© 2009 South-Western, a part of Cengage Learning, all rights reserved C H A P T E R Demand for Money & Equilibrium of Money Market E conomics P R I N C I P L E S O F N. Gregory Mankiw 30

The Demand for Money The Opportunity Cost of Holding Money  Short-term interest rates are the interest rates on financial assets that mature within six months or less.  Long-term interest rates are interest rates on financial assets that mature a number of years in the future.

The Demand for Money Interest Rates and the Opportunity Cost of Holding Money

Other determinants of money demand  Real GDP (+)  Price Level (+)  Technology  Institutions

Money demand function  MD = P *m(Y, R)  Y = Real GDP  R = Nominal Interest Rate  m(Y,R) = Real Money Demand  P* m(Y,R) = (Nominal) Money Demand  MD = P *m(Y, r+π)  r = Real interest rate  π = inflation rate  MD decreases with R, or with r and π.

The Money Demand Curve Interest rate, R Quantity of money Money demand

The Money Demand Curve Price Level, P Quantity of money Money demand MD = P *m(Y, R)

Money Supply, Money Demand, and Equilibrium Price Price Level, P Quantity of money MD = P *m(Y, R) Money Supply Quantity fixed By Central Bank A Equilibrium Price

The effects of money injection Price Level, P Quantity of money MD = P *m(Y, R) MS1 A MS2 1. An increase in money supply 2. An increase in price level

The Classical Dichotomy and Monetary Neutrality  Nominal variables are variables measured in monetary units.  Real variables are variables measured in physical units.

The Classical Dichotomy and Monetary Neutrality  According to the classical dichotomy, different forces influence real and nominal variables.  Changes in the money supply affect nominal variables but not real variables.  The irrelevance of monetary changes for real variables is called monetary neutrality.  The consensus among economists: money is neutral in the long run, but not in the short run.

Velocity of Money  The velocity of money refers to the speed at which the typical dollar bill travels around the economy from wallet to wallet. V = (P  Y)/M  V = velocity P = the price level Y = the quantity of output M = the quantity of money

 A simple example:  The quantity of money is fixed at M=$20  May 1: Alf paid $20 to Ben for a pizza  May 10: Ben paid $10 to Chris for donuts  May 31: Ben paid $10 to Alf for a sushi  Nominal value of transactions in May = $40. Each dollar is used twice on average.

 A simple example:  P x Y = $1000 = nominal GDP per year ≒ nominal value of transactions  M = $50 = quantity of money  (P x Y)/M = 20 = each dollar must be used for 20 times per year

Quantity Theory of Money Rewriting the equation gives the quantity equation: M  V = P  Y The quantity equation relates the quantity of money (M) to the nominal value of output (P  Y).

 The velocity is relatively stable over time  Because velocity is stable, changes in the quantity of money (M) causes proportional changes in nominal output (PY)  Y is primarily determined by real factors, not money. Thus, changes in PY caused by changes in M are reflected by changes in P.  Therefore, changes in M leads only to changes in P.

 From MV = PY, we can derive %ΔM + %ΔV = %ΔP + %ΔY  Money Growth + Velocity Growth = Inflation + Output Growth

20-18 The Quantity Theory of Money – Irving Fisher  Suppose now money supply increases.  assume that %ΔV = 0 and %ΔY = 0.  doubling the quantity of money doubles the price level.  Inflation is a monetary phenomenon (Milton Friedman).

Nominal GDP, the Quantity of Money, and the Velocity of Money Copyright © 2004 South-Western Indexes (1960 = 100) 2,000 1, , Nominal GDP Velocity M2

International Evidence of Monetary Neutrality  The figure on the next slide shows the annual percentage increases in the money supply and average annual increases in the aggregate price.  The scatter of points clearly lies close to a 45- degree line, showing a more or less proportional relationship between money and the aggregate price level.  The data support the concept of monetary neutrality in the long run.

The Long-Run Relationship Between Money and Inflation

The Inflation Tax  When the government raises revenue by printing money, it is said to levy an inflation tax.  If the annual inflation rate is 5%, one dollar will buy $1 worth of goods and services this year, but it would require $1.05 to buy the same goods or services the next year; this has the same effect as a 5% annual tax on cash holdings.

 An inflation tax is like a tax on everyone who holds money, as it reduces the value of the money held by the public.  The inflation ends when the government institutes fiscal reforms such as cuts in government spending.

Hyperinflation  Informal definition: 50 percent monthly inflation  In 1923, Germany’s money was worth so little that children used stacks of banknotes as building blocks or built kites with them.

Money and Prices During Four Hyperinflations Copyright © 2004 South-Western (a) Austria(b) Hungary Money supply Price level Index (Jan = 100) Index (July 1921 = 100) Price level 100,000 10,000 1, Money supply 100,000 10,000 1,

Money and Prices During Four Hyperinflations Copyright © 2004 South-Western (c) Germany 1 Index (Jan = 100) (d) Poland 100,000,000,000,000 1,000,000 10,000,000,000 1,000,000,000, ,000,000 10, Money supply Price level Price level Money supply Index (Jan = 100) ,000, ,000 1,000,000 10,000 1,

Taiwan’s hyperinflation,

Consumer Price Index, Taiwan,

Zimbabwe’s Inflation  Zimbabwe’s money supply growth was matched by almost simultaneous surges in its inflation rate. Why did Zimbabwe’s government pursue policies that led to runaway inflation?  The reason boils down to political instability, which in turn had its roots in Zimbabwe’s history.  Robert Mugabe, Zimbabwe’s president, tried to solidify his position by seizing farms and turning them over to his political supporters. But because this seizure disrupted production, the result was to undermine the country’s economy and its tax base. It became impossible for the country’s government to balance its budget either by raising taxes or by cutting spending.

Money Supply Growth and Inflation in Zimbabwe

Consumer Prices in Zimbabwe,

The banknote with the greatest number of zeros shown The worst monthly inflation rate = 7.96e+10% (November, 2008) Zimbabwe 100 trillion dollar bill

The banknote with the highest denomination Hungary 100 million b-pengo issued in 1946 Billion in long scale = trillion (1e+12) 100 million b. in long scale = 100 million trillion = 1e+20 Worst monthly inflation rate = 4.19e+16%

Money and Prices in Brazil,

Hyperinflation  By giving away its independence, the central bank work in concert with the treasury. The treasury issues debt, and the central bank monetizes the debt by creating money and buying the public debt.

The Vicious Circle of Hyperinflation  Government Spending ↑  Money growth rate ↑  Inflation rate ↑  The purchasing power of money ↓  Real seignorage ( 鑄幣稅 ) ↓  Government accelerate money growth to finance its spending

To Stop Hyperinflation…  Cutting down government spending  Monetary reform  Independent central bank  New money  More reserves (e.g. gold, foreign assets)  Restore the credibility of fiat money  Hyperinflation can be stopped very quickly once the credibility is restored.

THE COSTS OF INFLATION  A Fall in Purchasing Power?  Inflation does not in itself reduce people’s real purchasing power.  In particular, during a period of inflation, wages also rise. Sometimes wages rise faster than prices, and sometimes prices rise faster than wages.

THE COSTS OF INFLATION  Shoeleather costs  Menu costs  Relative price variability  Tax distortions  Confusion and inconvenience  Arbitrary redistribution of wealth

Shoeleather Costs  Shoeleather costs are the resources wasted when inflation encourages people to reduce their money holdings.  Inflation reduces the real value of money, so people have an incentive to minimize their cash holdings.

Shoeleather Costs  Less cash requires more frequent trips to the bank to withdraw money from interest-bearing accounts.  The actual cost of reducing your money holdings is the time and convenience you must sacrifice to keep less money on hand.  Also, extra trips to the bank take time away from productive activities.

Menu Costs  Menu costs are the costs of adjusting prices.  During inflationary times, it is necessary to update price lists and other posted prices.  This is a resource-consuming process that takes away from other productive activities.

Inflation-Induced Tax Distortion  The income tax treats the nominal interest earned on savings as income, even though part of the nominal interest rate merely compensates for inflation.  The after-tax real interest rate falls, making saving less attractive.

AB (1) Real Interest Rate 4% (2) Inflation Rate 08 (3) Nominal Interest Rate = (1) + (2) 412 (4) Reduced Interest Due to 25% tax rate = 0.25*(3) 13 (5) After-tax Nominal Interest Rate = 0.75*(3) 39 (6) After-tax Real Interest Rate = (3) – (2) 31

 The difference in the after-tax real rate between A and B is 2 percent, equal to the product of inflation rate and tax rate (8%*0.25)

Relative-Price Variability and the Misallocation of Resources  Inflation distorts relative prices.  Consumer decisions are distorted, and markets are less able to allocate resources to their best use.  例如 : 「什麼都漲，就是工資不漲」 => 勞動力的相對價格被扭曲。

Confusion and Inconvenience  When the Fed increases the money supply and creates inflation, it erodes the real value of the unit of account.  Inflation causes dollars at different times to have different real values.  Therefore, with rising prices, it is more difficult to compare real revenues, costs, and profits over time.

A Special Cost of Unexpected Inflation: Arbitrary Redistribution of Wealth  Unexpected inflation redistributes wealth among the population in a way that has nothing to do with either merit or need.  These redistributions occur because many loans in the economy are specified in terms of the unit of account—money.