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CHAPTER 4
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CHAPTER 4
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12%
long-run trend
9%
6%
3%
0%
1960 1965
1970 1975
1980 1985
1990 1995
2000 2005
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CHAPTER 4
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Money: Definition
CHAPTER 4
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Money: Functions
medium of exchange
we use it to buy stuff
store of value
transfers purchasing power from the present to
the future
unit of account
the common unit by which everyone measures
prices and values
CHAPTER 4
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Money: Types
1. fiat money
CHAPTER 4
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Discussion Question
Which of these are money?
a. Currency
b. Checks
c. Deposits in checking accounts
(demand deposits)
d. Credit cards
e. Certificates of deposit
(time deposits)
CHAPTER 4
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CHAPTER 4
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In India,
the central bank
is called the
Reserve Bank
of India.
CHAPTER 4
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(` Billion)
Components of Money Stock
Measures
Outstanding as on March 31
2013-14
1
12,483.4
12,837.4
166.0
7.4
527.3
8,063.5
8,043.9
19.7
20,547.0
423.6
20,970.6
74,426.3
94,973.3
1,572.0
96,545.3
http://www.rbi.org.in/scripts/BS_ViewBulletin.aspx
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Source: www.rbi.org.in
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CHAPTER 4
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Velocity
basic concept: the rate at which money circulates
definition: the number of times the average rupee
changes hands in a given time period
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98 146 151
United Kingdom
31 87 101 169 151
Hong Kong SAR, China
38 33
Korea, Rep.
30 34 65 131 134
Least developed countries: UN
classification
18 23 24 37 39
Sri Lanka
32 28 38 37 34
Middle East & North Africa (all
income levels)
35 56 58 62 58
Nigeria
29 20 22 21 22
High income: OECD
76 96 114 137 135
OECD members
74 93 111 133 131
Pakistan
41 39 39 41 41
South Asia
33 40 50 71 71
Thailand
42 76 115 116 135
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Velocity, cont.
This suggests the following definition:
T
V
M
where
V = velocity
T = value of all transactions
M = money supply
CHAPTER 4
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Velocity, cont.
Use nominal GDP as a proxy for total
transactions.
Then,
P Y
V
M
where
P
= price of output
= quantity of output
P Y = value of output
CHAPTER 4
(GDP deflator)
(real GDP)
(nominal GDP)
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It is an identity:
it holds by definition of the variables.
CHAPTER 4
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money demand:
quantity equation:
(M/P )d = k Y
M V = P Y
CHAPTER 4
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M V P Y
CHAPTER 4
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M V P Y
How the price level is determined:
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M V
P Y
M
V
P
Y
The quantity theory of money assumes
V
V is constant, so
= 0.
V
CHAPTER 4
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P
P
M
P Y
M
P
Y
CHAPTER 4
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CHAPTER 4
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CHAPTER 4
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Indonesia
Argentina
U.S.
Singapore
CHAPTER 4
Belarus
Switzerland
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Over
Over the
the long
long run,
run, the
the inflation
inflation and
and
money
money growth
growth rates
rates move
move together,
together,
M2 growth
as
theory
predicts.
as the
the quantity
quantity
theoryrate
predicts.
9%
6%
3%
0%
1960 1965
inflation
rate
1970 1975
1980 1985
1990 1995
2000 2005
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Seigniorage
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CHAPTER 4
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CHAPTER 4
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percent
per year
15
10
inflation rate
-5
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
CHAPTER 4
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Bulgaria
Israel
Germany
U.S.
Switzerland
CHAPTER 4
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Exercise:
Suppose V is constant, M is growing 5% per year,
Y is growing 2% per year, and r = 4.
a. Solve for i.
b. If the Fed increases the money growth rate by
2 percentage points per year, find i.
c. Suppose the growth rate of Y falls to 1% per year.
What will happen to ?
What must the Fed do if it wishes to
keep constant?
CHAPTER 4
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Answers:
V is constant, M grows 5% per year,
Y grows 2% per year, r = 4.
a. First, find = 5 2 = 3.
Then, find i = r + = 4 + 3 = 7.
b. i = 2, same as the increase in the money
growth rate.
c. If the Fed does nothing, = 1.
To prevent inflation from rising,
Fed must reduce the money growth rate by
1 percentage point per year.
CHAPTER 4
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(M P ) L(i , Y )
d
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(M P ) L(i , Y )
d
L(r , Y )
e
CHAPTER 4
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Equilibrium
M
e
L(r , Y )
P
The supply of real
money balances
CHAPTER 4
Real money
demand
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adjusts to make S = I
Y F (K , L )
M
L(i ,Y )
adjusts to make
P
CHAPTER 4
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How P responds to M
M
e
L(r , Y )
P
CHAPTER 4
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How P responds to e
M
L(r e , Y )
P
P to make M P fall
to re-establish eq'm
CHAPTER 4
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Discussion question
Why is inflation bad?
CHAPTER 4
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A common misperception
Common misperception:
inflation reduces real wages
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250
$18
200
hourly wage
$14
$12
150
$10
$8
100
$6
CPI (right scale)
wage in current dollars
wage in 2006 dollars
$4
$2
$0
1964
CHAPTER 4
1970
1976
1982
Money
and
Inflation
1988
1994
2000
$16
50
0
2006
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CHAPTER 4
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CHAPTER 4
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i
real money balances
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CHAPTER 4
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CHAPTER 4
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CHAPTER 4
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Hyperinflation
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CHAPTER 4
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A few examples of
hyperinflation
money
growth (%)
inflation
(%)
Israel, 1983-85
295
275
Poland, 1989-90
344
400
Brazil, 1987-94
1350
1323
Argentina, 1988-90
1264
1912
Peru, 1988-90
2974
3849
Nicaragua, 1987-91
4991
5261
Bolivia, 1984-85
4208
6515
CHAPTER 4
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the4 price
level:
The amount
CHAPTER
Money
and Inflation
of : Rupees needed
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Classical dichotomy:
the theoretical separation of real and nominal
variables in the classical model, which implies
nominal variables do not affect real variables.
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Chapter Summary
Money
the stock of assets used for transactions
serves as a medium of exchange, store of value, and
unit of account.
Commodity money has intrinsic value, fiat money
does not.
Central bank controls the money supply.
Quantity theory of money assumes velocity is stable,
concludes that the money growth rate determines the
inflation rate.
CHAPTER 4
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Chapter Summary
Nominal interest rate
equals real interest rate + inflation rate
the opp. cost of holding money
Fisher effect: Nominal interest rate moves
one-for-one w/ expected inflation.
Money demand
depends only on income in the Quantity Theory
also depends on the nominal interest rate
if so, then changes in expected inflation affect the
current price level.
CHAPTER 4
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Chapter Summary
Costs of inflation
Expected inflation
CHAPTER 4
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Chapter Summary
Hyperinflation
caused by rapid money supply growth when money
CHAPTER 4
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Chapter Summary
Classical dichotomy
In classical theory, money is neutral--does not affect
real variables.
So, we can study how real variables are determined
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