Week 3 pt1

Page 1

Title: Money and Inflation

• Presenter: Valerio Pieroni

• Date: 1/30

Page 2

Overview of Key Topics

1. Definition of Money

2. Creation of Money Supply

3. Long-Run Relationship Between Money Growth and Inflation

   • Concept: Quantity theory of money

4. Inflation and Interest Rates

   • Key Concepts: Fisher equation and Fisher effect

5. Money Demand

6. Long-Run Money Market Analysis

7. Impact of Monetary Policy on Expected Inflation

8. Costs of Inflation

Page 3

What is Money?

• Definition: An asset utilized without cost for exchanges of goods and services.

• Money Supply: Total quantity of money circulating in the economy at a specific time (stock variable).

• Monetary Policy: Actions by Central Bank to influence money supply and interest rates for macroeconomic goals:

  • Price stability

  • Macroeconomic stabilization

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Functions of Money

1. Medium of Exchange:

   • Facilitates buying and selling of goods/services.

   • Liquidity: Ease of converting an asset into cash. Money has the highest liquidity.

2. Store of Value:

   • Preserves value over time (e.g., $5 remains $5 tomorrow).

3. Unit of Account:

   • Provides a standard numeric unit of measurement for pricing goods/services.

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Types of Money

• Commodity Money:

  • Has intrinsic value (e.g., silver/gold coins).

• Commodity-backed Money:

  • Paper money exchangeable for a specific commodity.

• Fiat Money:

  • No intrinsic value; legal tender currency (e.g., U.S. dollar).

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Monetary Aggregates

• Different definitions of money supply:

  • M0: Cash and coins (currency).

  • M1: M0 + demand deposits.

  • M2: M1 + time deposits.

• Larger monetary aggregates: M3, M4 (including other liquid assets).

• Common measures: M1 or M2, with no consensus on the best measure.

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Creation of Money: Definitions

• Reserves (R): Currency banks hold, comprised of:

  • Required Reserves (RR)

  • Excess Reserves (ER)

• Deposits (D): Funds deposited in banks (e.g., current accounts, savings).

• Monetary Base (B): Currency + Reserves; controlled by the central bank.

• Monetary Supply (M): Currency + Deposits; influenced by the central bank, banks, and household savings.

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Creation of Money: Monetary Base Control

• Central bank controls the monetary base through:

  1. Open-Market Operations:

     • Buying/selling government bonds affects money supply.

  2. Refinancing Operations with Banks.

  3. Buying/Selling Currency on International Markets: More significant in modern economies.

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Creation of Money: Money Supply Influences

• Money creation occurs through:

  • Central bank operations on the monetary base.

  • Commercial banks' decisions.

  • Individual saving behaviors.

Page 10

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

• Originated by David Hume during the Scottish Enlightenment (1711-1776).

• Theory explains why exchanging gold does not increase wealth; only alters prices long-term.

• Monetarist ideas further developed by Milton Friedman.

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Short Run vs. Long Run

• Focus: Long run. By assumption, prices are fully flexible.

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Quantity Theory of Money: Quantity Equation

• Equation: M.V = P.T

  • M: Money supply

  • V: Velocity of money (how often a dollar changes hands)

  • P: Aggregate price level

  • T: Number of transactions (goods/services exchanged for money).

• Economic activity depends on the circulation speed of money and total quantity.

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Quantity Theory of Money: Assumptions

1. M is Exogenous: Determined outside the model by the central bank.

2. V is Constant (V̅).

3. T is Difficult to Measure: Replaced with Y (Real GDP).

   • T ↑ implies Y ↑; T ↓ implies Y ↓.

4. Y independent of M: Depends on preferences and technology; therefore, the equation simplifies to M.V̅ = P.Y.

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Impact of Money Supply Changes on Prices

• Quantity equation: M.V̅ = P.Y after applying log growth rates:

• Simplification leads to:

  • π = ∆M/M - ∆Y/Y

• Assumption Y does not depend on M:

  • Any change in M results in a corresponding change in P (inflation/deflation).

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Monetarist Insight and Effects

• Friedman’s View: "Inflation is always and everywhere a monetary phenomenon."

• Money is Neutral: Changes in money supply do not impact real variables (Y) but do affect nominal variables (P).

• Classical Dichotomy: Long-run independence of nominal (money, prices) versus real variables (real GDP, employment).

• Money is Super-neutral: Growth of Y does not depend on M.

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Take it to the Data: Long Run

• Graph: Inflation rate (percent, logarithmic scale) vs. Money Supply Growth (percent, logarithmic scale).

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Take it to the Data: Short Run

• Data Analysis: M2 growth rate vs. inflation from 1960-2005 shown in a line graph.

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Velocity of Money Analysis

• FRED Data: Velocity of M2 and M1 Money Stock from 1970-2020, highlighting economic recessions.

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Interest Rates Overview

• Interest Rate Definition: Cost of credit (borrowed funds for investment).

• Opportunity Cost of Holding Money: Liquidity (benefit) vs. lost interest (cost).

  • Higher interest rates decrease cash demand.

• Types of Interest Rates:

  • Nominal Interest Rate (i): Bank interest without inflation adjustment.

  • Real Interest Rate (r): Adjusted for inflation, reflecting change in purchasing power.

Page 20

Interest Rates and Inflation Example

• Scenario: One-period bond with 10% return vs. inflation expectation of 7%.

• Real rate of return (r) calculated as:

  • r = 10% - 7% = 3%

• Underlines importance of accounting for inflation in investment returns.

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Fisher Equation and Fisher Effect

• Fisher Equation: i = r + πe

• Fisher Effect: Changes in inflation expectations (πe) lead to corresponding adjustments in nominal interest rates (i).

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Data Analysis: Fisher Effect

• FRED Data: 1-Year Expected Inflation vs. 1-Year Treasury Bill rates from 1960-2020, indicating trends and economic recessions.