c 2 = 1 + r. However, the arrangement with bank is better than this one.

35 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Bank and Deposit Contract Offer deposit contract (c 1, c 2 ) to consumers. That is, early consumers receive c 1 at T=1, and late consumer receive c 2 at T=2. Banks behave competitively, so earn zero profits. Bank cannot tell who is who. That is, if late type come to withdraw at T=1, bank offers them c 1. However, the contract is designed in a way that late type have no incentive to withdraw early.

36 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Equation First constraint that a deposit contract must satisfy is At T=0, all consumers deposit goods at banks (N goods at T=0) and banks invest all deposits. At T=1, banks interrupt x fraction of investment to pay C 1 to early consumers.

37 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Equation Second constraint that a deposit contract must satisfy is At T=2, banks obtain (1+r)(1-x) N goods from production that is not interrupted and pay C 2 to late consumers.

38 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Equation Combine the two constraints to get one: Lifetime budget constraint for bank, which governs how the deposit contract (c 1, c 2 ) is determined.

39 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Equation Re-write the constraint:

40 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 15.8 The Equilibrium Deposit Contract Offered by the Diamond–Dybvig Bank A: optimal deposit contract. D: optimal arrangement without bank. B: arrangements where c 1 = c 2. Two features at A: 1. c 2 > c c 1 > 1, c 2 < (1 + r)

41 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Bank Run The fact that bank supplies consumers with insurance against the need for liquidity leaves the bank open to bank run. Good equilibrium: with optimal deposit contract, early consumers withdraw at T=1, and late consumers withdraw at T=2. Bad equilibrium: with optimal deposit contract, all consumers withdraw at T=1. Bank run happens because bank cannot satisfy total withdrawal demand at T=1. (N-1)c 1 > N

42 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Deposit Insurance Remove the incentive of late consumers to withdraw early by assuring them that they will receive c 2 given by bank deposit contract. In the U.S., deposits in depository institutions are insured up to $100,000 by the Federal Deposit Insurance Corporation. So even banks fail, each depositor can receive the value of their deposit up to $100,000.


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