Money

Page 1

Introduction to Money and Inflation

• Presenter: Valerio Pieroni
• Date: 1/30

Page 2

Overview of Key Concepts

1. Definition of money
2. Creation of the money supply
3. Relationship between money growth and inflation (Quantity Theory of Money)
4. Inflation and interest rates (Fisher equation and effect)
5. Money demand
6. Long-run money market dynamics
7. Impact of monetary policy on expected inflation
8. Costs associated with inflation

Page 3

What is Money?

• Definition: Money is an asset used to facilitate exchanges for goods and services without cost.
• Money Supply: The quantity of money in circulation at a given time; considered a stock variable.
• Monetary Policy: Actions by the Central bank to influence the money supply and interest rates to achieve objectives like price stability and macroeconomic stabilization.

Page 4

Functions of Money

1. Medium of Exchange: Used to buy goods/services; liquidity defined as the ease of conversion to cash; money is the most liquid asset.
2. Store of Value: Retains value over time, e.g., $5 today = $5 tomorrow.
3. Unit of Account: Prices are measured in monetary values.

Page 5

Types of Money

1. Commodity Money: Has intrinsic value (e.g., gold, silver coins).
2. Commodity-Backed Money: Paper money that can be exchanged for a specific commodity.
3. Fiat Money: No intrinsic value and accepted as legal tender (e.g., paper currency).

Page 6

Monetary Aggregates

• Definitions:
  • M0: Cash and coins (currency, C).
  • M1: M0 + demand deposits.
  • M2: M1 + time deposits.
  • Extensions include other liquid financial assets (M3, M4, etc.).
• Common measures are M1 and M2, but there's no consensus on the best measure.

Page 7

Creation of Money: Definitions

• Reserves (R): Currency held by banks, consisting of:
  • Required Reserves (RR)
  • Excess Reserves (ER)
• Deposits (D): Money individuals store in banks.
• Monetary Base (B): Currency + Reserves (controlled by the Central bank).
• Monetary Supply (M): Currency + Deposits (influenced by Central bank decisions and savings decisions).

Page 8

Creation of Money: Monetary Base

• Controlled by the Central bank using:
  1. Open-market operations: Buying/selling government bonds.
  • Buy bonds → money supply ↑
  • Sell bonds → money supply ↓
  1. Refinancing operations with banks.
  2. Buying/selling currencies on international markets; #2 is most critical in modern economies.

Page 9

Creation of Money: Monetary Supply

• The money supply definition includes resources beyond just currency and reserves.
• Central bank operations on the monetary base create money through commercial banks and household savings.

Page 10

Money and Inflation in the Long Run: Quantity Theory of Money

• Introduced by David Hume; explains that exporting for gold doesn't enhance wealth but alters prices.
• Developed further by Milton Friedman with monetarist ideas.

Page 11

Short Run vs. Long Run

• Focus is on the long run, where prices are assumed to be fully flexible.

Page 12

Quantity Theory of Money: The Quantity Equation

• $M imes V = P imes T$
  • M = Money supply
  • V = Velocity of money (average times $ changes hands)
  • P = Aggregate price level
  • T = Number of transactions (goods/services exchanged).

Page 13

Quantity Theory of Money: Assumptions

1. M is exogenous: Controlled by the Central bank.
2. V is constant (V̄): Stable velocity assumption.
3. T is replaced by Y: (Real GDP) since difficult to measure T.
4. Y is not a function of M: Depends on economic fundamentals.
   • $Y = f(K, L)$
   • Updated equation: $M imes V̄ = P imes Y$

Page 14

Money Supply Changes and Prices in the Long Run

• The relationship shown with $\frac{ riangle M}{M} =\frac{ riangle P}{P} + \frac{ riangle Y}{Y}$
• Rearranging gives inflation as: $\frac{ riangle P}{P} = \frac{ riangle M}{M} - \frac{ riangle Y}{Y}$
• With $Y$ not depending on $M$(inflation neutral), a change in $M$ leads to a proportional change in $P$.

Page 15

Insights on Money and Inflation

• Quote from Milton Friedman: “Inflation is always and everywhere a monetary phenomenon.”
• Money is neutral in that $Y$ does not depend on $M$; affects only nominal variables (prices).
• Classical dichotomy: Nominal variables (money, prices) independent from real variables (real GDP, employment).
• Money is super-neutral: $Y$ growth rate not dependent on $M$.

Page 16

Data Analysis: Long Run

• Inflation rate displayed (logarithmic scale) against money supply growth.

Page 17

Data Analysis: Short Run

• M2 growth rate against inflation rate (1960—2005) presented.

Page 18

Velocity of Money

• Relation of M2 and M1 velocity observed over years; shaded areas indicate U.S. recessions

Page 19

Interest Rates

• Interest Rate: Cost of borrowing; the opportunity cost of holding cash, which may yield no interest.
• Nominal interest rate (i): Rate paid on borrowed money (not adjusted for inflation).
• Real interest rate (r): Adjusted for inflation; change in purchasing power.

Page 20

Interest Rates and Inflation Example

• One-period bond with a 10% return is analyzed under expected inflation $ext{(πe)}$ of 7%.
• Real Rate of Return (r): Effectively 3% after inflation; opportunity less attractive.

Page 21

Fisher Equation and Effect

• Fisher Equation: $i = r + ext{πe}$
• Fisher Effect: A change in inflation expectations results in a 1-to-1 change in the nominal interest rate today.

Page 22

Data Analysis on Fisher Effect

• Comparison of 1-year expected inflation against U.S. Treasury Bill secondary market rates (shaded areas indicating recessions).