Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 15 Money, Inflation and Banking
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.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved Alternative Forms of Money Commodity money Circulating private bank notes Commodity-backed paper currency Fiat money Transactions deposits at banks
Copyright © 2008 Pearson Addison-Wesley. All rights reserved The Double-Coincidence Problem and the Role of Money Barter exchange is difficult in highly-developed, specialized economies. Economic exchange requires search costs, and these costs are high when economic agents are specialized in consumption and production, and can only trade a good or service for another good or service. Search costs are reduced dramatically if everyone accepts money in exchange for goods and services.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 15.1 An Absence-of-Double- Coincidence Economy
Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 15.2 Good 1 as a Commodity Money in the Absence-of-Double- Coincidence Economy
Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 15.3 Fiat Money in the Absence- of-Double-Coincidence Economy
Copyright © 2008 Pearson Addison-Wesley. All rights reserved The Effects of Long-Run Inflation Use the monetary intertemporal model from Chapter 10. Show that money is not superneutral – higher money growth causes higher inflation, which affects real economic variables. An increase in the money growth rate increases the inflation rate and the nominal interest rate, and reduces employment and output.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 15.4 Scatterplot of the Inflation Rate vs. the Growth Rate in M0 for the United States, 1960–2006
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.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved Equation 15.2 In equilibrium, money supply equals money demand.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved Equation 15.3 Money supply also equals money demand in the future period.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved Equation 15.4 Combine the previous two equations.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved Equation 15.5 The consumers intertemporal marginal condition.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved Equation 15.6 Marginal condition reflecting the consumers tradeoff between current leisure and future consumption:
Copyright © 2008 Pearson Addison-Wesley. All rights reserved Equation 15.7 Marginal condition reflecting the consumers tradeoff between current leisure and current consumption:
Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 15.5 The Long-Run Effects of an Increase in the Money Growth Rate
Copyright © 2008 Pearson Addison-Wesley. All rights reserved The Friedman Rule Inflation causes an inefficiency, in that it distorts intertemporal decisions. 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. In practice, no central bank appears to have adopted a Friedman rule to guide monetary policy.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved Equation 15.9 Pareto optimality requires that
Copyright © 2008 Pearson Addison-Wesley. All rights reserved Equation In a competitive equilibrium,
Copyright © 2008 Pearson Addison-Wesley. All rights reserved Equation Also, in a competitive equilibrium,
Copyright © 2008 Pearson Addison-Wesley. All rights reserved Properties of Assets Rate of return Risk Maturity Liquidity
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.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved The Diamond-Dybvig Banking Model Three periods, 0, 1, and 2. Two types of consumers: early (consume in period 1) and late (consume in period 2) Efficient economic arrangement is for consumers to set up a bank in order to share risk. Given the banks deposit contract, the bank is open to a run, which is a bad equilibrium.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 15.6 The Utility Function For a Consumer in the Diamond–Dybvig Model
Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 15.7 The Preferences of a Diamond–Dybvig Consumer
Copyright © 2008 Pearson Addison-Wesley. All rights reserved Equation The marginal rate of substitution of early consumption for late consumption is
Copyright © 2008 Pearson Addison-Wesley. All rights reserved Equation First constraint that a deposit contract must satisfy is
Copyright © 2008 Pearson Addison-Wesley. All rights reserved Equation Second constraint that a deposit contract must satisfy is
Copyright © 2008 Pearson Addison-Wesley. All rights reserved Equation Combine the two constraints to get one:
Copyright © 2008 Pearson Addison-Wesley. All rights reserved Equation Re-write the constraint:
Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 15.8 The Equilibrium Deposit Contract Offered by the Diamond–Dybvig Bank