March 10th – March 17th, 2015Chapter 5: Money and Inflation In this chapter, you will learn…- Why is there inflation? - Is inflation bad? A theory - The classical theory of inflation - Applies to the long run - This theory offers an answer to the question: what causes inflation in the long run? - It is called the “quantity theory of money” - We begin with some easy facts Velocity - Basic concept: the rate at which money circulates - Example: in 2007, o $500 billion in transactions o Money supply: $100 billion o The average dollar is used in five transactions in 2007o So, velocity = 5 - This suggests the following definition: V = T/M where V = velocity, T = value of all transactions, M = money supply - Use nominal GDP as a proxy for total transactions. Then, V = (PxY)/M where P = price of output (GDP deflator), Y = quantity of output (real GDP), P x Y = value of output (nominalGDP) The quantity equation- The quantity equation M x V = P x Y follows from the preceding definition of velocity. - It is an identity: it holds by definition of the variables Money market and the quantity equation- The quantity equation can also be derived with the money market equilibrium condition - The supplier is the central bank - The demanders are businesses, governments, and individuals - Is there a price for money? - M/P = real money balances, the purchasing power of the money supply - Example: if M = $100, price of bread = $2 per loaf, then real money (real purchasing power of money) = 100/2 = 50 loaves of bread - In practice, economists use a price index such as CPI to represent P - How much real money (purchasing power) do people like to hold?- In other words, what determines money demand? - A simple money demand function: (M/P)d = kY where k = how much money people wish to hold for each dollar of income (k is exogenous) - Let money demand equals supply M/P – we get the quantity equation - The connection between them: k = 1/V - When people hold lots of money relative to their income (k is high), money changes hands infrequently (V is low) Now the theory - So far we only derived a quantity equation - It is not a theory yet - We proceed by making an assumption, and derive some implications Back to the quantity theory of money - Start with quantity equation M x V = P x Y - Assumes V is constant & exogenous: V = Vbar- With this assumption, the quantity equation can be written as M x Vbar = P x Y- M x V bar = P x Y - The Fed can control M: o With V constant, the money supply determines nominal GDP (P x Y)o But real GDP is determined by the economy’s supplies of K and L and the production function o Hence, the only variable not yet determined is P - So the Fed’s actions directly affect the price level - Let’s proceed to check the impact on the inflation rate- Recall from chapter 2: the growth rate of a product equals the sum of the growth rates - The quantity equation in growth rates: (delta M/M) + (delta V/V) = (delta P/P)+ (delta Y/Y)o The quantity theory of money assumes V is constant, so (delta V/V) = 0- Pi (greek letter pi) denotes the inflation rate: pi = (delta P/P)- The result from the preceding slide was: (delta M/M) = (delta P/P) + (delta Y/Y)- Solve this result for pi to get pi = (delta M/M) – (delta Y/Y)- Pi = (delta M/M) – (delta Y/Y) - Normal economic growth requires a certain amount of money supply growth to facilitatethe growth in transactions - Money growth in excess of this amount leads to inflation - (delta Y/Y) depends on growth in the factors of production and on technological process (all of which we take as given, for now) - Hence, the Quantity Theory predicts a one-for-one relation between changes in the money growth rate and changes in the inflation rate Velocity- Velocity changes in real life - Example: when ATM was introduced, people started to hold less cash and make more frequent use of the ATMs. V increases - However, velocity does not change often. The constant velocity assumption will help us derive the theory - Later, we can alter this assumption to see if the theory is still valid Implications of the Theory - The central bank, which controls the money supply, has ultimate control over the rate of inflation - If the central bank keeps the money supply stable, the price level will be stable - If the central bank increases the money supply rapidly, the price level will rise rapidly Confronting the quantity theory with data- The quantity theory of money implies o Countries with higher money growth rates should have higher inflation rates o The long-run trend behavior of a country’s inflation should be similar to the long-run trend in the country’s money growth rate - Are the data consistent with these implications? Other evidence in history - 1880 – 1896, economy grew but the supply of gold was relatively constant. What does the theory predict? - Data: price fell 23% - 1896 – 1910, new gold was discovered in Alaska, Australia, and South Africa. What does the theory predict? - Price level rose 35% Question - If too much money causes inflation, why do governments still supply too much of it? - One reason is that governments make mistakes when they try to “stimulate” the economy by supplying too much money. - Example: U.S. inflation in the 70s - But this does not explain why some countries have sustained high inflation for decades Seigniorage - Main reason: printing money can be a source of revenue - Government’s “normal” revenue sources: o Taxes o Debts - The “revenue” raised from printing money is called Seigniorage - Most governments do not really “print” money to purchase things- Government issues bonds – central bank buys the bonds – credits the government’s account with more money – government spends the money - In the U.S., the Federal Reserve is not allowed to buy bonds directly from the government - The Fed can buy bonds from the financial market, or “open market” - Government issues bonds to financial market – Fed buys bonds from market – government collects Seigniorage indirectly - In the US, Seigniorage is a small fraction of government revenue - Private investors are usually willing to buy US Treasury bonds - There is no need for the Fed to “monetize” the debt - In some countries, Seigniorage can be a major source of revenue Case Study: Continental Currency - In 1775, the Continental Congress financed the Revolution by printing fiat money - In 1775 new issues of continental currency were about