copyright © 2002 by the mcgraw-hill companies, inc. all rights reserved. 8-1 chapter 8 money,...

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.8-1

CHAPTER 8

Money, Prices, and Inflation


Questions

• What do economists mean by “money”?

• Why is money useful?• What do economists mean when they

say that money is a unit of account?• What determines the price level and

the inflation rate?


Questions

• Why would a government ever generate “hyperinflation”?

• What determines the level of money demand?

• What determines the level of the money supply?

• Why is inflation seen as something to be avoided?


Inflation• In the 1970s, the United States

experienced an episode of relatively mild inflation– prices rose between five and ten percent

per year– caused significant economic and political

trauma• avoiding a repeat of the inflation of the 1970s

remains a major goal of economic policy


Figure 8.1 - Post-World War II Inflation in the United States, 1951-2000


The Flexible-Price Model• The Classical dichotomy implies

that real variables (real GDP, real investment spending, or the real exchange rate) can be analyzed and calculated without considering nominal variables (price level)– money is “neutral”

• This is a special feature of the full-employment flexible-price model


Money• is wealth that is held in a readily-

spendable form• is made up of

– coin and currency– checking account balances– other assets that can be turned into cash

or demand deposits nearly instantaneously, without risk or cost


The Usefulness of Money• Without money, market transactions

would have to be performed through barter

• In a barter economy, market exchange would require the coincidence of wants– you would have to have some good or

service that someone wants and he or she would have to have some good or service that you want


Figure 8.2 - Coincidence of Wants


The Usefulness of Money• Money also serves as a unit of

account– money is used as a yardstick to measure

value or quote prices

• Anything that alters the real value of money in terms of its purchasing power will also alter the real terms of existing contracts that use the money as a unit of account


The Demand for Money• Businesses and households have a

demand for money– they want to hold a certain amount of

wealth in the form of readily-spendable purchasing power to carry out transactions• a higher level of spending means a larger

money demand

• There is a cost of holding money– cash and checking deposits earn little or

no interest


Figure 8.3 - Reasons for and Opportunity Cost of Holding Money


The Quantity Theory of Money• assumes that the only important

determinant of the demand for money is the flow of spending

• can be summarized using– the Cambridge money-demand function

– the quantity equation

Y)(PV1

M

YPVM


The Quantity Theory of Money

• (P Y) represents the total nominal flow of spending

• M is the quantity of money• V is a measure of how fast money

moves through the economy– how many times the average unit of money

is used to buy a final good or service

YPVM


Figure 8.4 - The Velocity of Money


Determining the Price Level• In the flexible-price model of the

macroeconomy– real GDP (Y) is equal to potential GDP (Y*)– the velocity of money is determined by

the sophistication of the banking system– the money supply is determined by the

central bank

MYV

P


Determining the Price Level

• If the price level is higher than the quantity equation predicts– households and businesses will have less

wealth in the form of money than they wish• they will cut back on purchases

– sellers will note demand is weak and lower prices

MYV

P


Determining the Price Level

• If the price level is lower than the quantity equation predicts– households and businesses will have

more wealth in the form of money than they wish• they will increase purchases

– sellers will note demand is strong and raise prices

MYV

P


Determining the Price Level• Example (third quarter of 1998)

– real GDP = $7,566 billion– money stock = $1,072 billion– velocity = 7.964

1.1284$1,072$7,5567.964

MYV

P

• In the third quarter of 1998, the price level was equal to 112.84% of its 1992 level


The Money Stock• The Federal Reserve determines the

money stock in the U.S.– the determination of the money stock is

the basic task of monetary policy

• The Federal Reserve can directly impact the monetary base– the sum of currency in circulation and

deposits at the Federal Reserve’s twelve branches


The Money Stock• To reduce the monetary base, the

Federal Reserve sells short-term government securities

• To increase the monetary base, the Federal Reserve buys short-term government securities

• These transactions are called open market operations


Figure 8.5 - Open Market Operations


The Money Stock• The Federal Reserve directly controls

the monetary base• The other measures of the money stock

are determined by the interaction of the monetary base with the banking sector– regulatory requirements– the incentive of financial institutions to

have enough funds on hand to satisfy depositors’ demands


The Money Stock• Besides the monetary base (H), there are

other definitions of the money stock such as– M1 (currency, checking accounts, travelers

checks)– M2 (M1 plus savings accounts, small term

deposits, money held in money market accounts)

– M3 (M2 plus large term deposits and institutional money market balances)


Table 8.1 - Measures of the Money Stock


Inflation• The inflation rate is the proportional

rate of change in the price level• Since

• the inflation rate () will be

MYV

P

y-mv – v=growth rate of velocity– m=growth rate of the money stock– y=growth rate of real GDP


Inflation• Example

– growth rate of real GDP=4% per year– growth rate of velocity=2% per year– growth rate of the money stock=5% per

year

3%4%-5%2%y-mv


Inflation• The bulk of changes in the rate of

inflation are due to changes in the growth rate of the money stock– the growth rate of the money stock (m)

can change quickly and substantially– changes in the growth rates of real GDP

(y) and velocity (v) are generally smaller


Inflation• In the real world, inflation is not always

proportional to money growth– in the 1980s, both inflation and velocity fell

sharply but the money stock grew– in the first half of the 1990s, velocity fell

• meant that high growth of the money stock did not lead to high inflation

– in the second half of the 1990s, velocity grew• money supply growth was negative to keep

inflation from rising


Figure 8.6 - Money Growth and Inflation Are Not Always Parallel


Money Demand• Economic theory implies that money

demand should be inversely related to the nominal interest rate– cash and checking account balances earn

little or no interest– the purchasing power of money erodes at

the rate of inflation– the expected real return on money is -e


Money Demand• The opportunity cost of holding money

is the difference between the rate of return on other assets (r) and the rate of return on money (-e)– the opportunity cost of holding money is

the nominal interest rate [i=r+e]

• As the opportunity cost of holding money (i) rises, the quantity of money balances demanded falls


Figure 8.7 - Money Demand and theInflation Rate


Money Demand• The velocity of money can be

represented by

– VL represents the financial technology-driven trend in velocity

– V0+Vi(r+e) represents the dependence of the demand for money on the nominal interest rate

)](rVV[VV ei0

L


Money Demand• The demand for nominal money

balances is

)](rVV[VYP

M ei0

L


Money, Prices, and Inflation• Suppose that the rate of growth of the

money stock permanently increases– the inflation rate will rise– if the real interest rate is stable, the

opportunity cost of holding money will rise

– the velocity of money will increase– if the money stock and real GDP remain

fixed, the price level will jump suddenly and discontinuously


Figure 8.8 - Effects of a Rise in Money Growth


The Costs of Inflation• The costs of expected inflation are

small– requires you to make more trips to the

bank– firms must spend resources changing

their prices– households find it difficult to determine a

good deal from a bad one– our tax laws are not designed to deal well

with inflation


The Costs of Inflation• The costs of unexpected inflation are

more significant– redistributes wealth from creditors to

debtors• creditors receive less purchasing power than

they had anticipated• debtors find the payments they must make

less burdensome than they had expected


Hyperinflation• occurs when inflation rises to more

than 20 percent per month• arises when governments attempt to

obtain extra revenue by printing money– financing its spending by levying a tax on

holdings of cash– known as an inflation tax


Figure 8.9 - The Inflation Tax


Hyperinflation• Eventually prices rise so rapidly that

the monetary system breaks down– people would rather deal in barter terms

• Real GDP begins to fall– the economy loses the benefits of the

division of labor

• In the end, the currency becomes worthless


Chapter Summary• By “money” economists mean

something special: wealth in the form of readily-spendable purchasing power

• Without money it is hard to imagine how our economy could successfully function– the fact that everyone will accept money

as payment for goods and services is necessary for the market economy to function


Chapter Summary• Money is not only a medium of

exchange, it is also a unit of account: a yardstick that we use to measure values and to specify contracts


Chapter Summary

• Money demand is determined by– businesses’ and households’ desire to

hold wealth in the form of readily-spendable purchasing power to carry out transactions

– businesses’ and households’ recognition that there is a cost to holding money• wealth in the form of readily-spendable

purchasing power pays little or no interest


Chapter Summary• The velocity of money is how many

transactions a given piece of money manages to facilitate in a year– the principal determinant of velocity is

the economy’s “transactions technology”

• The stock of money is determined by the central bank– the Federal Reserve in the U.S.


Chapter Summary• The price level is equal to the money

stock times the velocity of money divided by the level of real GDP

• The inflation rate is equal to the proportional growth rate of the money stock plus the proportional growth rate of velocity minus the proportional growth rate of real GDP


Chapter Summary• Governments cause hyperinflation

because printing money is a way of taxing the public, and a government that cannot tax any other way will be strongly tempted to resort to it

copyright © 2002 by the mcgraw-hill companies, inc. all rights reserved. 8-1 chapter 8 money,...

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fast money moves

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