1. Money and Inflation He realised well that the abundance of money makes everything dear, but he did not analyse how that takes place. The great difficulty of this analysis consists in discovering by what path and in what proportion the increase of money raises the price of things. RICHARD CANTILLON (died 1734), Essai sur la nature du commerce en général, II, 6.

2. Money and Inflation Price = amount of money required to buy a good. Inflation rate = ΔP/P = the percentage increase in the average level of prices (e.g. π = 5 % p.a.).  Deflation = decrease in the average level of prices. (e.g. π = - 1 % p.a.)  Disinflation = decrease in the inflation rate (e.g. π 1 = 5 % → π 2 = 3 %)  Price level stability: π = 0 % p.a. Because prices are defined in terms of money, we need to consider the nature of money, the supply of money, the demand for money, and what impact it has on the economy.

3. Price of beer in the Czech Republic

4. CPI in the Czech Republic Price level has more than doubled since 1993

7. Food and rents in the CR

8. U.S. inflation rate (% per year)

9. Money What is money?  Money is the stock of assets that can be readily used to make transactions.  Money has three functions: 1. Medium of exchange 2. Unit of account 3. Store of value

10. Medium of exchange People accept money in exchange for the items they are selling. Hence, money is generally accepted medium of exchange. The ease with which money is converted into goods and services is called money’s liquidity.

11. Unit of account Money provides the terms in which prices are quoted and debts are recorded… … Stores post their prices in CZK (or EUR, $, etc.)  E.g. TV set costs 10,000 CZK; beer costs 20 CZK → relative price is 10,000/20 => TV costs 500 bottles of beer.  Resources are allocated according to relative prices. Money prices enable an immediate calculation.  Most debts require the debtor to deliver a specified number of CZK (or EUR,$ etc.) in the future.  Money is a standard of deffered payments. Hence, money is the yardstick with which we measure economic transactions.

12. Store of value Money is a way to transfer purchasing power from the present to the future. Money ( imperfectly ) retains its value over time, so you need not spend all your money as soon as you receive it. Obviously, money is not the only store of value in the economy.

13. Money In an economy without money- barter economy, trade requires the double coincidence of wants:  The unlikely situation of two people each having a good that the other wants at the right time and place.  A barter economy permits only simple transactions.  Money makes more indirect transactions possible.  In a modern complex economy, trade is indirect and requires the use of money.

14. Money In the past most societies used commodity money (e.g. gold, silver), with some intrinsic value (metal could be used for other purposes). Modern money is fiat money:  It has no intrinsic value.  It is established as money by government decree.  Everyone values (accepts) fiat money because they expect everyone else to value (accept) it as well. How money became fiat? (HW, pp.78-79)

15. What is money? Money is what money does. Empirical definition of money:  Money supply = the available quantity of liquid assets that can be „readily“ used to make transactions.  The problem is that in modern economies no single asset is used for all transactions.

16. Money Currency (cash) … C  The sum of outstanding paper money and coins.  Demand deposits … D  Funds people hold in their checking (current) accounts.  They are almost as convenient as currency in paying for goods and services.  M1 = C + D Legal restrictions give the government a monopoly on the printing of money.

17. Money Savings accounts (and time deposits)  Cannot be used for payments, but can be easily transferred into checking (current) accounts.  M2 = M1 + SA + TD  M3, M4 … every higher aggregate contains assets of lower liquidity, and it also includes the previous monetary aggregate.

18. Money It is hard to judge which assets should be included in the money stock. There is also no consensus about which measure of the money stock is the best. Economists usually work with M1 or M2.

20. Money creation process {See the BB} In the fractional-reserve banking, banks create money because with each deposit and loan more money is created. However, this system doesn’t create wealth:  Bank loans give borrowers some new money and an equal amount of new debt, so loans do not make them wealthier.  Creation of money increases (nominal!) liquidity in the economy, not wealth.

23. Money supply We have derived that M s is a function of 3 exogenous variables:  cr=C/D  rr=R/D  B... monetary base Currency -deposit ratio Reserve- deposit ratio High powered money If households deposit less of their money, then banks can’t make as many loans, so the banking system won’t be able to “create” as much money.

24. Control of M s by the CB Open-market operations:  The purchase or sale of government bonds (assets) by the central bank.  If CB buys bonds from the public, it pays with new dollars, increasing B and then (when?) M (always?) by higher amount.

25. Control of M s by the CB Reserve requirements:  CB´s regulations that require banks to hold a minimum reserve-deposit ratio.  If CB reduces reserve requirements → ↓rr → then banks can make more loans and “create” more money from each deposit.

26. Control of M s by the CB The discount rate:  The interest rate that the CB charges on loans it makes to banks.  When banks borrow from the CB, their reserves increase, allowing them to make more loans and “create” more money.  The CB can increase B by lowering the discount rate to induce banks to borrow more reserves from the CB.

27. Control of M s by the CB Can the CB perfectly control the money supply? Banks can hold excess reserves (reserves above the reserve requirement). ↑rr → ↓m → ↓M s Households can change cr, e.g. loss of confidence in banks causes preference of C over D: ↑cr → ↓m → ↓Ms HW - Bank failures in the Great Depression (pp. 488 - 489) HW - Financial Innovation, Near Money, and the Demise of the Monetary Aggregates (pp. 496 - 497)

28. The Quantity Theory of Money How does the quantity of money affect the economy? QTM - the quantity of money in the economy is related to the number of dollars exchanged in transactions.  Suppose that the supply of money in the economy is $10. In the first half of the year, 5 bottles of beer are sold for $2. The owners of money then buy 1 lb. of ham for $10.  The total value of transactions over the year: o $2×5 + $10×1 = $20  M = $10, so each unit of M was transacted twice/year.  $10 × 2 = $2×5 + $10×1  M × V = ∑p i q i Stock Flow Velocity of circulation

29. The Quantity Theory of Money Fisher (1911): The Purchasing Power of Money: Let us begin with the money side. If the number of dollars in a country is 5,000,000, and their velocity of circulation is twenty times per year, then the total amount of money changing hands (for goods) per year is 5,000,000 times twenty, or $100,000,000. This is the money side of the equation of exchange… 200,000,000 loaves of bread at $.10 a loaf, 10,000,000 tons of coal at 5.00 a ton, and 30,000,000 yards of cloth at 1.00 a yard. The value of these transactions is evidently $100,000,000, i.e. $20,000,000 worth of bread plus $50,000,000 worth of coal plus $30,000,000 worth of cloth. The equation of exchange therefore (remember that the money side consisted of $5,000,000 exchanged 20 times) is as follows:— $5,000,000 × 20 times a year = 200,000,000 loaves × $.10 a loaf +10,000,000 tons × 5.00 a ton +30,000,000 yards × 1.00 a yard.

30. The Quantity Theory of Money If we aggregate over the entire economy (and over all transactions), we may write: M × V T = P × T  T … the total number of transactions during some period of time  P … price of a typical transaction  PT … number of dollars exchanged in a year  M … quantity of money  V T … transactions velocity of money  The rate at which money circulates in the economy IDENTITY

31. The Quantity Theory of Money Number of transactions T is difficult to measure so it is replaced by the total output in the economy Y. Assume that Y is proportional to T: T = aY  M × V T = P × T  M × V T = P × aY  M × V T /a = P × Y  M × V Y = P × Y  V Y …Income velocity of money  Number of times a dollar bill enters someone’s income in a given period of time.

32. The Quantity Theory of Money V can be viewed as a ratio of nominal GDP (PY), to the quantity of money (M): V = PY/M Assume that V is constant and exogenous M × V = P × Y If V is constant, a change in the quantity of money (M) must cause a proportionate change in nominal GDP (PY).

33. U.S. Nominal GDP, M2, and Velocity 1960–2011 Nominal GDP M2 Velocity Velocity is fairly stable over the long run. 1960=100

34. The Quantity Theory of Money Recall that in the classical model: Y*=F(K fixed,L fixed ) M × V = P × Y Fixed The quantity theory implies that the price level is proportional to the money supply. MONEY IS NEUTRAL -Does not affect Y -Does not affect relative prices Classical Dichotomy (HW, p. 107)

35. The Quantity Theory of Money M × V = P × Y See the BB: %ΔM + %ΔV = %ΔP + %ΔY %ΔV = 0 by assumption %ΔY depends on the growth of K,L and A. All constant by assumption => %ΔY = 0 Hence, the growth in the money supply (%ΔM) determines the rate of inflation (%ΔP = π). Thus, the quantity theory of money states that the central bank, which controls(?) the money supply, has ultimate control over the rate of inflation. 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.

36. U.S. inflation and money growth, 1960-2006 slide 36 0% 3% 6% 9% 12% 15% 1960196519701975198019851990199520002005 M2 growth rate inflation rate Over the long run, the inflation and money growth rates move together, as the quantity theory predicts.

37. Money and prices in the CR

39. Money and prices (MA-12) Money growthInflation

40. International data on inflation and money growth Singapore U.S. Switzerland Argentina Indonesia Turkey Belarus Ecuador Milton Friedman: “Inflation is always and everywhere a monetary phenomenon.’’ HW (p.88) Seigniorage: The Revenue From Printing Money

41. The Demand for Money The relationship between M s and P has been rather technical so far. We need a more subtle explanation. The key question is: Why do people hold money?  Acquisition of income and its successive spending are not usually synchronized.  Holding money makes it easier to make transactions.  Hence, people demand money and we will model their money demand function.

42. The Demand for Money The money demand function is like the demand function for a particular good. Here the “good’’ is the convenience of holding money balances. Just as higher income leads to a greater demand for goods, higher income also leads to a greater demand for money. M d =kPY k … how much money people want to hold for every dollar of income. An increase in (real) income (other things equal) causes an increase in the consumer’s consumption and therefore spending. To facilitate this extra spending, the consumer will require more money.

43. The Demand for Money P M M d =kPY With higher prices People must hold more (nominal) money balances… … to keep their real money balances M/P constant.

44. The Demand for Money P M M d =kPY 1 With higher real income People want to hold more (nominal) money balances M d =kPY 2

45. The equlibrium Price level P M M d =kPY MSMS The nominal money supply is given by the central bank (banking system). P* There is only one price level, for which the given amount of money Ms is voluntarily held by people; Ms=Md P1P1 For P1>P*, the excess of money demand over money supply will push the price level down as people reduce their purchases of goods in the effort to get more money balances. P2P2 For P2<P*, the excess of money supply over money demand will increase the price level as people raise their purchases of goods in the effort to spend the excess of money balances. At P*: Ms=Md

46. The equlibrium Price level P M M d =kPY MSMS If the central bank raises the nominal money supply… P1*P1* M´ S …people hold more money than they want… …they will spend the excess of money on goods and services. If Y=Y*, P must go up. P2*P2* … At a higher price level P 2 *, people will be satisfied with their higher nominal money balances and the process of spending and increasing the price level halts. At the new equilibrium level P 2 *, Ms=Md again. Money is neutral: ↑M→↑P

47. The equlibrium Price level P M M d =kPY MSMS P* HW: Impact of ↑Y on P*

48. The Demand for Money The foregoing analysis suggests that people are interested in real money balances (M/P) d rather than in nominal money balances M d :  M d =kPY  (M/P) d =kY  Real money balances (M/P) measure the purchasing power of the stock of money.  If the quantity of money is $10, and the price of a bottle of beer is $2, then real money balances are 5 bottles of beer that our representative agent keeps in his wallet.  Notice that demand for real money balances (M/P) d is proportional to real income Y.  (Demand for nominal money balances M d was proportional to nominal income PY). If the nominal amount of his money is doubled to M=$20 and the price of beer is doubled as well (to P=$4), then his real demand for money is the same (M/P) d =5, even though his nominal demand for money has been doubled (due to higher prices). Hence, real demand for money (M/P) d ≡ L = kY does not depend on the price level. An increase in real income (other things equal) causes an increase in the consumer’s consumption and therefore spending. To facilitate this extra spending, the consumer will require more money.

49. Demand for Money and QTM In equilibrium, the demand for real money balances (M/P) d =kY must equal the supply M S /P: M S /P = kY M(1/k) = PY  which can be written as: MV = PY, where V = 1/k.  It shows the link between the demand for money and the velocity of money.  When people want to hold a lot of money for each dollar of income (k is large), money changes hands infrequently (V is small).  When people want to hold only a little money (k is small), money changes hands frequently (V is large). The growth rate approach – see the BB

50. Inflation and interest rates Suppose you deposit $100 in a bank account that pays i=8 % interest annually. Assume that the price of beer this year is P 1 =$2. Next year, you withdraw your savings and the accumulated interest: $100×(1+i)= $108  Assume that the price of beer next year is P 2 =$2.04 Are you 8 percent richer than you were when you made the deposit a year earlier?  In the first year, you could buy: $100/$2 = 50 bottles  In the second year, you can buy: $108/$2.04 = 53 bottles. o => You can buy 53/50-1 = 0.06 = 6 % more What is the inflation rate in this economy?

51. Inflation and interest rates Number of bottles next year = 53 Number of bottles this year = 50

52. Inflation and interest rates r … real interest rate

53. Inflation and interest rates Nominal interest rate, i … the interest rate that the bank pays:  is not adjusted for inflation Real interest rate, r … the interest rate that reflects the true increase in the purchasing power (6 % in our example) :  is adjusted for inflation.

54. Inflation and interest rates If we neglect π ×r = 0.02 × 0.06 = 0.0012 Fisher equation

55. Fisher equation and the Fisher effect i = r+π  r is determined by S = I (Classical model)  π is determined by the money growth (QTM) The one-for-one relation between the inflation rate and the nominal interest rate is called the Fisher effect. According to the QTM, an increase in the rate of money growth of 1 percent causes a 1-percent increase in the rate of inflation. According to the Fisher equation, a 1-percent increase in the rate of inflation in turn causes a 1-percent increase in the nominal interest rate. Hence, in the classical (long-run) theory, changes in money growth or inflation do not affect the real interest rate.

56. Fisher effect * S (r) I=S i=r+π S,I I(r) i* Higher inflation rate decreases the willingness of savers to save at the given nominal interest rate i (their loan will be repaid with money with lower purchasing power). … Higher inflation increases the willingness of investing firms to (borrow and) invest more at the given nominal interest rate i (their debts will be repaid with money with lower purchasing power). Nominal interest rate rises keeping the real S and I at the previous level (due to constant r).

57. Exercise: Suppose V is constant, M is growing 5% per year, Y is growing 2% per year, and r = 4. a.Solve for i. b.If the central bank increases the money growth rate by 2 percentage points per year, find  i. c.Suppose the growth rate of Y falls to 1% per year. What will happen to  ? What must the central bank do if it wishes to keep  constant?

58. Inflation and nominal interest rates in the U.S., 1955-2006 percent per year -5 0 5 10 15 19551960196519701975198019851990199520002005 inflation rate nominal interest rate

59. Inflation and nominal interest rates across countries Switzerland Germany Brazil Romania Zimbabwe Bulgaria U.S. Israel

60. Two Real Interest Rates: Ex Ante and Ex Post When a borrower and lender agree on a nominal interest rate, they do not know what the inflation rate over the term of the loan will be. Suppose that they expect π e = 3 %. If the agreed r is 4 %, then: i = r + π e = 7 %  If the realised inflation differs, e.g. π = 5 %, t hen the ex post real interest rate will be: o r ex post = 7 % - 5 % = 2 % Hence, we must distinguish between two concepts of the real interest rate:  The real interest rate the borrower and lender expect when the loan is made: o … ex ante real interest rate = i – π e = 4 %  and the real interest rate actually realized: o … ex post real interest rate = i – π = 2 % Who lost and who gained when π > π e ?

61. Two Real Interest Rates: Ex Ante and Ex Post Because the nominal interest rate agreed by lender and borrower can adjust only to expected inflation (not to the realized inflation), the Fisher effect is more precisely written as: i = r + π e The ex ante real interest rate r is determined by equilibrium in the market for goods and services (or I=S). The nominal interest rate i moves one-for-one with changes in expected inflation π e.

62. Money demand and the nominal interest rate In the quantity theory of money, the demand for real money balances depends only on real income Y. Money demand refers to the fraction of wealth the representative agent would like to hold in the form of money. Wealth consists of many assets:  Bonds, stocks, physical capital (e.g.houses), human capital…

63. Money demand and the nominal interest rate The other assets typically generate some type of income (e.g. interest income in the case of bonds), but are much less liquid than money.  The more money the consumer holds in his portfolio, the more interest income he foregoes.  The less money he holds, the more interest income he makes, but the less liquid is his portfolio.

64. Money demand and the nominal interest rate The higher the nominal interest rate (e.g. on bonds) the higher is the opportunity cost of holding money. Hence,  i   in money demand.

65. Money demand and the nominal interest rate Why does the real demand for money L(i,Y) depend negatively on the nominal interest rate? Money earns an expected real return of (- π e ), because its real value declines at the rate of inflation. Assets other than money earn the real return r. Thus, the cost of holding money is r -  (-  π e ), which (as the Fisher equation tells us) is the nominal interest rate i. Notice that during deflation (π<0), the real return on money is positive. What is the nominal return on money?

66. Money demand and the nominal interest rate i M/P L(i,Y) Liquidity preference theory (Keynes 1936) Microeconomic foundations of the demand for money: Portfolio theories – HW (p.490) Transactions theories – Baumol Tobin model (visit the Seminar) *Friedman (196???) demonstrated that the optimum quantity of money implies that money should earn the same real return as the other assets: r = -π e => i = r – (-π e ) = 0 %

67. Money demand and the nominal interest rate i M/P L(i,Y 1 ) L(i,Y 2 ) Increase in real income… … will shift the entire curve outward.

68. The money demand function When people are deciding whether to hold money or bonds, they don’t know what inflation will turn out to be. Hence, the nominal interest rate relevant for money demand is r +  e.

69. Equilibrium on the money market The supply of real money balances Real money demand

70. What determines what variablehow determined (in the long run) Mexogenous (the CB …) radjusts to make S = I Y P adjusts to make

71. The equlibrium Price level P M M d =P×L(i,Y) MSMS P* Equilibrium M/P: M s /P* CB determines the nominal M s … … but people decide about the real money balances M/P

72. How P responds to  M For given values of r, Y, and  e, a change in M causes P to change by the same percentage – just like in the quantity theory of money.

73. Neutrality of money P M M d =P×L(i,Y) MSMS P1*P1* M´ S P2*P2* Money is neutral: ↑M→↑P In the end, people hold more nominal money balances (M), but the same amount of real money balances (M/P)

74. What about expected inflation? Over the long run, people don’t consistently over- or under-forecast inflation, so  e =  on average. In the short run,  e may change when people get new information. EX: CB announces it will increase M next year. People will expect next year’s P to be higher, so  e rises. This affects P now, even though M hasn’t changed yet….

75. How P responds to   e For given values of r, Y, and M

76. How P responds to   e P M M d =P×L(i 1,Y) MSMS P1*P1* P2*P2* M d ´=P×L(i 2,Y) M s /P 2 * < M s /P 1 * * Money is not super-neutral: Different growth rate of the money supply ΔM/M (nominal variable) (→  e ) will change L≡M d /P (real variable). However, it is neutral, the level of the money supply has no influence on real magnitudes. In the end, people hold the same amount of nominal money balances (M), but a lower amount of real money balances (M/P)

77. The Linkages Among Money, Prices, and Interest Rates

78. The social costs of inflation …fall into two categories: 1. costs when inflation is expected 2. costs when inflation is different than people had expected

79. The costs of expected inflation : HW (pp. 95-98) 1.Shoeleather cost 2.Menu costs 3.Relative price distortions 4.Unfair tax treatment 5.General inconvenience

80. Cost of unexpected inflation: HW (pp. 98-100) Arbitrary redistribution of purchasing power

81. Hyperinflation HW, pp.102-107

82. The Determinants of the Nominal Exchange Rate Start with the expression for the real exchange rate: Solve for the nominal exchange rate:

83. The Determinants of the Nominal Exchange Rate So E depends on the real exchange rate and the price levels at home and abroad… …and we know how each of them is determined: NX(E r ) = NS(r*) - I(r*)

84. The Determinants of the Nominal Exchange Rate Rewrite this equation in growth rates (see “arithmetic tricks for working with percentage changes,” Chap 2 ): For a given value of E r the growth rate of E equals the difference between domestic and foreign inflation rates. %ΔE = %ΔE r + %ΔP - %ΔP* => %ΔE = %ΔE r + π – π* Relative version of purchasing power parity

85. Inflation differentials and nominal exchange rates U.K. South Africa Iceland Mexico South Korea Canada Singapore Japan