Lecture V Money and inflation

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Lecture VMoney and inflation
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Functions and forms of money (1)

• Definition stock of assets that can be readily
  used to make transactions
• It is generally accepted in payment for goods and
  services or in repayment of debts
• Distinguish money from wealth !
• Functions
• Medium of exchange
• liquidity
• Store of value
• From present into futue, risk of inflation
• Unit of account

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Functions and forms of money (2)

• Types of money
• Historically commodity money, namely gold
• Gold standard people use paper money that is
  redeemable for gold
• Today fiat money - currency (coins and paper),
  demand deposits, near money
• Government declares it as legal tender plus there
  is a social convention when people just accept it
  as means for transaction
• Classification
• Currency, i.e. paper money and coins in
  circulation (liquid)
• Demand depositis, i.e. peoples money on savings
  accounts, immediatelly available (liquid)
• Time deposits and other less liquid assets
• Designation M1, M2, M3, L (for Czech standard
  and for January 2009 figures, see next slide)

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Czech monetary aggregateslevels, 31.1.2009, mil.
CZK
Currency Overnight M1
Deposits Deposit
M2 in circulation deposits
up to 2y redeem.
3m 362.815,6 1.302.743,5
1.665.559,1 577.090,7 402.915,8
2.645.565,6 Repurchase Money
Debt
M3 agreements markets
securities 23.877,1 43.487,7
743,4 2.713.673,8
Source and for detailed explanation of terms
www.cnb.cz
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How much money in the economy?

• Financial markets
• A good like any other
• Demand for money
• Supply of money (controlled by state)
• Equilibrium between demand and supply determines
  amount of money in the economy
• Crucial impact of the economic performace
• inflation

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V.1 Demand for money
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Basic notions

• Two main reason why people demand money
• Transaction, people just keep so much money as
  they need to secure their transactions
• Portofolio, people decide between risks and
  returns from investing their money into various
  assets
• Return from an asset return from an investment
  (usualy annual), expressed as a percentage from
  investment
• Different forms interest, return on bonds,
  dividends, but even a rent paid to me when I own
  and rent a house
• Risk less liquid assets bear usually more risk
• Price of house might suddenly go down (see today)
• Liquidity of an asset costs of transforming the
  value of an asset into money (cash)
• Wider definition of costs (i.e. speed, etc.)
• House definitelly less liquid than a bank account

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V.1.1 Demand for money and QTM

• QTM - starting point for a transaction theory of
  money demand
• Very deep historical roots understanding that
  increase of amount of money in circulation does
  not lead to acceleration of investment and trade,
  but to increase of price level only
• First comprehensive explanation David Hume

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David Hume

• 1711 1776
• Philosopher, historian
• 1752 Political Discourses, especially essay Of
  Money
• Diplomat

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The Quantity Theory

• In the wider framework (long-term model of LII),
  QTM seeks to answer two basic questions
• How is the equilibrium amount of money in the
  economy determined?
• What is the impact of money on the economy (does
  the change of amount of money influence output,
  price, employment, etc.).
• In LII, we provided the answers
• price level P equilibrates between demand for and
  supply of money
• Money is neutral
• Here we concentrate on specification of demand
  for money
• Two versions of QTM, but first some more details
  on Quantity Equation

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The Quantity Equation in detail (1)

• Total expenditures in an economy expressed in
  two ways
• P.TRN, where P is aggregate price, TRN is number
  of transactions in the economy
• M.V, where M is nominal quantity of money, V is
  the transactions velocity of money
• V rate, at which the money circulates in the
  economy (how many times a unit of money changes
  hands)

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The Quantity Equation in detail (2)

• Both expressions must be equal, quantity
  equation M.VP.TRN
• Ex-post always true, identity (it is not a
  theory)
• When nominal income P.Y and amount of money M is
  know, the QE defines velocity VP.Y/M
• TRN impossible to measure, approximation by total
  income (product) Y M.V P.Y
• V income velocity of money
• Nevertheless still not a theory

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Fishers QTM (1)

• Two assumptions in the framework of classical
  model
• In equilibrium, real output determined by full
  employment labor (given at the cleared labor
  market). Real economy independent on money
  supply.
• Velocity of money is given by technical features
  of the markets and is not in any relation to
  amount of money in the economy
• Usual corollary (however, not stipulated by
  Fischer himself) around equilibrium (i.e. at
  least in the short-term) velocity V is constant

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Fishers QTM (2)

• How the quantity equation becomes a theory ? If
• V and Y is fixed with respect to money supply
• Money is required for transactions
• Money supply M is exogenous
• then M.V P.Y is an equation of the model
  (required to be valid ex-ante) which says that in
  equilibrium, when output Y is given in the real
  sector of the economy and V is constant, the
  supply of money, controlled by central bank,
  determines the price level P only (P is
  proportional to M)
• Corollary real variables (output and its
  components, unemployment, etc.) are independent
  on the amount of money or, change in the money
  supply has an impact on the price level only (but
  not on output)
• Fishers QTM develops from quantity equation,
  no explicit consideration of supply and demand
  for money

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Irving Fisher

• 1867-1947
• American
• Neoclassical Marginalist Revolution, mathematical
  methods
• Introduced Austrian economic school to the USA
  (Theory of capital and investment, 1896-1930),
  intertemporality
• Quantity theory of money (1911-1935)
• Loss of credibility during Great Depression

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Cambridge version (1)

• Problem of Fishers version aggregate approach,
  does not consider the decision on the individual
  level (not rooted in microeconomics)
• Determinant of money demand on individual level
  need to execute transactions, correlated with
  nominal value of total expenditures
• Demand for money, 2 possible angles
• MD k.P.Y, where Md is demand for nominal
  balances and k is that fraction of nominal income
  that society wishes to hold as money
• (M/P)d k.Y, where (M/P)d is demand for real
  balances, i.e. k says how much purchasing power
  (in terms of quantity of goods and services),
  expressed as a fraction of real income Y, people
  want to have

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Cambridge version (2)

• In both cases, demand for money is demand for a
  particular good - having this good makes
  transaction easier
• Equilibrium supply of money MS equals to demand,
  equilibrium condition
• M k.P.Y
• where k 1/V, hence the same equilibrium
  condition (and same contect with long-term model)
  as for Fishers version of QTM
• However, k has different economic interpretation

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Arthur Cecil Pigou

• 1877 1959
• British, Cambridge University
• Brought social welfare to the attention of
  economists (Wealth and Welfare, 1912)
• Theory of unemployment (1933) served to Keynes as
  a primary example of wrong approach
• Unjustly ridiculed by Keynes in General Theory
• The Classical Stationary State (1943) Pigou
  proved that Keynes was theoretically wrong

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QTM conclusions

• Both Fisher and Cambridge versions k (and V) is
  constant
• only Cambridge version leads to theory of money
  demand
• In the logic of long-term (classical) model
• consistency with the logic of supply side
  potential product determined in the real sector
  only
• consistency with Says law
• implies money neutrality
• price changes proportional to the change in stock
  of money
• Too many open questions (constant velocity,
  inconsistency, when more profound check with
  microeconomic Marshall?, etc.)
• refuted by Keynes in General Theory
• rehabilitated by Milton Friedman and monetarists

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V.1.2 Demand for money - beyond QTM
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Liquidity, risk and return

• Transaction demand people compare costs of
  holding liquidity with return when investing
  their money into interest bearing assets
• Useful when we consider only very liquid forms of
  money (M1)
• Portfolio demand people compare the return and
  risk, attached with the asset
• People just give up liquidity in favor of other
  asset that can increase their wealth, because it
  bears interest
• There is risk linked to many assets (e.g. their
  price might colapse) and there are implicit costs
  (you have less money for todays consumption)
• Useful when we consider money in its wider
  definition (M2 and higher)

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Transaction demand (1)

• The main cause time inconsistency between income
  and expenditure
• What determines transaction demand?
• Income the higher is the income, the more money
  is demanded for transactions
• Comparison of costs of transforming the less
  liquid assets into money against the return from
  investing into interest bearing assets
• costs to keep liquidity banking fees, provisions
  to bankers when byuing or selling the securities,
  etc.
• Advanced technology decreases these costs (e.g.
  ATM)
• Return best approximated by interest rate

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Transaction demand (2)

• Factors that determine demand for money
• Income (of household or firm), positive
  correlation
• Interest rate
• In the short term cost of transforming assets
  into money are relativelly stable
• The higher the interest rate, generally the
  higher the return from investing into all other
  assets, people willing to keep less transaction
  money ?
• negative correlation between transaction demand
  and interest rate

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Portfolio approach, precautionary balance

• Demand for precautionary balances people want to
  have (liquid) money not only because of
  transaction needs, but also because it is safe
• Money as an asset, that bears the least risk from
  loss of value (for more specification, see
  further slides of this Lecture)
• But again larger return from risk assets, that
  brings higher interest - the higher the interest,
  the less money people hold (lower precautionary
  demand)
• However, another factor of precautionary demand
• The higher the total wealth people hold
  proportionaly more precautionary money

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Portfolio approach, speculative demand

• This is a particular contribution of J.M.Keynes
• For a detailed discussion see LX
• People decide about investing into interest
  bearing assets by speculating on expected
  increase or decrease of the price of these assets
• For the purpose of this Lecture as precautionary
  demand, also speculative demand is negativelly
  correlated with interest rate

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V.1.3 Which interest rate?
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Nominal and real interest rate

• Interest in investment function in LII and LIV
• Real interest rate, as investors are concerned
  with real returns (in units of goods and
  services)
• Considering nominal terms (in current prices)
  implies potential loss of value due to inflation
• Interest, paid by the banks, is nominal interest,
  i.e. a return from the investment, expressed in
  money units (at current price level)
• Difference between nominal and real interest is
  inflation
• The real return (in units of goods and services)
  is diminished - compared to nominal interest, by
  increse of price level
• Relation between real and nominal interest

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The Fisher Effect

• Rearranging the equation from last slide we get
• This relation is called Fisher equation and in
  the logic of long-term model and QTM
• Real interest is determined by demand and supply
  of loanable funds
• Inflation (increase of price level) is determined
  by growth of money, proportionaly
• Nominal interest is then given by real interest
  plus inflation, i.e. nominal interest changes
  proportionaly to inflation (and nominal money
  growth)
• Previous slide, ex-post real interest, i.e. when
  inflation is known
• Distingush from ex-ante real interest, when only
  expected inflation is known

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Costs of holding money

• Holding the money means costs (disregarding if
  we speak about transaction or portfolio balances)
• Holding money ? foregoing nominal interest,
  provided by banks on government bonds
• In another words comparing real returns from
  investing into different assets
• Real return when storing the value in banks or in
  bonds real interest r
• Real return from holding money minus expected
  inflation, i.e.
• Costs of holding money difference between these
  two returns, i.e. nominal interest
• (Fishers equation)

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V.1.4 Demand for money summary
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Main determinants

• Transaction costs considered as constant (given
  by technology)
• Income demand for nominal balances depends on
  nominal income, for real balances on real income,
  positive correlation
• Wealth long-run angle, important when taking
  into account interporary models (similar to the
  one in LIII), positive correlation
• Interest rate, nominal, negative correlation

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Final specification (1)

• Generaly, demand for real balances
• In most of the models, a simplification is
  assumed
• Wealth W is approximated by income Y (wealth and
  income have a same dynamics in the long-term)
• Nominal interest is function of
  both real interest and expected inflation

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Final specification (2)

• Consequently, demand for money is taken as a
  function of income and nominal interest rates and
• Demand for real balances
• Demand for nominal balances (function of nominal
  income)
• Note general specification alows for demand for
  money being influenced by interest - important
  distinction form QTM

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V. 2 Supply of money

• Under the control of the governments (central
  banks), different policy instruments
• Influenced also by the behavior of households and
  commercial banks, because
• Households deposit money with commercial banks
• Households decide how much of money they have,
  they keep as cash, and how much they deposit as
  demand deposit in banks currency-deposit ratio
  aC/D, C currency, D demand deposits,
  determined by households behavior
• Commercial banks create money
• Banks keep only fraction of deposits and the rest
  they loan to households or firms reserve-deposit
  ratio bR/D, determined by behavior of banks and
  by regulatory laws

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Money multiplier

• Monetary base, directly controlled by central
  bank B C R
• C directly issued by central bank (coined and
  printed money)
• R are existing reserves, as resulted from the
  past
• Money supply, overall money available (M1), i.e.
  currency plus total demand deposits MS CD
• What is the relation between MS and B?

m money multiplier
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V.3 Equilibrium on money market and transmission
mechanism

• Equilibrium - demand equals supply (people hold
  only that amount of money they
• Need because of transaction demand
• Want, given the interest on other assets
• Equilibrium for real balances
• Adjustment towards equilibrium transmission
  mechanism

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Transmission mechanism -for increase of money
supply

• Four steps
• Excess supply on money market ? excess demand on
  the market with illiquid assets (bonds)
• Higher price of bonds ? lower nominal interest i
• ? higher aggregate demand (invetsment,
  consumption) ? pressure to increase of output Y
• Long-term model, QTM ? potential produkt Y fixed
  (determined on labor market) ? pressure to
  increase Y leads only to increase of price P

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i
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V.4 Inflation

• Inflation increase of overall (aggregate) price
  level (deflation decrease)
• Rate of inflation percentual change of overall
  price level
• In the context of the long-term model the time
  period of a static cut is sufficiently long to
  allow all price to adjust

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Inflation and stock of moneysupply view

• Long-term model potential product Y fixed,
  velocity of money V constant as well
• Quantitative equation MVPY expressed in growth
  terms
• where is percentage growth of variable ?
• It is and gp inflation ?
• hence inflation is a consequence of change in
  money supply

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Friedmans dictum

• Inflation is always and everywhere a monetary
  phenomena Milton Friedman
• In the long-term model indeed central bank,
  having control over money supply, directly
  controls inflation
• Relativelly well reflected in long-term data

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Inflation and stock of moneydemand view

• It is hence
• and
• Inflation rate difference between growth rate
  of nominal stock of money and demand for real
  balances the latter depends on real GDP and
  nominal interest, i.e. .
• In the long-run nominal interest stable ?
  inflation approximatelly equals the difference
  between growth rate of stock of money and GDP
  growth, i.e.

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Costs of infation

• Expected inflation
• Increases nominal interest ? decreases real
  balances ? higher transaction costst, but also
  higher inflation rate
• consequently actual inflation is given not only
  by actual growth of money stock, but also by
  expected inflation
• Frequent price changes very costly
• Undermines microeconomic efficiency of resource
  allocation
• Tax system always falls behind the inflation
• Higher uncertainty generaly
• Unexpected inflation
• Unfair redistribution of welfare

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Literature to Lecture V

• Mankiw, Ch. 7 and 18
• Holman, Ch. 2