macro
CHAPTER FOUR
Money and Inflation
macroeconomics
fifth edition
N. Gregory Mankiw
PowerPoint® Slides
by Ron Cronovich
© 2004 Worth Publishers, all rights reserved
Money: definition
Money is the stock
of assets that can be
readily used to make
transactions.
CHAPTER 4
Money and Inflation
slide 1
Money: functions
1. medium of exchange
we use it to buy stuff
2. store of value
transfers purchasing power from the
present to the future
3. unit of account
the common unit by which everyone
measures prices and values
CHAPTER 4
Money and Inflation
slide 2
Money: types
1. fiat money
• has no intrinsic value
• example: the paper currency we use
2. commodity money
• has intrinsic value
• examples: gold coins,
cigarettes in P.O.W. camps, stone wheels up to
12 feet (3.6 meters) in diameter (Yap)
CHAPTER 4
Money and Inflation
slide 3
Money Supply
 Government control over supply of money is
called monetary policy.
 In Ukraine, National Bank of Ukraine carries out
monetary policy
 The primary way of controlling the supply of
money is through the open-market operations:
Purchase of government bonds from public
increase money supply
– Sale of government bonds to public reduce
money supply
–
CHAPTER 4
Money and Inflation
slide 4
Measurement of Money
C or M0
currency
M1
currency and demand deposits
M2
M1+saving deposits
M3
M2+large time deposits
Table Structure of money supply in Ukraine
Symbol
* Currency outside banks (M0)
* Money (M1)
* Money (M2)
* Money (M3)
Unit
UAH, million
UAH, million
UAH, million
UAH, million
Date
Amount
07/06/06 66241.8
07/06/06 108585.9
07/06/06 220560.8
07/06/06 221535.8
%
29.9
49.0
99.6
100.0
Source: National Bank of Ukraine and my calculations
CHAPTER 4
Money and Inflation
slide 5
The Quantity Theory of Money
 A simple theory linking the inflation
rate to the growth rate of the
money supply.
 Begins with a concept called
“velocity”…
CHAPTER 4
Money and Inflation
slide 6
Velocity
 basic concept: the rate at which money
circulates
 definition: the number of times the average
dollar bill changes hands in a given time period
 example: In 2003,
• $500 billion in transactions
• money supply = $100 billion
• The average dollar is used in five
transactions in 2003
• So, velocity = 5
CHAPTER 4
Money and Inflation
slide 7
Velocity, cont.
 This suggests the following definition:
V 
T
M
where
V = velocity
T = value of all transactions
M = money supply
CHAPTER 4
Money and Inflation
slide 8
Velocity, cont.
 Use nominal GDP as a proxy for total
transactions.
Then,
V 
P Y
M
where
P = price of output
(GDP deflator)
Y = quantity of output (real GDP)
P Y = value of output
(nominal GDP)
CHAPTER 4
Money and Inflation
slide 9
The quantity equation
 The quantity equation
M V = P Y
follows from the preceding definition of
velocity.
 It is an identity:
it holds by definition of the variables.
CHAPTER 4
Money and Inflation
slide 10
Money demand and the quantity equation
 M/P = real money balances, the
purchasing power of the money supply.
 A simple money demand function:
(M/P )d = k Y
where
k = how much money people wish to hold
for each dollar of income.
(k is exogenous)
CHAPTER 4
Money and Inflation
slide 11
Money demand and the quantity equation
 money demand:
(M/P )d = k Y
 quantity equation: M V = P Y
 The connection between them: k = 1/V
 When people hold lots of money relative to
their incomes (k is high), money changes
hands infrequently (V is low).
CHAPTER 4
Money and Inflation
slide 12
back to the Quantity Theory of Money
 starts with quantity equation
 assumes V is constant & exogenous:
V V
 With this assumption, the quantity
equation can be written as
M V  P Y
CHAPTER 4
Money and Inflation
slide 13
The Quantity Theory of Money, cont.
M V  P Y
How the price level is determined:
 With V constant, the money supply
determines nominal GDP (P Y )
 Real GDP is determined by the economy’s
supplies of K and L and the production
function (chap 3)
 The price level is
P = (nominal GDP)/(real GDP)
CHAPTER 4
Money and Inflation
slide 14
The Quantity Theory of Money, cont.
 The quantity equation in growth rates:
M
M

V
V

P
P

Y
Y
T h e qu a n tity th e o ry o f m o n e y a ssu m e s
V is co n sta n t, so
CHAPTER 4
Money and Inflation
V
V
= 0.
slide 15
The Quantity Theory of Money, cont.
Let  (Greek letter “pi”)
denote the inflation rate:
The result from the
preceding slide was:
Solve this result
for  to get
CHAPTER 4
P
 
M
M
 
Money and Inflation
M
M

P
P
P


Y
Y
Y
Y
slide 16
The Quantity Theory of Money, cont.
 
M
M

Y
Y
 Normal economic growth requires a
certain amount of money supply growth
to facilitate the growth in transactions.
 Money growth in excess of this amount
leads to inflation.
CHAPTER 4
Money and Inflation
slide 17
The Quantity Theory of Money, cont.
 
M
M

Y
Y
Y/Y depends on growth in the factors of
production and on technological progress
(all of which we take as given, for now).
Hence, the Quantity Theory of Money predicts a
one-for-one relation between changes in the money
growth rate and changes in the inflation rate.
CHAPTER 4
Money and Inflation
slide 18
International data on
inflation and money growth
Inflation rat e
(percent,
logarit hmic
scale)
10,000
Democr atic Republic
of Congo
Nicaragua
1,000
Angola
Br azil
Georgia
100
Bulgaria
10
Germany
Kuwait
1
USA
Oman
0.1
0.1
1
Japan
Canada
10
100
1,000
10,000
M oney supply growth (p ercent, logarit hmic scale)
CHAPTER 4
Money and Inflation
slide 19
U.S. Inflation & Money Growth, 1960-2003
14%
12%
10%
8%
6%
4%
2%
0%
1960
1965
1970
1975
Inflation rate
CHAPTER 4
1980
1985
1990
1995
2000
Inflation rate trend
Money and Inflation
slide 21
Inflation and interest rates
 Nominal interest rate, i
not adjusted for inflation
 Real interest rate, r
adjusted for inflation:
r = i 
CHAPTER 4
Money and Inflation
slide 22
The Fisher Effect
 The Fisher equation:
i =r +
 S = I determines r .
 Hence, an increase in 
causes an equal increase in i.
 This one-for-one relationship
is called the Fisher effect.
CHAPTER 4
Money and Inflation
slide 23
U.S. inflation and nominal interest rates,
since 1954
Percent 18
16
14
12
10
8
Nominal
interest rate
6
4
2
0
Inflation rate
-2
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
CHAPTER 4
Money and Inflation
slide 24
Inflation and nominal interest rates
across countries
100
Nominal
interest rat e
(percent,
logarit hmic
scale)
Kazakhstan
Kenya
Ar menia
Uruguay
Italy
Fr ance
10
Nigeria
United Kingdom
United States
Japan
Germany
Singapore
1
1
10
100
1000
Inflation rat e (p ercent, logarit hmic scale)
CHAPTER 4
Money and Inflation
slide 25
Ex ante and ex post inflation
 Ex ante variable: e = expected inflation rate
 Ex post variable:  = actual inflation rate
(not known until after it has occurred)
 When lender and borrower agree on a nominal
interest rate, they do not know what the rate
of inflation is going to be, hence…
 Modified Fisher Effect:
i=r+ e
CHAPTER 4
Money and Inflation
slide 26
Nominal interest rate and the demand
for money
i is opportunity cost of holding money:
you can deposit it in a savings account which earn
the nominal interest rate rather then keep it under
the mattress
e
d
(M P )  L ( i , Y )  L ( r   , Y )
CHAPTER 4
Money and Inflation
slide 27
Equilibrium
M
P
 L (r   , Y )
The supply of real
money balances
CHAPTER 4
e
Money and Inflation
Real money
demand
slide 28
What determines what
M
P
variable
e
 L (r   , Y )
how determined (in the long run)
M
exogenous (the Central Bank)
r
adjusts to make S = I
Y
Y  F (K , L )
P
adjusts to make
CHAPTER 4
Money and Inflation
M
P
 L (i ,Y )
slide 29
How P responds to M
M
P
e
 L (r   , Y )
 For given values of r, Y, and e,
a change in M causes P to change by
the same percentage --- just like in the
Quantity Theory of Money.
CHAPTER 4
Money and Inflation
slide 30
How P responds to e
M
e
 L (r   , Y )
P
 For given values of r, Y, and M ,

e

i
(the Fisher effect)

 M P

P

d
to m ake
M
P

fall
to re-establish eq'm
CHAPTER 4
Money and Inflation
slide 31
Discussion Question
Why is inflation bad?
CHAPTER 4
Money and Inflation
slide 32
A common misperception
 Common misperception:
inflation reduces real wages
 This is true only in the short run, when
nominal wages are fixed by contracts.
 In the long run,
the real wage is determined by labor supply
and the marginal product of labor,
not the price level or inflation rate.
 Consider the data…
CHAPTER 4
Money and Inflation
slide 33
Average
hourly
earnings
& the
CPI
Average hourly
earnings
& the CPI,
1964-2004
250
Hourly earnings
in 2004 dollars
Wage ($ per hour)
18
16
200
14
12
10
150
Average hourly
earnings (nominal)
100
8
6
Consumer
Price Index
4
2
CPI (1982-84=100)
20
50
0
0
1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004
CHAPTER 4
Money and Inflation
slide 34
The classical view of inflation
 The classical view:
A change in the price level is merely a
change in the units of measurement.
So why, then, is inflation a
social problem?
CHAPTER 4
Money and Inflation
slide 35
Homework Assignment
 Read Section 4-6 of the textbook. Answer
the following questions:
– Do economists and other people differ in
their view on costs of inflation?
– What are the costs of expected inflation?
– What are the costs of unexpected
inflation?
– Is there anything good about inflation
anyway?
CHAPTER 4
Money and Inflation
slide 36
The Classical Dichotomy
Real variables are measured in physical units:
quantities and relative prices, e.g.
 quantity of output produced
 real wage: output earned per hour of work
 real interest rate: output earned in the future
by lending one unit of output today
Nominal variables: measured in money units, e.g.
 nominal wage: dollars per hour of work
 nominal interest rate: dollars earned in future
by lending one dollar today
 the price level: the amount of dollars needed
to buy a representative basket of goods
slide 37
The Classical Dichotomy
 Classical Dichotomy : the theoretical
separation of real and nominal variables in the
classical model, which implies nominal variables
do not affect real variables.
 Neutrality of Money : Changes in the money
supply do not affect real variables.
In the real world, money is approximately
neutral in the long run.
CHAPTER 4
Money and Inflation
slide 38
Chapter summary
1. Money
 the stock of assets used for transactions
 serves as a medium of exchange, store of
value, and unit of account.
 Commodity money has intrinsic value, fiat
money does not.
 Central bank controls money supply.
2. Quantity theory of money
 assumption: velocity is stable
 conclusion: the money growth rate
determines the inflation rate.
CHAPTER 4
Money and Inflation
slide 39
Chapter summary
3. Nominal interest rate
 equals real interest rate + inflation rate.
 Fisher effect: nominal interest rate moves
one-for-one w/ expected inflation.
 is the opp. cost of holding money
4. Money demand
 depends on income in the Quantity Theory
 more generally, it also depends on the
nominal interest rate;
if so, then changes in expected inflation
affect the current price level.
CHAPTER 4
Money and Inflation
slide 40
Chapter summary
5. Classical dichotomy
 In classical theory, money is neutral--does
not affect real variables.
 So, we can study how real variables are
determined w/o reference to nominal ones.
 Then, eq’m in money market determines
price level and all nominal variables.
 Most economists believe the economy
works this way in the long run.
CHAPTER 4
Money and Inflation
slide 41