

Macroeconomics
ECO 403
VU
LESSON
11
MONEY AND
INFLATION
Money
supply measures
_
Symbol
Assets
included___________
C
Currency
M1
C
+ demand deposits,
travelers'
checks,
other
checkable deposits
M2
M1
+ small time
deposits,
savings
deposits,
money
market mutual funds,
money
market deposit
accounts
M3
M2
+ large time
deposits,
repurchase
agreements,
institutional
money market
mutual
fund balances
The
Quantity Equation
·
The
quantity equation
M
×V
= P ×Y
follows
from the preceding
definition of velocity.
It is an
identity:
it
holds by definition of the
variables.
Money
demand and the quantity
equation
·
Let's
now express the quantity of
money in terms of the
quantity of goods and
services
it
can buy;
·
M/P = real
money balances,
the
purchasing power of the
money supply.
·
A
simple money demand
function:
(M/P
)d =
k Y
where
k
= how much money people
wish to hold for each
rupee of income (k is
exogenous)
·
This
equation states that the
quantity of real money
balances demanded is
proportional
to
real income.
·
(M/P
)d =
k Y
Money
demand:
·
Quantity
equation: M ×V = P ×Y
·
The
connection between them: k =
1/V
·
When
people hold lots of money
relative to their incomes (k is
high), money changes
hands
infrequently (V is low).
37
Macroeconomics
ECO 403
VU
THE
QUANTITY THEORY OF
MONEY
·
Recall
The
growth rate of a product
equals the sum of the
growth rates.
·
The
quantity equation in growth
rates:
ΔM
ΔV
ΔP
ΔY
+
=
+
M
V
P
Y
The
quantity theory of money
assumes
ΔV
V
is
constant, so
=
0.
V
Let
š
(Greek
letter "pi") denote the
inflation rate:
ΔP
š =
P
ΔM
ΔP
ΔY
We
have
=
+
M
P
Y
ΔM
ΔY
Solve
this result for š
to
get
š =

M
Y
·
Normal
economic growth requires a
certain amount of money
supply growth to
facilitate
the
growth in transactions.
·
Money
growth in excess of this
amount leads to
inflation.
ΔY/Y depends on
growth in the factors of
production and on technological
progress (all of
which
we take as given, for
now).
Hence,
the Quantity Theory of Money
predicts a oneforone relation
between changes in
the
money
growth rate and changes in
the inflation rate.
Inflation
and Money growth
Inflation
and Money Growth of
Pakistan
30
199192
25
199394
199091
20
199293
200203
199495
200102
199798
200304
199596
15
199900
199697
200001
10
199899
5
0
0
2
4
6
8
10
12
14
Inflation
(%)
38
Macroeconomics
ECO 403
VU
International
data on inflation and money
growth
10,000
Republic
.
Inflation
rate
of
Congo
Nicaragua
(%)(Log
scale)
Angola
1,000
Georgia
Brazil
100
Bulgaria
10
Germany
Kuwait
1
USA
Canada
Oman
Japan
0.1
0.1
1
10
100
1,000
10,000
Money
supply growth(%)
Log
scale
39
Macroeconomics
ECO 403
VU
Inflation
and Money growth in
Pakistan
30
25
20
Money
Growth (M2)
15
10
5
0
Inflation
rate
Years
SEIGNIORAGE
·
To
spend more without raising
taxes or selling bonds, the
govt. can print
money.
·
The
"revenue" raised from
printing money is called
seigniorage
(pronounced
SEENyourige)
·
The
inflation tax:
Printing
money to raise revenue
causes inflation. Inflation is
like a tax on people
who
hold
money.
Inflation
and interest
rates
·
Nominal
interest rate, i
not
adjusted for
inflation
·
Real
interest rate, r
adjusted
for inflation:
r=i
š
The
Fisher Effect
·
The
Fisher equation:
i=r+š
·
S = I determines
r.
·
Hence, an
increase in š
causes
an equal increase in i.
·
This
oneforone relationship
is
called the Fisher
effect.
40
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