Money and Inflation

Money Demand

Price Indices: Pt
Two most commonly used price indices
are GDP Deflator and Consumer Price
Index (CPI)
The CPI is the price of a representative
market basket of goods relative to the
price of that same basket during a
benchmark/base year (multiplied by 100).
The GDP deflator is the ratio of nominal
GDP to Real GDP (multiplied by 100).
Nominal GDP GDP
P GDP Deflator

Real GDP
Y

Hong Kong CPI vs. GDP Deflator

CPI vs. GDP Deflator

CPI is calculated monthly, GDP deflator is
calculated quarterly.
CPI measures the price of consumer goods.
GDP deflator measures the price of all goods
produced including investment or government
goods.
CPI measures the change in price of a constant
market basket. Market basket of GDP deflator
changes as goods produced changes.

The Data
Data on money supply is inevitably
measured by the central bank and usually
the data is available for free.
Example: Hong Kong Monetary Authority
Data on
Listing of Central Bank Websites.

What is a central bank?

Central banks have two main roles:
Banker to the government
Manage many financial assets of the government.
Monopoly on the issue of banknotes/currency (true
almost everywhere, but not HK)
Arm of government policymaking

Banker to commercial banks.

Operate the Payment System
Regulate Banking System
Lender of Last Resort during a crisis

 Central Bank:
A special
governmental
organization or
quasigovernmental
institution within
the financial
system that
controls the
medium of
exchange.

Economy
HK

Central Bank

USA

Federal Reserve

EU

European
Central Bank

PRC

Peoples Bank of
China

UK,
Canada,
Japan,
Korea

Bank of .

Hong Kong
Monetary Authority

Readings
Money Demand
Branson, Chapter 14, especially p.335-339
Sachs Chapter 8

Inflation

Money
Financial Asset Used in
Transactions
Legal Tender: Government
accepts money as payment for
taxes and a transfer of money as a
settlement for a contract.

Characteristics of Money
1. Medium of Exchange Token that can be offered
as a payment for goods.
2. Unit of Account All goods will have a value in
money and, thus, can be used to measure all
goods
3. Store of Value If money is to be accepted for
goods today it must have durable value. (Money is
an Asset).

Two categories of money

1. Definitive Money (sometimes known as
monetary base): Money that can be used
immediately for transactions without
conversion to more basic forms of money.
Currency+ Reserve accounts

2. Broad Money: A set of assets, typically

some form of bank deposit, which can be
easily converted to definitive money.
Checking Accounts, Savings Accounts, Liquid
Time Deposits and CDs

Categories
of Broad
Money

M1 Currency
+ Checking Acct.
M2 +Savings Acct.
+ More Liquid
Time Deposit
M1

M2

M3

M3 + Less Liquid
Time Deposit

Incremental M3 is trivial in HK

HK$ Money Categories

Source: HKMA http://www.info.gov.hk

Broad Money vs. Narrow Money

Broad money has grown much faster than
narrow money.
Narrow money is money directly controlled
by the government.
Broad money includes money printed by the
government plus deposits at banks.
Money multiplier is ratio of broad money to
narrow money.

Categories
M0 = Reserves + Cash
M2 = Cash + Demand Deposits + Savings
Deposits

CDS
MM

RC
C
S
1
D
D 1
R C

D D

Determinant of the Multiplier.

The greater is the currency-deposit ratio the
smaller is the multiplier.
The greater is the savings to demand
deposit ratio the greater is the multiplier.
The higher is the fraction of deposits kept
on reserve, the smaller is the multiplier.

Money Multiplier in China

14
12

24000
20000

10

16000

12000

8000
4
4000
0
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
MULTIPLIER

M2

M0

Monetary Theory
Two Assets
Money (M) can be used for transactions but
pays no interest.
Bonds (B) will pay a nominal interest rate of
i but cannot be used for transactions.
If you buy a bond with $1, you will get $(1+i)
from the issuer of the bond.

Liquidity Problem
The household earns an income equal to (PQ)
which they will spend evenly over the course of a
month.
If they keep their whole income in their back-pocket
to do shopping they will lose interest income.
If they buy interest earning bonds with all of their
income, they will have to make many costly trips to
the bank when they want to buy goods. The cost of
each trip to the bank will be Pb.

Liquidity Strategy
Household strategy will be to keep a
share of their income in the form of
money, M*, and put the rest into bonds.
They will spend that money until it is
gone, return to the bank, and convert
bonds into M* again.

Choose # of trips to the bank.

The household will have to make P Y
*
M
trips to the bank.
The average balances held by the
*
M
household will be
2

Money holdings over the month

Money

M*

M*
2

time

Bond holdings over the month

Bonds

time

Costs of Strategy
*

M
If the household is on average holding 2
they will forego the opportunity to earn
*
interest equal to M
i
2

The total transactions costs of converting

their bonds into cash is
P Y
P b *
M

Minimize Total Costs

Total liquidity costs of holding M *

P Y
M
P b * i
M
2

Choose the number of trips that would minimize

the total costs (including interest costs).

Cost Minimization
Trade-off: The more trips you make, the
more interest you will earn but the less will
be the transactions cost.
Choosing the number of trips is equivalent to
choosing M*

Optimal Money Demand

Money demand is an increasing function of the
price level, and output and a decreasing
function of interest rates.

P Y
min TC ( M ) P b * i
M*
M
P Y
i
TC ' 0 P b

2
*
2
M

*

M
2bY

P i

2bY
P
i

Money Demand
Intuition: The greater is P and Y, the greater
are the need for money for transactions. The
greater is i, the greater the interest rate
costs.
Money Demand is typically represented in
terms of money divided by the price level,
referred to as real balances. M

Money Demand Curve

i

M
P

Velocity
Velocity is defined as the speed at which
money circulates or as the number of
transactions that each unit of money is
used in per period.
Velocity is measured as the ratio of current
dollar GDP to the money supply.

PY
Yt
t t
V

Mt Mt

Pt

BT Theory and Velocity

According to Baumol-Tobin theory, money
velocity should grow with output.
Asian experience suggests the opposite.
Possible reason: If b represents the costs
of goods that could have been produced
in the absence of a trip to the bank, b
would likely grow with productivity.

Long Run
Demand for real balances a proportional
function of GDP as well as a function of
interest rates.

Mt
Mt
Yt f (it ) ex.
v Yt 1
it
Pt
Pt

The higher is the interest rate, the more willing

the household is to incur the costs of not
holding cash.

Empirical Studies of Money

Demand
The Baumol Tobin model suggests a loglinear form.

Mt
ln
a0 a1 ln Yt a2 ln it
Pt
mt a0 a1 yt a2 ln i

Empirical Studies of Money

Demand
The Baumol Tobin model suggests a log-linear
form.

Mt
ln
a0 a1 ln Yt a2 ln it
Pt
mt a0 a1 yt a2 ln i

Empirical reality suggests that this does not

capture short-term endogeneity between money,
interest rates, and output.

Inflation
We are concerned with explaining the rate
of change of the price level or the inflation
rate
Pt Pt 1
P&
t

Pt 1

ln Pt

First difference the log of the money

demand function

log M t t log Yt log it

g t g g
M
t

Y
t

i
t

Money Growth and the Nominal

Interest Rate
Define the real interest rate, as the
amount of extra goods that can be gained,
if you give up 1 good today.

1 it

1
1 rt
1 it Pt Pt 1
Pt 1
Pt

1 it

1 t 1

rt it t 1

Long Run Inflation Rate

Assume that there is a long run inflation
rate and real variables are unaffected by
inflation in the long run.
ln i = 0

Then long run inflation is money growth

minus output growth.

g g
M

Neo-classical Dichotomy
Assume given Y and r which is not affected by
money supply or growth rate.
Money is just paper which should not affect real
outcomes.

Then, in the long run, we can solve for the

price level as a function of the level of money
and output and their growth rates (in addition
to the real interest rate).

Price Level
Then, in the long run, we can solve for the
price level as a function of the level of
money and output and their growth rates
(in addition to the real interest rate).

1M
M
Y
P
r g g
v Y

Socially Optimal Inflation Rate

Friedman Rule: Socially optimal inflation
rate sets the interest rate equal to zero.
If the interest rate were zero, workers in
Baumol and Tobin model would keep all of
their pay in cash and not have to make any
costly trips to the bank.
Set money growth gM = r - gY

Zero Lower Bound

Friedman rule interest rate is also theoretical
lower bound on the interest rate.
Nominal interest rates on bonds cannot go below
0 because there is a freely available asset that
always pays an interest rate at least equal to
zero.
Main objection to Friedman rule is that if we have
a long run zero interest rate, the central bank will
never be in a position to reduce interest rates.

ZIRP: Japan
JP: Call Rate: Uncollaterized: Overnight
% pa
10
9
8
7
6
5
4
3
2
1
0
Jul-1985

Jul-1988

Jul-1991

Jul-1994

Jul-1997

Jul-2000

Jul-2003

Jul-2006

Why inflation?
If zero or negative inflation is socially
optimal, why is it so pervasive.
Possible reason (especially in developing
world): It is a source of government
revenue (called seignorage).
When the government prints new currency,
it can use the money to pay off its old debts
or buy new goods.

Real Seignorage
Amount of goods purchased by the printing
of money
M t M t 1 M t M t 1 M t 1 M t
gM M

Pt
M t 1
M t Pt 1 g M P

The higher is the money growth rate, the

higher is the fraction of real balances that
can be collected through seignorage.

Substitution Effect
Higher money growth reduces demand for
real balances. Higher inflation will mean
higher interest rates, which will mean that
people will spend money more quickly which
drives up prices at a given output level.
Assume r = gY, i=gM

g
M
g
M

g
Y
Y
M
M
M
1 g P 1 g
1 g
M

M 1

Inflation Tax
% of Y

gM

How does declining money demand

reduce the seignorage revenue?
Consumers facing high inflation and thus
high interest rates, want to hold relatively low
money balances and are willing to make
more trips to the bank.
With a given amount of money chasing a
given amount of output more quickly, prices
will be higher and the amount that any newly
printed dollar will buy will be reduced.

Hyper Inflation
Hyperinflation occurs when inflation increases at
a rate of 50% or more per month.
In the long run, this rate of inflation is counterproductive to the government in terms of raising
seignorage.
Usually, a sign of a government trying to
maximize short-term revenue by accelerating
money growth faster than inflationary
expectations.
Prices in China rose 250000% in Chungking from
1937-1945.

Current Chinese Inflation Rates

Between 1984 and 1996, China frequently
had very high inflation rates, reaching to
levels of 20% or more per year.
Since then inflation has been steady or
decreasing.

Chinese CPI and Broad Money

25000
20000
15000
10000

400

5000

350

300
250
200
150
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
CPICHINA

M2

Velocity in China

Deposits are major channel for

saving in PRC

Money & Inflation: 1975-1994

Causes of Extremely Rapid Inflation

Government generates revenues by printing
new money (referred to as seignorage).
Government facing borrowing constraints
may be forced to rely on inflation tax for
deficit financing.

Israel 1970-1990

Israel 1970-1990

Hyperinflation

Mid-term Exam III

Monday, December 13th 4:30-7:30PM
Lecture Theater A
Semi-open Book (Bring 1 A4 size paper
with handwritten notes)) also calculator
and writing instruments.
Coverage. Lecture notes including this
one.

 Lecture Theater A, 4:30-7:30