Chapter 4 – Money & Inflation
Recall that classical theory assumes flexible prices (accurate in LR, but prices sticky in SR)
4.1 – What is Money?
Money: stock of liquid financial assets that can be readily used to make transactions. The dollars in
the hands of the public make up the nation’s stocks of money.
Barter economy (double coincidence of wants): permits simple transactions requires the unlikely
chance of 2 people having a good that the other wants at right time & place
Functions of Money
1. Store of value
o Way to transfer purchasing power from the present to future (holding money for later use)
o Imperfection: the value of money changes (although people still hold money anyway)
2. Unit of account
o Money = unit used to measure economic transactions, to quote prices & record debts
o Resources are allocated according to relative prices (prices of goods relative to other goods),
yet stores post their prices in dollars and cents.
3. Medium of exchange
o Money = used to buy goods/services “this note is legal tender” printed on Canadian bills
o Liquidity: ease with which an asset can be converted into the medium of exchange & used.
Money is NOT
1. Income: income is a flow of purchasing power, while money is a stock of purchasing power
2. Wealth; money and wealth are both stocks, but wealth includes all assets (including money)
Types of money
Fiat money (the norm): has no intrinsic value; established as money by government decree (fiat)
Commodity money: historically, most societies have used a commodity with some intrinsic value for
money. The most widespread example is gold standard: when people use gold as money, the
economy is on a gold standard
Development of Fiat Money
Regardless of stage of an economy’s development, one form of commodity money arises to
facilitate exchange: people are willing to accept commodity currency due to intrinsic value
In an economy where people carry gold, exchange only happens when the seller is convinced that
the weight and purity of the gold are right
Government gets involved to reduce transaction costs. Using raw gold is costly (to verify purity &
measure quantity). So the government mints gold coins of known purity & weight
Government accepts gold from public in exchange for gold certificates (paper that can be redeemed
for certain amount of gold). So bills are just as valuable (& lighter!) as actual gold.
Eventually, nobody carries gold and the government bills become the monetary standard
In the end, the use of money in exchange is largely a social convention.
How the Quantity of Money is Controlled
Money supply: quantity of money (or, in some cases, commodity) available in an economy.
- In a fiat money system, legal restrictions give the government a monopoly on printing of money.
control over the money supply is called monetary policy delegated to a partially independent
institution (Bank of Canada). Each bill is signed by the Governor of the Bank of Canada.
Money supply is a product of the monetary base. Monetary policy is imprecise: the Bank can’t directly control the size of money multiplier.
Minister of Finance communicates the overall desires of the government to the Governor of the
Bank, and the Governor implements those broad instructions on a daily basis.
For 15 years, the mandate for monetary policy has been that the Governor issue enough money to
ensure that the Canadian annual inflation rate stays within target range of 1-3%
If the government lost confidence in the Governor, it must issue detailed written instructions
concerning the changes it wants. If the Governor feels that these instructions are inappropriate, he
resigns. But the Governor has power (governments don’t want resignation unless it is sure it can
defend itself under the scrutiny of the public.)
Open-market operations: the purchase and sale of government bonds (mostly SR bonds: treasury
bills) primary way in which the Bank attempts to control money supply
- Buy government bonds from the public to increase money supply, and vice versa
How the Quantity of Money is Measured
Quantity of money: quantity of the stock of assets used for transactions. It includes:
1. Currency: the most obvious asset to include in the quantity of money
2. Demand deposits: funds people hold in their chequing accounts. If most sellers accept personal
cheques, assets in a chequing account are almost as convenient as currency.
Credit cards are not a method of payment; they defer payment. When you later repay the bank and
pay your credit card bill, you write a cheque (this is what counts).
Debit cards count since it allows users immediate access to deposits
There are 5 measures of the money stock that the Bank calculates for the economy, and there’s a
list of which assets are included in each measure. From smallest to largest, the measures are B, M1,
M2, M2+, and M3. The most common ones are M1 and M2+.
M1: currency and chequable deposits of individuals and businesses. Excludes currency held by banks,
or currency and chequable deposits of the government of Canada
M2: consists of M1 + all other deposits the deposits in M2 that are not means of payment are
easily converted into a means of payment (currency or chequable deposits).
Disagreements about monetary policy arise because different measures of money are moving in
different directions; but usually the measures normally move together
4.2 – The Quantity Theory of Money
Leading explanation for how money affects the economy in the LR
Transactions and the Quantity Equation
The quantity of money in economy is related to # dollars exchanged in transactions, since the more
money we need for transactions, the more money we hold.
Quantity equation: link transactions & money; money*velocity=price*transactions (MV=PT)
right side tells about transactions; left side tells us about the money used to make the transactions
- T = total # of transactions (goods/services exchanged for money) during a period of time
- P = price of a typical transaction (# of dollars exchanged) or P = the GDP deflator
- The product PT = total # dollars exchanged in that time period
- M is the quantity of money
- V = transactions velocity of money: measures the rate at which money circulates in the economy;
# of times a dollar bill changes hands in a given period.
The equation is an identity: if one variable changes, 1 or more of the others must also change
Suppose we had only one final good: beer and 100 bottles were sold each day. If the price of beer
was $1.25 and the supply of money was $50 $50 × V = $1.25 × 100V $125/50 = V = 2.5 From Transactions to Income
The first equation uses T, which is hard to measure. So we replace T with total output Y.
- Not exactly the same, because selling a used car counts as T but not a Y
If Y = amount of output and P = price of 1 unit of output, the dollar value of the output is PY.
MV = PY money x velocity = price x output = nominal GDP (PY)quantity equation
- V here = income velocity of money: # of times a $bill enters someone’s income in a period
If we assume that V is constant, then the quantity equation = quantity theory of money
- Then, change in quantity of money M causes a proportionate change in PY (nominal GDP)
productivity of economy determines real GDP; quantity of money determines nominal GDP
Money Demand Function & the Quantity Equation
M/P =real money balances (RMB): measure the purchasing power of the stock of money.
- If quantity of money is $10, & price of bread is $0.5, then RMB = 20 loaves.
Money demand function: shows the determinants of the quantity of real money balances people
wish to hold. A simple money demand function is (M/P) = kY d
- k: a constant; tells us how much money people want to hold for every dollar of income.
- Equation states that QD of RMB is proportional to real income
- The function is like demand for a particular good; the good here = convenience of holding RMB
If we assume that quantity demanded for RMB = supply M/P, then M/P = kY, which is M(1/k) = PY,
which means MV = PY (quantity equation) 1/k = V When people want to hold a lot of money
for each dollar of income (k is large), money changes hands infrequently (V is small).
Money, Prices, and Inflation
The theory has 3 building blocks
1. The FoP and the production function determine the level of output Y.
2. The money supply determines the nominal value of output, PY. (assume V is fixed)
3. price level P is then the ratio of the nominal value of output, PY, to the level of output Y
If we assume that Y is fixed (due to fixed K & L) it implies that in LR, levels of real GDP & employment
are independent of M M is neutral in LR, so nominal GDP can adjust only if P changes. Hence
quantity theory implies that the P is proportionate to money s