5 Fiat money is money by declaration. It has no intrinsic value.Commodity money is money thathas intrinsic value.When people use gold as money, theeconomy is said to be on a gold standard.
6 Money Supply vs. Monetary Policy The money supply is the quantity of money available in an economy.The control over the money supply is called Monetary Policy.In the United States, monetary policy is conducted in a partiallyindependent institution called the Federal Reserve, or the Fed.
7 U.S. Treasury Bonds To expand the Money Supply: The Federal Reserve buys U.S. Treasury Bonds and pays for them with new money.To reduce the Money Supply:The Federal Reserve sells U.S. Treasury Bonds and receives the existing dollars and then destroys them.The bearer of the United StatesTreasury bond is hereby promisedthe repayment of the principlevalue plus the interest which itincurs through the terms statedthereof.The United States will justly repayits bearers in its entirety andwill not default under anycircumstances.Signature of the President___________________US. Treasury Bond
8 The Federal Reserve controls the money supply in three ways. 1) Open Market Operations (buying and selling U.S. Treasury bonds).2) D Reserve requirements (never really used).3) D Discount rate which member banks (not meeting the reserve requirements) pay to borrow from the Fed.The bearer of the United StatesTreasury bond is hereby promisedthe repayment of the principlevalue plus the interest which itincurs through the terms statedthereof.The United States will justly repayits bearers in its entirety andwill not default under anycircumstances.Signature of the President___________________US. Treasury Bond
9 The Quantity Theory of Money The quantity equation is an identity: the definitions of the four variables make it true. If one variable changes, one or more of the others must also change to maintain the identity. The quantity equation we will use from now on is the money supply (M) times the velocity of money (V) which equals price (P) times output (Y):Money Velocity = Price OutputM V = P YBecause Y is also total income, V in the quantity equations is called the income velocity of money. This tells us the number of times a dollar bill changes hands in a given period of time.
10 The Money Demand Function and the Quantity Equation Let’s now express the quantity of money in terms of the quantity ofgoods and services it can buy. This amount, M/P is called real moneybalances. Real money balances measure the purchasing power of thestock of money.A money demand function is an equation that shows what determines the quantity of real money balances people wish to hold. Here is a simple money demand function:where k is a constant that tells us how much money people want to hold for every dollar they earn. This equation states that the quantity of real money balances demanded is proportional to real income.(M/P)d = k Y
11 The Money Demand Function and the Quantity Equation The money demand function is like the demand function for a particular good. Here the “good” is the convenience of holding real money balances. Higher income leads to a greater demand for real money balances. The money demand equation offers another way to view the quantity equation (MV= PY) where V = 1/k.This shows the link between the demand for money and the velocityof money. When people hold a lot of money for each dollar of income (k is large), money changes hands infrequently (V is small).Conversely, when people want to hold only a little money (k issmall), money changes hands frequently (V is large). In other words, the money demand parameter k and the velocity of money V are opposite sides of the same coin.
12 The Assumption of Constant Velocity The quantity equation can be viewed as a definition: it defines velocity V as the ratio of nominal GDP, PY, to the quantity of money M. But, if we make the assumption that the velocity of money is constant, then the quantity equation MV=PY becomes a useful theory of the effects of money.So, let’s hold it constant!MV = PY
13 Money, Prices and Inflation Three building blocks that determine the economy’s overall level of prices:The factors of production and the production function determinethe level of output Y.The money supply determines the nominal value of output, PY.This follows from the quantity equation and the assumption thatthe velocity of money is fixed.The price level P is then the ratio of the nominal value of output,PY, to the level of output Y.
14 In other words, if Y is fixed (from Chapter 3) because it depends on the growth in the factors of production and on technological progress, and we just made the assumption that velocity is constant,MV = PYor in percentage change form:% Change in M + % Change in V = % Change in P + % Change in Yif V is fixed and Y is fixed, then it reveals that % Change in M is what induces % Changes in P.The quantity theory of money states that the central bank, whichcontrols the money supply, has the ultimate control over the inflation rate. If the central bank keeps the money supply stable,the price level will be stable. If the central bank increases the money supply rapidly, the price level will rise rapidly.
15 Seigniorage: The Revenue From Printing Money The revenue raised through the printing of money is called seigniorage. When the government prints money to finance expenditure, it increases the money supply. The increase in the money supply, in turn, causes inflation. Printing money to raise revenue is like imposing an inflation tax.
17 Real and Nominal Interest Rates Economists call the interest rate that the bank pays the nominalinterest rate and the increase in your purchasing power thereal interest rate.This shows the relationship between the nominal interest rateand the rate of inflation, where r is real interest rate, i is thenominal interest rate and p is the rate of inflation, and rememberthat p is simply the percentage change of the price level P.r = i – p
18 Fisher Equation: i = r + p The Fisher EffectThe Fisher Equation illuminates the distinction betweenthe real and nominal rate of interest.Fisher Equation: i = r + pThe one-to-one relationshipbetween the inflation rate and the nominal interest rate isthe Fisher Effect.Actual (Market)Nominal rate ofinterestReal rateof interestInflationIt shows that the nominal interest can change for two reasons: becausethe real interest rate changes or because the inflation rate changes.
19 The quantity theory and the Fisher equation together tell us how money growth affects the nominal interest rate. According to the quantity theory, an increase in the rate of money growth of one percent causes a 1% increase in the rate of inflation.According to the Fisher equation, a 1% increase in the rate of inflation in turn causes a 1% increase in the nominal interest rates.Here is the exact link between our two familiar equations: The quantity equation in percentage change form and the Fisher equation.% Change in M + % Change in V = % Change in P + % Change in Y% Change in M + % Change in V = p % Change in Yi = r + p
20 Ex Ante versus Ex Post Real Interest Rates The real interest rate the borrower and lender expect when a loan ismade is called the ex ante real interest rate. The real interestrate that is actually realized is called the ex post real interest rate.Although borrowers and lenders cannot predict future inflation withcertainty, they do have some expectation of the inflation rate. Let pdenote actual future inflation and pe the expectation of future inflation.The ex ante real interest rate is i - pe, and the ex post real interest rate isi - p. The two interest rates differ when actual inflation p differs fromexpected inflation pe.How does this distinction modify the Fisher effect? Clearly the nominalinterest rate cannot adjust to actual inflation, because actual inflationis not known when the nominal interest rate is set. The nominal interestrate can adjust only to expected inflation. The next slide presents amore precise version of the the Fisher effect.
21 i = r + peThe ex ante real interest rate r is determined by equilibrium in themarket for goods and services, as described by the model inChapter 3. The nominal interest rate i moves one-for-one withchanges in expected inflation pe.
22 The Cost of Holding Money The quantity theory (MV = PY) is based on a simple money demandfunction: it assumes that the demand for real money balances isproportional to income. But, we need another determinant of thequantity of money demanded– the nominal interest rate.The Cost of Holding MoneyThe nominal interest rate is the opportunity cost of holding money:it is what you give up by holding money instead of bonds. So, the newgeneral money demand function can be written as:(M/P)d = L(i, Y)This equation states that the demand for the liquidity of real moneybalances is a function of income (Y) and the nominal interest rate (i).The higher the level of income Y, the greater the demand for realmoney balances.
23 Costs of Expected Inflation The inconvenience of reducing moneyholding is metaphorically called theshoe-leather cost of inflation, becausewalking to the bank more often inducesone’s shoes to wear out more quickly.When changes in inflation require printingand distributing new pricing information,then, these costs are called menu costs.Another cost is related to tax laws. Oftentax laws do not take into considerationinflationary effects on income.
24 The Costs of Unexpected Inflation Unanticipated inflation is unfavorable because it arbitrarilyredistributes wealth among individuals.For example, it hurts individuals on fixed pensions. Often thesecontracts were not created in real terms by being indexed to aparticular measure of the price level.There is a benefit of inflation– many economists say that someinflation may make labor markets work better. They say it“greases the wheels” of labor markets.
25 HyperinflationHyperinflation is defined as inflation that exceeds 50 percent per month, which is just over 1% a day.Costs such as shoe-leather and menu costs are much worse with hyperinflation– and tax systems are grossly distorted. Eventually, when costs become too great with hyperinflation, the money loses its role as store of value, unit of account and medium of exchange. Bartering or using commodity money becomes prevalent.
26 The Classical Dichotomy Economists call the separation of the determinants of real and nominal variables the classical dichotomy. It suggests that changes in the money supply do not influence real variables.This irrelevance of money for real variables is called monetary neutrality. For the purpose of studying long-run issues-- monetary neutrality is approximately correct.
27 Key Concepts of Ch. 4 Inflation Hyperinflation Money Store of value Unit of accountMedium of exchangeFiat moneyCommodity moneyGold StandardMoney supplyMonetary policyCentral BankFederal ReserveOpen-market operationsCurrencyDemand depositsQuantity equationTransactions velocityof moneyIncome velocityReal money balancesMoney demand functionQuantity theory of moneySeigniorageNominal andreal interest ratesFisher equationFisher effectEx ante and ex postShoeleather costsMenu costsReal and nominalvariablesClassical dichotomyMonetary neutrality