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Money and Inflation.docx

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ECON 2000
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Money and Inflation • Inflation = overall increase in prices • Rate of inflation = the percentage change in overall level of prices (must be ongoing) • Hyperinflation = extraordinarily high inflation What is Money? • Money = stock of liquid financial assets that can be readily used to make transactions (i.e. dollars in hands of public = nation’s stock of money) Functions of Money • Money has three purposes 1. Store of value  Money is a way of transferring purchasing power from present to future  Imperfect store of value = if prices are rising, the amount you can buy with any money falls 2. Unit of account  Money provides the terms in which prices are quoted and debts are recorded  Money is the unit in which economic transactions are measured 3. Medium of exchange  Money is what we use to buy goods and services  Liquidity = the ease with which an asset can be converted into a medium of exchange and used to buy other things  Money is the most liquid asset • Barter economy = requires a double coincidence of wants  This means that both people have a good that the other wants at the right time and place to make an exchange  Only simple transactions can occur • Money makes indirect transactions possible Types of Money • Fiat money = money that has no intrinsic value (i.e. dollar bills and coins)  Given value through government decree  Norm of most societies • Commodity money = money that has intrinsic value (i.e. gold)  Gold standard = using gold as money The Development of Fiat Money How Quantity of Money is Controlled • Money supply = quantity of money available in economy  System of commodity money = money supply is quantity of that commodity  System of fiat money = government controls supply of money: legal restrictions give government a monopoly on printing of money • Monetary policy = the government’s control over money supply • Central bank = controls monetary policy • Central bank in Canada = Bank of Canada • Power of monetary policy decisions rests with federal cabinet • Minister of Finance communicates the desires of the government to Governor of Bank and Governor has to implement these instructions on a daily basis • Recently, money in Canada should be supplied to keep inflation between 1 – 3% • Governor of Bank cannot get fired easily and has enough power to influence policy as they have to explain why they are resigning by providing proof of the government’s inappropriate policy • Open – market operations = the primary way the government tries to control supply of money  It is the purchase and sale of government bonds  To increase supply of money, government uses dollars to buy Canadian bonds from public (increases supply of dollars in circulation)  To decrease supply of money, BOC sells some of its government bonds (decreases supply of dollars in circulation) • BOC also tries to adjust government’s deposits at chartered banks • Money supply = monetary base (BOC controls) and money multiplier (depends on behaviour of chartered banks and their customers – BOC has no control) How Quantity of Money is Measured • Money is a stock of assets used for transactions therefore, the quantity of money is the quantity of those assets • People use various assets to make transactions (i.e. cash or cheques) • Numerous ways to count quantity of money • Currency = sum of outstanding paper money and coins  Used in day to day transactions as a medium of exchange • Demand deposits = funds people hold in their checking accounts  If seller accepts personal cheques, they are almost as convenient as currency • Currency and demand deposits are added together when measuring quantity of money  Both can be easily used in their original form for a transaction • By including demand deposits, other assets can also be included in quantity of money like: savings accounts, accounts in trust companies, etc. • There are various measures available to count the quantity of money • Disagreements in monetary policy can occur because of the different measures of quantity of money  The different measures cause money to move in different directions but the different measures usually move together  This means that there is a consensus on whether the money is growing quickly or slowly The Quantity Theory of Money • Determines how money affects the economy in the long run Transactions and Quantity Equation • People hold money to buy goods or services • More money needed for transactions , the more money they hold • Quantity of money in economy = the number of dollars exchanged in transactions • Quantity equation: M * V = P * T  Money * velocity = price * transactions  T = the total number of transactions during some period of time (i.e. the number of times in a year that goods are exchanged for money)  P = price of typical transaction (i.e. number of dollars exchanged)  PT = number of dollars exchanged in a year  M = quantity of money  V = transactions velocity of money - measures the rate at which money circulates in economy (i.e. the number of times a dollar bill changes hand in a given period of time)  If velocity is made constant, then a change in money supply must affect price or transaction From Transaction to Income • First equation is often used because it’s difficult to measure the number of transactions • T is replaced with Y (output) • Transactions is similar to output (the more goods produced, the more goods are bought)  Not the same as used goods and other anomalies are not included in current GDP  Doesn’t matter because dollar value of transactions roughly equals dollar value of output • PY = dollar value of output • Y = real GDP • P = GDP deflator • PY = nominal GDP • M * V = P* Y  Money * Velocity = Price * Output  Y also = total income  V also = income velocity of money (i.e. the number of times a dollar bill enters someone’s income in a given period of time) The Money Demand Function and Quantity Equation • M / P = real money balances  Measures the purchasing power of the stock of money • Money demand function = shows the determinants of the quantity of real money balances people wish to hold d  (M / P) = kY  k = constant that tells us how much money people want to hold for every dollar of income  Equation states that quantity of real money balances demanded = real income  Money demand function = demand function for the convenience of holding real money balances  Higher income = higher demand for goods = higher demand for real money balances • (M / P) = M / P  M / P = Ky  M (1 / k) = PY  MV = PY (V = 1/k)  This shows link between demand of money and velocity of money  When people want to hold a lot of money from their income (k is large) then money changes hand infrequently (v is small)  When people want to hold little money from their income (k is small) then money changes hands frequently (v is large) TheAssumption of Constant Velocity • Quantity equation = defines velocity (V) as ration of nominal GDP (PY) to quantity of money (M) • Assume velocity is constant allows us to determine effects of money  This is called quantity theory of money • MV = PY • If velocity is fixed = the quantity of money determines the dollar value of economy’s output  Change in M causes a proportional change in PY Money, Prices, and Inflation • The theory has three building blocks: 1. Factors of production and production function determine the level of output Y. 2. The money supply determines the nominal value of output (PY) 3. The price level (P) is then the ratio of the nominal value of output (PY) to level of output (Y) • Productive capability of economy determines real GDP, the quantity of money determines nominal GDP, and GDPdeflator is ratio of nominal GDPto real GDP • Any change in money supply (M) done by BOC = proportional change in nominal GDP (PY) • Since real GDP (Y) is determined by production function and factors of production, nominal GDP can only adjust through price level changes • Changes in M = Changes in P • Theory of price level = theory of inflation rate • % ∆ in M + % ∆ in V = % ∆ in P + % ∆ in Y  % ∆ in M = under control of BOC  % ∆ in V = reflects shift in money demand (velocity is constant = 0)  % ∆ in P = inflation rate (we have to explain)  % ∆ in Y = depends on growth in factors of production and on technological progress (is given) • Growth in money supply determines rate of inflation  The quantity theory of money states that BOC controls money supply and controls inflation rate  If BOC keeps money supply stable, price level will be stable (inflation will be stable)  If BOC increases money supply, price level will increase (inflation will increase) Seigniorage: The Revenue from Printing Money • Government spends money to buy goods and to make transfer payments • Government can finance spending in 3 ways: 1. Raise revenue through taxes 2. Borrow from public by selling government bonds 3. Print money (i.e. sell bonds to BOC and have BOC issue new money to pay for bonds) • Seigniorage = the revenue raised from printing money • When money is printed for revenue, it increases money supply • Increasing money supply leads to increase in inflation  Known as inflation tax • The holder of money pays the inflation tax  When more money is printed, the money in the holder’s hands become less valuable (tax is applied on holding money) • Hyperinflation occurs when countries depend on seigniorage for revenue Inflation and Interest Rates Two Interest Rates: Real and Nominal • Nominal interest rate = the interest rate that the bank pays • Real interest rate = increase in purchasing power π • r = i -  i = nominal interest rate  r = real interest rate π  = inflation rate Fisher Effect π • Fisher equation: i = r + • Fisher equation = shows nominal interest rate can change for two reasons: 1. Because real interest rate changes 2. Because inflation rate changes • Real interest rate adjusts saving and investment to equilibrium • Quantity theory of money states rate of money growth determines inflation • Quantity theory and Fisher equation explains how money growth affects nominal interest rate  An increase in rate of money growth of 1% causes a 1% increase in rate of inflation (quantity theory)  A1% increase in rate of inflation causes a 1% increase in nominal interest rate (Fisher equation) • Fisher Effect = one for one relation between inflation rate and nominal interest rate Two Real Interest Rates: ExAnte and Ex Post • Ex ante real interest rate = the real interes
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