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MACROECONOMICS by wulinqing

VIEWS: 22 PAGES: 27

									MACROECONOMICS
           Chapter 4

       Money and Inflation




                             1
            Long Run View
 Money and inflation are related closely in
  the long run.
 Classical economists used Quantity
  Theory of Money to explain the
  connection.
 We start with definitions and go to QTM
  and proceed to modern adjustments.


                                               2
                What Is Money?
   Money (=money supply) any vehicle used as a
    means of exchange to pay for goods, services
    or debts.
   In today’s society, any asset that can quickly be
    transferred into cash is considered money.
   The more liquid an asset is, the closer it is to
    money.
   In economics,money does not mean wealth nor
    does it mean income.


                                                        3
      What Is Money?
 Functions   of Money
  Medium   of exchange
  Unit of Account
  Store of Value




                          4
              What Is Money?
   Medium of exchange
     By eliminating barter, this function of money
      increases efficiency in a society.
     As human societies started to engage in
      exchange money had to be invented.
     Any technological change that reduces
      transaction costs increases the wealth of
      the society.
     Any technological change that allows
      people to specialize also increases wealth.
                                                      5
                      What Is Money?
   Unit of Account
       We use money to measure the value of goods and
        services.
       Suppose we had 4 goods and no money. How do we
        measure the price of each good?
            A in terms of B
            B in terms of C        N!/2(N-2)!
            C in terms of D
            A in terms of C
            A in terms of D
            B in terms of D
       Money allows to quote prices in terms of currency only.

                                                              6
                    What Is Money?
   Store of Value
       All assets are stored value.
       Money, although without any return, is still desirable to
        hold because it allows purchases immediately.
       Other assets take time (transaction costs) to use as a
        payment for purchases.
       The more liquid an asset is, the less transaction cost it
        carries.
       Inflation erodes the value of money.
            Return on money: -π



                                                                7
        What Is Money?

 Commodity money
 Gold certificates
 Bank notes
 Fiat money
 Checks
 Electronic Payment
 E-money

                         8
             What Is Money?
   M1: Currency, demand deposits, travelers checks.
   M2: M1, saving deposits, small time deposits, retail
    MMMF.
   M3: M2, large time deposits, repos, Eurodollar
    deposits, institutional MMMF.
   MZM: M2, institutional MMMF minus small time
    deposits.
   Growth rates of these aggregates do not always go
    hand in hand, making monetary policy difficult since
    signals are conflicting.
    http://research.stlouisfed.org/publications/mt/page16.pdf



                                                                9
             Monetary Policy
   Central Bank is responsible for monetary
    policy.
     Open-market operations
     Changes in required reserve
     Changes in the discount rate
     Quantitative easing




                                               10
      Quantity Theory of Money
MVT=PT                        MVY=PY

The Classical economists included all
 transactions in this definition. If one
 includes only the transactions that
 create GDP, one gets the second one.

%Δ in M + %Δ in V = %Δ in P + %Δ in Y
                                           11
        Quantity Theory of Money
   In the classical approach, Y is determined by
    labor, capital, and technology.
       These resources are fixed in the short run, so Y is
        fixed.
   Like every other market, the monetary sector is in
    equilibrium, i.e. money supply is equal to money
    demand.
       Money supply, M, is determined by the central bank.



                                                              12
    Quantity Theory of Money
 In the short run Y is fixed.
 Velocity was thought to be constant by the
  Classical economists. Milton Friedman
  revised it to be “stable” easily forecast.
 If in the short run both Y and V were fixed,
  then %Δ in M = %Δ in P



                                             13
        Quantity Theory of Money
   How to test the hypothesis that %Δ in M is
    roughly equal to %Δ in P? (%Δ in P is
    defined as inflation).
       Longitudinal data
               4-1 for USA: On average, %Δ in M =
          Figure
          7%,%Δ in P = 3%. Why not equal?
       Cross-sectional data
          Figure   4-2


                                                    14
       Money Demand Function
   Suppose real money balances
    depend on real income       {M    }  kY
                                       d
                                     P
   But, by definition, MV=PY.
   Therefore,          1
                     k
                        V
   It is useful to remember that
    velocity and money demand
    are inversely related.
                                               15
         Examples of k Changes
   Credit card usage increases
       People hold less real money balances => k
        falls => V rises.
   ATMs introduced
       Same as above
   Nominal interest rates rise
       Same as above. WHY?


                                                    16
                     Seigniorage
    How government gets revenue?
    1.   Taxes
    2.   Borrowing
    3.   Printing money = seigniorage
            M increase leads to P increase but because
             nominal assets lose value, government transfer
             that value to itself.
            http://www.npr.org/blogs/money/2009/01/what_is
             _seigniorage_1.html
            http://en.wikipedia.org/wiki/Seigniorage
                                                          17
http://research.stlouisfed.org/publications/usfd/page16.pdf

                                                              18
    Inflation and Interest Rates
When a borrower and a lender agree on a
 real return on the loan (r), they still have to
 agree on the expected inflation (πe) to
 determine the nominal interest rate (i).
 (1+r ) (1+πe ) = (1+i)
 1 + r + πe + r πe = 1 + i
For simplicity, we use the Fisher equation:
 i = r + πe
                                               19
        Inflation and Interest Rates
   What happens if the borrower and lender
    misjudged the expected inflation? Who gains
    and who loses?
       See slide 24.
   What happens when actual inflation (instead of
    expected) exceeds the nominal interest rate?
       See Figure 4-3
   How do people form expectations, anyway?
       Static, adaptive, rational

                                                     20
         Demand for Money and i
   What does one give up by holding money?
       The opportunity to earn r
   What does one gain from holding money?
       Deflation makes money more valuable
       Inflation: -πe
   What is the net opportunity cost?
       r – (-πe ) = r + πe = i.
   Therefore, as i increases, opportunity cost of
    holding money increases.
       Money demand should decrease.

                                                     21
           Demand for Money
                  M        L(i, Y )
                      P

The demand for real money balances (liquidity
preference) is a negative function of i and a positive
function of Y.




                                                         22
         Demand Responds to i
   Increase Money Supply => Y fixed means i has
    to go down to equate the higher M/P to demand.
   However, Quantity Theory of Money says money
    demand is not affected by interest rates.
   This was Keynes’ objection to Classical Theory.
             i




                                   M/P
                                                  23
         Classical Revenge
 M increase => P increase => π increase
  => i increase => M/P decrease.
 In the long run, M increase does not
  create a lower i.
         i




                            M/P
                                           24
The Costs of Expected Inflation
 Shoe leather costs
 Menu costs
 Firms not changing “menus” are not
  keeping up with inflation. Relative prices
  change creating inefficiencies.
 Tax liability increases
 Uncertainty increases undermining
  planning
                                               25
 The Costs of Unexpected Inflation
 Impact on debtors
 Impact on creditors
 Impact on fixed incomes
 Impact on risk taking




                                     26
              Benefit of Inflation
   Money illusion can adjust real wages and
    reduce unemployment
        W/P




                              L


                                               27

								
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