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Money and Inflation

Define money and explain its functions.

Explain how the Federal Reserve changes the money supply.

Describe and use the quantity theory of money.

Discuss the relationships among the growth rate of money, inflation, and nominal interest rates.

Explain the costs of a monetary policy that allows positive inflation.

Explain the causes of hyperinflation.

Explain how to derive the formula for the money multiplier.

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Learning Objectives
After studying this chapter, you should be able to:
7.1
7.2
7.3
7.4

7.5
7.6
7.A

What can you buy with $100 trillion?

1923 Germany and 2009 Zimbabwe faced hyperinflation, inflation of over 50% per month.

In Germany in 1923, paper currency was used to fuel stoves instead of wood or coal.

Money supply rose from 1.3 billion marks to 497 “billion billion” during 1923.

In Zimbabwe in 2009, paper currency became so worthless that the Zimbabwean government abandoned it in favor of the U.S. dollar.

In 2008, a tourist received a bill of $1,243,255,000,000 Zimbabwean dollars: dinner, two beers, and a mineral water.

Inflation was 15 billion percent in 2008.

Venezuela!

Even moderate inflation reduces the purchasing power of money over time.

3% inflation over 30 years would mean something that cost $1 today would cost $2.43 in 30 years.

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The Federal Reserve’s actions during the financial crisis of 2007-2009 led some economists and policymakers to worry that the inflation rate in the United States would be increasing.

What is the connection between changes in the money supply and the inflation rate?

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Key Issue and Question

Issue:

Question:

Money and inflation

In this chapter, we focus on behavior of nominal variables.

Real GDP and real GDP per hour worked are “real” variables.

Price levels, inflation rates, and nominal interest rates are “nominal” variables.

In the long run, there is a separation between nominal and real variables: the classical dichotomy.

Classical dichotomy The assertion that in the long run, nominal variables, such as the money supply or the price level, do not affect real variables, such as the levels of employment and real GDP.

This implies, for example, money neutrality: in the long run, changes in the money supply have no effect on real variables.

Not neutral in the short run, however.

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Define money and explain its functions.

7.1

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Learning Objective

What is money, and why do we need it?

Central banks like the Federal Reserve try to control the rate of inflation.

In the long run, the inflation rate is determined by the growth rate of the money supply.

Barter economies exist in the early stages of economic development.

Barter occurs where individuals trade goods directly with one another.

Problem occurs when a double coincidence of wants is lacking.

High transactions costs exist in barter economies.

Money reduces transactions costs and allows individuals to take advantage of specialization, yielding higher productivity, and higher incomes.

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The functions of money

Money has particular functions that we must understand in order to understand why we need money.

Medium of exchange Something that is generally accepted as payment for goods and services.

Unit of account A way of measuring value in an economy in terms of money; a function of money.

Store of value The accumulation of wealth by holding dollars or other assets that can be used to buy goods and services in the future; a function of money.

Standard of deferred payment An asset that facilitates transactions over time; a function of money.

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Money as a medium of exchange

To be considered money, an asset must fulfill the functions on the previous slide.

An asset can be used effectively as a medium of exchange only if it is:

Acceptable to most people.

Standardized in terms of quality, so all units are identical

Durable, so value is not quickly lost

Valuable relative to its weight

Divisible, since prices can vary

There are two types of assets with these characteristics: commodity money and fiat money.

Commodity money A good used as money that has value independent of its use as money.

Fiat money Money, such as paper currency, that has no value apart from its use as money.

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Commodity money versus fiat money

Throughout history, many types of commodity money have been used.

Cigarettes in U.S. prisons

Tobacco in colonial Virginia

Chicken eggs Venezuela

Most important have been precious metals: copper, silver, and especially gold.

Commodity money has disadvantages, like a difficult-to-control money supply, and transportation issue.

Fiat money, such as paper currency, was an important development.

Initially, paper currency was redeemable for gold/silver, but no longer.

Paper currency is legal tender: required by the government to be acceptable for paying taxes and debts.

Requires confidence of the public—eroded when hyperinflation occurs.

Hyperinflation Extremely high rates of inflation, exceeding 50% or more per month.

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Businesses are not required to accept paper currency. So when the gas station tells you it won’t accept a $50 or $100 bill, it is (annoyingly!) within its rights.

When money is no longer money: hyperinflation

Reserve Bank of Zimbabwe (RBZ) was not independent of the government.

Increased government spending in mid-2000s.

Did not raise taxes or borrow money by selling bonds.

RBZ increased the money supply to pay for goods and services.

RBZ increased money supply at an annual rate of 7,500%.

Inflation rose from 130% to 15 billion percent in 2008.

Exchange rate from 1,000 Zimbabwean dollars per U.S. dollar to 10,000,000,000,000,000 per dollar.

Imports plunged and economy resorted to barter.

Unemployment rose to around 80%–95%.

In 2009, government of Zimbabwe abandoned currency for the U.S. dollar.

Inflation fell to <3%; real GDP rose at 5% per year.

Public remains distrustful of government control of money supply.

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Making the Connection

How money is measured: monetary aggregates

M1 A narrow measure of the money supply: The sum of currency in circulation, checking account deposits, and the holdings of traveler’s checks.

M2 A broad measure of the money supply: All the assets that are included in M1, as well as time deposits with a value of less than $100,000, savings accounts, money market deposit accounts at banks, and noninstitutional money market mutual fund shares.

M1 and M2 in the United States, July 2012

Figure 7.1

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Which measure of the money supply should we use?

Changes in the quantity of money are associated with changes in nominal interest rates and prices.

M1 and M2 often have similar growth rates, but can diverge.

New assets emerged in the 1980s, making relationship between M1 and M2 and other economic variables unreliable.

So since early 1990s, Fed has de-emphasized M1 and M2 in policymaking.

Growth rates of M1 and M2 in the United States, 1960-2012

Figure 7.2

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Explain how the Federal Reserve changes the money supply.

7.2

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Learning Objective

The Federal Reserve and the money supply

Monetary base (or high-powered money) The sum of currency in circulation and bank reserves.

Monetary base = Currency in circulation + Reserves

Reserves A bank asset consisting of vault cash plus bank deposits with the Federal Reserve.

Relationship between the monetary base and aggregates considers three actors:

The Federal Reserve: Responsible for controlling the money supply and regulating the banking system.

The banking system: Creates checking accounts that are the most important component of the M1 measure of the money supply.

The nonbank public: All households and firms. Decides the form in which they wish to hold money (for instance, as currency or as checking accounts).

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The Federal Reserve and the money supply

The money supply is generally larger than the monetary base, because banks are only required to hold a fraction of their checking account deposits as reserves.

Money multiplier The number indicating how much the money supply increases when the monetary base increases by $1.

Money supply = Money multiplier  Monetary base

By controlling the reserves in the banking system the Fed can control the monetary base, and hence the money supply.

Though since the financial crisis of 2007-2009, banks have held reserves far in excess of required amounts.

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How the Fed changes the monetary base

The 12-member Federal Open Market Committee (FOMC) makes monetary policy decisions at the Fed.

The FOMC controls the monetary base, and therefore the money supply, through open market operations.

Open market operations The Federal Reserve’s purchases and sales of securities, usually U.S. Treasury securities, in financial markets.

If the Fed bought $1 million in bonds from JP Morgan, it would pay for them by increasing banks’ reserves.

JP Morgan would then usually increase the loans it makes.

More loans lead to increased deposits and/or currency and money supply.

If the Fed instead sold $1 million in bonds to JP Morgan, the bank’s reserves would decrease by $1 million.

JP Morgan would respond by decreasing the loans that it makes.

Currency and/or deposits fall and the money supply decreases.

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The process of money creation

Open market purchases increase either currency or bank reserves by the amount of the purchase, meaning the monetary base increases.

Increased monetary base usually leads to increased money supply.

Increased monetary base becomes deposits through the money multiplier process.

Banks and the public affect the money supply through the multiplier.

Let M be the money supply, MB the monetary base, and m the money multiplier. Then:

Using the M1 definition of the money supply, , currency and checking account deposits respectively. The monetary base , where RR and ER are required and excess reserves. Then:

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The process of money creation—continued

It is useful to express the money multiplier in terms of ratios: the currency-to-deposit ratio (C/D) that the public wants to hold, for example.

The ratio or required reserves to checking account deposits is the required reserve ratio (rrD); therefore:

Then we can rewrite the equation for the money supply itself as:

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Observations about this expression

Increases to the monetary base or money multiplier will increase the money supply.

Increases in the currency-to-deposit ratio (C/D) leads to a decline in the multiplier, and therefore the money supply, if the base is unchanged.

Increases in the required reserve ratio, rrD cause the money multiplier to decline, and therefore the money supply if the base remains unchanged.

Increases in the excess reserves-to-deposit ratio (ER/D) cause the money multiplier to decline, and therefore the money supply, if the base remains unchanged.

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2. Occurs because the required and excess reserve ratios sum to less than 1.

The M1 multiplier for the United States

The M1 multiplier has been trending downward in past decades as house-holds are more reliant on financial assets other than checking accounts and currency.

Banks tightened guidelines for loans during the financial crisis of 2007-2009 and began keeping extra reserves, increasing ER/D and leading to a rapidly falling multiplier.

The M1 multiplier for the United States, 1960-2012

Figure 7.3

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Describe the quantity theory of money and use it to explain the connection between changes in the money supply and the inflation rate.

7.3

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Learning Objective

The quantity equation and velocity of money

Quantity equation (or the equation of exchange) An identity that states that the money supply multiplied by the velocity of money equals the price level multiplied by real GDP.

Velocity of money For a given period, the average number of times that each dollar in the money supply is used to purchase a good or service that is included in GDP.

Using P x Y = Nominal GDP for 2011, the value of velocity was estimated at:

On average during 2011, each dollar of M1 was spent about 7.5 times on goods and services included in GDP.

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The quantity theory of money

As an identity, V=(PxY)/M must always hold.

Irving Fisher assumed that velocity of money was constant, as it depended on factors that do not change very often: how often you get paid, shop, and receive or pay bills.

Quantity theory of money A theory about the connection between money and prices that assumes that the velocity of money is constant.

Velocity may not be constant if these factors change over time.

We can adapt the equation of exchange to reflect the addition of growth rates:

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The quantity theory of money

The quantity theory of money assumes that V does not change:

% Change in P is the change in prices: inflation, represented by π:

Rearranging:

Important conclusion: Inflation results from the money supply growing faster than real GDP.

This conclusion depends on the assumption that velocity of money is constant. In the long run, most economists agree that the central bank, by controlling the growth rate of the money supply, determines the long run rate of inflation.

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Is the inflation rate going to increase?

Through 2012, central banks increased bank reserves to help economies recover from the financial crisis, increasing the monetary base.

Increasing the monetary base can lead to increases in the money supply, and higher prices.

European Central Bank (ECB) also bought bonds to support financial markets.

By mid-2012, euro-zone inflation rose to 2.4%, above 2% target.

Fed undertook quantitative easing, also buying bonds.

Inflation in U.S. remained less than Fed’s 2% target.

Why have large increases in the monetary base not caused inflation?

Banks held large excess reserves, decreasing money multiplier.

Some economists remain concerned that large inflation will occur when banks start to lend out reserves.

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Making the Connection

The effect of a decrease in the growth rate of M

The average annual growth rate of real GDP for the United States since World War II has been 3%.

Suppose that the growth rate of velocity is 0%. What happens to the inflation rate if the money supply growth rate decreases from 5% to 2%? Assume that:

The growth rate of velocity remains 0%

Changes in the growth rate of the money supply do not affect the growth rate of real GDP.

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Solved Problem

The effect of a decrease in the growth rate on M

Step 1 Review the chapter material.

Step 2 Calculate the initial inflation rate. Use the quantity equation:

Growth rate of velocity is 0, so

Insert the known quantities: money supply growing at 5%, real GDP at 3%:

Step 3 Calculate the new inflation rate.

Money supply growth rate decreases to 2%, real GDP still grows at 3%

Note: our assumption about velocity staying constant in the short run is quite strong; the connection between money supply and inflation is not this exact.

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Solved Problem

Can the QTM accurately predict the inflation rate?

If velocity grows at a constant rate, increases in money supply and inflation will be closely related.

Velocity can be erratic and difficult to predict, meaning the quantity equation has difficulty predicting inflation in the short run.

There is a pattern that decades with higher growth rates in the money supply were decades with higher inflation.

The relationship between money growth and inflation over time for the United States: inflation and money supply growth in the U.S., 1870s-2000s

Figure 7.4a

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Can the QTM accurately predict the inflation rate?

We also see that countries with rapid money growth tend to have higher inflation rates.

Conclusion: basic prediction of QTM holds: if the central bank increases the growth rate of the money supply, then in the long run, this increase will lead to a higher inflation rate.

The relationship between money growth and inflation across countries, 1995-2011

Figure 7.4b

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Discuss the relationships among the growth rate of money, inflation, and nominal interest rate.

7.4

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Learning Objective

Real interest rates, and expected real interest rates

The real interest rate is:

where i is the nominal interest rate, and π is the rate of inflation.

The expected real interest rate is the real interest rate borrowers and lenders expect, at the time a loan is made:

Expected real interest rate The nominal interest rate minus the expected inflation rate:

The relationship between the expected real interest rate and the real interest rate

Table 7.1

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The Fisher effect

Fisher equation The equation stating that the nominal interest rate is the sum of the expected real interest rate and the expected inflation rate:

There are many real interest rates in the economy.

Example: In the market for Treasury securities, there is a real interest rate that the Treasury must pay to borrow funds, determined by the market for loanable funds.

According to the Fisher equation, factors affecting the real interest rate will also affect the nominal interest rate, as long as the expected inflation rate doesn’t change.

In the expected inflation rate does change, the nominal interest rate will change in step. This is the Fisher effect:

Fisher effect The assertion by Irving Fisher that the nominal interest rate rises or falls point-for-point with changes in the expected inflation rate.

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Do the data support the Fisher effect?

There is a clear positive relationship between the inflation rate and the nominal interest rate for the 56 countries in the figure.

The relationship is not exact, but the Fisher effect provides a useful approximation of how inflation rates affect nominal interest rates.

The relationship between the inflation rate and the nominal interest rate, 1995-2011

Figure 7.5

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Money growth and the nominal interest rate

Combining the quantity theory of money and the Fisher effect:

In the long run, increased growth in the money supply causes increases to inflation rates.

This in turn increases the nominal interest rate.

U.S. data from 1919-2011 (averages)

Growth rate of M2 velocity = ~0%

Growth rate of real GDP = 3%

Expected real interest rate on Aaa corporate bonds = 2.8%

Assume Fed sets growth rate of money supply at 5%. What will be the nominal interest rate on Aaa corporate bonds?

Then using the Fisher equation,

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We measure the expected real interest rate as the nominal interest rate minus the inflation rate during

the previous year. The inflation rate is calculated as the growth rate of the consumer price index.

Explain the costs of a monetary policy that allows inflation to be greater than zero.

7.5

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Learning Objective

Costs of expected inflation

Seigniorage: Money held erodes in value when inflation is positive; this value is transferred to the government as seigniorage. Also known as inflation tax.

Seigniorage The government’s profit from issuing fiat money; also called inflation tax.

Shoe-leather costs: Avoiding inflation tax requires more attention to how much cash you are holding.

Shoe-leather costs The costs of inflation to households and firms from holding less money and making more frequent trips to the bank; costs related to expected inflation.

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Costs of expected inflation—continued

Tax distortion: The government taxes capital gains, but part of capital gains are due to inflation. Therefore people are overtaxed, and their behavior will be distorted.

Menu costs: Frequently changing prices are inconvenient and costly for businesses, and annoying for consumers.

Menu costs The costs to firms of changing prices due to reprinting price lists, informing customers, and angering customers; costs related to expected inflation.

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How large are the costs of expected inflation?

Average inflation in the U.S. has been 2% for the last 20 years.

Martin Feldstein at Harvard University believes there would be benefits of going to a 0% average inflation rate.

Estimates welfare costs of 0.6% to 1.0% of GDP.

Translates into $90.5 billion to $145.1 billion per year.

Present value of 35% of current GDP: >$5.3 trillion in 2011 dollars

Large possible losses because distortions persist into the future.

Reduced investment from tax distortions.

Reduced savings because of low returns.

May raise real interest rates and reduce investment expenditures.

Reduced future capital stock.

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Note: figure in book for upper limit of estimated welfare cost is $301.5 billion; this appears to be a typo. I have corrected to make it consistent.

Costs of unexpected inflation

Wealth is redistributed when the inflation rate is not what was expected.

For example, you purchase a $500 iPad on credit.

Assume a nominal interest rate of 10% on a one-year loan.

Assume an expected inflation rate of 4%, thus a real rate of 6%.

If borrowing, you pay back $550 after one year.

Bank’s real compensation for lending to you is 6% of $500 = $30.

If the inflation rate turns out to be 8%, the bank’s real compensation falls to 2% of $500 or $10.

True economic costs do result from unexpected inflation.

Resources spent on forecasting inflation.

Avoidance of borrowing and lending.

Some people are better able to adjust to unexpectedly high or low inflation rates.

Example: After financial crisis of 2007-2009, mortgage rates fell dramatically. Some, but not all, homeowners are able to refinance to take advantage of the low rates.

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What is the expected inflation rate?

The expected inflation rate is not observable.

But we can look at sales of Treasury Inflation-Protected Securities, which have a fixed real face value: their redemption value increases with the inflation rate.

Comparing the prices of these to the prices of comparable standard Treasury notes, we can infer what inflation rate investors in the bond market are expecting over the term of the bond.

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Macro Data

The financial crisis and expected inflation

Did the Fed’s actions during the financial crisis of 2007-2009 increase the expected inflation rate?

The Fed enacted quantitative easing (QEI) during the financial crisis by purchasing over $1 trillion in U.S. Treasury bonds and mortgage-backed securities.

Goal was to reduce long-term interest rates.

Result was a dramatic increase in the monetary base.

The Fed announced it would take actions to reduce the base as the economy recovered.

Inflation expectations increased during the latter part of 2007–2009.

Using inflation expectations from the Treasury and TIPS markets:

Expected inflation –2.2% on November 28, 2008.

Expected inflation +2.0% on April 6, 2010.

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Making the Connection

The financial crisis and expected inflation

Did the Fed’s actions during the financial crisis of 2007-2009 increase the expected inflation rate?

While this was an increase in expected inflation of over 4%, it really just brought inflation expectations back to “normal” pre-crisis levels.

Were the markets’ expectations about inflation correct?

CPI inflation in 2010: <2%

CPI inflation in 2011: 3.0%

CPI inflation in first half of 2012: <2%

Markets seem to remain confident the Fed can keep inflation under control; and so far, they are correct.

June 2012 expected inflation rate: 1.8%

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Making the Connection

Inflation uncertainty

Relative prices play an important role in allocating resources.

A higher relative price indicates society values the item more; and more resources flow into producing that item.

With volatile inflation, relative prices become distorted.

Menu costs are different for different items; so the prices of some items change faster than others.

The more the inflation rate changes, the more likely it is to distort relative prices and cause misallocation of resources.

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Inflation and inflation volatility

Inflation volatility tends to increase as the annual average inflation rate increases.

Inflation rates are less predictable, leading to additional unexpected inflation costs.

Inflation and inflation volatility around the world, 1996-2011

Figure 7.6

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Benefits of inflation

Inflation may have some benefits too:

Inflation allows for adjustments in relative prices where nominal prices are “sticky.”

Real wages, nominal wages divided by the price level, determines how many workers firms hire.

Real wages may need to decrease to restore equilibrium in the labor market.

Without inflation, firms can cut nominal wages.

Workers are reluctant to let nominal wages fall.

With inflation, firms can keep nominal wages constant, while inflation erodes real wages.

This is sometimes referred to as greasing the wheels of the labor market.

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Explain the causes of hyperinflation.

7.6

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Learning Objective

Causes of hyperinflation

During periods of hyperinflation, inflation rates are high and typically volatile.

Great deal of misallocation of resources.

Difficulty determining relative prices of goods and services.

Firms may misinterpret rising prices to mean increased demand.

Hyperinflations begin when governments rapidly increase the growth rate of the money supply.

Typically due to persistently large budget deficits.

Government makes purchases (G) and transfer payments (TR).

Government receives tax revenue (T).

If G + TR > T, difference is made up through selling bonds (B), or increasing the supply of money (M):

G + TR = T + Change in B + Change in M

G + TR − T = Change in B + Change in M

Hyperinflations end when the growth rate of the money supply is reduced.

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German hyperinflation after World War I

German government after World War I was unable to balance budget by raising taxes or cutting expenditures.

Tax increases could not fund the difference because taxes were collected nominally and there were lags in collecting taxes.

Government underestimated inflation rate.

Real tax revenues lagged behind expenditures.

Eventually, government funded nearly 100% of expenditures by printing money.

Policy changes in 1923 ended hyperinflation.

Established the Rentenbank, and issued new currency, Rentenmark.

1 Rentenmark = 1 trillion old German marks (10/15/1923)

Government stopped borrowing from central bank.

Cut 25% of government workers in 1923, and 10% more in 1924.

Negotiated relief from U.K. and France on reparations which were part of the Treaty of Versailles.

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Answering the key question

“What is the connection between changes in the money supply and the inflation rate?”

The growth rate of money determines the inflation rate in the long run.

Quantity theory: the inflation rate should equal the rate of growth of money supply minus the rate of growth of real GDP.

Holds only if velocity of money is constant.

In the short run, velocity can fluctuate, so relationship may be unstable.

Example: During and after the recession of 2007-2009, the money supply grew rapidly, but the inflation rate remained low.

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Explain how to derive the formula for the money multiplier.

7.A

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Learning Objective

The Fed’s balance sheet

The monetary base and the Fed’s balance sheet are closely connected.

Most important assets are Treasury securities and discount loans

Discount loans are made to troubled banks.

Most important liabilities are currency in circulation and reserves.

A simplified Federal Reserve balance sheet

Table 7A.1

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Appendix

Open market operations

Fed can increase the money supply by using open market operations.

T-accounts only show the transactions in a balance sheet.

Fed can buy $1 million in treasuries, increasing their own assets and liabilities.

Reserves and thus the base rises by the amount of the purchase.

Bank balance sheets are only made less liquid, with no change in the size of the balance sheet.

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Appendix

The simple deposit multiplier

Step 1: Fed buys securities from Bank of America, increasing their excess reserves by $100,000.

Step 2: Bank of America makes new loans to Rosie’s Bakery, and creates a new checking account. Both sides of the balance sheet rise by $100,000.

Step 3: Rosie’s Bakery writes a $100,000 check to Bob’s Bakery Equipment for two new ovens.

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Appendix

The simple deposit multiplier—continued

Step 4: Bob’s Bakery Equipment deposits the check from Rosie’s Bakery in its checking account at PNC Bank. The money is moved from Bank of America to PNC Bank.

Step 5: Before the transaction, PNC had no excess reserves. With new deposits, PNC Bank is required to hold some (say 10%) on reserve. The remaining 90% is excess reserves and can be lent out. PNC Bank here lends $90,000 to Jerome’s Printing for new office equipment.

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Appendix

The simple deposit multiplier—continued

Step 6: Jerome’s Printing writes a check to Computer Universe for new equipment. Computer Universe has an account at SunTrust Bank where it deposits the newly received funds.

Step 7: SunTrust faces the same decision as Bank of America and PNC, which is whether or not to lend out new excess reserves. If SunTrust is required to hold 10% of new deposits, it can make $81,000 in new loans

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Appendix

Multiple deposit creation

Another loan by SunTrust bank would increase total new checking deposits by $271,000 for an open market purchase of $100,000. The money supply increases with each new loan.

This process can continue until excess reserves are at the level that banks desire.

The final increase in deposits can be $1,000,000 for $100,000 in open market purchases, yielding a simple deposit multiplier of $1,000,000/$100,000 = 10.

Multiple deposit creation, assuming a Fed open market purchase of $100,000 and a required reserve ratio of 10%

Table 7A.2

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Appendix

A more realistic money multiplier

This simple deposit multiplier assumed that banks hold no excess reserves.

The simple deposit multiplier also assumed the nonbank public chooses to keep its holdings of currency constant.

Our more realistic money multiplier, which relaxes these assumptions, was developed earlier:

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Appendix