EFL Lesson 9

1
EFL Lesson 9

• Money Inflation

2
What is money?

• Money is ANYTHING that is generally accepted in
  payment for goods and services.

3
Money Reduces the Transaction Costs of Exchange
?
?

• Barter may work, but its inefficient and time
  consuming its a hassle!

4
Functions of Money
Medium of exchange Standard of Value Store of
Value
5
In the U.S. today, money is

• Currency, Coin, and Checks
• (Demand Deposits)

6
Primary Measure of Money(April 2006, in
billions)

• Currency (paper coins) 739
• (in public, not in bank vaults)
• Checkable account deposits
• (plus other checkable travelers ck)
• Total Money Supply (M1) 1,391

7
Interest the opportunity cost of holding money

• What could you do instead of holding money?
• You could hold interest-earning assets like
  Certificates of Deposit, or bonds

8
Where do interest rates come from?

• Market for funds
• Who are the suppliers?
• Who are the demanders?
• What is the equilibrium price?

9
Interest RatePrice of Money

• Prices (and interest rates) are set by the
  marketnot by the FED.
• Producers influence price through the quantity of
  goods.
• The FED influences interest rates (the price of
  money) through the quantity of money.

10
Money supply

• Currency coins in circulation demand deposits
• Total available purchasing power in the economy
  at any point in time

1363.6 billion 1,363,600,000,000 1.3636
trillion
11
Why do we worry about the money supply?

• Experience has shown us that the money supply is
  the most important factor affecting general price
  levels, that is -
• Inflation
• Inflation must be taken seriously it alters
  incentives and peoples economic behavior, and
  consequently, it negatively impacts the economy
  as a whole.

12
Inflation

• A general, sustained increase in the price level.
• The erosion or decline of purchasing power.
• The best-known measure of inflation is the CPI,
  or Consumer Price Index

Market Basket of Goods and Services
13
Inflation is a Reduction in the Value of the
Dollar
Price Level
14
Which would you rather have?
15
In Harare a beer cost 100 billion Zimbabwean
dollars at 5 pm on July 4. An hour later the
price had jumped to 150 billion.
16
The Zimbabwean government is threatened by its
inability to get enough paper to print money.
This printed money is how it pays its security
forcestrouble for Mugabe.
17

• Hyperinflation in Zimbabwe
• This kind of hyperinflation is rare in history,
  but we are seeing it once again, in Zimbabwe.
  Government officials claim an inflation rate of
  66,212 percent (most months they refuse to
  release inflation figures at all). The
  International Monetary Fund believes the rate is
  closer to 150,000 about the level reached by
  Weimar Germany. By some estimates, about 50 of
  Zimbabwes government revenue comes from the
  printing of money. At independence in 1980, the
  Zimbabwean dollar was worth more than one U.S.
  dollar. Recently, the state-controlled newspaper
  raised its cover price to 3 million Zimbabwean
  dollars. Two pounds of chicken were recently
  reported to cost about 15 million Zimbabwean
  dollars.
• A Zimbabwean friend who runs a business recently
  told me, If you dont get a bill collected in 48
  hours, it isnt worth collecting, because it is
  worthless. Whenever we get money, we must
  immediately spend it, just go and buy what we
  can. Our pension was destroyed ages ago. None of
  us have any savings left.
• http//davidcoltart.com/archive/2008/376 Dying
  Silently in Zimbabwe, by Michael Gerson,
  Washington Post, Feb 20, 2008

18

• HARARE, April 25,2006 How bad is inflation in
  Zimbabwe? Well, consider this at a supermarket
  near the center of this tatterdemalion capital,
  toilet paper costs 417.
• No, not per roll. Four hundred seventeen
  Zimbabwean dollars is the value of a single
  two-ply sheet. A roll costs 145,750 in
  American currency, about 69 cents.
• The price of toilet paper, like everything else
  here, soars almost daily, spawning jokes about an
  impending better use for Zimbabwe's 500 bill,
  now the smallest in circulation.

http//www.nytimes.com/2006/05/02/world/africa/02z
imbabwe.html
19
Measuring Inflation - the CPI

• The Department of Labors Bureau of Statistics
• Determines the items in the market basket
• Gathers the prices of the items in the basket
  during a base year
• Gathers the prices of the items in the current
  year.
• Calculates the CPI

X 100
CPI
Price of basket in current year
Price of basket in base year
20
Suppose CPIthis year 125

• What does it mean?
• 25 increase in prices between the base year and
  this year
• Inflation Rate percentage change in the index

21
Same Products Higher Prices
22
Same Products Higher Prices
Sectors experiencing largest price increases
since 1990

• Energy
• Food
• College Tuition
• Medical Care

23
Same Products Higher Prices
24
Real vs. Nominal Prices

• nominal int. rate rate of inflation real int.
  rate
• 8 - 3 5

Anticipated vs. Unanticipated Inflation

• 1000 saved turns into 1080 after 1 year
• can only buy 1050 worth of stuff at higher prices

25
Same Products Higher Prices
26
Manage the Money Supply to Avoid Inflation The
Job of the Federal Reserve System

• All periods of significant sustained inflation
  have been accompanied by increases in the money
  supply.

27
Federal Reserve System
28
HOW do we manage the money supply?
It all begins with commercial banking
Money Supply 100
29
Lending creates additional purchasing power
Money Supply 100 50 150
30
More lending creates more money
50
100
Bill
John
Sue
Money Supply increases 100 50 25 175
31
Key to controlling the money supply

• Commercial banks ability to make loans

100
50
25
75
50
32
Fed tools for influencing banks willingness to
make loans

• Reserve requirement
• Discount rate
• Open market operations

100
50
25
75
50
33
Open Market Operations

• The most important tool of the Fed in controlling
  the money supply
• Can be, and is, used on a daily basis
• Its effect is immediate
• Can be used to target interest rates

34
Fed purchases of government securities increase
the availability of money to the public.

• When the Federal Reserve buys government
  securities, reserves in the banking system
  increase.
• Increased reserves means increased ability to
  lend, which increases the money supply.

1000
1000
Fed
bond
Bills Bank
Bill
35
Open Market OperationsWhen the Fed Sells Bonds

bond

• Questions
• Who ends up with the money?
• Who ends up with the bond?
• What happened to the money supply? (It
  decreased.)

Fed Bond Sales
36
Open Market OperationsWhen the Fed Buys Bonds
bond

Fed Bond Sales

• Questions
• Who ends up with the money?
• Who ends up with the bond?
• What happened to the money supply? (It
  increased.)

37
Open Market Operations allows the Fed to manage
interest rates, lending and the money supply.

• If Open Market Operations increase the money
  supply
• Bank deposits increase
• Bank reserves increase
• The supply of money to lend increases
• Interest rates fall

• If Open Market Operations
• reduce the money supply
• Bank deposits decrease
• Bank reserves decrease
• The supply of money to lend decreases
• Interest rates rise

38
A sound well-managed money supply is one of the
keys to the wealth of nations
39
Monetary Freedom - top
Source Heritage Economic Freedom of the World
Annual Report, 2007
40
Monetary Freedom - bottom
http//www.heritage.org/research/features/index/do
wnloads/2008PastScores.xls
41
The Big Ideas from Lesson 9

• Money is an innovation that significantly
  improved the operation of markets by reducing the
  costs of exchange.
• The money supply changes with the lending
  activities of commercial banks.
• Inflation is the consequence of the money supply
  growing faster than production.
• The Fed tries to manage the money supply to avoid
  inflation.
• Inflation reduces purchasing power, disrupts the
  economy, and reduces economic growth.