Macroeconomics & The global economy

Ace Institute of Management Session 3: Money and Inflation

Instructor Sandeep Basnyat Sandeep_basnyat@yahoo.com 9841 892281

Money

Stock of assets Used for transactions A type of wealth

 Store of value: You can postpone your purchase for next period. Unit of account: units in which prices are quoted and debts recorded A medium of exchange.: used to buy goods and services
The ease with which money is converted into other things such as goods and services--is sometimes called moneys liquidity.

 Measures economic transactions like yardsticks. Without it, we would be forced to barter. Problem with barter: requires the double coincidence of wants.

Fiat money is money by declaration. It has no intrinsic value.

Commodity money is money that has intrinsic value. Eg. Gold or cigarettes in P.O.W. camps When people use gold as money, the economy is said to be on a gold standard.

 The money supply: quantity of money available in an economy. Monetary policy: The control over the money supply (increasing or decreasing). Central Bank: Institution that conduct monetary policy. Open Market Operation: Primary way of controlling Money Supply To expand the money supply: Central banks buys government bonds and pays for them with new money. To reduce the money supply: Central banks sells government bonds and receives the existing money and then destroys them.

Other instrument of Monetary Policy

Changing the Reserve requirements. Minimum reserves each Commercial bank must hold Changing the Discount rate (which member banks (not meeting the reserve requirements) pay to borrow from the Central Banks.)

 Currency Demand Deposits M1, M2, M3 For Nepal: Broad Money (M2) and Narrow Money (M1)

Monetary Statistics for US and Nepal for 2008/2009 Nepal US Rs. 18307 million or $1.99 Monetary Base (M1) Approx. $250 trillion million M2 Reserve Requirements

Rs. 67644 million or $8.36 Approx. $926 trillion million 5.50% 10%

Equilibrium in Money Market

Value of Money, 1 /P (High) 1 Price Level, P 1 (Low)

Money supply

4 /

1.33

12

Equilibrium value of money

Equilibrium price level

14

4 Money demand

(Low)

Quantity fixed by the Central Bank

Quantity of Money

(High)

Quantity Theory of Money

The Quantity Theory of Money states that there is a direct relationship between the quantity of money in an economy and the level of prices of goods and services sold.
If the amount of money in an economy doubles, price levels also double, causing Inflation (the percentage rate at which the level of prices is rising in an economy).

The consumer therefore pays twice as much for the same amount of the good or service.
Money is like any other commodity: increases in its supply decrease marginal value (the buying capacity of one unit of currency). So an increase in money supply causes prices to rise (inflation) as they compensate for the decrease in moneys marginal value.

Quantity Theory of Money-Derivation

Md = T x P
T = Number of transactions in an economy P = General price Level. It is the nominal GDP

Ms = M x V
M = Amount of Money in circulation V = Velocity of money (the number of times money changes hands)

From Equilibrium condition, Md = Ms TxP=MxV

The Quantity Theory of Money

Transactions calculation not easy Replaces with Total Output (Transactions and output are related as
the more the economy produces, the more goods are bought and sold).

Money Velocity = Price Output M V = P Y

Fixed Y = as K, L are fixed, and Fixed V : supposed constant over time

MV = PY

MP

Price Level is directly proportional to the Quantity of Money in the Economy.

The Quantity Theory of Money

MV = PY

MP

Price Level is directly proportional to the Quantity of Money in the Economy. or in percentage change form: % Change in M + % Change in V = % Change in P + % Change in Y If V is fixed and Y is fixed, then it reveals that % Change in M is what induces % Changes in P. The quantity theory of money states that the central bank, which controls the money supply, has the ultimate control over the inflation rate. 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.

The Effects of Monetary Injection

Value of Money, 1 /P (High) 1

MS1

MS2

Price Level, P

1
1. An increase in the money supply . . . A

(Low)

2. . . . decreases the value of mone y . . .

4 /

1.33 3. . . . and increases the price level.

12

14

B Money demand

(Low) 0
M1 M2

(High)

Quantity of Money

Money and Prices During Four Hyperinflations

(a) Austria Index (Jan. 1921 = 100) 100,000 10,000 1,000 100 Price level Money supply Index (July 1921 = 100) 100,000

(b) Hungary

Price level 10,000 1,000 100 Money supply

1921

1922

1923

1924

1925

1921

1922

1923

1924

1925

Money and Prices During Four Hyperinflations

(c) Germany
Index (Jan. 1921 = 100) 100,000,000,000,000 1,000,000,000,000 10,000,000,000 100,000,000 1,000,000 10,000 100 1 Price level Money supply Index (Jan. 1921 = 100) 10,000,000 1,000,000 100,000 10,000 1,000 1921 1922 1923 1924 1925

(d) Poland

Price level Money supply

100

1921

1922

1923

1924

1925

Fisher Equation: i = r + p
The one-to-one relationship between the inflation rate and the nominal interest rate is the Fisher effect. Actual (Market) Inflation Real rate nominal rate of of interest interest It shows that the nominal interest can change for two reasons: because the real interest rate changes or because the inflation rate changes.

Adjustment to Fisher Effects People have expectation of the inflation rate. Let

p = actual future inflation and pe = expectation of future inflation.

Actual inflation is not known when the nominal interest rate is set. But people can adjust to expected inflation.

i=r+

e p

The nominal interest rate i moves one-for-one with changes in expected inflation pe.

Shoe-leather cost of inflation: walking to the bank more often induces ones shoes to wear out more quickly. Menu costs: When changes in inflation require printing and distributing new pricing information. Tax Laws: Often tax laws do not take into consideration inflationary effects on income.

 Unanticipated inflation is unfavorable because it arbitrarily redistributes wealth among individuals. For example, it hurts individuals on fixed pensions. There is a benefit of inflationmany economists say that some inflation may make labor markets work better. They say it greases the wheels of labor markets.

Hyperinflation: inflation that exceeds 50 percent per month, which is just over 1percent a day. Costs such as shoe-leather and menu costs are much worse with hyperinflationand tax systems are grossly distorted. Eventually, when costs become too great with hyperinflation, the money loses its role as store of value, unit of account and medium of exchange. Bartering or using commodity money becomes prevalent.

Thank You