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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).
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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 (%)
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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
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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.
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