Chapter 4 Money and Inflation October 8 2009 1 Money and Policy Money the stock of assets that can be readily used to make transactions Functions of money 1 Medium of exchange can be traded for goods services 2 Store of value transfer purchasing power across time 3 Unit of account a common unit to measure relative prices 4 Method of deferred payment acceptable for debt repayment Money supply the quantity of money available in the economy Monetary policy control of the money supply by a country s central bank to achieve macroeconomic stability 2 The Quantity Theory of Money Velocity of money the rate that money circulates throughout the economy transactions per unit time Example In 2007 500 billion in transactions money supply 100 billion The average dollar is used in five transactions in 2007 So velocity 5 Mathematical definition V T M V is velocity T value of all transactions and M is money supply Use nominal GDP as a proxy for total transactions V PY M P is the price of output and Y is the quantity of real output real GDP Econ 302 Week 6 UW Madison TAs Lihan Liu and Scott Swisher 1 Quantity equation M V P Y Assumes V is constant and exogenous V V then M V P Y the money supply determines the price level M V P Y M V P Y M P Y gM gY gM controlled by central bank V 0 gY depends on growth in the factors of production and technological progress gM determines the rate of inflation Normal economic growth requires a minimum level of gM to support output growth gY Money growth in excess of this amount leads to inflation Fisher equation r i Nominal interest rate i not adjusted for the rate of inflation Real interest rate r adjusted for inflation S I in the loanable funds market determines r thus i is the actual inflation rate e is the expected inflation rate rex ante i e real interest rate people expect when they buy a bond or take out a loan rex post i realized actual interest rate M d d e Real money demand M P L i Y L r Y What does P depend on 1 i nominal interest rate is the opportunity cost of holding money 2 Y higher income means that you want to hold more cash to finance purchases M d s Money market equilibrium M P P M P L r e Y M M is exogenous set by the central bank r adjusts to equate savings and investment S I goods market equilibrium Y F K L aggregate production function e P adjusts to equate real money supply and demand M P L r Y money market equilibrium 3 The Costs of Inflation Costs of expected inflation 1 menu costs 2 shoeleather costs 3 relative price distortions 4 unfair tax treatment 5 difficulty in comparing prices across time Costs of unexpected inflation 1 arbitrary redistribution of purchasing power borrowers are better off and lenders are worse off in real terms 2 increased uncertainty instability in the economy Benefit of inflation allows real wages to reach equilibrium without nominal wage cuts wages are usually inflexible downward Improves the functioning of labor markets if real wages are sticky 2
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