Intermediate macroeconomics chapt04

Chapter 4: Money and Inflation Functions of Money Medium of Exchange Store of Value Unit of Account Standard of Deferred Payment Types of Money Commodity money: a commodity with some intrinsic value used as a medium of exchange (e.g., cigarettes in POW camps) Fiat money: a commodity with no intrinsic value established by a government decree as money (e.g., coins & bills) Characteristics of Money Limited in supply Widely accepted Portable Divisible Uniform Durable Money Supply M1 – Currency: coins & bills (25%) – Demand Deposits: checking account deposits (75%) M2 – M1 – Time Deposits: savings account deposits less than $100,000 Money Supply M3 – M2 – Time Deposits: savings account deposits more than $100,000 L – M3 – Liquid assets (e.g., T-Bills) The Measures of Money C M1 M2 M3 L $434 billion in April 1998 $1,081 $4,165 $5,574 $6,826 Money Supply Line The quantity of money in circulation is controlled by the central bank in real value = M/P Interest Rate (%) (M/P)s 10 80 Quantity of Money Money Demand The amount of money demanded for transaction and speculation purposes depends on personal income and interest rate At any level of personal income, quantity demanded of money is a negative function of interest rate Money Demand Line M/P = f(Y, r) Y = income r = real interest rate Interest Rate (%) 10 (M/P)d 80 100 Quantity of Money Money and Inflation Take percentage change from MV = PY %ΔM * %ΔV = %ΔP * %ΔY V = 1/k and Y at full employment are constant %ΔM = %ΔP : a 1% increase in the money supply causes a 1% increase in the general price level Sources of Gov’t Revenues Taxes Public Debt Seigniorage or printing money: operates like an inflation tax on money holding as money loses real value Fisher Effect Define – i = nominal rate of interest – r = real rate of interest – π = inflation rate i=r+π r=i-π Money, Inflation, Interest Rate Quantity Theory of Money: a 1% increase in the money supply causes a 1% increase in inflation Fisher Effect: a 1% increase in the inflation causes a 1% increase in the nominal interest rate Historical Data International Data Real Interest Rate Ex-ante: real interest rate when loan are made (known) Ex-post: real interest rate when loans are paid (unknown, but measured by forecasting inflation rate) Revised Fisher Effect Define – i = nominal rate of interest – r = real rate of interest – π* = expected inflation rate i = r + π* r = i – π* Revised Demand for Money (M/P)d = L(i, Y) where L is for liquidity (M/P)d = L(r + π* , Y) Money demand depends on the – real rate of interest (-) – expected inflation rate (-) – personal income (+) Linkage Among Money, Prices, and Interest Rates Changes in money demand and supply determine the price level Changes in the price level determine the inflation rate The inflation rate affects the interest rate The nominal interest rate affects the money demand Linkage Among Money, Prices, and Interest Rates Money Supply Price Level Money Demand Inflation Rate Nominal Interest Rate Cost of Expected Inflation Inflation Tax Menu Cost Inefficiency due to inflation variability Increase in tax liability Consumer inconvenience Cost of Unexpected Inflation Loss of returns: – creditors lose if π* > π – borrowers lose if π* < π Loss of real income when income is fixed Hyperinflation When π > 50% per month All unexpected costs get larger Delay in tax collection Inflation psychology Caused by excessive printing press Cure required fiscal reform Hyperinflation in Germany