1. Money

2. Money: Definition Money Money is the stock of assets that can be readily used to make transactions.

3. Money and inflation Film about inflation and the ECB

4. U.S. inflation and its trend, 1960- 2006 slide 4 0% 3% 6% 9% 12% 15% 1960196519701975198019851990199520002005 long-run trend % change in CPI from 12 months earlier

5. The connection between money and prices Inflation rate = the percentage increase in the average level of prices. Because prices are defined in terms of money, we need to consider the nature of money, the supply of money, and how it is controlled.

6. Money: Functions Medium of exchange we use it to buy stuff store of value (IMPORTANT) transfers purchasing power from the present to the future unit of account the common unit by which everyone measures prices and values

7. Money: Types 1.fiat money –has no intrinsic value –example: the paper currency we use 2.commodity money –has intrinsic value –examples: gold coins, cigarettes in P.O.W. camps

8. Discussion Question Questions: Which of these are money? Please work in pairs a. Currency b. Checks c. Deposits in checking accounts (“demand deposits”) d. Credit cards e. Certificates of deposit (“time deposits”)

9. The money supply and monetary policy definitions The money supply is the quantity of money available in the economy. Monetary policy is the control over the money supply.

10. The central bank Monetary policy is conducted by a country’s central bank. for Europe for the U.S. The Federal Reserve Building Washington, DC ECB Building, Frankfurt, Germany

11. 8,202.3 M1+ deposits with an agreed maturity of up to two years or redeemable at a period of notice of up to three months M2 4,539.9 C + balances that can immediately be converted into currency or used for cashless payments, such as overnight deposits. M1 759.6 Currency ( i. e. banknotes and coins) C What amount ?(€ billions) Are the same assets included ?symbol Money supply measures, for the EU, Feb. 2010

12. Quantity theory of money The equation

13. The quantity theory of money The quantity equation M  V = P  Y It is an identity: it holds by definition of the variables.

14. The Quantity Theory of Money A simple theory linking the inflation rate to the growth rate of the money supply. Begins with the concept of velocity…

15. Velocity What is velocity? basic concept: the rate at which money circulates definition: the number of times the average dollar bill changes hands in a given time period Example: In 2007, –$500 billion in transactions –money supply = $100 billion –The average dollar is used in five transactions in 2007 –So, velocity = 5

16. Velocity, cont. This suggests the following definition: where V = velocity T = value of all transactions (nomianal GDP is used) M = money supply

17. Velocity (2) Use nominal GDP as a proxy for total transactions. Then, where P = price of output (GDP deflator) Y = quantity of output (real GDP) P  Y = value of output (nominal GDP) (= T)

18. Money demand and the quantity equation M/P = real money balances, the purchasing power of the money supply. A simple money demand function: (M/P ) d = k Y where k = how much money people wish to hold for each dollar of income. (k is exogenous)

19. Real money balance What is real money balance? money demand: (M/P ) d = k Y Example: Imagine the whole economy of Germany would produce only potatoes, one at a price of 0.5 €. The stock of money would be 100 €, than we could buy 200 potatoes, this is called the real money balance.

20. Money demand and the quantity equation quantity equation: M  V = P  Y The connection between them: k = 1/V = as faster the money circulates, as less is needed

21. Money demand and the quantity equation or explained differently When people hold lots of money relative to their incomes (k is high), money changes hands infrequently (V is low). Example: If you earn 700Euro a month and keep it in cash in your pocket, it will be spend once ! But this implies that a lot of cash is needed!

22. Back to the quantity theory of money starts with quantity equation assumes V is constant & exogenous: With this assumption, the quantity equation can be written as

23. The quantity theory of money, cont. How the price level is determined: With V constant, the money supply determines nominal GDP (P  Y ). Real GDP is determined by the economy’s supplies of K (capital e.g. machines) and L (labour) and the production function. The price level is P = (nominal GDP)/(real GDP).

24. The quantity theory of money, cont.  (Greek letter “pi”) denotes the inflation rate: The result from the preceding slide was: Solve this result for  to get

25. The quantity theory of money, cont. Normal economic growth requires a certain amount of money supply growth to facilitate the growth in transactions. Money growth in excess of this amount leads to inflation.

26. The quantity theory of money, cont.  Y/Y depends on growth in the factors of production and on technological progress (all of which we take as given, for now). Hence, the Quantity Theory predicts a one-for-one relation between changes in the money growth rate and changes in the inflation rate. on the long run

27. Confronting the quantity theory with data The quantity theory of money implies 1.countries with higher money growth rates should have higher inflation rates. 2.the long-run trend behavior of a country’s inflation should be similar to the long-run trend in the country’s money growth rate. Are the data consistent with these implications?

28. International data on inflation and money growth Singapore U.S. Switzerland Argentina Indonesia Turkey Belarus Ecuador Annual average per country over the period 1996 – 2004

29. U.S. inflation and money growth, 1960-2006 slide 29 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.

30. Task