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QuestionsWhat do economists mean by“money”?Why is money useful?What do economists mean when they say that money is a unit of account?What determines the price level and the inflation rate?1Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.QuestionsWhy would a government ever generate“hyperinflation”?What determines the level of money demand?What determines the level of the money supply?Why is inflation seen as something to be avoided?2Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.InflationIn the 1970s,the United States experienced an episode of relatively mild inflationprices rose between five and ten percent per yearcaused significant economic and political traumaavoiding a repeat of the inflation of the 1970s remains a major goal of economic policy3Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 8.1-Post-World War II Inflation in the United States,1951-20004Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Flexible-Price ModelThe Classical dichotomy implies that real variables(real GDP,real investment spending,or the real exchange rate)can be analyzed and calculated without considering nominal variables(price level)money is“neutral”This is a special feature of the full-employment flexible-price model5Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Moneyis wealth that is held in a readily-spendable formis made up ofcoin and currencychecking account balancesother assets that can be turned into cash or demand deposits nearly instantaneously,without risk or cost6Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Usefulness of MoneyWithout money,market transactions would have to be performed through barterIn a barter economy,market exchange would require the coincidence of wantsyou would have to have some good or service that someone wants and he or she would have to have some good or service that you want7Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 8.2-Coincidence of Wants8Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Usefulness of MoneyMoney also serves as a unit of accountmoney is used as a yardstick to measure value or quote pricesAnything that alters the real value of money in terms of its purchasing power will also alter the real terms of existing contracts that use the money as a unit of account9Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Demand for MoneyBusinesses and households have a demand for moneythey want to hold a certain amount of wealth in the form of readily-spendable purchasing power to carry out transactionsa higher level of spending means a larger money demandThere is a cost of holding moneycash and checking deposits earn little or no interest10Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 8.3-Reasons for and Opportunity Cost of Holding Money11Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Quantity Theory of Moneyassumes that the only important determinant of the demand for money is the flow of spendingcan be summarized usingthe Cambridge money-demand functionthe quantity equation12Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Quantity Theory of Money(P Y)represents the total nominal flow of spendingM is the quantity of moneyV is a measure of how fast money moves through the economyhow many times the average unit of money is used to buy a final good or service13Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 8.4-The Velocity of Money14Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Determining the Price LevelIn the flexible-price model of the macroeconomyreal GDP(Y)is equal to potential GDP(Y*)the velocity of money is determined by the sophistication of the banking systemthe money supply is determined by the central bank15Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Determining the Price LevelIf the price level is higher than the quantity equation predictshouseholds and businesses will have less wealth in the form of money than they wishthey will cut back on purchasessellers will note demand is weak and lower prices16Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Determining the Price LevelIf the price level is lower than the quantity equation predictshouseholds and businesses will have more wealth in the form of money than they wishthey will increase purchasessellers will note demand is strong and raise prices17Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Determining the Price LevelExample(third quarter of 1998)real GDP=$7,566 billionmoney stock=$1,072 billionvelocity=7.964In the third quarter of 1998,the price level was equal to 112.84%of its 1992 level18Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Money StockThe Federal Reserve determines the money stock in the U.S.the determination of the money stock is the basic task of monetary policyThe Federal Reserve can directly impact the monetary basethe sum of currency in circulation and deposits at the Federal Reserves twelve branches19Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Money StockTo reduce the monetary base,the Federal Reserve sells short-term government securitiesTo increase the monetary base,the Federal Reserve buys short-term government securitiesThese transactions are called open market operations20Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 8.5-Open Market Operations21Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Money StockThe Federal Reserve directly controls the monetary baseThe other measures of the money stock are determined by the interaction of the monetary base with the banking sectorregulatory requirementsthe incentive of financial institutions to have enough funds on hand to satisfy depositors demands22Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Money StockBesides the monetary base(H),there are other definitions of the money stock such asM1(currency,checking accounts,travelers checks)M2(M1 plus savings accounts,small term deposits,money held in money market accounts)M3(M2 plus large term deposits and institutional money market balances)23Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Table 8.1-Measures of the Money Stock24Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.InflationThe inflation rate is the proportional rate of change in the price levelSincethe inflation rate()will bev=growth rate of velocitym=growth rate of the money stocky=growth rate of real GDP25Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.InflationExamplegrowth rate of real GDP=4%per yeargrowth rate of velocity=2%per yeargrowth rate of the money stock=5%per year26Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.InflationThe bulk of changes in the rate of inflation are due to changes in the growth rate of the money stockthe growth rate of the money stock(m)can change quickly and substantiallychanges in the growth rates of real GDP(y)and velocity(v)are generally smaller27Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.InflationIn the real world,inflation is not always proportional to money growthin the 1980s,both inflation and velocity fell sharply but the money stock grewin the first half of the 1990s,velocity fellmeant that high growth of the money stock did not lead to high inflationin the second half of the 1990s,velocity grewmoney supply growth was negative to keep inflation from rising28Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 8.6-Money Growth and Inflation Are Not Always Parallel29Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Money DemandEconomic theory implies that money demand should be inversely related to the nominal interest ratecash and checking account balances earn little or no interestthe purchasing power of money erodes at the rate of inflationthe expected real return on money is-e30Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Money DemandThe opportunity cost of holding money is the difference between the rate of return on other assets(r)and the rate of return on money(-e)the opportunity cost of holding money is the nominal interest rate i=r+eAs the opportunity cost of holding money(i)rises,the quantity of money balances demanded falls31Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 8.7-Money Demand and theInflation Rate32Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Money DemandThe velocity of money can be represented byVL represents the financial technology-driven trend in velocityV0+Vi(r+e)represents the dependence of the demand for money on the nominal interest rate33Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Money DemandThe demand for nominal money balances is34Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Money,Prices,and InflationSuppose that the rate of growth of the money stock permanently increasesthe inflation rate will riseif the real interest rate is stable,the opportunity cost of holding money will risethe velocity of money will increaseif the money stock and real GDP remain fixed,the price level will jump suddenly and discontinuously35Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 8.8-Effects of a Rise in Money Growth36Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Costs of InflationThe costs of expected inflation are smallrequires you to make more trips to the bankfirms must spend resources changing their priceshouseholds find it difficult to determine a good deal from a bad oneour tax laws are not designed to deal well with inflation37Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Costs of InflationThe costs of unexpected inflation are more significantredistributes wealth from creditors to debtorscreditors receive less purchasing power than they had anticipateddebtors find the payments they must make less burdensome than they had expected38Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Hyperinflationoccurs when inflation rises to more than 20 percent per montharises when governments attempt to obtain extra revenue by printing moneyfinancing its spending by levying a tax on holdings of cashknown as an inflation tax39Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 8.9-The Inflation Tax40Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.HyperinflationEventually prices rise so rapidly that the monetary system breaks downpeople would rather deal in barter termsReal GDP begins to fallthe economy loses the benefits of the division of laborIn the end,the currency becomes worthless41Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Chapter SummaryBy“money”economists mean something special:wealth in the form of readily-spendable purchasing powerWithout money it is hard to imagine how our economy could successfully functionthe fact that everyone will accept money as payment for goods and services is necessary for the market economy to function42Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Chapter SummaryMoney is not only a medium of exchange,it is also a unit of account:a yardstick that we use to measure values and to specify contracts43Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Chapter SummaryMoney demand is determined bybusinesses and households desire to hold wealth in the form of readily-spendable purchasing power to carry out transactionsbusinesses and households recognition that there is a cost to holding moneywealth in the form of readily-spendable purchasing power pays little or no interest44Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Chapter SummaryThe velocity of money is how many transactions a given piece of money manages to facilitate in a yearthe principal determinant of velocity is the economys“transactions technology”The stock of money is determined by the central bankthe Federal Reserve in the U.S.45Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Chapter SummaryThe price level is equal to the money stock times the velocity of money divided by the level of real GDPThe inflation rate is equal to the proportional growth rate of the money stock plus the proportional growth rate of velocity minus the proportional growth rate of real GDP46Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Chapter SummaryGovernments cause hyperinflation because printing money is a way of taxing the public,and a government that cannot tax any other way will be strongly tempted to resort to it47Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.
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