Money, Financial System and

the Economy 7Topic

Part I: Money and the Financial

System
Money: What Is It and How Did It Come to
Be?
Money: A Definition
To the layperson, the words income, credit, and wealth are synonyms
for money. In each of the next three sentences, the word money is
used incorrectly; the word in parentheses is the word an economist
would use.
1. How much money (income) did you earn last year?
2. Most of her money (wealth) is tied up in real estate.
3. It sure is difficult to get money (credit) in todays tight mortgage
market.
In economics, the words money, income, credit, and wealth are not
synonyms. The most general definition of money is any good that
is widely accepted for purposes of exchange (payment for goods
and services) and the repayment of debt.
Money: What Is It and How Did It Come to
Be?
Three Functions of Money
Money has three major functions; it is a:
Medium of exchange
Unit of account
Store of value
Money: What Is It and How Did It Come to
Be?
Medium of Exchange
A medium of exchange is an object that is generally
accepted in exchange for goods and services.
In the absence of money, people would need to exchange
goods and services directly, which is called barter.
Barter requires a double coincidence of wants, which is
rare, so barter is costly it requires either much search, or
lots of specialized middle-men.
Money: What Is It and How Did It Come to
Be?
Unit of Account
In a money economy, a person
doesnt have to know the price of an
apple in terms of oranges, pizzas,
chickens, or potato chips, as in a
barter economy. A person needs only
to know the price in terms of money.
A unit of account is an agreed
measure for stating the prices of
goods and services.
This Table illustrates how money
simplifies comparisons.
Because all goods are denominated in
money, determining relative prices is
easy and quick.
Money: What Is It and How Did It Come to
Be?
Store of Value
The store of value function is related to a goods ability to
maintain its value over time. This is the least exclusive
function of money because other goodsfor example,
paintings, houses, and stampscan store value too. At
times, money has not maintained its value well, such as
during high-inflationary periods. For the most part, though,
money has served as a satisfactory store of value.
This function allows us to accept payment in money for our
productive efforts and to keep that money until we decide
how we want to spend it.
Money: What Is It and How Did It Come to
Be?
From a Barter to a Money Economy: The Origins of
Money
How did we move from a barter to a money economy? Did a
king or queen issue an edict: Let there be money? Actually,
money evolved in a much more natural, market-oriented
manner.
Making exchanges takes longer (on average) in a barter
economy than in a money economy because the transaction
costs are higher in a barter economy since it requires double
coincidence of wants.

In a barter economy, some goods are more readily accepted

than others in exchange.
Money: What Is It and How Did It Come to
Be?
From a Barter to a Money Economy: The Origins of
Money
Suppose that, of 10 goods AJ, good G is the most marketable (the
most acceptable) of the 10. On average, good G is accepted 5 of
every 10 times it is offered in an exchange, whereas the remaining
goods are accepted, on average, only 2 of every 10 times.

Given this difference, some individuals accept good G simply because

of its relatively greater acceptability, even though they have no plans
to consume it.

The more people accept good G for its relatively greater acceptability,
the greater its relative acceptability becomes, in turn causing more
people to accept it.
Money: What Is It and How Did It Come to
Be?
From a Barter to a Money Economy: The Origins of
Money

This is how money evolved. When good Gs acceptance

evolves to the point that it is widely accepted for
purposes of exchange, good G is money.

Historically, goods that have evolved into money include

gold, silver, copper, cattle, salt, cocoa beans, and shells.

In many of the World War 2 prisoner of war (POW)

camps, the cigarette was being used as money among
the prisoners.
Money: What Is It and How Did It Come to
Be?
Money, Leisure, and Output
Exchanges take less time in a money economy than in a
barter economy because a double coincidence of wants is
unnecessary: Everyone is willing to trade for money.

The movement from a barter to a money economy therefore

frees up some of the transaction time, which people can use
in other ways.

Some will use them to work, others will use them for leisure,
and still others will divide the available time between work and
leisure.
Money: What Is It and How Did It Come to
Be?
Money, Leisure, and Output
Thus, a money economy is likely to have both more output
(because of the increased production) and more leisure time
than a barter economy.
In other words, a money economy is likely to be richer in both
goods and leisure than a barter economy.

A persons standard of living depends, to a degree, on the

number and quality of goods consumed and on the amount of
leisure consumed. We would expect the average persons
standard of living to be higher in a money economy than in a
barter economy.
Money: What Is It and How Did It Come to
Be?
Finding Economics with William Shakespeare in
London (1595)
It is 1595, and William Shakespeare is sitting at a desk writing the
Prologue to Romeo and Juliet. Where is the economics? More
specifically, what is the connection between Shakespeares writing a
play and the emergence of money out of a barter economy?

For Shakespeare, living in a barter economy would mean writing

plays all day and then going out and trying to trade what he had
written that day for apples, oranges, chickens, and bread.

Would the baker trade two loaves of bread for two pages of Romeo
and Juliet?
 Money: What Is It and How Did It Come to
Be?
Finding Economics with William Shakespeare in London
(1595)
Had Shakespeare lived in a barter economy, he would have soon
learned that he did not have a double coincidence of wants with many
people and that if he were going to eat and be housed, he would need to
spend time baking bread, raising chickens, and building a shelter
instead of thinking about Romeo and Juliet.

In a barter economy, trade is difficult; so people produce for themselves.

In a money economy, trade is easy, and so individuals produce one
thing, sell it for money, and then buy what they want with the money.

A William Shakespeare who lived in a barter economy no doubt spent

his days very differently from the William Shakespeare who lived in
England in the sixteenth century. Put bluntly: Without money, the world
might never have enjoyed Romeo and Juliet.
Money: What Is It and How Did It Come to
Be?
Components of Money
Money consists of
Currency
Deposits at banks and other depository institutions
Currency is the notes and coins held by households and
firms.
Money: What Is It and How Did It Come to
Be?
Official Measures of Money
The two main official measures of money are M1 and M2.
M1 consists of currency and travelers checks and
checking deposits owned by individuals and businesses.
M2 consists of M1 plus time, saving deposits, money
market mutual funds, and other deposits.
Money: What Is It and How Did It Come to
Be?

The figure illustrates

the composition of
M1
and M2.
It also shows the
relative magnitudes of
the components.
Money: What Is It and How Did It Come to
Be?
Are M1 and M2 Really Money?
All the items in M1 are means of payment. They are
money.
Some saving deposits in M2 are not means of payments
they are called liquid assets.
Liquidity of an asset measures how quickly the asset can
be converted into cash (a means of payment) with little/no
loss of value.
Money: What Is It and How Did It Come to
Be?
Deposits are Money but Checks Are Not
In defining money, we include, along with currency, deposits
at banks and other depository institutions.
But we do not count the checks that people write as money.
A check is an instruction to a bank to transfer money.

Credit Cards Are Not Money

Credit cards are not money.
A credit card enables the holder to obtain a loan, but it must
be repaid with money.
Money: What Is It and How Did It Come to
Be?

Always be prudent when using credit cards.

How Banking Developed

Just as money evolved, so did banking.

The Early Bankers

Our money today is easy to carry and transport, but it was not
always so portable.
For example, when money consisted principally of gold coins,
carrying it about was neither easy nor safe.

Gold was not only inconvenient for customers to carry, but it was
also inconvenient for merchants to accept - gold is heavy.
Gold is unsafe to carry around - can easily draw the attention of
thieves.
Storing gold at home can also be risky.
How Banking Developed

The Early Bankers

Most individuals therefore turned to their local goldsmiths for help
because they had safe storage facilities.

Goldsmiths were thus the first bankers. They took in other peoples
gold and stored it for them.

To acknowledge that they held deposited gold, goldsmiths issued

receipts, called warehouse receipts, to their customers.

Once peoples confidence in the receipts was established, they used

the receipts to make payments instead of using the gold itself.

In time, the paper warehouse receipts circulated as money.

How Banking Developed

The Early Bankers

At this stage of banking, warehouse receipts were fully backed by
gold; they simply represented gold in storage.

Goldsmiths later began to recognize that, on an average day, few

people redeemed their receipts for gold. Many individuals traded the
receipts for goods and seldom requested the gold itself.

In short, the receipts had become money, widely accepted for

purposes of exchange.

Sensing opportunity, goldsmiths began to lend some of the stored

gold, realizing that they could earn interest on the loans without
defaulting on their pledge to redeem the warehouse receipts when
presented.
 How Banking Developed

The Early Bankers

In most cases, however, the gold borrowers also preferred warehouse
receipts to the actual gold. Thus the warehouse receipts came to
represent a greater amount of gold than was actually on deposit.

Consequently, the money supply increased, now measured in terms of

gold and the paper warehouse receipts issued by the Goldsmith/bankers.

Thus fractional reserve banking had begun. In a fractional reserve

system, banks create money by holding on reserve only a fraction of the
money deposited with them and lending the remainder. Our modern-day
banking operates within such a system.
Direct and Indirect Finance
Lenders can get together with borrowers directly or indirectly; that is,
there are two types of finance: direct and indirect.

Direct finance
In direct finance, the lenders and borrowers come together in a market
setting, such as the bond market. In the bond market, people who
want to borrow funds issue bonds.
For example, company A might issue a bond that promises to pay an
interest rate of 10 percent annually for the next 10 years. A person with
funds to lend might then buy that bond for a particular price.

The buying and selling in a bond market are simply lending and
borrowing. The buyer of the bond is the lender, and the seller of the
bond is the borrower.
Direct and Indirect Finance

Indirect finance
In indirect finance, lenders and borrowers go through a financial
intermediary, which takes in funds from people who want to save
and then lends the funds to people who want to borrow.

For example, a commercial bank is a financial intermediary, doing

business with both savers and borrowers.

Through one door the savers come in, looking for a place to deposit
their funds and earn regular interest payments. Through another
door come the borrowers, seeking loans on which they will pay
interest.

The bank, or the financial intermediary, ends up channeling the

saved funds to borrowers.
Depository Institutions

A depository institution is a firm that accepts deposits

from households and firms and uses the deposits to make
loans to other households and firms.
The deposits of three types of depository institution are
part of the nations money:
Commercial banks
Thrift institutions
Money market mutual funds
Depository Institutions

Commercial Banks
A commercial bank is a private firm that is licensed to
receive deposits and make loans.
A commercial banks balance sheet summarizes its
business and lists the banks assets, liabilities, and net
worth.
The objective of a commercial bank is to maximize the net
worth of its stockholders, by making profits.
Adverse Selection and Moral Hazard
Problems
When it comes to lending and borrowing, both adverse
selection and moral hazards can arise. Both are the result of
asymmetric information.

Asymmetric information relates to one side of a transaction

having information that the other side does not have.

Suppose Rahima is going to sell her house. As the seller of

the house, she has more information about the house than
potential buyers. Rahima knows whether the house has
plumbing problems, cracks in the foundation, and so on.
Potential buyers do not.
Adverse Selection and Moral Hazard
Problems
The effect of asymmetric information can be either an adverse selection
problem or a moral hazard problem. The adverse selection problem
(hidden type) occurs before the loan is made, and the moral hazard
problem (hidden action) occurs afterward.

Before the loan is made

An adverse selection problem occurs when the parties on one side
of the market, having information not known to others, self-select in
a way that adversely affects the parties on the other side of the
market.

Think of it this way: Two people want a loan. One person is a good
credit risk, and the other is a bad credit risk. The person who is the
bad credit risk is the person more likely to ask for the loan.
Adverse Selection and Moral Hazard
Problems
Before the loan is made
Suppose two people, Selim and Salina, want to borrow Tk. 100,000 ,
and Malek has Tk. 100,000 to lend.
Salina wants to borrow the Tk. 100,000 to buy a piece of equipment for
her small business. She plans to pay back the loan, and she takes her
loan commitments very seriously. She is the Good type.
Selim wants to borrow the Tk. 100,000 so that he can gamble. He will
pay back the loan only if he wins big gambling. He is not the type of
person who takes his loan commitments seriously. He is the Bad type.

Who is more likely to ask Malek for the loan, Selim or Salina?

Selim is because he knows that he will pay back the loan only if he
wins big in gambling; he sees a loan as essentially free money.
Heads, Selim wins; tails, Malek loses!
Adverse Selection and Moral Hazard
Problems
Before the loan is made
If Malek cant separate the good types from the bad types, what can
he do? He might just decide not to give a loan to anyone. In other
words, his inability to solve the adverse selection problem may be
enough for him to decide not to lend to anyone.
At this point, a financial intermediary can help. A bank does not
require Malek to worry about who will and who will not pay back a
loan. Malek needs simply to turn over his saved funds to the bank, in
return for the banks promise to pay him say a 5 percent interest rate
per year.
Then, the bank takes on the responsibility of trying to separate the
good types from the bad ones. The bank will run a credit check on
everyone; the bank will collect information on who has a job and who
doesnt; the bank will ask the borrower to put up some collateral on
the loan; and so on. In other words, the banks job is to solve the
adverse selection problem.
 Adverse Selection and Moral Hazard
Problems
After the loan is made
The moral hazard problem exists when one party to a transaction
changes his or her behavior in a way that is hidden from and costly to
the other party.

Suppose you want to lend some saved funds. You give Selim a Tk.
100,000 loan because he promised you that he was going to use the
funds to help him get through university. Instead, once Selim receives
the money, he decides to use the funds to buy some clothes and take a
vacation to Thailand.

Because of such potential moral hazard problems, you might decide to

cut back on granting loans. You want to protect yourself from borrowers
who do things that are costly to you.
Adverse Selection and Moral Hazard
Problems
After the loan is made
Again, a financial intermediary has a role to play.

A financial intermediary, such as a bank, might try to solve the

moral hazard problem by specifying that a loan can only be
used for a particular purpose (e.g., paying for university).

It might require the borrower to provide regular information on

and evidence of how the borrowed funds are being used,
giving out the loan in installments (Tk. 10,000 this month, Tk.
10,000 next month), and so on.
Financial Regulation

There are four main balance sheet rules:

Capital requirements
Reserve requirements
Deposit rules
Lending rules
How Banks Create Money

To achieve its objective, a bank makes (risky) loans at an

interest rate higher than that paid on deposits.
But the banks must balance profit and prudence; loans
generate profit, but depositors must be able to obtain their
funds when they want them.
Banks funds come from their assets, which we divide into
two important parts: reserves and loans.
Reserves are the cash in a banks vault and the banks
deposits at Federal Reserve Banks.
Bank assets also include buildings and equipment, liquid
assets, investment securities, and loans.
How Banks Create Money

Reserves: Actual and Required

The fraction of a banks total deposits held as reserves is
the reserve ratio.
The required reserve ratio is the fraction that banks are
required, by regulation, to keep as reserves. Required
reserves are the total amount of reserves that banks are
required to keep.
Excess reserves equal total reserves minus required
reserves.
How Banks Create Money

Creating Deposits by Making Loans in a One-Bank

Economy
When a bank receives a deposit of currency, its reserves
increase by the amount deposited, but its required
reserves increase by only a fraction (determined by the
required reserve ratio) of the amount deposited.
The bank has excess reserves, which it loans. These
loans can only end up as deposits in our one and only
bank, where they boost deposits without changing total
reserves, which creates money.
How Banks Create Money

This Figure
illustrates
how one
bank create
money by
making
loans.
How Banks Create Money

The Deposit Multiplier

The deposit multiplier is the amount by which an
increase in bank reserves is multiplied to calculate the
increase in bank deposits.
The deposit multiplier = 1/Required reserve ratio.
How Banks Create Money

Creating Deposits by Making Loans with Many Banks

With many banks, one bank lending out its excess
reserves cannot expect its deposits to increase by the full
amount loaned; some of the loaned reserves end up in
other banks.
But then the other banks have excess reserves, which
they loan.
Ultimately, the effect in the banking system is the same as
if there was only one bank, so long as all loans are
deposited in banks.
 How Banks Create Money

This Figure
illustrates
money creation
with many
banks.
Money, Financial System and
the Economy 7Topic

Part II: Money and the Economy

Money and the Price Level

Classical economists believed that changes in the money supply affect

the price level in the economy. Their position was based on the equation
of exchange and on the simple quantity theory of money.

The Equation of Exchange

The equation of exchange is an identity stating that the money supply
() multiplied by velocity () must be equal to the price level () times
Real GDP ().

where means must be equal to. This is an identity, and an identity is

valid for all values of the variables.
Money and the Price Level

The Equation of Exchange

As we learned in an earlier chapter, velocity is the average number
of times a dollar is spent to buy final goods and services in a year.

For example, assume an economy has only five $1 bills. Suppose

that over the course of the year, the first dollar bill changes hands 3
times; the second, 5 times; the third, 6 times; the fourth, 2 times; and
the fifth, 7 times.

Given this information, we can calculate the average number of

times a dollar changes hands in purchases. In this case, the number
is 4.6, which is velocity.
Money and the Price Level

The Equation of Exchange

In reality, counting how many times each dollar changes hands
is impossible; so calculating velocity as we did in our example is
impossible. In reality, we use a different method.
We compute velocity using the equation of exchange:

Money and the Price Level

The Equation of Exchange

The equation of exchange can be interpreted in different ways:

1. The money supply multiplied by velocity must equal the price level
times Real GDP:

2. The money supply multiplied by velocity must equal GDP:

(because ).

3. Total spending or expenditures of buyers (measured by ) must

equal the total sales revenues of business firms (measured by ):

 Money and the Price Level

From the Equation of Exchange to the Simple Quantity

Theory of Money
The equation of exchange is an identity, not an economic theory. To turn it
into a theory, we make some assumptions about the variables in the
equation. Many eighteenth-century classical economists, as well as
American economist Irving Fisher (18671947) and English economist
Alfred Marshall (18421924), made the following assumptions:

1. Changes in velocity are so small that for all practical purposes velocity
can be assumed to be constant (especially over short periods of time).

2. Real GDP, or , is fixed in the short run.

Money and the Price Level

From the Equation of Exchange to the Simple Quantity

Theory of Money

With these two assumptions, we have the simple

quantity theory of money: If and are constant, then
changes in will bring about strictly proportional
changes in .

In other words, the simple quantity theory of money

predicts that changes in the money supply will bring
about strictly proportional changes in the price level.
Money and the Price Level
Money and the Price Level

From the Equation of Exchange to the Simple Quantity

Theory of Money
How well does the simple quantity theory of money predict?
The answer is that the strict proportionality between changes
in the money supply and changes in the price level does not
show up in the data (at least not very often).

Generally, though, the evidence supports the spirit (or

essence) of the simple quantity theory of money: the higher
the growth rate in the money supply, the greater the growth
rate in the price level.
Money and the Price Level

From the Equation of Exchange to the Simple Quantity

Theory of Money
To illustrate, we would expect that a growth rate in the money
supply of, say, 40 percent would generate a greater increase
in the price level than, say, a growth rate in the money supply
of 4 percent.

Generally, this effect is what we see. For example, countries

with more rapid increases in their money supplies often
witness more rapid increases in their price levels than do
countries that witness less rapid increases in their money
supplies.
Money and the Price Level

The Simple Quantity Theory of Money in an ADAS

Framework
AD curve in the Simple Quantity Theory of Money
Recall that one way of interpreting the equation of exchange is that the
total expenditures of buyers (MV) must equal the total sales of sellers
(). So,

= ().
However,
= + + +

= + + +
Money and the Price Level

The Simple Quantity Theory of Money in an ADAS

Framework
AD curve in the Simple Quantity Theory of Money
At a given price level, anything that changes , , , or changes
aggregate demand and thus shifts the aggregate demand () curve. If
equals + + + , then a change in the money supply ()
or a change in velocity () will change aggregate demand and therefore
lead to a shift in the curve.
In other words, aggregate demand depends on both the money supply
and velocity. But in the simple quantity theory of money, velocity is
assumed to be constant. Thus, only changes in the money supply can
shift the curve.
Money and the Price Level

The Simple Quantity Theory of Money in an ADAS

Framework
The AS curve in the simple quantity theory of money
In the simple quantity theory of money, the level of Real
GDP is assumed to be constant in the short run. The AS
curve is vertical at that constant level of Real GDP.
Money and the Price Level

The Simple Quantity Theory of Money in an ADAS

Framework
AD and AS in the simple quantity theory of money
Money and the Price Level

Dropping the Assumptions that and Are Constant

If we drop the assumptions that velocity () and Real GDP () are
constant, we have a more general theory of the factors that cause
changes in the price level. In this theory, changes in the price level
depend on three variables:

1. Money supply
2. Velocity
3. Real GDP

Lets again start with the equation of exchange:

If the equation of exchange holds, then:

Money and the Price Level

Dropping the Assumptions that and Are Constant

This last equation shows that the price level depends on the money
supply, velocity, and Real GDP.

What kinds of changes in , , and will bring about inflation (an

increase in the price level), ceteris paribus?

Inflationary tendencies: , ,

What will bring about deflation (a decrease in the price level), ceteris
paribus?

Deflationary tendencies: , ,
Monetarism

Economists who call themselves monetarists have not been content to

rely on the simple quantity theory of money. They do not hold that
velocity is constant, nor do they hold that output is constant.

The Four Monetarist Positions

1. Velocity changes in a predictable way
2. Aggregate demand depends on the money supply and on velocity
3. The curve is upward sloping
4. The economy is self-regulating (prices and wages are flexible)
Monetarism

The Four Monetarist Positions

1. Velocity changes in a predictable way

Monetarists do not assume that velocity is constant, but rather that it

can and does change. However, they believe that velocity changes
in a predictable way, that is, not randomly, but in a way that can be
understood and predicted.

Monetarists hold that velocity is a function of certain variablesthe

interest rate, the expected inflation rate, the frequency with which
employees receive paychecks, and moreand that changes in it
can be predicted.
Monetarism

The Four Monetarist Positions

2. Aggregate demand depends on the money supply and on velocity
Just like the Keynesians focus on components of , the Monetarists
focus on the money supply () and velocity (). For example,
Keynesians argue that changes in , , , , or can change aggregate
demand, whereas monetarists argue that and can change aggregate
demand.

3. The curve is upward sloping

In the simple quantity theory of money, the level of Real GDP () is
assumed to be constant in the short run. So the aggregate supply curve is
vertical. According to monetarists, Real GDP may change in the short run,
and therefore the curve is upward sloping.
Monetarism

The Four Monetarist Positions

4. The economy is self-regulating (prices and wages are
flexible)
Similar to Classical economists, Monetarists believe that prices and
wages are flexible. Monetarists therefore believe that the economy
is self-regulating; it can move itself out of a recessionary or
inflationary gap and into long-run equilibrium, producing Natural
Real GDP.
Monetarism

Monetarism and ADAS

Monetarism

Monetarism and ADAS

Monetarism

The Monetarist View of the Economy

According to the diagrams, the monetarists believe that:

The economy is self-regulating.

Changes in velocity and the money supply can change aggregate

demand.

Changes in velocity and the money supply will change the price
level and Real GDP in the short run but only the price level in the
long run.
Monetarism

The Monetarist View of the Economy

We need to make one other important point with respect to
monetarists. Consider this question: Suppose velocity falls and
the money supply rises. Can a change in velocity offset a
change in the money supply?
Monetarists think that this conditiona change in velocity
completely offsetting a change in the money supplydoes not
occur often. They believe (1) that velocity does not change very
much from one period to the next (i.e., it is relatively stable) and
(2) that changes in velocity are predictable.
Monetarism

The Monetarist View of the Economy

So in the monetarist view of the economy, changes in velocity
are not likely to offset changes in the money supply.
Therefore, changes in the money supply will largely determine
changes in aggregate demand and thus changes in Real GDP
and the price level.

According to monetarists, for all practical purposes, an

increase in the money supply will raise aggregate demand,
increase both Real GDP and the price level in the short run,
and increase only the price level in the long run. A decrease in
the money supply will lower aggregate demand, decrease
both Real GDP and the price level in the short run, and
decrease only the price level in the long run.
Inflation

In everyday usage, the word inflation refers to any increase in the price
level. Economists, though, like to differentiate between two types of
increases in the price level: a one-shot increase and a continued
increase.

One-Shot Inflation
One-shot inflation can be thought of as a one-shot, or one-time,
increase in the price level. More precisely, if price level increases but
not on a continued basis, we call the price increase one-shot inflation.
Suppose the CPI for years 1 to 5 is as follows:
Inflation
One-shot inflation: demand-side induced

Price levels that go from 1 to 2 to 3 may seem like more than a one-
shot increase. But because the price level stabilizes (at 3 ), we cannot
characterize it as continually rising. So the change in the price level is
representative of one-shot inflation.
Inflation

One-shot inflation: supply-side induced

Inflation
Continued Inflation
Continued inflation can be demand-side induced (Demand-pull
inflation) or supply-side induced (Cost-push inflation)
Demand-pull inflation is an inflation that results from an initial
increase in aggregate demand.
Demand-pull inflation may begin with any factor that increases
aggregate demand, e.g., increases in the quantity of money,
increases in government purchases, or cuts in net taxes, an
increase in exports etc.

70
 Inflation

Demand-pull inflation
This Figure illustrates
the start of a demand-
pull inflation.
Starting from full
employment, an
increase in aggregate
demand shifts the AD
curve rightward.

71
 Inflation
Demand-pull inflation
Real GDP
increases, the
price level rises,
and an
inflationary gap
arises.
The rising
price level is
the first step
in the
demand-pull
inflation. 72
 Inflation

Demand-pull
inflation
This Figure
illustrates the
money wage
response.
The higher level
of output means
that real GDP
exceeds potential
GDPan
inflationary gap.
73
 Inflation

Demand-pull
inflation
The money
wage rises and
the SRAS curve
shifts leftward.
Real GDP
decreases back
to potential
GDP but the
price level rises
further. 74
 Inflation

Demand-pull
inflation
This Figure
illustrates a
demand-pull
inflation spiral.
Aggregate
demand keeps
increasing and the
process just
described repeats
indefinitely. 75
 Inflation

Demand-pull inflation
Although any of several
factors can increase
aggregate demand to start a
demand-pull inflation, only
an ongoing increase in the
quantity of money can allow
it to continue.
Demand-pull inflation
occurred in the United States
during the late 1960s and
early 1970s.

76
Inflation

Cost-push inflation is an inflation that results from an

initial increase in costs.
There are two main sources of increased costs:
An increase in the money wage rate
An increase in the money price of raw materials, such as
oil.

77
 Inflation

Cost-push inflation
This Figure
illustrates the start
of cost-push
inflation.
A rise in the price
of oil decreases
short-run
aggregate supply
and shifts the
SRAS curve
leftward.
78
 Inflation

Cost-push
inflation
Real GDP
decreases and
the price level
risesa
combination
called stagflation.
The rising price
level is the start
of the cost-push
inflation.
79
Inflation

Cost-push inflation
The initial increase in costs creates a one-shot rise in the
price level, not a continued inflation.
To create continued inflation, aggregate demand must
increase; which can happen because the Government or
the central bank may react to the rise in unemployment by
increasing aggregate demand.

80
 Inflation

Cost-push
inflation
This Figure
illustrates an
aggregate demand
response to
stagflation, which
might arise because
the CB stimulates
demand to counter
the higher
unemployment rate
and lower level of
real GDP. 81
 Inflation

Cost-push
inflation
The increase in
aggregate
demand shifts
the AD curve
rightward.
Real GDP
increases and
the price level
rises again.

82
 Inflation

Cost-push
inflation
This Figure
illustrates a
cost-push
inflation spiral.

83
 Inflation
Cost-push
inflation
If the oil producers raise
the price of oil to try to
keep its relative price
higher, and the Govt. or
the central bank responds
with an increase in
aggregate demand, a
process of cost-push
inflation continues.
Cost-push inflation
occurred in the United
States during 1974
1978.
84
Inflation

Inflation is always and everywhere a monetary

phenomenon
The money supply is the only factor that can continually increase
without causing a reduction in one of the four components of total
expenditures (consumption, investment, government purchases, or
net exports).

This point is important because someone might ask, Cant

government purchases continually increase and so cause continued
inflation? This is unlikely for two reasons.
Inflation
Inflation is always and everywhere a monetary
phenomenon
1. Government purchases cannot go beyond both real and political limits.
The real upper limit is 100 percent of GDP. No one knows what the
political upper limit is, but it is likely to be substantially less than 100
percent of GDP. In either case, once government purchases reach
their limit, they can no longer increase.

2. Some economists argue that government purchases that are not

financed with new money may crowd out one of the other expenditure
components. For example, for every additional dollar government
spends on public education, households may spend $1 less on private
education.
Inflation

Inflation is always and everywhere a monetary

phenomenon
The emphasis on the money supply as the only factor that can
continue to increase and thus cause continued inflation has led
most economists to agree with Nobel Laureate Milton Friedman
that inflation is always and everywhere a monetary phenomenon.
Inflation
Can You Get Rid of Inflation with Price Controls?
Say, in country A, the government uses price control to stem
inflation. Price ceilings (price control mechanism) are always set
below equilibrium price.

So, if the government has set up price ceiling say for good at $4
where the equilibrium price is $8 then there will be a shortage for
good , and very likely, people will line up to buy it. Lets say that, on
average, 25 people stand in line. If the price goes up to say $12 but
the price ceiling for the good remains set at $4, people will continue
to line up to buy the good, but now the lines will be longer. The
average line may stretch out to, say, 50 people.

So how is inflation felt in a country that imposes and maintains price

ceilings? The answer is in the length of the lines of people: the
longer the lines, the higher the inflation rate.
Money and Interest Rates

What Economic Variables Does a Change in the Money

Supply Affect?
Money supply can affect interest rates, but to understand how, we
need to review how the money supply affects different economic
variables.

Changes in the money supply (or changes in the rate of growth of

the money supply) can affect:

1. The supply of loans.

2. Real GDP.
3. The price level.
4. The expected inflation rate.
Money and Interest Rates

What Economic Variables Does a Change in the Money

Supply Affect?
1. Money and the Supply of Loans
When the Central Bank (CB) undertakes an open market purchase
(buy government bonds from commercial banks), reserves in the
banking system increase. With greater reserves, banks can extend
more loans raising money supply. In other words, as a result of the
CBs conducting an open market purchase, the supply of loans rises.
Similarly, when the Fed conducts an open market sale (sell government
bonds to commercial banks), the supply of loans decreases, i.e.,
money supply decreases. So, money supply and supply of loans go
hand in hand.
Money and Interest Rates
What Economic Variables Does a Change in the Money
Supply Affect?
2. Money and Real GDP
In the short run, an increase in the money supply shifts the AD curve
rightward increasing real GDP. Similarly, in the short run, a decrease in
the money supply produces a lower level of Real GDP
 Money and Interest Rates
What Economic Variables Does a Change in the Money Supply
Affect?
3. Money and the Price Level
An increase in the money supply shifts the curve rightward from 1 to 2 .
In the short run, the price level in the economy moves from 1 to 2 . In the long
run, the economy is at point 3, and the price level is 3 . Panel (b) shows how a
decrease in the money supply affects the price level.
Money and Interest Rates
What Economic Variables Does a Change in the Money
Supply Affect?
4. Money and the Expected Inflation Rate
Many economists say that because the money supply affects the price
level, it also affects the expected inflation rate, which is the inflation rate
that you expect. Changes in the money supply affect the expected
inflation rate, either directly or indirectly. The equation of exchange
indicates that the greater the increase in the money supply is, the
greater the rise in the price level will be. And we would expect that the
greater the rise in the price level is, the higher the expected inflation
rate will be, ceteris paribus. For example, we would predict that a
money supply growth rate of, say, 10 percent a year generates a
greater actual inflation rate and a larger expected inflation rate than a
money supply growth rate of 2 percent a year.
 Money and Interest Rates
The Money Supply, the
Loanable Funds Market, and
Interest Rates
The demand for loanable funds ( )
is downward sloping, indicating that
borrowers will borrow more funds as
the interest rate declines. The supply
of loanable funds ( ) is upward
sloping, indicating that lenders will
lend more funds as the interest rate
rises. The equilibrium interest rate (1 )
is determined through the forces of
supply and demand. If there is a
surplus of loanable funds, the interest
rate falls; if there is a shortage of
loanable funds, the interest rate rises.
Money and Interest Rates

The Money Supply, the Loanable Funds Market,

and Interest Rates
Anything that affects either the supply of or the demand for
loanable funds will obviously affect the interest rate. All four
of the factors that are affected by changes in the money
supplythe supply of loans, Real GDP, the price level, and
the expected inflation rateaffect either the supply of or
demand for loanable funds.
Money and Interest Rates

The Money Supply, the

Loanable Funds Market,
and Interest Rates
The Supply of Loans:
A CB open market purchase
increases reserves in the banking
system and therefore increases the
supply of loanable funds. As a
result, the interest rate declines.
This change in the interest rate due
to a change in the supply of
loanable funds is called the
liquidity effect.
Money and Interest Rates
The Money Supply, the Loanable Funds Market, and
Interest Rates
Real GDP:
A change in Real GDP affects both the supply of and the demand for
loanable funds. When Real GDP rises, peoples wealth is greater.
When people became wealthier, they often demand more bonds.
Demanding more bonds (buying more bonds), however, is nothing
more than lending more money to others. So, as Real GDP rises, the
supply of loanable funds increases.

When Real GDP rises, profitable business opportunities arise all

around, and businesses issue or supply more bonds to take
advantage of those opportunities. But supplying more bonds is nothing
more than demanding more loanable funds. So, when Real GDP
rises, corporations issue or supply more bonds, thereby demanding
more loanable funds.
Money and Interest Rates

The Money Supply, the

Loanable Funds Market,
and Interest Rates
Real GDP:
In summary, when Real GDP
increases, both the supply of and
the demand for loanable funds
increase. The overall effect on the
interest rate is that, usually, the
demand for loanable funds
increases by more than the supply
so that the interest rate rises. The
change in the interest rate due to a
change in Real GDP is called the
income effect.
Money and Interest Rates

The Money Supply, the

Loanable Funds Market,
and Interest Rates
The Price Level:
When the price level rises, the
purchasing power of money falls.
People may therefore increase their
demand for credit or loanable funds
to borrow the funds necessary to
buy a fixed bundle of goods. This
change in the interest rate due to a
change in the price level is called
the price-level effect.
Money and Interest Rates

The Money Supply, the Loanable Funds Market, and

Interest Rates
The Expected Inflation Rate:
Suppose the expected inflation rate is zero and that when the expected
inflation rate is zero, the equilibrium interest rate is 6%. Now suppose
the expected inflation rate rises from 0% to 4%. What will this rise in the
expected inflation rate do to the demand for and supply of loanable
funds?
As inflation is expected to rise in the future, households and firms will
want to buy more goods and services now, thus raising demand for
loanable funds shifts to the right.
Lenders on the other hand will know that if they lend today and price
level increases tomorrow then the money they will get back tomorrow
will have less value than today. Therefore, they will be willing to lend
each dollar (or taka) at higher interest rate shifts to the left.
 Money and Interest Rates
The Money Supply, the
Loanable Funds Market,
and Interest Rates
The Expected Inflation Rate:
Thus an expected inflation rate of
4 percent increases the demand
for loanable funds and decreases
the supply of loanable funds. So
the interest rate is 4 percent higher
than it was when the expected
inflation rate was zero. A change in
the interest rate due to a change in
the expected inflation rate is
referred to as the expectations
effect or Fisher effect, after
economist Irving Fisher.
Money and Interest Rates
Money and Interest Rates

What Happens to the Interest Rate as the Money

Supply Changes?
Suppose:
Point 1 in Time: CB says it will increase the growth rate of the
money supply.

Point 2 in Time: If the expectations effect kicks in immediately,

then

Point 3 in Time: Interest rates rise.

At point 3 in time, a natural conclusion is that an increase in the rate of

growth in the money supply raises the interest rate. The problem with
this conclusion, though, is that not all the effects (liquidity, income, etc.)
have occurred yet.
Money and Interest Rates
What Happens to the Interest Rate as the Money
Supply Changes?
In time, the liquidity effect puts downward pressure on the interest rate.
Suppose,

Point 4 in Time: Liquidity effect kicks in.

Point 5 in Time: As a result of what happened at point 4, the interest

rate drops. The interest rate is now lower than it was at point 3.

Then, someone at point 5 in time could say, Obviously, an increase in

the rate of growth of the money supply lowers interest rates.

The main idea is that a change in the money supply affects the
economy in many ways. The timing and magnitude of these effects
determine the changes in the interest rate.
Money and Interest Rates

The Nominal and Real Interest Rates

Nominal interest rate is the growth rate of your money whereas Real
interest rate is the growth rate of your purchasing power.

Fisher effect: Approximation

nominal interest rate = real interest rate + expected inflation rate

= + or =

Example: = 9%, = 6%

= = 9% 6% = 3%

In words, the real rate of interest is the nominal rate reduced by the
loss of purchasing power resulting from inflation.
Money and Interest Rates
Fisher effect: Exact
Growth factor of your purchasing power, 1 + , equals the growth factor
of you money, 1 + , divided by the new price level, that is, 1 + times
its value in the previous period. Therefore, the exact relationship would
be

1 + = (1 + )/(1 + )

= ( ) / (1 + )

= (9% 6%) / (1.06)

= 2.83%

Empirical Relationship
Inflation and nominal interest rates move closely together.