Money and Inflation

Money Demand

Price Indices: Pt

• Two most commonly used price indices are GDP Deflator and Consumer Price Index (CPI)

• The CPI is the price of a representative market basket of goods relative to the price of that same basket during a benchmark/base year (multiplied by 100).

• The GDP deflator is the ratio of nominal GDP to Real GDP (multiplied by 100).

Nominal GDP GDPP GDPDeflator

Real GDP Y

Hong Kong CPI vs. GDP Deflator

0

20

40

60

80

100

120

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

CPI

GDP Deflator

CPI vs. GDP Deflator

• CPI is calculated monthly, GDP deflator is calculated quarterly.

• CPI measures the price of consumer goods. GDP deflator measures the price of all goods produced including investment or government goods.

• CPI measures the change in price of a constant market basket. Market basket of GDP deflator changes as goods produced changes.

The Data

• Data on money supply is inevitably measured by the central bank and usually the data is available for free.

Example: Hong Kong Monetary Authority

• Data on

Listing of Central Bank Websites.

What is a central bank?• Central banks have two main roles:

– Banker to the government• Manage many financial assets of the government.• Monopoly on the issue of banknotes/currency (true

almost everywhere, but not HK)• Arm of government policymaking

– Banker to commercial banks.• Operate the Payment System• Regulate Banking System• Lender of Last Resort during a crisis

• Central Bank: A special

governmental organization or quasi-governmental institution within the financial system that controls the medium of exchange.

Economy Central Bank

HK Hong Kong Monetary Authority

USA Federal Reserve

EU European Central Bank

PRC People’s Bank of China

UK, Canada, Japan, Korea

Bank of ….

Readings

• Money Demand– Branson, Chapter 14, especially p.335-339– Sachs Chapter 8

• Inflation

Money

• Financial Asset Used in Transactions

• Legal Tender: Government accepts money as payment for taxes and a transfer of money as a settlement for a contract.

Characteristics of Money

1.Medium of Exchange – Token that can be offered as a payment for goods.

2.Unit of Account – All goods will have a value in money and, thus, can be used to measure all goods

3.Store of Value – If money is to be accepted for goods today it must have durable value. (Money is an Asset).

Two categories of money

1. Definitive Money (sometimes known as monetary base): Money that can be used immediately for transactions without conversion to more basic forms of money.

– Currency+ Reserve accounts

2. Broad Money: A set of assets, typically some form of bank deposit, which can be easily converted to definitive money.

– Checking Accounts, Savings Accounts, Liquid Time Deposits and CD’s

Categories of Broad Money

M1

M2

M3

M1 Currency + Checking Acct.

M2 +Savings Acct.

+ “More Liquid” Time Deposit

M3 + “Less Liquid” Time Deposit

China

-0.05

0

0.05

0.1

0.15

0.2

0.25

0.3

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Inflation Money

Velocity

0.45

0.5

0.55

0.6

0.65

0.7

0.75

0.8

0.85

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Mpney Types in HK

M1

M2

M3

Incremental M3 is trivial in HK

HK$ Money CategoriesSource: HKMA http://www.info.gov.hk

Legal tender notes

and coins in hands of public

Demand deposits

with licensed

banks M1

145,852 207,444 353,297

Savings deposits

with licensed

banks

Time deposits

with licensed

banks

NCDs issued by licensed

banks and held

by public M2

788,211 1,288,193 76,342 2,506,043

Broad Money vs. Narrow Money

• Broad money has grown much faster than narrow money.

• Narrow money is money directly controlled by the government.

• Broad money includes money printed by the government plus deposits at banks.

• Money multiplier is ratio of broad money to narrow money.

Categories

• M0 = Reserves + Cash

• M2 = Cash + Demand Deposits + Savings Deposits

11

C D SMM

R CC SD DR CD D

Determinant of the Multiplier.

• The greater is the currency-deposit ratio the smaller is the multiplier.

• The greater is the savings to demand deposit ratio the greater is the multiplier.

• The higher is the fraction of deposits kept on reserve, the smaller is the multiplier.

Money Multiplier in China

0

4000

8000

12000

16000

20000

24000

4

6

8

10

12

14

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04

MULTIPLIER M2 M0

Monetary Theory• Two Assets

• Money (M) can be used for transactions but pays no interest.

• Bonds (B) will pay a nominal interest rate of i but cannot be used for transactions.

• If you buy a bond with $1, you will get $(1+i) from the issuer of the bond.

Liquidity Problem

• The household earns an income equal to (PQ) which they will spend evenly over the course of a month.

• If they keep their whole income in their back-pocket to do shopping they will lose interest income.

• If they buy interest earning bonds with all of their income, they will have to make many costly trips to the bank when they want to buy goods. The cost of each trip to the bank will be P∙b.

Liquidity Strategy

• Household strategy will be to keep a share of their income in the form of money, M*, and put the rest into bonds.

• They will spend that money until it is

gone, return to the bank, and convert bonds into M* again.

Choose # of trips to the bank.

• The household will have to make trips to the bank.

• The average balances held by the household will be

*

P Y

M

*

2

M

Money holdings over the month

time

Money

M*

*

2

M

Bond holdings over the month

time

Bonds

Costs of Strategy

• If the household is on average holding they will forego the opportunity to

earn interest equal to

• The total transactions costs of converting their bonds into cash is

*

2

M

*

2

Mi

*

P YP b

M

Minimize Total Costs

• Total liquidity costs of holding M*

• Choose the number of trips that would minimize the total costs (including interest costs).

*

* 2

P Y MP b i

M

Cost Minimization

• Trade-off: The more trips you make, the more interest you will earn but the less will be the transactions cost. – Choosing the number of trips is equivalent to

choosing M*

Optimal Money Demand

• Money demand is an increasing function of the price level, and output and a decreasing function of interest rates.

1

2

**

**

*2*

*

min ( )2

2' 0

2

2

M

P Y MTC M P b i

M

P Y i bYTC P b M P

iM

M bY

P i

Money Demand

• Intuition: The greater is P and Y, the greater are the need for money for transactions. The greater is i, the greater the interest rate costs.

• Money Demand is typically represented in terms of money divided by the price level, referred to as real balances. M

P

Money Demand Curve

i

M

P

Y↑

Velocity

• Velocity is defined as the speed at which money circulates or as the number of transactions that each unit of money is used in per period.

• Velocity is measured as the ratio of current dollar GDP to the money supply.

t t t

tt

t

PY YV

MMP

BT Theory and Velocity

• According to Baumol-Tobin theory, money velocity should grow with output.

• Asian experience suggests the opposite.• Possible reason: If b represents the costs

of goods that could have been produced in the absence of a trip to the bank, b would likely grow with productivity.

Long Run

• Demand for real balances a proportional function of GDP as well as a function of interest rates.

• The higher is the interest rate, the more willing the household is to incur the costs of not holding cash.

1( ) .t tt t t

tt t

M MY f i ex v Y

iP P

Empirical Studies of Money Demand

• The Baumol Tobin model suggests a log-linear form.

0 1 2

0 1 2

ln ln ln

ln

tt t

t

t t

Ma a Y a i

P

m a a y a i

Empirical Studies of Money Demand

• The Baumol Tobin model suggests a log-linear form.

• Empirical reality suggests that this does not capture short-term endogeneity between money, interest rates, and output.

0 1 2

0 1 2

ln ln ln

ln

tt t

t

t t

Ma a Y a i

P

m a a y a i

Inflation

• We are concerned with explaining the rate of change of the price level or the inflation rate

• First difference the log of the money demand function

1

1

lnt tt t

t

P P PP

P P

log log logt t t t

M Y it t t t

M Y i

g g g

Money Growth and the Nominal Interest Rate

• Define the real interest rate, as the amount of extra goods that can be gained, if you give up 1 good today.

11

11

111 1

1

1

t

t

tt t t P

t P

tt t t

t

ir i P

P

ir i

Long Run Inflation Rate

• Assume that there is a long run inflation rate and real variables are unaffected by inflation in the long run.

Δln i = 0

• Then long run inflation is money growth minus output growth.

M Yg g

Neo-classical Dichotomy

• Assume given Y and r which is not affected by money supply or growth rate. – Money is just paper which should not affect real

outcomes.

• Then, in the long run, we can solve for the price level as a function of the level of money and output and their growth rates (in addition to the real interest rate).

Price Level

• Then, in the long run, we can solve for the price level as a function of the level of money and output and their growth rates (in addition to the real interest rate).

1 M YMP r g g

v Y

Socially Optimal Inflation Rate

• Friedman Rule: Socially optimal inflation rate sets the interest rate equal to zero.

• If the interest rate were zero, workers in Baumol and Tobin model would keep all of their pay in cash and not have to make any costly trips to the bank.

• Set money growth gM = r - gY

Zero Lower Bound

• Friedman rule interest rate is also theoretical lower bound on the interest rate.

• Nominal interest rates on bonds cannot go below 0 because there is a freely available asset that always pays an interest rate at least equal to zero.

• Main objection to Friedman rule is that if we have a long run zero interest rate, the central bank will never be in a position to reduce interest rates.

ZIRP: Japan

Jul-1985 Jul-1988 Jul-1991 Jul-1994 Jul-1997 Jul-2000 Jul-2003 Jul-2006

10

9

8

7

6

5

4

3

2

1

0

JP: Call Rate: Uncollaterized: Overnight% pa

Why inflation?

• If zero or negative inflation is socially optimal, why is it so pervasive.

• Possible reason (especially in developing world): It is a source of government revenue (called seignorage).

• When the government prints new currency, it can use the money to pay off its old debts or buy new goods.

Real Seignorage

• Amount of goods purchased by the printing of money

• The higher is the money growth rate, the higher is the fraction of real balances that can be collected through seignorage.

1 1 1

1 1

Mt t t t t t

Mt t t t

M M M M M M g M

P M M P g P

Substitution Effect• Higher money growth reduces demand for

real balances. Higher inflation will mean higher interest rates, which will mean that people will spend money more quickly which drives up prices at a given output level.

• Assume r = gY, i=gM

1

1 1 1

MM MM

M M M

gg M gg Y Y

g P g g

Inflation Tax

% of Y

gM

How does declining money demand reduce the seignorage revenue?

• Consumers facing high inflation and thus high interest rates, want to hold relatively low money balances and are willing to make more trips to the bank.

• With a given amount of money chasing a given amount of output more quickly, prices will be higher and the amount that any newly printed dollar will buy will be reduced.

Hyper Inflation

• Hyperinflation occurs when inflation increases at a rate of 50% or more per month.

• In the long run, this rate of inflation is counter-productive to the government in terms of raising seignorage.

• Usually, a sign of a government trying to maximize short-term revenue by accelerating money growth faster than inflationary expectations. – Prices in China rose 250000% in Chungking from

1937-1945.

Current Chinese Inflation Rates

• Between 1984 and 1996, China frequently had very high inflation rates, reaching to levels of 20% or more per year.

• Since then inflation has been steady or decreasing.

Chinese CPI and Broad Money

150

200

250

300

350

400

0

5000

10000

15000

20000

25000

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04

CPICHINA M2

Velocity in China

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

5

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

M1 Velocity

M2 Velocity

Deposits are major channel for saving in PRC

Bank Deposits as Share of GDP

0.0%

20.0%

40.0%

60.0%

80.0%

100.0%

120.0%

140.0%

160.0%

180.0%

200.0%

China USA

Money & Inflation: 1975-1994

Inflation & Money OECD Countries

0

0.02

0.04

0.06

0.08

0.1

0.12

0.14

0.16

0.18

0.2

0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18

Average Money Growth

Ave

rag

e In

flat

ion

Rat

e

Causes of Extremely Rapid Inflation

• Government generates revenues by printing new money (referred to as seignorage).

• Government facing borrowing constraints may be forced to rely on inflation tax for deficit financing.

Israel 1970-1990

Inflation

0

50

100

150

200

250

300

350

400

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

Israel 1970-1990Surplus (% of GDP)

-30.00%

-25.00%

-20.00%

-15.00%

-10.00%

-5.00%

0.00%

5.00%

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

Hyperinflation

Mid-term Exam III

• Monday, December 13th 4:30-7:30PM

• Lecture Theater A

• Semi-open Book (Bring 1 A4 size paper with handwritten notes)) also calculator and writing instruments.

• Coverage. Lecture notes including this one.

• Lecture Theater A, 4:30-7:30