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MoneyandInflation

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					Money and Inflation

   Money Demand
             Price Indices: Pt
• Two most commonly used price indices
  are GDP Deflator and Consumer Price
  Index (CPI)
• The CPI is the price of a representative
  market basket of goods relative to the
  price of that same basket during a
  benchmark/base year (multiplied by 100).
• The GDP deflator is the ratio of nominal
  GDP to Real GDP (multiplied by 100).
                      Nominal GDP GDP
   P  GDP Deflator                 
                        Real GDP         Y
Hong Kong CPI vs. GDP Deflator
 120


 100


 80

                         CPI
 60
                         GDP Deflator

 40


 20


  0
    75

    77

    79

    81

    83

    85

    87

    89

    91

    93

    95

    97

    99

    01

    03
 19

 19

 19

 19

 19

 19

 19

 19

 19

 19

 19

 19

 19

 20

 20
        CPI vs. GDP Deflator
• CPI is calculated monthly, GDP deflator is
  calculated quarterly.
• CPI measures the price of consumer goods.
  GDP deflator measures the price of all goods
  produced including investment or government
  goods.
• CPI measures the change in price of a constant
  market basket. Market basket of GDP deflator
  changes as goods produced changes.
               The Data
• Data on money supply is inevitably
  measured by the central bank and usually
  the data is available for free.
Example: Hong Kong Monetary Authority
• Data on
Listing of Central Bank Websites.
          What is a central bank?
• Central banks have two main roles:
  – Banker to the government
    • Manage many financial assets of the government.
    • Monopoly on the issue of banknotes/currency (true
      almost everywhere, but not HK)
    • Arm of government policymaking
  – Banker to commercial banks.
    • Operate the Payment System
    • Regulate Banking System
    • Lender of Last Resort during a crisis
• Central Bank:        Economy   Central Bank
A special              HK        Hong Kong
  governmental                   Monetary Authority
  organization or
  quasi-               USA       Federal Reserve
  governmental
  institution within   EU        European
  the financial
  system that
                                 Central Bank
  controls the         PRC       People’s Bank of
  medium of                      China
  exchange.
                       UK,       Bank of ….
                       Canada,
                       Japan,
                       Korea
                Readings
• Money Demand
  – Branson, Chapter 14, especially p.335-339
  – Sachs Chapter 8
• Inflation
              Money
• Financial Asset Used in
  Transactions
• Legal Tender: Government
  accepts money as payment for
  taxes and a transfer of money as a
  settlement for a contract.
    Characteristics of Money

1. Medium of Exchange – Token that can be offered
   as a payment for goods.
2. Unit of Account – All goods will have a value in
   money and, thus, can be used to measure all
   goods
3. Store of Value – If money is to be accepted for
   goods today it must have durable value. (Money is
   an Asset).
    Two categories of money
1. Definitive Money (sometimes known as
   monetary base): Money that can be used
   immediately for transactions without
   conversion to more basic forms of money.
  – Currency+ Reserve accounts
2. Broad Money: A set of assets, typically
   some form of bank deposit, which can be
   easily converted to definitive money.
  – Checking Accounts, Savings Accounts, Liquid
    Time Deposits and CD’s
Categories        M1 Currency
 of Broad            + Checking Acct.
                  M2 +Savings Acct.
  Money              + “More Liquid”
                     Time Deposit
             M1   M3 + “Less Liquid”
                     Time Deposit

             M2



         M3
                   Mpney Types in HK



                          M3
                                  M1




                   M2




Incremental M3 is trivial in HK
        HK$ Money Categories
               Source: HKMA http://www.info.gov.hk


       Legal     Demand
tender notes     deposits
   and coins         with
    in hands     licensed
   of public        banks            M1

  145,852       207,444       353,297
                                    NCDs
   Savings           Time      issued by
   deposits       deposits       licensed
       with           with          banks
   licensed       licensed      and held
      banks          banks     by public             M2

  788,211      1,288,193        76,342      2,506,043
Broad Money vs. Narrow Money

• Broad money has grown much faster than
  narrow money.
• Narrow money is money directly controlled
  by the government.
• Broad money includes money printed by the
  government plus deposits at banks.
• Money multiplier is ratio of broad money to
  narrow money.
             Categories
• M0 = Reserves + Cash
• M2 = Cash + Demand Deposits + Savings
  Deposits
                   CDS
             MM         
                     RC
             C      S
                1
             D      D 1
               R C
                 
              D D
  Determinant of the Multiplier.

• The greater is the currency-deposit ratio the
  smaller is the multiplier.
• The greater is the savings to demand
  deposit ratio the greater is the multiplier.
• The higher is the fraction of deposits kept
  on reserve, the smaller is the multiplier.
Money Multiplier in China

                                                         14

                                                         12
  24000

  20000                                                  10

  16000                                                  8

  12000
                                                         6
   8000
                                                         4
   4000

     0
          90 91 92 93 94 95 96 97 98 99 00 01 02 03 04

                    MULTIPLIER       M2      M0
           Monetary Theory
• Two Assets
• Money (M) can be used for transactions but
  pays no interest.
• Bonds (B) will pay a nominal interest rate of i
  but cannot be used for transactions.
• If you buy a bond with $1, you will get $(1+i)
  from the issuer of the bond.
            Liquidity Problem

• The household earns an income equal to (PQ)
  which they will spend evenly over the course of a
  month.
• If they keep their whole income in their back-
  pocket to do shopping they will lose interest
  income.
• If they buy interest earning bonds with all of their
  income, they will have to make many costly trips
  to the bank when they want to buy goods. The
  cost of each trip to the bank will be P∙b.
          Liquidity Strategy

• Household strategy will be to keep a
  share of their income in the form of
  money, M*, and put the rest into bonds.

• They will spend that money until it is
  gone, return to the bank, and convert
  bonds into M* again.
 Choose # of trips to the bank.
• The household will have to make P  Y
  trips to the bank.              M*


• The average balances held by the
  household will be M *
                    2
 Money holdings over the month

Money




  M*


  M*
  2



                       time
  Bond holdings over the month

Bonds




                        time
           Costs of Strategy
                                         M*
• If the household is on average holding 2
 they will forego the opportunity to earn
 interest equal to M *
                   i
                       2
• The total transactions costs of converting
  their bonds into cash is         P Y
                             P b *
                                   M
        Minimize Total Costs

• Total liquidity costs of holding M*

                       P Y     M    *
                 P b  *  i 
                       M         2

• Choose the number of trips that would
  minimize the total costs (including interest
  costs).
          Cost Minimization

• Trade-off: The more trips you make, the
  more interest you will earn but the less will
  be the transactions cost.
  – Choosing the number of trips is equivalent to
    choosing M*
           Optimal Money Demand
• Money demand is an increasing function of the
  price level, and output and a decreasing
  function of interest rates.
                       P Y     M*
 min TC ( M )  P  b  *  i 
             *
  M*                    M        2
                    P Y    i        2bY
 TC '  0  P  b          M P *

                  
                         2
                    M*      2         i
                  1
       2bY 
       *              2
   M
         
   P  i 
            Money Demand

• Intuition: The greater is P and Y, the greater
  are the need for money for transactions. The
  greater is i, the greater the interest rate
  costs.
• Money Demand is typically represented in
  terms of money divided by the price level,
  referred to as real balances. M

                                 P
Money Demand Curve

 i
                Y↑




                     M
                     P
                 Velocity
• Velocity is defined as the speed at which
  money circulates or as the number of
  transactions that each unit of money is
  used in per period.
• Velocity is measured as the ratio of current
  dollar GDP to the money supply.
            PYt   Yt
         V  t
                
            Mt Mt
                          Pt
      BT Theory and Velocity
• According to Baumol-Tobin theory, money
  velocity should grow with output.
• Asian experience suggests the opposite.
• Possible reason: If b represents the costs
  of goods that could have been produced in
  the absence of a trip to the bank, b would
  likely grow with productivity.
                   Long Run
• Demand for real balances a proportional
  function of GDP as well as a function of
  interest rates.
     Mt                  Mt
         Yt f (it ) ex.     v  Yt  1 
     Pt                 Pt             it

• The higher is the interest rate, the more willing
  the household is to incur the costs of not
  holding cash.
     Empirical Studies of Money
              Demand
• The Baumol Tobin model suggests a log-
  linear form.


           Mt
        ln     a0  a1 ln Yt  a2 ln it
           Pt
        mt  a0  a1 yt  a2 ln i
      Empirical Studies of Money
               Demand
• The Baumol Tobin model suggests a log-linear
  form.
           Mt
        ln     a0  a1 ln Yt  a2 ln it
           Pt
        mt  a0  a1 yt  a2 ln i
• Empirical reality suggests that this does not
  capture short-term endogeneity between money,
  interest rates, and output.
                        Inflation
• We are concerned with explaining the rate
  of change of the price level or the inflation
  rate      Pt  Pt 1      P
         t               ln Pt 
                Pt 1                  P
• First difference the log of the money
  demand function
  log M t   t   log Yt   log it
 g  t  g   g
   t
    M             Y
                  t
                               i
                               t
  Money Growth and the Nominal
         Interest Rate
• Define the real interest rate, as the amount
  of extra goods that can be gained, if you
  give up 1 good today.

     1  rt 
               1                      1  it 
                     1  it   Pt  Pt 1
              Pt 1                      Pt


     
          1  it        rt  it   t 1
         1   t 1 
      Long Run Inflation Rate
• Assume that there is a long run inflation
  rate and real variables are unaffected by
  inflation in the long run.
               Δln i = 0
• Then long run inflation is money growth
  minus output growth.


                  g g   M   Y
        Neo-classical Dichotomy

• Assume given Y and r which is not affected by
  money supply or growth rate.
  – Money is just paper which should not affect real
    outcomes.
• Then, in the long run, we can solve for the
  price level as a function of the level of money
  and output and their growth rates (in addition
  to the real interest rate).
              Price Level
• Then, in the long run, we can solve for the
  price level as a function of the level of
  money and output and their growth rates
  (in addition to the real interest rate).


                                 
              1M                      
           P      rg g
                       M   Y

              v Y
  Socially Optimal Inflation Rate

• Friedman Rule: Socially optimal inflation rate
  sets the interest rate equal to zero.
• If the interest rate were zero, workers in
  Baumol and Tobin model would keep all of
  their pay in cash and not have to make any
  costly trips to the bank.
• Set money growth gM = r - gY
          Zero Lower Bound

• Friedman rule interest rate is also theoretical
  lower bound on the interest rate.
• Nominal interest rates on bonds cannot go
  below 0 because there is a freely available asset
  that always pays an interest rate at least equal to
  zero.
• Main objection to Friedman rule is that if we have
  a long run zero interest rate, the central bank will
  never be in a position to reduce interest rates.
                      ZIRP: Japan
                            JP: Call Rate: Uncollaterized : Overnight
                                              % pa


10


9


8


7


6


5


4


3


2


1


 0
Jul-1985   Jul-1988   Jul-1991       Jul-1994       Jul-1997       Jul-2000   Jul-2003   Jul-2006
            Why inflation?

• If zero or negative inflation is socially
  optimal, why is it so pervasive.
• Possible reason (especially in developing
  world): It is a source of government
  revenue (called seignorage).
• When the government prints new currency,
  it can use the money to pay off its old debts
  or buy new goods.
            Real Seignorage
• Amount of goods purchased by the printing
  of money
        M t  M t 1 M t  M t 1 M t 1 M t   gM M
                                            
            Pt          M t 1    M t Pt 1  g M P

• The higher is the money growth rate, the
  higher is the fraction of real balances that
  can be collected through seignorage.
           Substitution Effect
• Higher money growth reduces demand for
  real balances. Higher inflation will mean
  higher interest rates, which will mean that
  people will spend money more quickly which
  drives up prices at a given output level.
• Assume r = gY, i=gM

     g M
          M
            
              g
                  g
                    M
                    M 
                         Y 
                              g  Y M 1 


    1 g P 1 g
        M       M
                               1 g M
         Inflation Tax

% of Y




                         gM
 How does declining money demand
  reduce the seignorage revenue?
• Consumers facing high inflation and thus
  high interest rates, want to hold relatively low
  money balances and are willing to make
  more trips to the bank.
• With a given amount of money chasing a
  given amount of output more quickly, prices
  will be higher and the amount that any newly
  printed dollar will buy will be reduced.
               Hyper Inflation
• Hyperinflation occurs when inflation increases at
  a rate of 50% or more per month.
• In the long run, this rate of inflation is counter-
  productive to the government in terms of raising
  seignorage.
• Usually, a sign of a government trying to
  maximize short-term revenue by accelerating
  money growth faster than inflationary
  expectations.
   – Prices in China rose 250000% in Chungking from
     1937-1945.
Current Chinese Inflation Rates

• Between 1984 and 1996, China frequently
  had very high inflation rates, reaching to
  levels of 20% or more per year.
• Since then inflation has been steady or
  decreasing.
Chinese CPI and Broad Money
                                                     25000

                                                     20000

                                                     15000

                                                     10000
400
                                                     5000
350
                                                     0
300

250

200

150
      90 91 92 93 94 95 96 97 98 99 00 01 02 03 04

                     CPICHINA      M2
                 Velocity in China
 5

4.5

 4

3.5

 3
                                                                M1 Velocity
2.5
                                                                M2 Velocity
 2

1.5

 1

0.5

 0
   79

           81

           83

                   85

                   87

                           89

                                   91

                                   93

                                           95

                                           97

                                                   99

                                                           01

                                                           03
19

        19

        19

                19

                19

                        19

                                19

                                19

                                        19

                                        19

                                                19

                                                        20

                                                        20
Deposits are major channel for
       saving in PRC
             Bank Deposits as Share of GDP


 200.0%
 180.0%
 160.0%
 140.0%
 120.0%
 100.0%
 80.0%
 60.0%
 40.0%
 20.0%
  0.0%
          China                              USA
                                            Money & Inflation: 1975-1994

                                            Inflation & Money OECD Countries

                          0.2
                         0.18

                         0.16
Average Inflation Rate




                         0.14
                         0.12

                          0.1

                         0.08
                         0.06

                         0.04

                         0.02

                           0
                                0   0.02   0.04   0.06   0.08    0.1    0.12   0.14   0.16   0.18
                                                     Average Money Growth
  Causes of Extremely Rapid Inflation


• Government generates revenues by printing
  new money (referred to as seignorage).
• Government facing borrowing constraints
  may be forced to rely on inflation tax for
  deficit financing.
            50
                 100
                       150
                             200
                                   250
                                         300
                                               350
                                                     400




        0
19
   70
19
   71
19
   72
19
   73
19
   74
19
   75
19
   76
19
   77
19
   78
19
   79
19
   80
                                                           Inflation




19
   81
19
   82
19
   83
19
   84
19
   85
19
                                                                       Israel 1970-1990




   86
19
   87
19
   88
19
   89
19
   90
                                      Israel 1970-1990
                                                           Surplus (% of GDP)


 5.00%


 0.00%
          1970
                 1971
                        1972
                               1973
                                      1974
                                             1975
                                                    1976
                                                            1977
                                                                   1978
                                                                          1979
                                                                                 1980
                                                                                        1981
                                                                                               1982
                                                                                                      1983
                                                                                                             1984
                                                                                                                    1985
                                                                                                                           1986
                                                                                                                                  1987
                                                                                                                                         1988
                                                                                                                                                1989
                                                                                                                                                       1990
 -5.00%


-10.00%


-15.00%


-20.00%


-25.00%


-30.00%
Hyperinflation
          Mid-term Exam III
• Monday, December 13th 4:30-7:30PM
• Lecture Theater A
• Semi-open Book (Bring 1 A4 size paper
  with handwritten notes)) also calculator
  and writing instruments.
• Coverage. Lecture notes including this
  one.
• Lecture Theater A, 4:30-7:30

				
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