Macro Session 5

7/27/2019 Macro Session 5

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Macroeconomics & the GlobalEconomy

Ace Institute of Management

Session 5: Money and Inflation

InstructorRijan Dhakal

[email protected]

9851069004
mailto:[email protected]:[email protected]


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Stock of assets

Used for transactions

A type of wealthMoney


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Store of value: You can postpone your purchase for next period.

Unit of account: units in which prices are quoted and debts

recorded

A medium of exchange.: used to buy goods and services

The ease with which money is converted into other things such as

goods and services--is sometimes called moneys liquidity.


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Measures economic transactions likeyardsticks. Without it, we would be

forced to barter.

Problem with barter: requires the double

coincidence of wants.


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Fiat moneyis money by declaration.

It has no intrinsic value.

Commodity moneyis money that

has intrinsic value.

Eg. Gold or cigarettes in P.O.W. camps

When people use gold as money, theeconomy is said to be on a gold standard.


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The money supply: quantity of money available in an economy.

Monetary policy: The control over the money supply (increasingor decreasing).

Central Bank: Institution that conducts monetary policy.

Open Market Operation: Primary way of controlling Money

SupplyTo expand the money supply(expansionary mon. policy):

Central bank buys government bonds and pays for them

with new money.

To reduce the money supply(contractionary mon. policy):

Central bank sells government bonds and receives the

existing money.


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Other instruments of Monetary Policy

Changing the Reserve requirements.

Minimum reserves each Commercial

bank must hold

Changing the Discount rate

(which member banks (not meeting the

reserve requirements) pay to borrow

from the Central Banks.)


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Currency

Demand Deposits

M1, M2, M3

For Nepal: Broad Money (M2) and Narrow

Money (M1)


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Equilibrium in Money Market

Quantity ofMoney

Value ofMoney, 1/P

Price

Level, P

Quantity fixedby the Central Bank

Money supply

0

1

(Low)

(High)

(High)

(Low)

1/2

1/4

3/4

1

1.33

2

4Equilibriumvalue ofmoney

Equilibriumprice level

Moneydemand

A


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Quantity Theory of Money

The Quantity Theory of Money states that there is adirect relationship between the quantity of money in aneconomy and the level of prices of goods and servicessold.

If the amount of money in an economy doubles, price levels alsodouble, causing Inflation (the percentage rate at which the levelof prices is rising in an economy).

The consumer therefore pays twice as much for the sameamount of the good or service.

Money is like any other commodity: increase in its supply

decreases marginal value (the buying capacity of one unit ofcurrency).

So an increase in money supply causes prices to rise (inflation)as they compensate for the decrease in moneys marginalvalue.


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Quantity Theory of Money-Derivation

Md = T x P

T = Number of transactions in an economy

P = General price Level.

Ms = M x V

M = Amount of Money in circulation

V = Velocity of money (the number of times

money changes pockets)

For Equilibrium condition, Md = Ms

i.e. T x P = M x V


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Transactions calculation not easy

Replaces with Total Output (Transactions and output are related : asthe more the economy produces, the more goods are bought and sold).

Money Velocity = Price Output

M V = P Y

The Quantity Theory of Money

MV = PY M P

Fixed Y : as K, L are fixed, and

Fixed V : supposed constant over time

Price Level is directly proportional to the Quantity of

Money in the Economy.


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Price Level is directly proportional to the Quantity of Money in

the Economy.

or in percentage change form:

MV = PY

% Change in M + % Change in V = % Change in P + % Change in Y

If V is fixed and Y is fixed, then it reveals that % Change in M is what

induces % Change in P.

M P

The Quantity Theory of Money

The quantity theory of money states that the central bank, whichcontrols the money supply, has the ultimate control over the inflation

rate. If the central bank keeps the money supply stable, the price level

will be stable. If the central bank increases the money supply rapidly,

the price level will rise rapidly.


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The Effects of Monetary Injection

Quantity ofMoney

Value ofMoney, 1/P PriceLevel, P

Moneydemand

0

1

(Low)

(High)

(High)

(Low)

1/2

1/4

3/4

1

1.33

2

4

M1

MS1

M2

MS2

2. . . . decreasesthe value ofmoney . . . 3. . . . and

increasesthe pricelevel.

1. An increasein the moneysupply . . .

A

B


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Fisher Equation: i= r+ p

Actual (Market)

nominal rate of

interest

Real rate

of interest

Inflation

The one-for-one relationship

between the inflation rate

and the nominal interest

rate is the Fisher effect.

It shows that the nominal interest can change for two reasons:

because the real interest rate changes or because the inflation rate

changes.


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People have expectation of the inflation rate.

Let p = actual future inflation andpe = expectation of future inflation.

Adjustment to Fisher Effects

i= r+ pe

Actual inflation is not known when the nominal interest rate is

set. But people can adjust to expected inflation.

The nominal interest rate imoves one-for-one with changes in

expected inflation pe.


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Shoe-leather costof inflation:walking to the bank more often induces ones

shoes to wear out more quickly.

Menu costs:

When changes in inflation require printing and

distributing new pricing information.

Tax Laws:

Often tax laws do not take into considerationof

inflationary effects on income.


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Unanticipated inflation is unfavorable because it arbitrarily

redistributes wealth among individuals. For example, it hurts

individuals on fixed pensions.

There is a benefit of inflationmany economists say that some

inflation may make labor markets work better. They say it greasesthe wheels of labor markets.


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Hyperinflation: inflation that exceeds 50 percent

per month, which is just over 1percent a day.

Costs such as shoe-leather and menu costs are

much worse with hyperinflationand tax systems

are grossly distorted. Eventually, when costs

become too great with hyperinflation, the moneyloses its role as store of value, unit of account and

medium of exchange. Bartering or using

commodity money becomes prevalent.


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Thank You

Macro Session 5

Documents

Transcript of Macro Session 5