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Lecture 4

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					Lecture 4


Money and inflation
Example: Zimbabwe hyperinflation
Example: Zimbabwe hyperinflation
Example: Zimbabwe hyperinflation
What happened?
   A dramatic increase in government
    expenditure.

   For example, in 2006:
   Soldiers salary was raised by 300%
   Police’ salary was raised by 200%

   Government had no money to do that –
    they print money.
Right now
   Since April 2009, all transactions are done
    in foreign currencies, such as the US dollar
    or South Africa’s Rand.
Price of a daily newspaper

   Jan 1921: 0.30 mark
   May 1922: 1 mark
   Oct 1922: 8 marks
   Feb 1923: 100 marks
   Sep 1923: 1,000 marks
   Oct 1, 1923: 2,000 marks
   Oct 15, 1923: 1 million marks
   Nov 17, 1923: 17 million marks
This lecture

   Quantity theory of money  how
    inflation is determined.

   Demand for money  a link
    between output and money

   Fisher equation
Why could this happen?
   What is money?

   A store of value

   A medium of exchange

   A unit of account
Money supply measure
   C   Currency                      $715.4 billion

   M1 Currency +
       demand deposits +
       Checking accounts              $1363.4 billion


   M2 M1 +
       retail money market mutual fund +
       Saving deposits              $6587.9 billion

   M3 M2 + repurchase agreements $9976.2 billion

   Note: US GDP is 14.256 trillion
Money supply in US
   Open market operations
       Sell bond  decrease money supply
       Buy bond  increase money supply


   Reserve requirement

   The discount rate
Money supply in US
                          M1 Money Supply (08/08 -- 07/10)

                  1750

                  1700

                  1650
Billions of US$




                  1600

                  1550

                  1500

                  1450

                  1400   08/08

                  1350
                                           Month
            Banks borrowing from Fed

                         2008 Banks borrowing from Fed

           800
           700
           600
           500
Billions




           400
           300
           200
           100
            0
                 0   2        4       6           8   10   12   14
                                          Month
          US money supply
                            Changes in Fed Discount Rate
7
              2006-6-29
6                                                  2007-8-17

                                                      2007-9-18
5                                                         2007-10-31
                                                               2007-12-11


4                                                                 2008-1-22

                                                                   2008-1-30
                                                                       2008-3-17
3
                                                                        2008-3-18
                                                                            2008-4-30
2
                                                                                           2008-10-8

                                                                                             2008-10-29
1
                                                                                                 2008-12-16

0
3-24-06   7-2-06 10-10-06 1-18-07   4-28-07   8-6-07 11-14-07 2-22-08       6-1-08   9-9-08 12-18-08 3-28-09
Velocity

   Basic concept: the rate at which
    money circulates.
   Example: In 2009,
       US GDP: $14000 billion
       Money supply = $700 billion (M1)
       The average dollar is used 20 times.
       So velocity = 20
Quantity theory of money

   V = velocity
   T = value of all transactions (T = PY)
   M = money supply.

    Money * Velocity = Price * Output
     M    *   V      = P * Y
Quantity theory of money
    Take the log of previous equation:
          log M t  log Vt  log Pt  log Yt          (1)

    Since it works for time t, it also works for time t-1:
      log M  log V  log P  log Y            (2)
            t 1       t 1       t 1         t 1



    Equations (1) – (2), we have:

     log M t   log Vt   log Pt   log Yt        (3)
Quantity theory of money
   Equation (3) says:
    % change in M + % change in V =
    % change in P + % change in Y
Inflation and money supply
Inflation and money supply
Demand for money
   Consider the “trip to the bank” story:

   People would have some of their income in their
    pocket, and the rest in a bank.

   When the money in his pocket is lower than some
    number, he would take a trip to the bank to
    “refill” his pocket.

   Therefore, factors that affect the number of the
    trips would affect his demand for money.
Demand for money

   Income effect:
       When a person has a higher income, it
        is more costly for him to go to the bank
        (opportunity cost is high).

       When a person has a higher income, he
        would typically consume more –
        therefore he needs more money in his
        pocket.
Demand for money

   Interest effect:
       When the nominal interest rate is
        higher, putting money in the bank
        would earn more interests  less
        money in his pocket.


   Price effect:
       Higher price would require more money
        in the pocket.
Demand for money

   Money demand equation
              d
         M 
            Li , Y   Y    i
          P
   α and β are two positive numbers:
     α represents the relationship between
      money demand and the income
     β represents the relationship between
      money demand and nominal interest
      rate.
Discussion:
   If, because of increasing popularity of
    credit use, people carry almost no cash in
    their pockets, regardless of their income.
    What would happen to the money demand
    equation?

   The value of α would be reduced to almost
    zero -- people’s income levels would no
    longer have any effects on their demand for
    money in their pockets.
Fisher equation
   At the beginning of a year, Bill has 1 million
    dollars. Two options:

   Option #1: Deposit into a bank to earn a
    preset nominal interest. At the end of the
    year, he would have:
              $ (1 + i) million
Fisher equation
   Option #2: Invest.

   At the current price p, he would buy 1/p
    million units machines.

   Each unit of machine would produce (1+r)
    units of output. At the end of the year, he
    would produce total output:
              1/p x (1+r)
Fisher equation:
   Option #2 (continued):

   At the end of the year, the new price is
             px(1+π )

   He would sell the output at the new price to
    get money:

       1/p x (1 + r) x px(1+π) = (1+r) x(1+π)
Fisher equation:
   Two options should generate exact same
    amount of money:
      (1 + i) = (1+r) x(1+π)
     1+i=1+r+π+rxπ

    Since r x π is generally very small, we have
    the Fisher equation:

             i≈r+π
Fisher equation
   Since at the beginning of the year we do
    not know the inflation, so we use expected
    inflation:

                i  r    e
Discussions:
   Since real interest rate does not vary much
    across time, nominal interest rate and the
    inflation should be highly correlated. See
    graphs next.
The Fisher equation: time series evidence
The Fisher equation: cross country evidence
Cost of expected inflation

   Cost of expected inflation

   Menu cost: first may have to change their
    posted prices more often.

   Tax laws: many provision of the tax code
    do not account for the inflation.
Cost of unexpected inflation

   Unexpected redistribution.
Summary
   Quantity theory suggests that inflation is
    almost entirely due to the money supply.

   Demand for money depends on income,
    price level, and nominal interest rate.

   Fisher equation suggests that
    nominal interest = real interest + expected
    inflation

				
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