ECON 3133 Chapter 7

Money and Inflation

barter

direct exchange of goods and services without money. can be costly and time-consuming

double coincidence of wants

each person must want what the other person offers

medium of exchange

function of money that explains how it is widely accepted as a payment of goods and services, and that it eliminates the need for a double coincidence of wants. to be effective, it must be:

1. widely accepted

2. standardized

3. durable

4. portable

5. divisible

unit of account

function of money, explains how every good can be expressed in a common unit such as dollars

store of value

function of money, allows households & firms to transfer purchasing power from present to future

standard of deferred payment

function of money, allows contracts, loans, and future payments to be expressed in a common unit

commodity money

derives its value from a physical good w/ worth (gold, silver, salt) and has value independent of its use as money. disadvantages include transportation costs and difficulties controlling supply

flat money (paper money)

no significant intrinsic value, and its usefulness can deterioriate significantly during hyperinflation. issued by monetary authorities

M1

narrow measure of highly liquid money. includes: currency (flat money + coins) outside of banks, demand deposits, and other liquid deposits including savings accounts (majority, over 60%) and other checkable deposits. currently about $20 trillion

M2

broader measure of less liquid money. includes everything in M1 + small-denomination time deposits (<$100,000) and retail money market mutual funds (for individual investors). small-time deposits and money market funds make up 5%, while M1 makes up 95%. currently about $23 trillion.

credit cards

allows consumers to borrow money to purchase goods and services, where the card issuer pays the merchant and the cardholder later repays the loan. therefore, it is a form of credit and not money itself

payment apps

platforms that withdraw money from checking accounts located in M1 and provide loans to consumers

bitcoin

decentralized digital asset that can be transferred w/o banks. it violates the unit of account function of money, as goods & services are not widely priced in bitcoin, store value, as it is extremely volatile, medium of exchange, as it has high transaction fees, and standard of deferred payment

influences of money supply

1. the federal reserve, through policies

2. the banking system, through lending, which expands money

3. nonbank public (households and firms), through demand for deposits & loans

monetary base (MB)

$C+R$ , where C is the currency held by nonbank public and R is bank reserves, including vault cash and balances held at federal reserve

money supply (M)

$mMB$ , where m is the money multiplier, and explains how much M expands for every single dollar change in MB, which is monetary base

open market operations

the federal reserve purchases or sells securities, such as U.S treasuries and MBS

money multiplier (m)

$\frac{M}{MB}$ , where M is money supply in per dollars of MB, which is monetary base

currency-to-deposit ratio c

$\frac{C}{D}$ , where C is currency held by nonbank public and D is checking, savings, and other liquid deposits in M1, reflecting the public’s preference for holding currency relative to deposits

required-reserve-to-deposit ratio rr

$\frac{R\mathbb{R}}{D}$ , where RR is required reserves and D is checking, savings, and other liquid deposits in M1, reflecting the reserve requirement

excess-reserve-to-deposit ratio er

$\frac{ER}{D}$ , where ER is excess reserves and D is checking, savings, and other liquid deposits in M1, measuring banks’ excess reserves relative to deposits

derived money multiplier m’

$\frac{\frac{C}{D}+1}{\frac{C}{D}+\frac{R}{D}+\frac{ER}{D}}=\frac{c+1}{c+rr+er}$ , and if M=mMb = m’MB, higher c, rr, and er takes away from money available to create deposits, decreasing money supply M

quantity equation of money

$MV=PY$ , where M is money supply, V is velocity of money, P is price level, and Y is real GDP (so PY is nominal GDP)

velocity of money V

$\frac{PY}{M}$ , it measures nominal GDP relative to the money supply, and indicates how frequently money is used to support all transactions in goods and services

predicted inflation

$\pi=g_{M-}g_{Y}$ , given constant velocity, it grows when money supply grows faster than real GDP

nominal variables

price level, inflation rate, nominal interest rate, money supply, and in the short and long run, is affected by changes in the money supply

real variables

real GDP, real interest rate, and employment, and in only the short run, is affected by changes in the money supply

$$\pi>\pi^{e}$$

means that the realized interest rate is lower than expected; the borrower benefits relative to the lender.

$$\pi<\pi^{e}$$

means that the realized interest rate is higher than expected; the lender benefits relative to the borrower

expected real interest rate

$$r^{e}=i-\pi^{e}$$

the fisher effect

$i=r^{e}+\pi^{e}$ , holding the expected real interest rate constant, a one-percentage-point increase in expected inflation raises the nominal interest rate by approximately one percentage point

seigniorage

revenue the government obtains through the creation (printing) of money, helps government pay off their debt

inflation tax effect

households lose purchasing power to this effect, having paid a “tax” of that power, but lightens government’s debt

shoeleather cost

where households and firms hold less cash in their wallets during high inflation and make frequent trips to the bank to transfer money to interest-bearing assets

tax distortions

although higher expected inflation rates increase nominal interest rates (through the fisher effect), the real cash you get back is proportionally taxed despite less purchasing power, so real after-tax returns fall and discourage saving and investment

menu costs

inflation requires changing prices frequently, involving things like changing websites, menus, adjusting accounting records, etc., which could’ve been devoted to increasing production

redistribution of wealth

high unexpected inflation means higher nominal returns, so borrowers win and lenders lose. in the opposite direction, if low unexpected inflation means lower nominal returns, borrowers lose and lenders win

economic costs

unexpected inflation cause a loss in money spent on forecasting inflation, designing contracts to reduce inflation risk, and reduced willingness to borrow and lend b/c of uncertainty

benefits of inflation

given that nominal wages W are sticky and difficult to reduce, firms can let inflation reduce real wage w, thus reducing a cost of theirs, while keeping nominal wage W constant

hyperinflation

episode of extremely rapid increases in general price level, leading to loss of purchasing power, high volatility, price adjustment and transaction costs, resource misallocation, reduced usefulness of money as a medium of exchange, store of value, and unit of account

government financing identity

$G+TR+T=\Delta B+\Delta H$ , where ∆B is additional government borrowing from outside the consolidated government-central-bank sector and ∆𝐻 is additional central bank printing money. if G+TR > T, then government must finance

cost of expected inflation

seigniorage and inflation tax, shoeleather costs, tax distortions, and menu costs

costs of unexpected inflation

redistribution of wealth (nominal loans) and economic costs (resource misallocation)