layout: true background-image: url(figs/tcb-logo.png) background-position: bottom right background-attachment: fixed; background-origin: content-box; background-size: 10% --- class: title-slide .row[ .col-7[ .title[ # Principles of Macroeconomics ] .subtitle[Money and Infliation] .author[ ### Dennis A.V. Dittrich ] .affiliation[ ] ] .col-5[ ] ] --- class: pratice-slide # 1. .col-8[ What is Money? What are the functions of Money? ] --- # What is Money? .row[.col-7[ Money (or the _money supply_): anything that is generally accepted in payment for goods or services or in the repayment of debts. **Currency** is a **system of money** in common use. Money (a stock concept) is different from: **Wealth**: the total collection of pieces of property that serve to store value **Income**: flow of earnings per unit of time (a flow concept) ]] .row[ .col-8[.center[.large[ Money's a matter of functions four, A Medium, a Measure, a Standard, a Store ]] ]] --- ## Definition and Functions of Money .row[ .col-6[ Money is a highly liquid financial asset that serves as a: **Medium of exchange** **Unit of account** **Standard of deferred payment** **Store of wealth** ![](img08/yap1.jpg) ] .col-6[ **Liquid** means to be easily changeable into another asset or good Stone money on the island Yap, Pacific Ocean http://www.npr.org/blogs/money/2011/02/15/131934618/the-island-of-stone-money ![](img08/yap2.jpg) ]] --- class: practice-slide # 2. .col-8[ What characteristics / properties are necessary so that something can fulfill the functions of money? ] --- ## Functions of Money: Medium of Exchange .col-7[ Eliminates the trouble of finding a double coincidence of needs (reduces transaction costs) Promotes specialization A medium of exchange must * be easily standardized * be widely accepted * be divisible * be easy to carry * not deteriorate quickly ] --- # Functions of Money: Unit of Account .col-7[ Used to measure value in the economy Reduces transaction costs A Unit of Account must * be be divisible * fungible * countable ] --- ## Functions of Money: Standard of Deferred Payment & Store of Value .col-7[ Money is used to save purchasing power over time * other assets also serve this function * Individuals' deposits in savings and checking accounts serve the same function as does currency and are also considered to be money A Standard of Deferred Payment must * be able to act as debt & credit * be (legal) tender A Store of Value must * be savable * be storable * retrievable * valuable upon retrieval ] --- class: practice-slide # 3. .col-8[ What are the differences of commodity money vs fiat money? ] --- ## Evolution of Payments System (Currencies) .col-7[ **Commodity Money**: valuable, easily standardized and divisible commodities (e.g. precious metals, cigarettes). **Fiat Money**: paper money decreed by governments as legal tender. **Checks**: an instruction to your bank to transfer money from your account **Electronic Payment** (e.g. online bill pay). **E-Money** (electronic money): * Debit card * Stored-value card (smart card) * E-cash ] --- # Quantity Measures of Money .row[ .col-6[ Economists have developed different measures of money **M1** is a measure of the money supply; it consists of currency in the hands of the public plus checking accounts and traveler's checks **M2** is a measure of the money supply; it consists of M1 plus other relatively liquid assets ![](img08/3003.jpg) ] .col-6[ ![](img08/f3402.jpg) ] ] --- ## Distinguishing Between Money and Credit .col-7[ **Credit cards** are not money * Credit card balances are assets of a bank in the form of a prearranged loan and liabilities of the credit card user * Generally credit card holders carry less cash A **debit card** is part of the monetary system because it serves the same function as a checkbook ] --- # Are We Headed for a Cashless Society? .col-7[ Predictions of a cashless society have been around for decades, but they have not come to fruition * Although e-money might be more convenient and efficient than a payments system based on paper, several factors work against the disappearance of the paper system * Still, the use of e-money will likely still increase in the future ] --- class: practice-slide # 4. .col-8[ Why do people hold cash? ] --- # Why People Hold (Cash) Money .row[.col-7[ The only reason people would be willing to hold money is if they get some benefit from doing so * The **transactions motive** is the need to hold money for spending * The **precautionary motive** is holding money for unexpected expenses and impulse buying * The **speculative motive** is holding cash to avoid holding financial assets whose prices are falling ]] .row[ .col-7[ * The demand for money is downward-sloping: as the interest rate falls the cost of holding money falls * When interest rates rise, bonds and other financial assets become more attractive, so you hold more financial assets and less money ] .col-5[ ![](img08/3004.jpg) ]] --- class: practice-slide # 1. .col-8[ If I get more money, does that typically make me richer? If society gets more money, does it make society richer? What’s the contradiction? ] ??? If I get more money, that does make me richer, but if more colored pieces of paper get printed, a society isn’t any richer. The apparent contradiction is resolved if we remember that money is a claim on resources. If the total quantity of money stays the same but I have more, then I have a greater claim on resources because someone else has less. But if everyone has more money, then everyone may think that they have a greater claim on resources, but they don’t because resources have not increased. --- .row[ .col-7[# Inflation **Inflation** is a continual rise in the price level * is measured with price indexes * Expectations of inflation can become built into individuals' behavior and economic institutions and cause a small inflation to accelerate * Inflation creates feelings of injustice and destroys the informational value of prices and the market **Deflation** is a continual fall in the price level * Inflation and deflation are measured with changes in price indexes **Price index** is a number that summarizes what happens to a weighted composite of prices of a selection of goods over time **Real price** is the price of a good that has been corrected for inflation. ] .col-5[ ![](img08/f3101.jpg) ] ] --- # Real World Price Indexes .row[ .col-6[ **GDP deflator** is an index of the price level of aggregate output relative to a base year **Consumer price index (CPI)** measures the prices of a fixed basket of consumer goods, weighted according to each component's share of a average consumer's expenditures **Personal consumption expenditure (PCE) deflator** is a measure of prices of goods that consumers buy that allows yearly changes in the basket of goods that reflect actual consumer purchasing habits **Producer price index (PPI)** measures average change in the selling prices received by domestic producers ] .col-6[ ![](img08/2407.jpg) ]] --- # Nominal and Real Prices .row[ .col-8[ ![](img08/f3103.jpg)] .col-4[ 1982 price of gasoline was $1.25/gal. 2006 it was double that at $2.50/gal. CPI was 100 in 1982 and 202 in 2006. The real price of gasoline was about the same in 2006 as it was in 1982. ]] --- class: practice-slide # 2. .col-8[ When is the inflation rate more likely to have a big change either up or down: when inflation is high or when it is low? ] ??? When inflation is high. High inflation tends to be more volatile. --- ## Hyperinflation: extremely high rates of inflation .row[ .col-6[ * Many governments have fallen into the trap of inflating their currency in order to pay debts. * Hungary's hyperinflation is the highest on record. What cost 1 Hungarian pengo in 1945 cost 1.3 septillion pengos at the end of 1946. Prices doubled every 15 hours! ] .col-6[ ![](img08/f3102.jpg)]] --- # Theories of Inflation .col-7[ Two theories of inflation are the quantity theory and the institutional theory * The **quantity theory** emphasizes the connection between money and inflation; if the money supply rises, the price level rises * The **institutional theory** emphasizes the relationship between market structure and price-setting institutions and inflation The two theories overlap significantly, but they come to different policy conclusions ] --- ## The Quantity Theory of Money and Inflation .row[ .col-6[ Inflation is always and everywhere a monetary phenomenon The equation of exchange is: MV = PQ * M = Quantity of money * Q = Real output * V = Velocity of money * P = Price level **Velocity of money** is the number of times per year, on average, a dollar goes around to generate a dollar's worth of income Velocity = Nominal GDP / Money Supply ] .col-6[ Three assumptions of quantity theory: 1. Velocity of money is stable compared to the money supply. 2. Real output (Q) is stable and independent of money supply 3. If Output is fixed by real factors of production and Velocity is stable, then it follows that inflation is caused by an increase in the supply of money. `$$\%\Delta M \rightarrow \%\Delta P$$` ]] --- class: practice-slide # 3. .col-8[ What does the quantity theory of money predict will happen in the long run in these cases? According to the quantity theory, a rise in the money supply can’t change v or Y in the long run, so it must affect P. Let’s use that fact to see how changes in the money supply affect the price level. Fill in the following table: |M|v|P|Y| |---|---|---|---| |150| 5| ? |50| |200| 5| ? |50| |100| 5| ? |50| ] ??? 15 20 10 --- class: practice-slide # 4. .col-8[ It is sometimes suggested that central banks should try to achieve zero inflation. If we assume that velocity is constant, does this zero inflation goal require that the rate of money growth equal zero? If yes, explain why. If no, explain what the rate of money growth should equal. ] ??? No, money growth should equal real growth. --- ## The Quantity Theory of Money and Inflation .row[ .col-6[ Growth rate of money + change in velocity equals the rate of inflation + growth rate of real GDP. ] .col-6[ If the growth rates of velocity and GDP are small compared to the growth rate of M, the rate of inflation will be approximately equal to the increase in money supply. ]] ![](img08/f3104.jpg) --- # Inflation and Money Growth .row[ .col-9[ ![](img08/f3105.jpg)] .col-3[ The empirical evidence that supports the quantity theory of money is most convincing in countries that experience substantial inflation. ]] --- ## The Quantity Theory of Money and Inflation .col-7[ Some Important Caveats: * If M and v grow more slowly than GDP, prices will fall; this is called deflation. * Changes in velocity will affect prices. **Hyperinflation**: People will spend their money faster (increase v) `\(\rightarrow\)` even faster increase in prices. **Great Depression**: Fear `\(\rightarrow\)` less spending (decreased v) `\(\rightarrow\)` deflation `\(\rightarrow\)` worse depression. * In the long run, money is neutral. * Under some circumstances, changes in M can temporarily change GDP. * Increase in M can boost the economy in the short run but as firms and workers come to expect and adjust to the influx of new money, output (real GDP) will not grow any faster than normal. ] --- class: practice-slide # 5. .col-9[ Much of the economic news we read about can be reinterpreted into our “Mv = PY ” framework. Turn each of the following news headlines into a precise statement about M, v, P, or Y. 1. “Deposits in U.S. banks fell in 2015.” 2. “American businesses are spending faster than ever.” 3. “Prices of most consumer goods rose 12% last year.” 4. “Workers produced 4% more output per hour last year.” 5. “Real GDP increased 32% in the last decade.” 6. “Interest rates fall: Consumers hold more cash.” ] ??? 1. fall in M 2. rise in v 3. rise in P 4. rise in Y 5. rise in Y 6. fall in v --- ## Quantity vs. Institutionalist Theories of Inflation .col-7[ Both quantity theorists and institutionalists agree that money and inflation are positively related, but they have different causes and effects * Quantity theorists believe that increases in money cause direct increases in prices * Institutionalists believe that increases in prices force government to increase the money supply or cause unemployment According to the quantity theory, changes in money cause changes in prices `$$MV \rightarrow PQ$$` According to the institutionalists, increases in prices force the government to increase the money supply `$$MV \leftarrow PQ$$` ] --- # Institutionalist Theories of Inflation .row[ .col-6[ * The source of inflation is firms who pass on higher wages, rents, taxes, or other costs on to consumers in the form of higher prices * If the government increases the money supply so that demand is sufficient to buy the goods at higher prices, inflation is the result * If the government doesn't increase the money supply unemployment increases ] .col-6[ **The Insider/Outsider Model and Inflation** * The insider-outsider model is an institutionalist story of inflation where insiders bid up wages and outsiders are unemployed * If markets were purely competitive, wages, profits, and rents would be pushed down to equilibrium levels * Because insiders develop barriers such as unions and brand recognition to prevent outsider competition, outsiders must take dead-end low paying jobs ] ] --- # Demand-Pull and Cost-Push Inflation .col-7[ **Demand-pull inflation** occurs when the economy is at or above potential output * It is generally characterized by shortages of goods and workers **Cost-push inflation** occurs when the economy is below potential output * Significant proportions of markets or one very important market experience price increases not related to demand pressure ] --- class: practice-slide # 6. .col-8[ If all prices (including wages) are going up, then why is inflation a problem? In other words, what are potential costs of inflation to society? ] ??? 1. Inflation causes price confusion and money illusion. Money Illusion: when people mistake changes in nominal prices for changes in real prices. Inflation makes price signals more difficult to interpret. A consumer may not know if the price of a product is increasing... Because of increased demand? or As a result of all prices going up with inflation. 2. Inflation interacts with other taxes. People pay taxes on illusory (nominal not real) capital gains. Longer-run effect is to discourage investment in the first place. 3. Inflation is painful to stop. Slowing down the money supply can create a recession. 4. Inflation redistributes wealth. --- # The Costs of Inflation .col-7[ Inflation causes price confusion and money illusion. * Money Illusion: when people mistake changes in nominal prices for changes in real prices. * Inflation makes price signals more difficult to interpret. A consumer may not know if the price of a product is increasing... * Because of increased demand? or * As a result of all prices going up with inflation. Inflation interacts with other taxes. * People pay taxes on illusory (nominal not real) capital gains. * Longer-run effect is to discourage investment in the first place. Inflation is painful to stop. * Slowing down the money supply can create a recession. Inflation redistributes wealth. ] --- class: practice-slide # 7. .col-8[ Who gets helped by a surprise inflation: People who owe money or people who lend money? ] ??? People who owe money benefit from a surprise inflation. If prices and wages suddenly rise after you borrow $10,000, then it’s much easier to make your monthly payments. --- ## Inflation redistributes wealth among the public .row[ .col-4[ The **lender** is now **losing** money on the loan. The **borrower gains**. What happens if people expect inflation to go up? * Lenders will increase nominal rates of interest. * **Fisher effect**: the tendency for nominal interest rates to rise with expected inflation. * The nominal rate of interest will be equal to expected inflation rate plus the equilibrium rate of return. ] .col-8[ ![](img08/f3106.jpg) ]] --- class: practice-slide # 8. .col-8[ If everyone expects inflation to rise by 10% over the next few years, where, according to the Fisher effect, will the biggest effect be: on nominal or real interest rates? ] ??? The biggest effect will be on the nominal interest rate because the Fisher effect is the tendency of nominal interest rates to rise with expected inflation rates. --- ## Inflation is a type of tax .row[ .col-6[ * Inflation transfers wealth to the government that prints money to pay its bills. * **Monetizing the debt**: when the government pays off its debts by printing money. ] .col-6[ Why don't they always inflate their debt away? * The **Fisher effect**: if banks know the government is doing this, they will simply raise interest rates. * Political cost: People who buy government bonds usually vote. ]] .col-11[.row[.col-1[].col-5[ ![](img08/aruoba_inst_tax.png)] .col-1[].col-5[ ![](img08/aruoba_inst_inf.png)]] ] --- class: practice-slide # 9. .col-8[ Consider the interaction between inflation and the tax system (assume the inflation is expected). Does high inflation encourage people to save more or discourage saving? If a government wants to raise more tax revenue in the short run, should it push for higher or lower inflation? ] ??? High inflation discourages saving. Savers have to pay tax based on the nominal interest rate, not the real interest rate. When inflation is high, the nominal interest rate rises, so the tax bill rises. A government that wants to raise more revenue in the short run should push for higher inflation. --- ## Workers and firms are affected by inflation .col-7[ Wage agreements are often made several years in advance. Underestimating inflation * wages are too low `\(\rightarrow\)` supply of labor: too low. Overestimating inflation * wages are too high `\(\rightarrow\)` demand for labor: too low. Errors in estimating the rate of inflation * a misallocation of resources `\(\rightarrow\)` lower economic growth. ] --- class: practice-slide # 10. .col-8[ Nobel laureate Milton Friedman often said that “inflation is the cruelest tax.” Who is it a tax on? 1. People who hold currency and coins in their wallet, purse, or at home 2. Businesses that hold currency and coins in their cash registers 3. People or businesses who keep deposits in a checking account that pays zero interest 4. People or businesses who keep deposits in a savings account that pays an interest rate higher than the rate of inflation 5. People or businesses who invest in gold, silver, platinum, or other metals ] ??? The first three are all correct: In those cases, the “money” being held pays no interest, so it loses value whenever prices rise. In case 4, the saver gains value when inflation rises. In case 5, when inflation rises, the value of these forms of wealth often rises or at least stay approximately constant --- # Expected and Unexpected Inflation .row[.col-7[ Expected and unexpected inflations affect behavior differently ]] .row[ .col-6[ **Expected inflation** is inflation people expect to occur **Rational expectations** are the expectations that the economists' models predict **Adaptive expectations** are expectations based in some way on the past **Extrapolative expectations** are expectations that a trend will continue ] .col-6[ **Unexpected inflation** is inflation that surprises people It may redistribute income from lenders to borrowers * If lenders charge a nominal rate of 5% and expect inflation to be 2%, the expected real rate is 3% * If inflation is actually 4%, the real rate is only 1% People who do not expect inflation and who are tied to fixed nominal contracts will likely lose in an inflationary period ]] .row[.col-7[ Expectations of inflation play an important role in any ongoing inflation Inflationary expectations can accelerate large inflation ]] --- ## Redistribution through unexpected inflation .row[.col-7[ If inflation is moderate and stable * Lenders and borrowers can forecast well. * Loans can be signed with rough certainty regarding the value of future payment. Unexpected inflation redistributes wealth throughout society in arbitrary ways ![](img08/t3101.jpg) ] .col-5[ When inflation is high and volatile **unexpected inflation** is difficult to avoid. * Long-term risk becomes high and loans may not be signed at all. * Financial intermediation breaks down. * Long-term contracting grinds to a halt. * Economic growth suffers. ]] --- class: practice-slide # For Reflection .col-8[ Are there any benefits from moderate and stable inflation? ]