1. Money What is money? Anything people will accept in place of the goods and services they seek to obtain. Money is a stock of assets that can be readily used to make transactions. Examples from history: salt in Egypt; rice in Japan; dried fish in Iceland; cigarettes in Romania in the 1970s; liquor in Germany after World War II; rocks such as gold and silver. Fiat money—paper currency from government. Commodity money—gold and other things of value

2. In the U.S. M1 = Currency (cash) + Demand Deposits (checking accounts) + other checkable deposits M2 = M1 + savings accounts, time deposits, money market mutual funds How much money? M1 = $2.4 trillion 11/12 M2 = $10.3 trillion 11/12

3. Roles of Money Account keeping The way we keep track of prices and values Store of Value Transfer purchasing power through time Medium of Exchange Use money to buy things—better than barter. If people do not trust official money, they use other things when possible

4. Money Creation Governments create money Role of central banks (Federal Reserve in U.S.) Independence from politics important? Ask the central bank of Argentina (and the U.S.?) Many views on how the banks should manage money creation — fixed rules versus flexibility — most use flexibility

5. Inflation What is inflation? It is a general rise in prices. Not all prices rise the same percent, but in general prices are rising. Usually it is caused by more money in the hands of people who are trying to buy the same quantity of goods in an economy.

6. Inflation Is Not an Increase in One Price If the price of one good rises, it does not cause inflation. It is a change in relative prices. People have no more money to spend than before, they change spending mix. Example: Price of gasoline up in U.S. 2007: 4.6% of personal expenditures on gas; in 1997: 2.6% Where does the extra money spent on gas (2% of personal income) come from? Less spending on other goods, especially nice things.

7. MV = PT The quantity theory of money is: MV = PT M = money in circulation V = velocity (# of times money spent per year) P = average price level T = number of transactions Note: this (MV or PT) is national income.

8. Suppose Price of Gas Rises Because Price of Oil Has Gone Up (Globally) MV = PT Assume M and V constant. P of gasoline rises; assume T constant If quantity demanded of gasoline constant (T not changing), since more spent on gas due to higher oil prices, other transactions must fall. People cut back on spending on nice things. It hurts, but is not inflation.

9. M1 jumped 40% in three years

10. So why no inflation? Velocity (and economy) falling. Called deleveraging— people borrow less, government more M1 velocity down from about 10 to 6.7

11. M2 money up 25% in three years

12. M2 velocity also falling in the recession People (and banks) holding on to money

13. Monetary base (currency plus bank reserves held by Federal Reserve) up 300% in 4 years. Banks not lending, people not borrowing.

14. Monetary Base (currency plus reserves) have exploded. No inflation (yet) as bank reserves way up. What will happen of money comes out?

15. Excess reserves in banks—amount greater than required to hold—up from zero to $1.6T

17. Federal reserve books show $2 Trillion new assets & liabilities

18. So What Causes Inflation? In general, inflation is caused by more money (M) chasing the same quantity of goods. If M rises and V constant then PT must rise to balance equation. People have more money so willing to make more transactions (T rises). That means more demand for same level of goods in existence, so prices (P) bid higher.

19. Origins of Inflation So why do we get inflation? The government creates more money. Why? Not stupidity. It is deficit spending. 1. Print money. 2. Borrow money from Central Bank or from citizens or from foreigners. [Ex.: If U.S. government budget is $3.8 trillion and revenue is $2.4 trillion—need to get $1.4 trillion more money for the government to spend.]

20. Deficit Spending 1. Government (Treasury) sells bonds to get cash— sell to foreigners (China and Japan especially)—or to U.S. citizens (thereby “crowding out” private sector borrowing (investment), which hurts growth). 2. If cannot sell enough bonds to the public—Treasury sells bonds to Federal Reserve which gives the Treasury new money—cash (via checking accounts) that is injected into the economy by the government—more cash can pushes prices up (sooner or later).

21. Why Do We Care About Inflation? Destructive Effects When inflation rising (and is expected to continue to rise): ▲ spending and borrowing ▼ savings and investment ▲ incentive to inflate currency even more, depending on political forces

22. Real vs. Nominal Interest Rate Suppose inflation averages 10% per year (the value of the currency falls by 10% each year). If interest rate paid is 12%, that is the nominal interest rate. What is real (after inflation) interest rate? 12% – 10% = 2% Long run real interest rate near 2% but negative today—savings are punished.

23. Inflation Hurts People, Business, and Society Businesses have a difficult time planning for future — which means less investment. How do you time payments? Do you accept currency? There are winners and losers in every transaction just due to changes in the value of the currency — up or down.

24. Real World Example Assume a person in the U.S. invested $10,000 in 1971 for their retirement in 1991 when the investment is worth $35,000 — a normal rate of return. What is the gain? Due to inflation, $10,000 in 1971 = $34,000 in 1991. So gain is only $1,000. But the entire “gain” of $25,000 is subject to taxes of about $7,000, leaving $28,000 in 1991 — less than the original investment in real spending power. So if people think there will be inflation—what actions do they rationally take?

25. Rational Decision Makers People try to avoid losses imposed by inflation: ● invest in hard assets ● invest in other countries ● avoid currency of own country Due to international flows of currency, inflation is punished in the market. Local people with few options suffer the most. Political instability more likely if currency unstable.