Docstoc

PPT - Mailer Fsu

Document Sample
PPT - Mailer Fsu Powered By Docstoc
					     CHAPTER 13:

Money, Interest, and
    Inflation
  CHAPTER CHECKLIST


1. Explain what determines the demand for money
   and how the demand for money and supply of
   money determine the nominal interest rate.
2. Explain how in the long run, the quantity of
   money determines the price level and money
   growth brings inflation.
3. Identify the costs of inflation and the benefits of a
   stable value of money.
  LECTURE TOPICS


Money and the Interest Rate

Money, the Price Level, and Inflation

The Cost of Inflation
      WHERE WE ARE; WHERE WE’RE HEADING
 The Real Economy
  Real factors that are independent of the price level
  determine real GDP and the natural unemployment
  rate.
  Investment and saving determine the real interest rate
  and, along with population growth and technological
  and systemic change, determine the growth rate of
  real GDP.
The Money Economy
  Money is created by banks and its quantity is
  controlled by the Fed; it influences the price level.
     WHERE WE ARE; WHERE WE’RE HEADING

The Money Economy
  The effects of money can be best understood in three
  steps:
     • The effects of the Fed’s actions on the short-term
       nominal interest rate
     • The long-run effects of the Fed’s actions on the
       price level and the inflation rate
     • The connections between the short-run and long-
       run effects
 13.1 MONEY AND THE INTEREST RATE


 The Demand for Money
  Quantity of money demanded
  How much money households and firms want to hold,
  given the costs and benefits of holding money rather
  than doing something else, and the current situation.
  Benefits of Holding Money
  Traditionally, the motives for holding money [rather
  than goods or income-earning assets] are three:
  Transactions; precautionary; and speculative.
   Motives for holding money


Transactions Demand: The major benefit of holding
money is the ability to make payments. The more money
you hold, the easier it is for you to make payments. So
how much you transact – how much you make in
payments – will influence strongly how much money you
want to hold.
Precautionary Demand: “Just in case” -- money is liquid,
you can make payments with it; most people hold some
money in case they need to make unexpected payments.
Speculative Demand: If you have money, you can take
advantage quickly of any opportunity that comes along –
which you maybe couldn’t, if you weren’t liquid.
13.1 MONEY AND THE INTEREST RATE


The marginal benefit of holding money decreases as
the quantity of money held increases.
Opportunity Cost of Holding Money
The opportunity cost of holding money is the interest
income forgone on the best alternative asset.
Opportunity Cost: The Nominal Interest rate is the
cost of holding money
The opportunity cost of holding money is the nominal
interest because it is the sum of the real interest rate
on an alternative asset plus the expected inflation
rate, which is the rate at which money loses buying
power.
13.1 MONEY AND THE INTEREST RATE


The Demand for Money Schedule and Curve
The demand for money is the relationship between
the quantity of money demanded and the nominal
interest rate [which is the ‘price’ of holding money],
when all other influences on the amount of money that
people want to hold remain the same.
Figure 13.1 on the next slide illustrates the demand for
money.
      13.1 MONEY AND THE INTEREST RATE




The lower the nominal
interest rate—the
opportunity cost of
holding money—the
greater is the quantity
of money demanded.
      13.1 MONEY AND THE INTEREST RATE




1. Other things
  remaining the same,
  an increase in the
  nominal interest rate
  decreases the
  quantity of money
  demanded.
2. A decrease in the
   nominal interest rate
   increases the quantity
   of money demanded.
 13.1 MONEY AND THE INTEREST RATE


 Changes in the Demand for Money
  A change in the nominal interest rate brings a change
  in the quantity of money demanded.
  A change in any other influence on money holdings
  changes the demand for money. The three main
  influences are:
     • The price level
     • Real GDP
     • Financial technology and institutional
       arrangements
13.1 MONEY AND THE INTEREST RATE


The Price Level
An x percent rise in the price level brings an x percent
increase in the quantity of money that people plan to
hold because the number of dollars we need to make
the same volume of real payments is proportional to
the price level.
Real GDP
The demand for money increases as real GDP
increases because the volume of transactions and
real payments increase when real GDP increases.
13.1 MONEY AND THE INTEREST RATE


Financial Technology and Institutional
Arrangements
Daily interest on checking deposits, automatic
transfers between checking and savings accounts,
automatic teller machines, and debit cards and smart
cards have increased the marginal benefit of money
and increased the demand for money.
Credit cards have made it easier to buy goods on
credit and have decreased the demand for money.
Institutional issues like the frequency of wage and
other regular payments [rent etc; e.g. weekly or
monthly] also influence the demand for money.
  13.1 MONEY AND THE INTEREST RATE


Shifts in the Demand Curve for Money
 Curve
  A change in any influence on money holding other
  than the nominal interest rate changes the demand for
  money and shifts the demand for money curve.
  Figure 13.2 on the next slide illustrates these shifts.
13.1 MONEY AND THE INTEREST RATE
  13.1 MONEY AND THE INTEREST RATE


 The Nominal Interest Rate
  The nominal interest rate, the ‘price’ [opportunity cost]
  of holding money, adjusts to make the quantity of
  money demanded equal to the quantity of money
  supplied.

  The supply of money is the relationship between
  the quantity of money supplied and the nominal
  interest rate.

  On any given day, the quantity of money is fixed.
13.1 MONEY AND THE INTEREST RATE


  • When the interest rate is above its equilibrium
    level, the quantity of money supplied exceeds the
    quantity of money demanded.
  • People are holding too much money, so they try
    to get rid of money by buying other financial
    assets.
  • The demand for financial assets increases, the
    prices of these assets rise, and the interest rate
    falls.
  • Why? Which assets? Consider bonds – you
    may not buy them, but financial institutions do.
  Bond prices and interest rates


A bond has a ‘coupon’ -- a $100 face-value
 5% bond pays $5 a year; if you buy the
 bond, you get $5 a year.

If interest rates on new borrowing are 2.5%,
 what would you pay to get $5 a year? $200.

If interest rates on new borrowing are 10%,
 what would you pay to get $5 a year? $50.
  Interest Rate Determination


The percentage yield on a financial security
 [or bond] is the nominal interest rate.

The price of existing ‘paper’ -- bonds or bills --
 moves in the opposite direction to the interest
 rate.

We will focus on the market for money,
 because the Fed can influence the supply of
 money.
Interest Rate Determination


Money Market Equilibrium
The interest rate is determined by the supply of and
demand for money.
At any given moment in time, the quantity of real
money supplied is a fixed amount.
The ‘supply of money’ is thus vertical, determined by
the Fed’s monetary policy [the quantity of reserves it
has provided to banks]
13.1 MONEY AND THE INTEREST RATE


   • When the interest rate is below its equilibrium
     level, the quantity of money demanded exceeds
     the quantity of money supplied.
   • People are holding too little money, so they try to
     get more money by selling other financial assets.
   • The demand for financial assets decreases, the
     prices of these assets fall, and the interest rate
     rises.
Figure 13.4 on the next slide illustrates the equilibrium
and adjustment toward it.
      13.1 MONEY AND THE INTEREST RATE




1. If the interest rate is 6 percent a year,
  the quantity of money held exceeds
  the quantity demanded. People buy
  bonds, the price of a bond rises, and
  the interest rate falls.

  A decrease in the nominal interest
  rate increases the quantity of money
  demanded.
      13.1 MONEY AND THE INTEREST RATE



2. If the interest rate is 4 percent a year,
  the quantity of money held is less
  than the quantity demanded. People
  sell bonds, the price of a bond falls,
  and the interest rate rises.
  A rise in the nominal interest rate
  decreases the quantity of money
  demanded.
3. If the interest rate is 5 percent a
  year, the quantity of money held
  equals the quantity demanded and
  the money market is in equilibrium.
  13.1 MONEY AND THE INTEREST RATE


Changing the Interest Rate
  To change the interest rate, the Fed changes the
  quantity of money.
  If the Fed increases the quantity of money, the interest
  rate falls.
  If the Fed decreases the quantity of money, the
  interest rate rises.
  Figure 13.4 on the next slide illustrates these
  changes.
      13.1 MONEY AND THE INTEREST RATE




1. The Fed increases the money
  supply to MS1, and the interest
  rate falls to 4 percent a year.

2. The Fed decreases the money
   supply to MS2, and the interest
   rate rises to 6 percent a year.
       Reality check ….


 This is a little misleading. The Fed targets the ‘Federal
  Funds Rate’ – the interest rate at which banks borrow and
  lend reserves among themselves.
 When the Fed increases the money supply, what it does is
  increase the reserves available to the system by buying
  securities [tending to push up their prices] on the open
  market.
 The Fed has increased the supply of reserves to the
  Federal Funds market, without initially having done
  anything to demand. So the Federal Funds rate declines to
  make the quantity demanded equal to the quantity supplied.
  The interest rates that decline are the short-term rates tied
  to the Federal Funds rate [the opportunity cost of reserves
  to the banks].
  Reality check continued …


 Bonds have a long life – when issued, usually at least
  ten years, maybe twenty or thirty, maybe indefinite.
 In reality, sometimes when the Fed increases the
  money supply, the Federal Funds rate and other short-
  term interest rates fall, but long-term interest rates [on
  bonds, on fixed-rate mortgages] may not change, or
  even rise.
 Why? Because actual interest rates, on bonds and
  fixed-rate mortgages, are nominal interest rates – in
  terms of dollars, not real purchasing power. So long
  term interest rates reflect expectations of the average
  real interest rate plus the average inflation rate over
  the borrowing term – and an expanding money supply
  may make lenders believe inflation will increase.
 13.2 THE PRICE LEVEL AND INFLATION


 The Money Market in the Long Run
  The long run refers to the economy at full employment
  or when we smooth out the effects of the business
  cycle.
  In the short run, the interest rate adjusts to make the
  quantity of money demanded equal the quantity of
  money supplied.
  In the long run, the price level does the adjusting.
13.2 THE PRICE LEVEL AND INFLATION


Potential GDP and Financial Technology
Potential GDP and financial technology, which
influence the demand for money, are determined by
real factors and are independent of the price level.

The Nominal Interest Rate in the Long Run
The nominal interest rate equals the real interest rate
plus the expected inflation rate.
The real interest rate is independent of the price level
in the long run. The expected inflation rate depends
on monetary policy in the long run.
13.2 THE PRICE LEVEL AND INFLATION


Money Market Equilibrium in the Long Run
All the influences on money holding except the price
level are determined by real forces in the long run and
are given.
Money market equilibrium determines the price level.
Figure 13.5 on the next slide illustrates the long-run
equilibrium.
     13.2 THE PRICE LEVEL AND INFLATION




1. The demand for money
  depends on the price level.

2. The equilibrium nominal
   interest rate also depends on
   the price level.
     13.2 THE PRICE LEVEL AND INFLATION



3. The long-run equilibrium real
  interest rate

4. Plus the inflation rate
  determine . . .

5. The long-run equilibrium
  nominal interest rate.
6. The price level adjusts to 100
  to achieve money market
  equilibrium at the long-run
  equilibrium interest rate.
  13.2 THE PRICE LEVEL AND INFLATION


A Change in the Quantity of Money
  If the Fed increases the quantity of money from $1
  trillion to $1.02 trillion—a 2 percent increase—the
  nominal interest rate falls.
  But eventually, the nominal interest rate returns to its
  long run equilibrium level and the price level rises by 2
  percent.
  Figure 13.6 on the next slide illustrates this outcome.
     13.2 THE PRICE LEVEL AND INFLATION




1. The money supply
   increases by 2 percent
   from $1 trillion to $1.02
   trillion and the supply
   curve shifts from MS0 to
   MS1.

2. In the short run, the
  interest rate falls to 4
  percent a year.
     13.2 THE PRICE LEVEL AND INFLATION




3. In the long run, the price
  level rises by 2 percent
  from 100 to 102, the
  demand for money
  increases from MD0 to
  MD1, and the nominal
  interest rate returns to its
  long-run equilibrium level.
13.2 THE PRICE LEVEL AND INFLATION


The Price Level in a Baby-Sitting Club – silly
example:
A baby sitting club uses tokens to pay for neighbors’
baby sitting services. One sit costs one token.
The organizers double the number of tokens by giving
a token to each member for each token currently held.
Equilibrium in this local baby-sitting market is restored
when the price of a sit doubles to two tokens.
Nothing real has changed, but the nominal quantity of
tokens and the price level have doubled.
 13.2 THE PRICE LEVEL AND INFLATION


Money Growth and Inflation
  Steady Inflation
  If the quantity of money increases by 2 percent a year
  and keeps increasing at that rate, year after year the
  economy experiences inflation.
  If potential GDP remains constant (which we’ll assume
  for the moment), the price level increases by the same
  percentage as the percentage increase in the quantity
  of money.
  Figure 13.7(a) on the next slide illustrates inflation.
      13.2 THE PRICE LEVEL AND INFLATION




1. The money supply is growing
   by 2 percent a year.

2. The price level is rising by 2
   percent a year, so the supply
   of money and the demand for
   money increase at the same
   rate and the nominal interest
   rate remains constant at its
   long-run equilibrium level.
13.2 THE PRICE LEVEL AND INFLATION


Increase in the Inflation Rate

If the Fed increases the growth rate of the quantity of
money, the inflation rate rises.

Figure 13.7(b) on the next slide shows this outcome.
       13.2 THE PRICE LEVEL AND INFLATION



3. The money supply growth rate
  increases to 3 percent a year.

4. Initially, the nominal interest
  rate falls.

5. But eventually, the price level
  rises, the demand for money
  increases.

6. The nominal interest rate
   rises to 6 percent a year.
13.2 THE PRICE LEVEL AND INFLATION


Potential GDP Growth
The growth of potential GDP brings a growth in the
demand for money.
If the Fed makes the quantity of money grow at the
same rate as the growth rate of potential GDP, the
price level remains constant, so long as financial
technology and institutional arrangements stay
unchanged.
In the long run, the inflation rate equals the growth
rate of the quantity of money minus the growth rate of
potential GDP.
 13.2 THE PRICE LEVEL AND INFLATION


The Quantity Theory of Money
  Quantity theory of money
  The proposition that in the long run, an increase in the
  quantity of money brings an equal percentage
  increase in the price level (other things remaining the
  same).
  Velocity of circulation
  The average speed with which a dollar circulates in
  the economy as people use it to buy final goods and
  services—nominal GDP divided by quantity of money.
13.2 THE PRICE LEVEL AND INFLATION


To calculate the velocity of circulation:
Divide nominal GDP by the quantity of money.
   • The velocity of circulation = V
   • The quantity of money = M
   • The price level = P
   • Real GDP = Y
Then nominal GDP is P  Y, and the velocity of
circulation is defined as
          V = (P  Y)  M
13.2 THE PRICE LEVEL AND INFLATION


Multiple both sides by M to obtain the equation of
exchange, which states that the quantity of money
multiplied by the velocity of circulation equals nominal
GDP.
That is,
                    MV=PY
Divide both sides of the above equation by Y to obtain
                    P = (M  V)  Y
13.2 THE PRICE LEVEL AND INFLATION


                     P = (M  V)  Y

On the left is the price level.
On the right are all the things that influence the price
level.
Assume velocity does not change when the quantity of
money changes; and that real GDP grows at a pace
that is independent of the changes in the quantity of
money.
Then, if M increases, P must increase, and by the
same percentage.
       Reality check


 Note the definition of velocity. It is NOT the average number of
  times each dollar is used in transactions each year, because
  most transactions do NOT involve purchases of final goods and
  services – they involve financial transactions, purchases of
  used goods or of intermediates. Velocity is not observable, it is
  defined as a ratio that does not correspond to something that
  actually happens.
 In reality, velocity is not constant. It changes with financial
  technology and institutional arrangements [like whether most
  people are paid weekly or monthly], and for large changes in
  money supply also changes with money – if inflation becomes
  very rapid, what would you expect to happen to velocity?
  13.2 THE PRICE LEVEL AND INFLATION


  If the quantity of money grows very rapidly, the
  inflation rate will be very high.
  An inflation rate that exceeds 50 percent a month is
  called hyperinflation.
  Workers are often paid daily
     • Money loses value rapidly
     • Workers spend their incomes quickly
1996 inflation rates:
     • Angola — about 400% per month
     • Turkmenistan — about 40% per month
13.3 THE COST OF INFLATION


Inflation is costly to individuals and society for at least
four reasons:

   • Tax costs

   • Shoe-leather costs

   • Confusion costs

   • Uncertainty costs
 13.3 THE COST OF INFLATION


Tax Costs
  Government revenue often increases when inflation
  increases.
  Inflation has the effect of a tax!
  Because the net profits of the Federal Reserve
  System are paid to the US Treasury, and when the
  money supply increases the Fed’s profits increase,
  the government does receive the ‘seignorage’ income
  from more rapid money creation because of inflation.
13.3 THE COST OF INFLATION


  Inflation Tax, Saving, and Investment

  • The “inflation tax” is bigger than losses from
    holding money that is losing real value, because
    inflation interacts with the income tax to lower
    saving and investment and distort investment.
  • One part of the problem is that inflation increases
    the nominal interest rate, and because income
    taxes are paid on nominal interest income, the
    true income tax rate on real interest income rises
    with inflation.
    13.3 THE COST OF INFLATION


The higher the inflation rate, the higher is the true income tax
rate on real income from capital.
And the higher the tax rate, the higher is the interest rate paid
by borrowers and the lower is the after-tax interest rate
received by lenders. This may lead to ‘financial
disintermediation,’ lower investment, and a distortion of
investment patterns away from more productive investments
toward asset-holding that has a higher probability of preserving
real purchasing power.
There is considerable international evidence to suggest that
high and variable inflation rates damage economic growth
rates.
 13.3 THE COST OF INFLATION


Shoe-Leather Costs
  So-called “shoe-leather” costs arise from an increase
  in the velocity of circulation of money and an increase
  in the amount of running around that people do to try
  to: avoid incurring losses from the falling value of
  money; and find out what prices are – if inflation is
  rapid, that implies individual prices change relatively
  frequently, so what may have been a ‘good buy’
  yesterday may not be today.
13.3 THE COST OF INFLATION


When money loses value at a rapid anticipated rate, it
does not function well as a store of value and people
try to avoid holding it.
They spend their incomes as soon as they receive
them, and firms pay out incomes—wages and
dividends—as soon as they receive revenue from
their sales.
The velocity of circulation increases.
 13.3 THE COST OF INFLATION


Confusion Costs
  Money is our measuring rod of value.
  Borrowers and lenders, workers and employers, all
  make agreements in terms of money.
  Inflation makes the value of money change, so it
  changes the units on our measuring rod.
  This makes long-term contracts highly uncertain, and
  discourages investment projects that have long
  gestation periods or expected lives. This is not good
  for economic growth.
 13.3 THE COST OF INFLATION


Uncertainty Costs
  A high inflation rate brings increased uncertainty about
  the long-term inflation rate.
  Increased uncertainty also misallocates resources.
  Instead of concentrating on the activities at which they
  have a comparative advantage, people find it more
  profitable to search for ways of avoiding the losses
  that inflation inflicts.
  Gains and losses occur because of unpredictable
  changes in the value of money.
  13.3 THE COST OF INFLATION


How Big Is the Cost of Inflation?
  The cost of inflation depends on its rate and its
  predictability.
  The higher the rate, the greater is the cost.
  And the more unpredictable the rate, the greater is the
  cost.
• The Costs of Unanticipated Inflation

  (1) The redistribution of income to
      employers from workers:
Nominal wages                   $10.00            $10.00
Expected                           100
 price level
Expected          10 100 = $10.00
 real wage       100
Actual price                                         110
Actual                                    10 100 = $9.09
 real wage                               110

         Here we see that workers earn a real
         wage less than they expected.
• The Costs of Unanticipated Inflation
    (2) The redistribution of income from borrowers
        to lenders as lenders get to repay with
        ”cheaper dollars.”
                        No Inflation                 5% Inflation
Loan                           $100                         $100
Nominal                           5%                            5%
  interest rate
Nominal payment
after a year                     $105                          $105
Real value
                   
of payment 100 100  .05 100  $105    100 100  .05 100  $100
                                          105
after a year 100
         Unanticipated inflation means lenders are paid
         $105. However, the $105 dollars will purchase
         only $100 worth of goods.
  Costs of Unanticipated Inflation


Losers are net nominal creditors and those
 who have incomes fixed in money terms;

Gainers are net monetary debtors, and those
 who own or are owed real assets.

If inflation is less than expected, the reverse is
 true -- monetary debtors lose, creditors gain.

				
DOCUMENT INFO
Shared By:
Categories:
Tags:
Stats:
views:0
posted:5/3/2013
language:Unknown
pages:60