Money & Central Banks
Chapter 2, 15,16
Quantity Theory
• Simplest monetary theory is the Quantity
Theory of Money.
– Purchasing power of money is equal to the
quantity of money (Mt) times the speed of
circulation (V, # of transactions)
– Purchasing power means # of goods (Yt)
multiplied by price per good (Pt)
Moneyt * Velocity = Pt * Yt
Rule of Thumb
• Rule of Thumb The growth rate of product
is approximately equal to the sum of the
growth rates of the elements of a product.
Z t  X t  Yt  g  g  g
Z
t
X
t
Y
t
Z t  Z t 1
g 
Z t 1
Z
t
Money and Inflation
• Assuming stable velocity
g  g  t
M
t
Y
t
t  g
P
t
• Inflation occurs when money growth
speeds ahead of output growth. The
unbounded creation of fiat money leads to
inflation which ultimately will make the
money worthless.
Money & Inflation: 1975-1994
Inflation & Money OECD Countries
0.2
0.18
Average Inflation Rate
0.16
0.14
0.12
0.1
0.08
0.06
0.04
0.02
0
0
0.02
0.04
0.06
0.08
0.1
0.12
Average Money Growth
0.14
0.16
0.18
Ex Ante Rate and the Fisher Effect
• Savings and investment decisions must be
made before future inflation is known so
they must be made on the basis of an ex
ante (predicted) real interest rate.
• Fisher Hypothesis: Ex ante real interest
rate is determined by forces in the
financial market. Money interest rate is just
the real ex ante rate plus the market’s
consensus forecast of inflation.
it  rt
EA

FORECAST
t 1
Great Inflation of the 1970’s
US Inflation Rates & Interest Rates
18.00
16.00
14.00
%
12.00
10.00
Interest Rates
Inflation
8.00
6.00
4.00
2.00
Mar-03
Mar-00
Mar-97
Mar-94
Mar-91
Mar-88
Mar-85
Mar-82
Mar-79
Mar-76
Mar-73
Mar-70
Mar-67
Mar-64
Mar-61
Mar-58
Mar-55
0.00
Source: St. Louis Federal Reserve http://research.stlouisfed.org/fred2/
Fisher Effect: OECD Economies
Great Inflation of 1970’s
20
18
Interest Rates-1984
16
14
12
10
8
6
4
2
0
0
2
4
6
8
10
12
Average Inflation 1970-1984
14
16
18
Loanable Funds Market
Fisher Effect
S
i*
r*

 tE1
E
t 1
LF*
I
LF
Ex Ante vs. Ex post
• We can also examine the ex post real
return on a loan as the money interest rate
less the actual outcome for inflation.
rt
ExP
 it  
ACTUAL
t 1
• The gap between actual and forecast
inflation determines the gap between the
ex post (actual) and ex ante (forecast)
return.
ExP
ExA
FORECAST
ACTUAL
rt
 rt
  t 1
  t 1
Unexpected Inflation
Winners and Losers
– Higher than expected inflation means ex
post real rates are lower than ex ante.
Borrowers are winners/lenders are
losers.
– Lower than expected inflation means ex
post real rates are higher than ex ante.
Lenders are winners/borrowers are
losers.
Inflation Risk
• When inflation is variable, lenders will
demand some premium for inflation risk.
This will put cost on borrowers.
• High inflation rates tend to be associated
with unpredictable inflation.
Costs of Anticipated Inflation
• Shoe Leather Costs – Money is a technology for
engaging in transactions. The greater is inflation,
the greater the cost for individuals of holding
money. Individuals must make efforts as a
substitute for the convenience of holding money.
• Menu Costs – Firms must engage in costs of
changing posted prices. More generally, when
prices change rapidly over time, more time and
effort must be put into calculating relative prices.
The Inflation Tax
• Banknotes do not pay interest.
• The real interest rate on banknotes is
rt
CASH
  t 1
• If inflation is high, currency has sharply
negative returns. People will avoid holding
money leading to society losing the
convenience of money transactions.
Inflation Tax
• Government prints money which can be
used to finance expenditures: Mt – Mt-1 .
• What fraction of GDP can be collected?
M t  M t 1 M t 1
gtM
1
M t  M t 1 

 Mt 
  GDP
M
M t 1
Mt
1  gt V
Problem
• Assume velocity is fixed at 4. What
fraction of GDP can be gained if money
growth rate is 5%?
.05 1
  0.0119
1.05 4
• What fraction can be gained if money
growth rate is 20%?
Causes of Extremely Rapid Inflation
• Government generates revenues by printing
new money (referred to as seignorage).
• Government facing borrowing constraints
may be forced to rely on inflation tax for
deficit financing and real returns to owning
money.
• Explain the link between deficits and inflation.
19
70
19
71
19
72
19
73
19
74
19
75
19
76
19
77
19
78
19
79
19
80
19
81
19
82
19
83
19
84
19
85
19
86
19
87
19
88
19
89
19
90
Israel 1970-1990
Inflation
400
350
300
250
200
150
100
50
0
Israel 1970-1990
Surplus (% of GDP)
5.00%
-5.00%
-10.00%
-15.00%
-20.00%
-25.00%
-30.00%
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
1978
1977
1976
1975
1974
1973
1972
1971
1970
0.00%
A Bias toward Expansionary
monetary policy
1. Central Bank
repeatedly
expands the
money supply
YP
P
2. Inflation
recurs
5
4
3
P*
SRAS′
SRAS
2
1
AD′
AD
Inflationary Gap
Y
3. After a time,
as inflation
becomes
expected it
will cease to
impact output
even in the
short run.
Discretion vs. Rules
• Central bank can use monetary policy to fight
recessionary and inflationary conditions, but they
might have a bias toward getting the economy out
of a recession because of short-term-ism.
• Some economists suggest that the government
create rules that restrict the ability of policy
makers to act in a biased manner.
• Others believe that it is necessary for the central
bank to act using discretion.
Features of Inflation Targeting
A medium term communication strategy
• Commitment to price stability as goal of
monetary policy.
• Clear statement of numerical target for
inflation over the medium (1-2 year) term.
• Communication with public about current
forecasts of inflation and policy actions
used to achieve target.
• Central Bankers accountable for achieving
goals.
Trend toward Independence
• In late 1998, the Bank of Japan, and the Bank of
England, were removed from the direct control of
the Ministry of Finance and the Chancellor and
the Exchequer respectively.
• In 1997 and 2003 revisions of the Bank of Korea
Act, the Bank of Korea were removed from the
direct and indirect control of the Ministry of
Economy and Finance.
Stabilization Policy Consensus
Can expansionary monetary/fiscal
policy affect output in the long run?
No
Is expansionary monetary policy
helpful in fighting recessions?
Is expansionary fiscal policy helpful in
fighting recessions?
Should we use discretionary fiscal
policy?
Should we use discretionary monetary
policy?
Yes
Yes
No
Maybe
Discussion Topic
• Yield Curves
• Monetary Policy
• Business Cycles
Learning Outcome
• Calculate the impact of inflation on long-term
nominal interest rates using the theory of the
Fisher effect.
• Calculate real return on debt as a function of
inflation and expected inflation.
• Use velocity and money growth to calculate the
share of GDP that can be collected as revenue.
• Calculate real return on money as a function of
inflation.