1. EFL Lesson 9
Money & Inflation

2. What is money?
Money is ANYTHING that is generally accepted in payment for goods and services.

3. Money Reduces the Transaction Costs of Exchange? ? = =
Barter may work, but it’s inefficient and time consuming; it’s a hassle!

4. Functions of Money
Medium of exchange
Standard of Value
Store of Value

5. In the U.S. today, money is:
Currency, Coin, and Checks
(Demand Deposits)

6. Primary Measure of Money (April 2006, $ in billions)
Currency (paper + coins) $739
(in public, not in bank vaults)
Checkable account deposits
(plus other checkable & travelers ck)
Total Money Supply (M1) $1,391

7. Interest: the opportunity cost of holding money
What could you do instead of holding money?
You could hold interest-earning assets like Certificates of Deposit, or bonds

8. Where do interest rates come from?
Market for funds:
Who are the suppliers?
Who are the demanders?
What is the equilibrium price?

9. Interest Rate=Price of Money
Prices (and interest rates) are set by the market—not by the FED.
Producers influence price through the quantity of goods.
The FED influences interest rates (the price of money) through the quantity of money.

10. Money supply: Currency & coins in circulation + demand deposits
Total available purchasing power in the economy at any point in time
$ billion
$1,363,600,000,000
$ trillion

11. Why do we worry about the money supply?
Experience has shown us that the money supply is the most important factor affecting general price levels, that is -
Inflation
Inflation must be taken seriously it alters incentives and people’s economic behavior, and consequently, it negatively impacts the economy as a whole.

12. Market Basket of Goods and Services
Inflation
A general, sustained increase in the price level.
The erosion or decline of purchasing power.
The best-known measure of inflation is the CPI, or Consumer Price Index
Market Basket of Goods and Services

13. Inflation is a Reduction in the Value of the Dollar
Price Level

14. Which would you rather have?

15. In Harare a beer cost 100 billion Zimbabwean dollars at 5 pm on July 4
In Harare a beer cost 100 billion Zimbabwean dollars at 5 pm on July 4. An hour later the price had jumped to 150 billion.

16. The Zimbabwean government is threatened by its inability to get enough paper to print money. This printed money is how it pays its security forces—trouble for Mugabe.

17. Hyperinflation in Zimbabwe
This kind of hyperinflation is rare in history, but we are seeing it once again, in Zimbabwe. Government officials claim an inflation rate of 66,212 percent (most months they refuse to release inflation figures at all). The International Monetary Fund believes the rate is closer to 150,000% — about the level reached by Weimar Germany. By some estimates, about 50% of Zimbabwe’s government revenue comes from the printing of money. At independence in 1980, the Zimbabwean dollar was worth more than one U.S. dollar. Recently, the state-controlled newspaper raised its cover price to 3 million Zimbabwean dollars. Two pounds of chicken were recently reported to cost about 15 million Zimbabwean dollars.
A Zimbabwean friend who runs a business recently told me, “If you don’t get a bill collected in 48 hours, it isn’t worth collecting, because it is worthless. Whenever we get money, we must immediately spend it, just go and buy what we can. Our pension was destroyed ages ago. None of us have any savings left.”
“Dying Silently in Zimbabwe,” by Michael Gerson, Washington Post, Feb 20, 2008

18. HARARE, April 25,2006 — How bad is inflation in Zimbabwe
HARARE, April 25,2006 — How bad is inflation in Zimbabwe? Well, consider this: at a supermarket near the center of this tatterdemalion capital, toilet paper costs $417.
No, not per roll. Four hundred seventeen Zimbabwean dollars is the value of a single two-ply sheet. A roll costs $145,750 — in American currency, about 69 cents.
The price of toilet paper, like everything else here, soars almost daily, spawning jokes about an impending better use for Zimbabwe's $500 bill, now the smallest in circulation.
Inflation is a monetary phenomenon, and almost always occurs because increases in the stock of money exceed growth in output of goods and services.
Rapid increases in the money supply can be the result of poor management by the central bank or by a decision to print money to support government spending.
A frequent problem in developing nations is that governments without stable or consistent tax collections often resort to printing money to finance government spending.
Inflation increases pressure on government to impose price controls which tends to make conditions worse instead of better.
Intended to halt rising prices, price controls instead disguise inflation and disrupt the allocation of goods and services.

19. Measuring Inflation - the CPI
The Department of Labor’s Bureau of Statistics:
Determines the items in the market basket
Gathers the prices of the items in the basket during a base year
Gathers the prices of the items in the current year.
Calculates the CPI: =
X 100
CPI
Price of basket in current year
Price of basket in base year

20. Suppose CPIthis year = 125
What does it mean?
25% increase in prices between the base year and this year
Inflation Rate = percentage change in the index

21. Same Products – Higher Prices

22. Same Products – Higher Prices
Sectors experiencing largest price increases since 1990:
Energy
Food
College Tuition
Medical Care

23. Same Products – Higher Prices

24. Real vs. Nominal Prices Anticipated vs. Unanticipated Inflation
nominal int. rate – rate of inflation = real int. rate
8% - 3% = 5%
Anticipated vs. Unanticipated Inflation
$1000 saved turns into $1080 after 1 year
can only buy $1050 worth of stuff at higher prices

25. Same Products – Higher Prices

26. “All periods of significant sustained inflation have been accompanied by increases in the money supply.”
Manage the Money Supply to Avoid Inflation: The Job of the Federal Reserve System

27. Federal Reserve System

28. HOW do we manage the money supply?
John
$100
It all begins with commercial banking:
Money Supply = $100

29. Lending creates additional purchasing power
John
$100
Sue
$50
Money Supply = $100 + $50 = $150

30. More lending creates more money
$50
$25
$50
$100
Bill
John
Sue
Money Supply increases = $100 + $50 + $25 = $175

31. Key to controlling the money supply:
Commercial banks’ ability to make loans
$100
$50
$25
$75
$50

32. Fed tools for influencing banks’ willingness to make loans:
Reserve requirement
Discount rate
Open market operations
$100
$50
$25
$75
$50

33. Open Market Operations
The most important tool of the Fed in controlling the money supply
Can be, and is, used on a daily basis
Its effect is immediate
Can be used to target interest rates

34. Fed purchases of government securities increase the availability of money to the public.
When the Federal Reserve buys government securities, reserves in the banking system increase.
Increased reserves means increased ability to lend, which increases the money supply.
$1000
$1000
Fed
bond
Bill’s Bank
Bill

35. Open Market Operations: When the Fed Sells Bonds
$$$$
bond
Questions:
Who ends up with the money?
Who ends up with the bond?
What happened to the money supply? (It decreased.)
Fed Bond Sales

36. Open Market Operations: When the Fed Buys Bonds
$$$$
Fed Bond Sales
Questions:
Who ends up with the money?
Who ends up with the bond?
What happened to the money supply? (It increased.)

37. Open Market Operations allows the Fed to manage interest rates, lending and the money supply.
If Open Market Operations increase the money supply:
Bank deposits increase
Bank reserves increase
The supply of money to lend increases
Interest rates fall
If Open Market Operations
reduce the money supply:
Bank deposits decrease
Bank reserves decrease
The supply of money to lend decreases
Interest rates rise

38. A sound & well-managed money supply is one of the keys to the wealth of nations

39. Monetary Freedom - top 11 Denmark 86.5 12 Estonia 82.0 13 Netherlands
86.9 14
Iceland
74.8 15
Luxembourg
79.8 16
Finland
88.5 17
Japan
94.3 18
Mauritius
75.7 19
Bahrain
74.3 20
Belgium
80.4 1
Hong Kong
87.2 2
Singapore
88.9 3
Ireland
84.9 4
Australia
83.7 5
United States 6
New Zealand 7
Canada
81.0 8
Chile
78.8 9
Switzerland
83.6 10
United Kingdom
80.7
Source: Heritage – Economic Freedom of the World Annual Report, 2007

40. Monetary Freedom - bottom
137
Laos
73.0
138
Haiti
65.3
139
Sierra Leone
74.4
140
Togo
78.2
141
Central African Rep.
72.5
142
Chad
73.6
143
Angola
57.8
144
Syria
66.2
145
Burundi
74.7
146
Congo, Rep.
147
Guinea Bissau
75.7
148
Venezuela
60.6
149
Bangladesh
68.9
150
Belarus
66.2
151
Iran
61.3
152
Turkmenistan
66.4
153
Burma (Myanmar)
56.5
154
Libya
74.9
155
Zimbabwe
0.0
156
Cuba
64.6
157
Korea, North

41. The “Big Ideas” from Lesson 9:
Money is an innovation that significantly improved the operation of markets by reducing the costs of exchange.
The money supply changes with the lending activities of commercial banks.
Inflation is the consequence of the money supply growing faster than production.
The Fed tries to manage the money supply to avoid inflation.
Inflation reduces purchasing power, disrupts the economy, and reduces economic growth.