Notesale: Turn your study into money

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EC201 Intermediate Macroeconomics

EC201 Intermediate Macroeconomics

Lecture 3: Money and Inflation

Lecture Outline:
- Money: definition and functions
- The quantity theory of money
- The classical theory of inflation
Essential reading:
Mankiw: Ch
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1) Classical Theory of Inflation
What causes inflation? According to Milton Friedman (Nobel Prize in economics
1976): “inflation is always and everywhere a monetary phenomenon”
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“Classical Theory”: it is called classical because it assumes prices are
flexible and markets clear
...
Those economists believed that
markets were perfect and thanks to price flexibility the markets automatically adjust
to booms and recession without any need for government intervention
...

In this lecture we focus on the long-run trend behaviour of prices and inflation
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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 in order to understand inflation
...

The ease at which an asset can be used in transaction is known as liquidity of that
asset
...
On the other hand a 3-months government bond is an asset that
is less liquid than money in your pocket
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In such an economy, in order
for an exchange to take place there must be the double coincidence of wants: two
people must have a good that the other wants at the right time and place
...
Furthermore, only simple
exchanges can take place
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Trade
possibilities increase
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Example: the paper currency we use
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2) Commodity money
Has intrinsic value
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Question: why fiat money that is just a piece of paper with no intrinsic value has value
for transactions? Why a good that has intrinsic value of £10 can be exchanged with a
piece of paper where there is written £10 on it?
The money supply and monetary policy definitions
The money supply is the quantity of money available in the economy
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Monetary policy is conducted
by a country’s central bank
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However, the previous definition
is still a good one, since indeed the central bank controls the money supply and
furthermore, there is a close link between money supply and the interest rate
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If the central bank wants to increase the money supply in the country: it buys
government bonds from the public, therefore the money leaves the central bank and
go to the public, this increases the total supply of money
...
The money leaves the hands of the public and therefore money
supply is reduced
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Quantitative easing
simply means printing money
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However, while open market
operations are conducted regularly by a central bank in order to affects the interest
rate, quantitative easing is used as an ultimate tool when the interest rate is already
very low (possibly zero, as it was in many cases during the credit crunch crisis)
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An example of the role of quantitative easing in monetary policy is provided by the
following statement that you can find in the webpage of the Bank of England (the UK
central bank):
“In March 2009 the Bank's Monetary Policy Committee announced that in addition to
setting Bank Rate, it would start to inject money directly into the economy
...
Therefore, how can we
measure the quantity of money in a given country in a given period of time?
There are different measures of money supply, according to the assets included in the
measures:
C: Currency
M1: C + demand deposits, travelers’ checks, other checkable deposits
M2: M1 + small time deposits, savings deposits, money market mutual funds,
money market deposit accounts
The most common measures of money supply are M1 and M2; however, there is no
consensus about which measure of the money stock is the best
...
What is true is that the Central Bank affects a part of the money supply that is
the Monetary Base
...

Why? Most banking systems are a fractional reserve system, meaning that banks
must hold a part of their deposits as reserves in accounts at the Central Bank
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Reserves are a proportion of deposits that cannot be lent
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Their main business is retail deposits and
loans
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The profit of those banks is given

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by the difference between the interest rate they pay on deposits and the interest
rate they receive on loans;
2) Wholesale banks: investment banks, brokers, etc
...
;
3) Building societies: they borrow money and offer deposits
...

Let’s concentrate on retail banks only and on their balance sheet
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The central bank controls directly only the monetary base that is defined as:
B=C+R

Where C denotes currency and R denotes reserves
...
etc
...
Notice that reserves are deposits that banks hold at the central bank
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What they do is to buy government bonds for £100, for example from a Bond dealer
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The bond dealer will deposit this cheque
in a bank, called for example Firstbank
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The balance sheet of the Firstbank cahnes in the following way:
Firstbank Balance Sheet
Assets

Liabilities

Loans: 90

Deposits: 100

Reserve with the Central Bank: 10
Now we have £90 that are lent to someone, for example me
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The balance sheet of Secondbank then
becomes:
Secondbank Balance Sheet

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Assets

Liabilities

Loans: 81

Deposits: 90

Reserve with the Central Bank: 9
Now there are £81 that are lent to someone and that will be deposited in some other
bank (or the same bank) and so on
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In practice the Banking System is

creating money
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The money
stock will increase even further
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Once the central bank increases the monetary base through open market operations
the stock of money supply in the economy will increase more than proportionally
...

To see this define:
Reserve-deposit ratio: rr =

R
D

Currency-deposit ratio: cr =

C
D

From the money supply definition:

M =C+D=
where m =

C+D
× B = mB
B

C+D
is the money multiplier
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In practice the money supply is proportional to the monetary base
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The link between Money and Inflation: the Quantity Theory of Money
It is a simple theory linking the inflation rate to the growth rate of the money supply
...
This is a simple theory that explains
what determines the general level of prices in the long-run in a given economy
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Velocity of Money
Definition: the number of times the average pound bill changes hands in a given time
period
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Example: suppose that in 2007 we have £500 billion in transactions and money
supply is £100 billion
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So, velocity = 5
This is because in order for £500 billion in transactions to occur when the money
supply is only £100b, each pound must be used, on average, in five transactions
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This is just an
approximation
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The same when total
output decreases as also transactions will decrease
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Then, Y can represent the Real GDP, and therefore PY represents the
nominal GDP (and so P is the GDP deflator)
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The quantity equation gives us a simple relationship between the aggregate level of
prices and the stock of money in the economy
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However, if Real GDP is determined by the economy’s supplies of K (capital) and L
(labour) and the production function (see Lecture 2), then, the equation above implies
that changes in money will translate into changes in the price level
...

The quantity theory says that the price level is proportional to the quantity of money
supplied in the economy (now it becomes clearer where the expression “quantity
theory” comes from)
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The quantity theory is one of the building blocks of the “monetarism”, a
macroeconomic theory developed mainly by Milton Friedman
...
For example, if in a given year, the money supply increases, the year after the
nominal GDP increases as well
...
According to Friedman and Schwartz
this is evidence that is money that causes changes in nominal GDP and therefore on
prices
...
M
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In particular the main critique is the following:
The increase in the money supply is not the “cause” of the increase in the aggregate
price level, but the causality must be inverted
...
This
implies that the money supply is not “exogenous” as the quantity theory assumed, but
it is “endogenous” and depends on the market forces working in the economy
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Another important aspect of the quantity theory of money is that, in the long-run the
money supply only affects nominal variables through its effect on prices and NOT
REAL VARIABLES
...

Since we have a theory that tells us how the aggregate price level is determined in the
long-run, we can also see the quantity theory as a theory that tells us what determines
inflation in the long-run
...
For
example, suppose two periods of time: t and t+1
...
Eliminating the time subscripts we can write:
Pt
Pt

∆P
, to indicate the inflation rate in a given period of time
...
The quantity equation in growth rates:
∆M ∆V ∆P ∆Y
+
=
+
M
V
P
Y

The quantity theory assumes that the velocity V is a constant and therefore
Denote the inflation rate as π =

∆V
=0
V

∆P
P

Then the quantity equation in growth rates implies that:

π=

∆M ∆Y
−
M
Y

Normal economic growth requires a certain amount of money supply growth to
facilitate the growth in transactions
...
Suppose real GDP is growing by 3% per year over the long run
...
This means that the volume
of transactions will be growing as well
...
Since the real GDP is mainly determined by the factors of
production, also ∆Y/Y depends on growth in the factors of production all of which we
take as given, for now
...
In particular the theory doesn’t
predict that the inflation rate will equal the money growth rate
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To summarise:
The quantity theory of money implies:
1
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2
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Are the data consistent with these implications?
Consider the following scatter plot (each point corresponds to a particular country)
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If the theory works well, we should see a positive relationship from
the graph, meaning that countries with high money growth should also have high
inflation, while countries with low money growth rates should have a low inflation
rate
...
1
The strong positive0
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S
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The quantity theory of money is intended to explain the long-run relation of inflation
and money growth, not the short-run relation
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Is the Velocity of Money constant?

The answer is: not really
...
There are two series: one where the velocity of money is
calculated using M1 as the measure of money supply and one where M2 is used
instead
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Inflation and interest rates: the Fisher Effect
Define:

π = actual inflation rate (not known until after it has occurred)
π e = expected inflation rate
We define two interest rates:
- Nominal interest rate, i, not adjusted for inflation
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After one year you
withdraw the money from the bank and so you have 5% more money in your hand
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If the prices are now 3% higher, you are only 2% richer than
before, meaning that the amount of goods you can purchase now has increased by
only 2%
...

Suppose you are in period t and you must decide to buy a one-period bond that pays
you a nominal interest rate of 10% in period t+1
...
Therefore, in taking your decision you
must have an idea of what is going to be the inflation rate in period t+1
...
Now it is easy to see why controlling inflation is
important
...
In practice, keeping inflation stable
makes future less uncertain
...
This is known as the Fisher
effect
...
It implies that CHANGES in the nominal interest rate equal
CHANGES in the inflation rate, given a constant value of the real interest rate
...
S
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However, they are not perfectly correlated, which

absolutely does not invalidate the Fisher effect

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