Monetary System & Money Growth–Inflation Notes

Meaning of Money

• Definition (memorize): Money is the set of assets that people regularly use to buy goods and services from others.
• Implies routine acceptability in exchange; distinguishes money from other assets (e.g., houses, bonds) that may store value but are not universally accepted at checkout.

Functions of Money

• Medium of Exchange
  • Item buyers hand to sellers to obtain goods/services.
  • Universally acceptable, eliminates double-coincidence-of-wants problem in barter.
• Unit of Account
  • Common yard-stick for posting prices & recording debts.
  • Facilitates price comparisons across products (e.g., "car = \$40,000" vs. "2,000 pizzas").
• Store of Value
  • Transfers purchasing power from present to future.
  • Necessarily an asset; must not lose value immediately after trade.
  • Acceptability as medium hinges on credibility of this store-of-value property.
• Liquidity
  • Ease of converting an asset into the economy’s medium of exchange.
  • Money = most liquid asset; examples of low liquidity: real estate, specialized machinery.

Types of Money

• Commodity Money: Has intrinsic value.
  • Examples: gold, silver, cigarettes (POWs & prisons), salt in ancient times.
  • Gold Standard: Unit of account defined as fixed amount of gold; constrains money supply.
• Fiat Money: Value by government decree; no intrinsic value.
  • Examples: modern coins, paper currency, checkable deposits.

Money Stock Measures in the U.S.

• Currency (C): Paper bills & coins in public hands.
• Demand Deposits (DD): Checkable bank balances accessible on demand.
• M0: All physical currency. $M0 = \text{dollar bills} + \text{coins}$
• Monetary Base (MB): $MB = M0 + \text{Reserves at Fed}$
• M1: $M1 = M0 + \text{Demand Deposits} + \text{Traveler’s Checks} + \text{Other Checkable Deposits}$
• M2: $M2 = M1 + \text{Savings Deposits} + \text{Small Time Deposits} + \text{Money-Market Mutual Funds} + \text{Minor Categories}$
• 2019: $M1$ & $M2$ are the most-watched aggregates (Figure shown in slides).

Where Is All the Currency?

• 2016 stock ≈ \$1.7 trillion ⇒ ≈ \$6,500 per adult.
• Large share held abroad or by criminal economy (drug trade, tax evasion).
• Currency = poor long-term wealth store (theft risk, no interest).

The Central Bank (Federal Reserve & Others)

• Three primary Fed roles
  1. Regulate & supervise banking system (safety & soundness).
  2. "Banker’s bank"—lender of last resort.
  3. Conduct monetary policy (set money supply).
• Bank of Korea functions (for comparison): issuing currency, monetary policy, payment systems, FX reserves, research, education, etc.

Open Market Operations (OMO)

• Central bank’s main instrument for changing money supply.
  • Buy bonds ⇒ injects reserves ⇒ money supply ↑.
  • Sell bonds ⇒ drains reserves ⇒ money supply ↓.
• FRED graphs show dramatic balance-sheet expansions (e.g., QE after 2008, pandemic 2020).

Banks, Reserves, and Money Supply

• Reserves (R): Deposits received but not loaned out.
• Fractional-Reserve Banking: Banks keep only a fraction $R$ of deposits and lend the rest.
• Reserve Ratio (r): $r = R/\text{Deposits}$ (regulated minimum called reserve requirement).
• Deposits = liability for bank; loans & reserves = assets.

Money Creation & The Money Multiplier

• New loan spending re-deposited → further loans → chain expansion.
• Money Multiplier (m): $m = \frac{1}{r}$ (reciprocal of reserve ratio).
  • Example: $r=0.10$ ⇒ $m=10$; initial \$100 excess reserves → eventual \$1,000 total money.
• Slide example (Hana → Dul → Set → Net Banks): with $r=0.10$, money supply grew from \$100 to \$343.90 and continues toward limit.

Tools of Monetary Control (Fed’s Toolbox)

1. Open-Market Operations (described above).
2. Reserve Requirement changes
   • ↑ requirement ⇒ banks hold more ⇒ $m↓$ ⇒ money supply ↓.
   • ↓ requirement ⇒ opposite.
3. Discount Rate (interest on Fed loans to banks)
   • ↑ rate ⇒ banks borrow less ⇒ reserves ↓ ⇒ money supply ↓.
   • ↓ rate ⇒ money supply ↑.
4. Federal Funds Rate (FFR) target
   • Overnight inter-bank rate; Fed uses OMO to steer it.
   • Influences entire spectrum of interest rates.

Challenges in Controlling the Money Supply

• Central bank cannot directly set:
  1. Portion of currency households keep outside banks.
  2. Banks’ willingness to lend (choice of excess reserves).
• These behavioral margins shift $r$ and $m$, making control imprecise.

Bank Runs & Deposit Insurance

• Bank run: Mass withdrawals; can force closure or emergency liquidity.
• 1930s Great Depression: runs ↑ ⇒ banks raise $r$ ⇒ $m$ ↓ ⇒ money supply contracted.
• Today: FDIC insurance (\$250k per account) largely prevents runs; trade-off: moral hazard (less incentive to avoid risky loans).

Financial Crisis 2008–2009: Bank Capital & Leverage

• Bank Capital: Owner equity financing assets; cushions losses.
• Leverage Ratio: $\text{Assets}/\text{Capital}$ (e.g., 20).
  • 5 % asset gain ⇒ capital doubles (\$50→\$100) ⇒ +100 % for owners.
  • 5 % loss ⇒ capital wiped out ⇒ insolvency.
• Crisis: mortgage losses ↓ capital ⇒ credit crunch (lending cut).
• Treasury & Fed recapitalized banks (public funds, temporary partial ownership) so credit normalized by late 2009.

Price Level, Value of Money, and Inflation Basics

• Inflation = rise in overall price level $P$, equivalently fall in $1/P$ (value of money).
  • $\text{Value of money} = 1/P$.
• Hyperinflation: ≥50 % per month.
• Deflation: Sustained fall in $P$ (19th-century U.S.; Japan 1990s "lost decade").

Classical Theory of Money & Monetary Neutrality

• Long-run determinant of $P$ is money supply.
• Classical Dichotomy: Nominal variables (prices, wages) vs. real variables (output, employment) determined separately.
• Monetary Neutrality: Changes in money affect nominal variables only in the long run; real $Y$ unchanged.

Money Demand, Money Supply, and Monetary Equilibrium

• Money Demand (L) downward-sloping in $1/P$: higher $P$ ⇒ need more nominal money to buy same goods.
  • Other shifters: real income, ATMs, preferences.
• Money Supply (M) vertical; set by central bank through MB & multiplier.
• Equilibrium $P$ adjusts so $M^S = M^D$.
• Monetary Injection (shift $M^S$ right): excess supply ⇒ higher spending ⇒ $P$ ↑ until new equilibrium.

Quantity Equation & Velocity of Money

• Velocity (V): $V<em>t = \frac{P</em>t Y<em>t}{M</em>t}$ (average number of times a dollar turns over per year).
• Quantity Equation: $M<em>t V</em>t = P<em>t Y</em>t$.
  • Empirically, $V$ fairly stable ⇒ often taken as constant $\bar V$.

Quantity Theory of Money: Price Level & Inflation Rate

• With long-run real output $\bar Y$ fixed by technology/resources:
  $P<em>t = \frac{M</em>t V_{!\bar{}}}{\bar Y}$.
• Growth form: $\pi<em>t = \mu</em>t - g<em>t$ where $\mu</em>t$ = money growth, $g_t$ = real GDP growth; velocity growth assumed $0$.
  • Implication: In long run, money growth drives inflation (Friedman: “always and everywhere a monetary phenomenon”).
• Cross-country plots (1990-2017) and U.S. historical data show positive money-growth–inflation correlation (hyperinflation cases supply stark evidence).

Inflation Tax & Fiscal Perspective

• Government budget constraint: $G = T + \Delta B + \Delta M$.
• When financed by $\Delta M$, public pays an inflation tax (real purchasing power of money balances falls).
• Sargent: Inflation can be viewed as a fiscal phenomenon; hyperinflations end after fiscal reforms (spending cuts, revenue increases).

Fisher Effect

• Fisher Equation: $i = \bar r + \pi$ (nominal = real + expected inflation).
• With monetary neutrality, $\bar r$ long-run constant ⇒ 1-for-1 pass-through from higher $\pi$ to higher $i$.
• Data: nominal Treasury bill rates track PCE inflation over decades.

Costs of Inflation

1. Shoeleather Costs – resources & time spent reducing money balances.
2. Menu Costs – expenses of changing posted prices (printing, re-programming, web updates).
3. Relative Price Variability – asynchronous price adjustments distort allocation decisions.
4. Tax Distortions – nominal gains taxed; real after-tax return on saving falls (example table: 8 % inflation cuts after-tax real rate from 3 % to 1 %).
5. Confusion & Inconvenience – unit of account instability hampers comparison across time.
6. Arbitrary Redistribution of Wealth – unexpected inflation benefits borrowers (repay in cheaper dollars) and hurts lenders/savers; deflation reverses pattern.

• Note: Moderate, predictable inflation still imposes these costs, though smaller.

Hyperinflation Case Studies

• Austria, Hungary, Weimar Germany, Poland 1921-1925: Money supply & price level rose in lockstep (ratio-scale charts).
• German example: value of a gold mark in paper marks collapsed from 1→$10^{12}$ within five years.
• Demonstrates quantity theory dynamics compressed into months.

Summary of Key Insights

• Money = medium of exchange, unit of account, store of value; highest liquidity.
• Commodity vs. fiat money; U.S. relies on fiat with multiple monetary aggregates (M0→M2).
• Fractional-reserve banking amplifies base money by multiplier $1/r$; Fed controls base via OMO plus reserve, discount, and FFR levers.
• Control imperfect due to behavioral choices of households & banks; deposit insurance stabilizes system but creates moral hazard.
• 2008–09 crisis highlighted importance of bank capital & leverage; public recapitalization restored lending.
• Classical theory & quantity equation explain long-run link between money growth and inflation; monetary neutrality separates real from nominal.
• Inflation can serve as implicit tax; Fisher effect adjusts nominal rates.
• Even predictable inflation imposes six real economic costs.
• Hyperinflations empirically validate quantity theory: explosive money growth ⇒ explosive prices.