Money and inflation Money • = asset regularly used to buy goods and services from other people • Liquidity Function • Medium of exchange • Unit account • Store of value • Wealth and money • Medium of exchange (liquidity) vs. store of value Kind of money • Commodity money (gold, silver, cigarettes): Intrinsic value • Fiat money: no intrinsic value Usually decreed by government. People have to accept such money, trust them. Kind of money • Currency • Deposits • Money aggregates: M1: currency + demanded deposits • M2: M1 + saving deposits + money market mutual funds • http://www.youtube.com/watch?v=DjTs-rjVkB8 Money and banking • • • • • Fractional-reserving banking Reserve ratio Minimal reserve ratio Money multiplier = 1/reserve ratio Money multiplies in „good“ and „bad“ times – excessed reserve • Liquidity trap • Bank run Money and banking • Central bank operations: - open market operations - reserve requirements - discount rate Money supply and demand • Supply: determined by central bank and operations of commercial bank • Demand: determined by willingness economic subject (people, firm and other corporation) to hold money. Depend on value of money. Value of money • = how much goods and services is possible to buy per a money unit. Change of value of money • If money amount changes without change of amount good and services value of money also changes. Monetary neutrality • Nominal variables: measured in monetary unit, influenced by monetary system. • Real variables: measured in physical units, influenced by real factors (amount of labor, capital, technology ….). • Classical dichotomy: separation on nominal and real variables. • A change in money amount in long run does not affect real variable. However, it does in short run. Monetary neutrality and quantity equation • M*V=P*Y • V = velocity of money, sped how money unit is used. • Expected to be stable or to change due to real change (debit and credit card, internet banking). • Y = amount of goods and services, determined by real factors. • Change of M (amount of money) results in change of P (price level). Nominal and real interest rate • i = nominal rate, r = real rate, Π =rate of inflation. All in decimal shape. • (1 + i) = (1 + r) * (1 + Π) • i = (1 + r) * (1 + Π) – 1 • r = (1 + i)/(1 + Π) - 1 Nominal and real interest rate • For small value of inflation (till 5 – 10 %) the approximate relationship: i=r+Π r=i–Π • Fisher effect: the value of nominal interest rate is determined (adjusted) by inflation rate. Inflation • Money growth rate is higher that money demand growth rate. • Money demand growth rate is determined mostly by real factor (real GDP, technological progress, including progress affecting using of money as internet banking). • Inflation = money loose its value, it is possible to buy less goods and services per money unit => inflation tax. Examples of inflation • Germany 1923: http://www.youtube.com/watch?v=QmZ36uA BULY • Zinbabwe 2008: http://www.youtube.com/watch?v=Jt15F21jp N8 Costs of inflation • Money loose their value – not used as store of value. • Shoeleather costs. • Menu costs. • Relativity price variability and misallocation of resources. • Inflation-induced tax distortion. • Confusion and inconvenience. • Arbitrary redistribution of wealth.