Macroeconomics fifth edition N. Gregory Mankiw PowerPoint ® Slides by Ron Cronovich macro © 2004...

macroeconomics fifth edition

N. Gregory Mankiw

PowerPoint® Slides by Ron Cronovichm

acro

© 2004 Worth Publishers, all rights reserved

CHAPTER FOUR

Money and Inflation

CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 2

Money: definitionMoney: definition

MoneyMoney is the stock is the stock of assets that can of assets that can be readily used to be readily used to make transactions.make transactions.

CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 3

Money: functionsMoney: functions

1. medium of exchangewe use it to buy stuff

2. store of valuetransfers purchasing power from the present to the future

3. unit of accountthe common unit by which everyone measures prices and values

CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 4

Money: typesMoney: 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, stone wheels up to 12 feet (3.6 meters) in diameter (Yap)

CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 5

Money SupplyMoney Supply

Government control over supply of money is called monetary policy.

In Ukraine, National Bank of Ukraine carries out monetary policy

The primary way of controlling the supply of money is through the open-market operations:– Purchase of government bonds from

public increase money supply– Sale of government bonds to public

reduce money supply

CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 6

Measurement of MoneyMeasurement of MoneyC or M0 currency

M1 currency and demand deposits

M2 M1+saving deposits

M3 M2+large time deposits

Table Structure of money supply in Ukraine

Symbol Unit Date Amount %* Currency outside banks (M0) UAH, million 07/06/06 66241.8 29.9* Money (M1) UAH, million 07/06/06 108585.9 49.0* Money (M2) UAH, million 07/06/06 220560.8 99.6* Money (M3) UAH, million 07/06/06 221535.8 100.0

Source: National Bank of Ukraine and my calculations

CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 7

The Quantity Theory of MoneyThe Quantity Theory of Money

A simple theory linking the inflation rate to the growth rate of the money supply.

Begins with a concept called “velocity”…

CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 8

VelocityVelocity

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 2003, • $500 billion in transactions• money supply = $100 billion• The average dollar is used in five

transactions in 2003• So, velocity = 5

CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 9

Velocity, Velocity, cont.cont.

This suggests the following definition:

T

VM

where

V = velocity

T = value of all transactions

M = money supply

CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 10

Velocity, Velocity, cont.cont.

Use nominal GDP as a proxy for total transactions.

Then, P YV

M

where

P = price of output (GDP deflator)

Y = quantity of output (real GDP)

P Y = value of output (nominal GDP)

CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 11

The quantity equationThe quantity equation

The quantity equationM V = P Y

follows from the preceding definition of velocity.

It is an identity: it holds by definition of the variables.

CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 12

Money demand and the quantity equationMoney 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

wherek = how much money people wish to hold for each dollar of income. (k is exogenous)

CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 13

Money demand and the quantity equationMoney demand and the quantity equation

money demand: (M/P )d = k Y

quantity equation: M V = P Y

The connection between them: k = 1/V

When people hold lots of money relative to their incomes (k is high), money changes hands infrequently (V is low).

CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 14

back to the Quantity Theory of Moneyback to the Quantity Theory of Money

starts with quantity equation

assumes V is constant & exogenous:

V V

With this assumption, the quantity equation can be written as

M V P Y

CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 15

The Quantity Theory of MoneyThe Quantity Theory of Money, cont., 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 and L and the production function (chap 3)

The price level is P = (nominal GDP)/(real GDP)

M V P Y

CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 16

The Quantity Theory of MoneyThe Quantity Theory of Money, cont., cont.

The quantity equation in growth rates:

M V P YM V P Y

The quantity theory of money assumes

is constant, so = 0.V

VV

CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 17

The Quantity Theory of MoneyThe Quantity Theory of Money, cont., cont.

Let (Greek letter “pi”) denote the inflation rate:

M P YM P Y

PP

The result from the preceding slide was:

Solve this result

for to get

CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 18

The Quantity Theory of MoneyThe Quantity Theory of Money, cont., 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.

CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 19

The Quantity Theory of MoneyThe Quantity Theory of Money, cont., 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 of Money predicts a one-for-one relation between changes in the money growth rate and changes in the inflation rate.

CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 20

International data on International data on inflation and money growthinflation and money growth

Inflation rate(percent, logarithmicscale)

1,000

10,000

100

10

1

0.1

Money supply growth (percent, logarithmic scale)0.1 1 10 100 1,000 10,000

Nicaragua

AngolaBrazil

Bulgaria

Georgia

Kuwait

USA

Japan Canada

Germany

Oman

Democratic Republicof Congo

CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 22

U.S. Inflation & Money Growth, 1960-2003U.S. Inflation & Money Growth, 1960-2003

0%

2%

4%

6%

8%

10%

12%

14%

1960 1965 1970 1975 1980 1985 1990 1995 2000

Inflation rate Inflation rate trend

CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 23

Inflation and interest ratesInflation and interest rates

Nominal interest rate, inot adjusted for inflation

Real interest rate, radjusted for inflation:

r = i

CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 24

The Fisher EffectThe Fisher Effect

The Fisher equation: i = r +

S = I determines r .

Hence, an increase in causes an equal increase in i.

This one-for-one relationship is called the Fisher effect.

CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 25

U.S. inflation and nominal interest rates, U.S. inflation and nominal interest rates, since 1954since 1954

-2

0

2

4

6

8

10

12

14

16

18

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Percent

Nominal interest rate

Inflation rate

CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 26

Inflation and nominal interest rates Inflation and nominal interest rates across countriesacross countries

Inflation rate (percent, logarithmic scale)

Nominal interest rate(percent, logarithmicscale)

100

10

11 10 100 1000

KenyaKazakhstan

Armenia

Nigeria

Uruguay

United Kingdom

United States

Singapore

GermanyJapan

France

Italy

CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 27

Ex ante and ex post inflationEx ante and ex post inflation

Ex ante variable: e = expected inflation rate

Ex post variable: = actual inflation rate (not known until after it has occurred)

When lender and borrower agree on a nominal interest rate, they do not know what the rate of inflation is going to be, hence…

Modified Fisher Effect:

i=r+ e

CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 28

Nominal interest rate and the demand Nominal interest rate and the demand for moneyfor money

i is opportunity cost of holding money:

you can deposit it in a savings account which earn the nominal interest rate rather then keep it under the mattress

( ) ( , )dM P L i Y ( , )eL r Y

CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 29

EquilibriumEquilibrium

( , )eML r Y

P

The supply of real money balances

Real money demand

CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 30

What determines whatWhat determines what

variable how determined (in the long run)

M exogenous (the Central Bank)

r adjusts to make S = I

Y

( , )eML r Y

P

( , )Y F K L

P adjusts to make ( , )M

L i YP

CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 31

How How PP responds to responds to MM

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.

( , )eML r Y

P

CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 32

How How PP responds to responds to ee

( , )eML r Y

P

(the Fisher effect)e i

d M P

to make fall

to re-establish eq'm

P M P

For given values of r, Y, and M ,

CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 33

Discussion Question Discussion Question

Why is inflation bad?

CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 34

A common misperceptionA common misperception

Common misperception: inflation reduces real wages

This is true only in the short run, when nominal wages are fixed by contracts.

In the long run, the real wage is determined by labor supply and the marginal product of labor, not the price level or inflation rate.

Consider the data…

CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 35

Average hourly earnings & the CPIAverage hourly earnings & the CPIAverage hourly earnings & the CPI, 1964-2004

0

2

4

6

8

10

12

14

16

18

20

1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004

Wag

e ($

per

hou

r)

0

50

100

150

200

250

CP

I (1

982-

84=

100)

Hourly earnings

in 2004 dollars

Consumer Price Index

Average hourly earnings (nominal)

CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 36

The classical view of inflationThe classical view of inflation

The classical view: A change in the price level is merely a change in the units of measurement.

So why, then, is inflation So why, then, is inflation a social problem?a social problem?

CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 37

Homework Assignment Homework Assignment

Read Section 4-6 of the textbook. Answer the following questions:

– Do economists and other people differ in their view on costs of inflation?

– What are the costs of expected inflation?

– What are the costs of unexpected inflation?

– Is there anything good about inflation anyway?

The Classical DichotomyThe Classical DichotomyReal variables are measured in physical units: quantities and relative prices, e.g.

quantity of output produced real wage: output earned per hour of work real interest rate: output earned in the future

by lending one unit of output today

Nominal variables: measured in money units, e.g. nominal wage: dollars per hour of work nominal interest rate: dollars earned in future

by lending one dollar today the price level: the amount of dollars needed

to buy a representative basket of goods

slide 38

CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 39

The Classical DichotomyThe Classical Dichotomy

Classical Dichotomy : the theoretical separation of real and nominal variables in the classical model, which implies nominal variables do not affect real variables.

Neutrality of Money : Changes in the money supply do not affect real variables. In the real world, money is approximately neutral in the long run.

CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 40

Chapter summaryChapter summary

1. Money the stock of assets used for transactions

serves as a medium of exchange, store

of value, and unit of account. Commodity money has intrinsic value,

fiat money does not. Central bank controls money supply.

2. Quantity theory of money assumption: velocity is stable conclusion: the money growth rate

determines the inflation rate.

CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 41

Chapter summaryChapter summary

3. Nominal interest rate equals real interest rate + inflation rate. Fisher effect: nominal interest rate

moves one-for-one w/ expected inflation. is the opp. cost of holding money

4. Money demand depends on income in the Quantity

Theory more generally, it also depends on the

nominal interest rate; if so, then changes in expected inflation affect the current price level.

CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation slide 42

Chapter summaryChapter summary

5. Classical dichotomy In classical theory, money is neutral--

does not affect real variables. So, we can study how real variables are

determined w/o reference to nominal ones.

Then, eq’m in money market determines price level and all nominal variables.

Most economists believe the economy works this way in the long run.