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MONEY AND INFLATION:The Quantity Equation, Inflation and interest rates

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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
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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 one-for-one 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
1991-92
25
1993-94
1990-91
20
1992-93
2002-03
1994-95
2001-02
1997-98
2003-04
1995-96
15
1999-00
1996-97
2000-01
10
1998-99
5
0
0
2
4
6
8
10
12
14
Inflation (%)
38
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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
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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 SEEN-your-ige)
·
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 one-for-one relationship
is called the Fisher effect.
40
Table of Contents:
  1. INTRODUCTION:COURSE DESCRIPTION, TEN PRINCIPLES OF ECONOMICS
  2. PRINCIPLE OF MACROECONOMICS:People Face Tradeoffs
  3. IMPORTANCE OF MACROECONOMICS:Interest rates and rental payments
  4. THE DATA OF MACROECONOMICS:Rules for computing GDP
  5. THE DATA OF MACROECONOMICS (Continued…):Components of Expenditures
  6. THE DATA OF MACROECONOMICS (Continued…):How to construct the CPI
  7. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES
  8. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  9. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  10. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  11. MONEY AND INFLATION:The Quantity Equation, Inflation and interest rates
  12. MONEY AND INFLATION (Continued…):Money demand and the nominal interest rate
  13. MONEY AND INFLATION (Continued…):Costs of expected inflation:
  14. MONEY AND INFLATION (Continued…):The Classical Dichotomy
  15. OPEN ECONOMY:Three experiments, The nominal exchange rate
  16. OPEN ECONOMY (Continued…):The Determinants of the Nominal Exchange Rate
  17. OPEN ECONOMY (Continued…):A first model of the natural rate
  18. ISSUES IN UNEMPLOYMENT:Public Policy and Job Search
  19. ECONOMIC GROWTH:THE SOLOW MODEL, Saving and investment
  20. ECONOMIC GROWTH (Continued…):The Steady State
  21. ECONOMIC GROWTH (Continued…):The Golden Rule Capital Stock
  22. ECONOMIC GROWTH (Continued…):The Golden Rule, Policies to promote growth
  23. ECONOMIC GROWTH (Continued…):Possible problems with industrial policy
  24. AGGREGATE DEMAND AND AGGREGATE SUPPLY:When prices are sticky
  25. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  26. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  27. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  28. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  29. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  30. AGGREGATE DEMAND IN THE OPEN ECONOMY:Lessons about fiscal policy
  31. AGGREGATE DEMAND IN THE OPEN ECONOMY(Continued…):Fixed exchange rates
  32. AGGREGATE DEMAND IN THE OPEN ECONOMY (Continued…):Why income might not rise
  33. AGGREGATE SUPPLY:The sticky-price model
  34. AGGREGATE SUPPLY (Continued…):Deriving the Phillips Curve from SRAS
  35. GOVERNMENT DEBT:Permanent Debt, Floating Debt, Unfunded Debts
  36. GOVERNMENT DEBT (Continued…):Starting with too little capital,
  37. CONSUMPTION:Secular Stagnation and Simon Kuznets
  38. CONSUMPTION (Continued…):Consumer Preferences, Constraints on Borrowings
  39. CONSUMPTION (Continued…):The Life-cycle Consumption Function
  40. INVESTMENT:The Rental Price of Capital, The Cost of Capital
  41. INVESTMENT (Continued…):The Determinants of Investment
  42. INVESTMENT (Continued…):Financing Constraints, Residential Investment
  43. INVESTMENT (Continued…):Inventories and the Real Interest Rate
  44. MONEY:Money Supply, Fractional Reserve Banking,
  45. MONEY (Continued…):Three Instruments of Money Supply, Money Demand