Chapter 17 Money,

Inflation, and Banking

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Chapter 17 Topics

•  Alternative forms of money. •  Money and the absence of double coincidence of wants. •  The causes and effects of long-run inflation. •  Financial intermediation and banking.

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Alternative Forms of Money

•  Commodity money •  Circulating private bank notes •  Commodity-backed paper currency •  Fiat money •  Transactions deposits at banks

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The Double-Coincidence Problem and the Role of Money

•  Barter exchange is difficult in highly-developed, specialized economies.

•  Economic exchange requires search costs, and these costs are high when economic agents are specialized in consumption and production, and can only trade a good or service for another good or service.

•  Search costs are reduced dramatically if everyone accepts money in exchange for goods and services.

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Figure 17.1 An Absence-of-Double-Coincidence Economy

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Figure 17.2 Good 1 as a Commodity Money in the Absence-of-Double-Coincidence Economy

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Figure 17.3 Fiat Money in the Absence-of-Double- Coincidence Economy

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The Effects of Long-Run Inflation

•  Use the monetary intertemporal model from Chapter 12.

•  Show that money is not superneutral – higher money growth causes higher inflation, which affects real economic variables.

•  An increase in the money growth rate increases the inflation rate and the nominal interest rate, and reduces employment and output.

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Figure 17.4 Inflation vs. Money Growth: 1960-2007

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Figure 17.5 Inflation vs. Money Growth: 2008-2012

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Money Growth

•  Assume that the central bank causes the money supply to grow at a constant rate.

MxM )1(' +=

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Equilibrium

In equilibrium, money supply equals money demand.

),( irYPLM +=

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In the Future

•  Money supply also equals money demand in the future period.

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Then,

Combine the previous two equations.

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Consumer Optimization

The consumer’s intertemporal marginal condition.

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Another Marginal Condition

•  Marginal condition reflecting the consumer’s tradeoff between current leisure and future consumption:

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And Another One

•  Marginal condition reflecting the consumer’s tradeoff between current leisure and current consumption:

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Figure 17.6 The Long-Run Effects of an Increase in the Money Growth Rate

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The Friedman Rule

•  Inflation causes an inefficiency, in that it distorts intertemporal decisions.

•  The Friedman rule is a prescription for monetary growth that eliminates the inefficiency caused by inflation.

•  The Friedman rule specifies that the money stock grow at a rate that makes the nominal interest rate zero.

•  In practice, no central bank appears to have adopted a Friedman rule to guide monetary policy.

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Pareto Optimality

Pareto optimality requires that

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Competitive Equilibrium

In a competitive equilibrium,

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Competitive Equilibrium

Also, in a competitive equilibrium,

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Friedman Rule

•  Therefore, for efficiency, R = 0 and x = -r. That is, the money supply should shrink over time to produce a long-run deflation. This gives money the same rate of return as on other safe assets, and removes the inefficiency.

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Properties of Assets

•  Rate of return •  Risk •  Maturity •  Liquidity

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Defining Characteristics of Financial Intermediaries

1.  Borrow from one group of economic agents and lend to another.

2.  Well-diversified with respect to both assets and liabilities.

3.  Transform assets. 4.  Process information.

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The Diamond-Dybvig Banking Model

•  Three periods, 0, 1, and 2. •  Two types of consumers: early (consume in period 1)

and late (consume in period 2) •  Efficient economic arrangement is for consumers to set

up a bank in order to share risk. •  Given the bank’s deposit contract, the bank is open to

a run, which is a bad equilibrium.

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Figure 17.7 The Utility Function for a Consumer in the Diamond–Dybvig Model

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The Preferences of a Diamond–Dybvig Consumer

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Marginal Rate of Substitution

•  The marginal rate of substitution of early consumption for late consumption is

Figure 17.8 The Preferences of a Diamond–Dybvig Consumer

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Constraints on Deposit Contract

Combine the two constraints to get one:

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Rewrite the Constraint

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Figure 17.9 The Equilibrium Deposit Contract Offered by the Diamond–Dybvig Bank