Econ 2 Chapter 17
Crumbling US dollars bailed out Zimbabwe
-American dollars has created a host of bizarre issues. The bills are filthy, crumbling and often in short supply. There are no U.S. coins to make change, so chocolate is handed out instead. There is, oddly, an abundance of $2 bills. -Restaurants often have trouble providing change. Customers who are finished and have paid their tabs with large bills sometimes have to wait for others to finish and pay with smaller bills so that change becomes available. -It seems odd, but this kind of change is common in Zimbabwe. That's because there are no U.S. coins. They're heavy and expensive to import. So Chivandile says most stores offer small snacks instead.
Monetarist View of Money
-As their name might suggest, monetarists are particularly interested in the economic effects of policies regarding the size and structure of the money supply -- questions regarding price levels, the value of currency and the availability of credit. -Monetarist academics are generally followers of the theories of Milton Friedman, a macroeconomist of the mid-20th century. -In general, monetarists believe that practices and events that affect the amount of money available for use by the economy have a more substantial impact on short-term productivity than do factors such as employment levels, aggregate demand or government fiscal policy.
Quantity Theory of Money
-Asserts that the quantity of money determines the value of money -began in the 16th century. As gold and silver inflows from the Americas into Europe were being minted into coins, there was a resulting rise in inflation -This led Henry Thornton in 1802 to assume that more money equals more inflation and that an increase in money supply does not necessarily mean an increase in economic output
Why does increasing money supply cause the price level, P, to rise?
-At the initial P, an increase in MS causes an excess supply of money. -People get rid of their excess money by spending it on g&s or by loaning it to others, who spend it. Result: increased demand for goods. -But supply of goods does not increase, so prices must rise.
Hyperinflation in Hungary
-Daily inflation rate: 207 percent Prices doubled every: 15 hours
Hyperinflation in Zimbabwe
-Daily inflation rate: 98 percent Prices doubled every: 25 hours -The jobless — officially 70 percent of Zimbabwe's 4.2 million workers, but widely placed at 80 percent when idle farmers are included — selling tomatoes and ground corn from roadside tables, an occupation banned by the police. -Those with spare cash put it not in banks, which pay 4 to 10 percent annual interest on savings, but in real investments like bags of corn meal and sugar, guaranteed not to lose their value -toilet paper cost $417 for one square -Large govt budget deficits led to the creation of large quantities of money and high inflation rates
QTM The bottom line:
-Economic growth increases # of transactions. -Some money growth is needed for these extra transactions. -Excessive money growth causes inflation.
Hyperinflation
-Hyperinflation is generally defined as inflation exceeding 50% per month. -Recall one of the Ten Principles from Chapter 1: Prices rise when the government prints too much money. -Excessive growth in the money supply always causes hyperinflation.
Cost of inflation: tax distortions
-Inflation makes nominal income grow faster than real income. -Taxes are based on nominal income, and some are not adjusted for inflation. -So, inflation causes people to pay more taxes even when their real incomes don't increase.
Speculative motive
-Money, like other stores of value, is an asset. The demand for an asset depends on both its rate of return and its opportunity cost. -Typically, money holdings provide no rate of return and often depreciate in value due to inflation. -The opportunity cost of holding money is the interest rate that can be earned by lending or investing one's money holdings. The speculative motive for demanding money arises in situations where holding money is perceived to be less risky than the alternative of lending the money or investing it in some other asset.
The Fisher Effect
-Nominal interest rate=inflation rate+real interest rate -The real interest rate is determined by saving & investment in the loanable funds market. -Money supply growth determines inflation rate. -So, this equation shows how the nominal interest rate is determined. -In the long run, money is neutral: a change in the money growth rate affects the inflation rate but not the real interest rate. -So, the nominal interest rate adjusts one-for-one with changes in the inflation rate. -This relationship is called the Fisher effect after Irving Fisher, who studied it.
The price level=P
-P is the price of a basket of goods measured in money -1/P is the value of $1, measured in goods -ex) if P=$2, value of $1 is 1/2 candy bar. If P=$3, value of $1 is 1/3 candy bar -Inflation drives up prices and drives down the value of money.
Money demand
-Refers to how much wealth people want to hold in liquid form. -Depends on P: An increase in P reduces the value of money, so more money is required to buy g&s. -quantity of money demanded is negatively related to the value of money and positively related to P, other things (real income, interest rates, availability of ATM) equal
Quantity equation
-Take the velocity formula V=PxY/M and multiply both sides by M, we get MxV=PxY
Keynesian View of Money
-The Keynesian theory of money is primarily supported by the academic followers of John Maynard Keynes, an early 20th century economist who proposed alternatives to classical economic theories. -In the Keynesian theory, the economy was divided into two basic features: the "real economy," which determined factors of material production such as labor, and the "monetary economy," which affects factors of valuation such as price level. -Keynesians generally believe that events in the real economy, such as reduced labor demand or government fiscal policies, have a greater effect on economic growth or recession than events that affect the supply of credit or money alone.
Monetarist Vs. Keynesian
-The debate between Monetarist and Keynesian theories of money is often raised in times of economic recession, when productivity declines and unemployment levels rise. -Keynesian economists often seek to address weak economic conditions using fiscal government stimulus : efforts to increase government expenditure, lower taxation and invest in long-term productive output: with the expectation that these policies will increase economic demand. -Monetarists, by contrast, are more interested in increasing the supply of money available to lenders and businesses, with the expectation that easier access to credit is more effective in generating productive growth. -Governments and central banks often enact policies to respond to recessions that are based to some degree in both theories of money.
Liquidity
-The degree to which an asset or security can be bought or sold in the market without affecting the asset's price -characterized by a high level of trading activity. Assets that can be easily bought or sold are known as liquid assets -The ability to convert an asset to cash quickly. Also known as "marketability."
The fisher effect and the inflation tax
-The inflation tax applies to people's holdings of money, not their holdings of wealth. -The Fisher effect: an increase in inflation causes an equal increase in the nominal interest rate, so the real interest rate (on wealth) is unchanged
Quantity theory of money
-The quantity theory of money states that there is a direct relationship between the quantity of money in an economy and the level of prices of goods and services sold. -According to QTM, if the amount of money in an economy doubles, price levels also double, causing inflation (the percentage rate at which the level of prices is rising in an economy). -The consumer therefore pays twice as much for the same amount of the good or service. -Another way to understand this theory is to recognize that money is like any other commodity: increases in its supply will cause a decrease marginal value (the buying capacity of one unit of currency). -So an increase in money supply causes prices to rise (inflation) as they compensate for the decrease in money's marginal value.
In classical dichotomy: If central bank doubles the money supply, Hume & classical thinkers contend:
-all nominal variables—including prices— will double. -all real variables—including relative prices— will remain unchanged.
Real vs nominal wage
-an important relative price is the real wage -real wage is the price of labor relative to the price of output: W/P=$15/$5=3 units output per hour -W=nominal wage=price of labor -P=price level
Nominal variables
-are measured in monetary units. -Examples: nominal GDP, nominal interest rate (rate of return measured in $), nominal wage ($ per hour worked)
Real variables
-are measured in physical units. -Examples: real GDP, real interest rate (measured in output), real wage (measured in output)
Value of money vs Price level
-as value of money rises, the price level falls -a fall in value of money causes increase in price level and increase in quantity demanded of money
Most economists believe the classical dichotomy and neutrality of money
-describe the economy in the long run. -Keynesian's believe that in the short-run prices tend to be sticky and therefore, money can have real effects in the short-run
Value of a dollar
-does not stay constant when there is inflation. -is observed in terms of purchasing power, which is the real, tangible goods that money can buy. -When inflation goes up, there is a decline in the purchasing power of money.
If fed increases money supply...
-equilibrium value of money decreases, equilibrium price level increases (value of money falls and P rises)
The inflation fallacy
-inflation fallacy: most people think inflation erodes real incomes -But inflation is a general increase in prices of the things people buy and the things they sell (e.g., their labor). -In the long run, real incomes are determined by real variables, not the inflation rate.
Doubling money supply causes all nominal prices to double; what happens to relative prices?
-initial relative price of cd in terms of pizza=price of cd/price of pizza=$15/$10=1.5 pizzas per cd -After nominal prices double=price of cd/price of pizza=$30/$20=1.5 pizzas per cd -As you can see, nominal prices change but relative price is unchanged
Cost of inflation: menu costs
-is the costs of changing prices -printing new menus, mailing new catalogs, etc.
Cost of inflation: Shoeleather costs
-is the resources wasted when inflation encourages people to reduce their money holdings -includes time and transactions costs of more frequent bank withdrawals
The demand for money is affected by several factors, including
-level of income -interest rates -inflation -uncertainty about the future.
Similarly to money neutrality, the real wage W/P remains unchaged. So:
-quantity of labor supplied does not change -quantity of labor demanded does not change -total employment of labor does not change -the same applies to employment of capital and other resources -Since employment of all resources is unchanged, total output is also unchanged by the money supply.
real wage
-the purchasing power of the wage, it is corrected for inflation. -"purchasing power of wage" is the quantity of output workers can buy with their wage. Hence, the real wage is measured in units of output. -"corrected for inflation" example: Suppose the nominal wage rises 20% and the price level also rises 20% -measured in units of output
Velocity of money
-the rate at which money changes hands -Velocity formula: V=PxY/M -Where PxY=nominal GDP=(price level)x(real GDP) and M=money supply
The Inflation Tax
-the revenue from printing money is the inflation tax: printing money causes inflation, which is like a tax on everyone who holds money -When tax revenue is inadequate and ability to borrow is limited, govt may print money to pay for its spending. -Almost all hyperinflations start this way. -In the US inflation tax today accounts for less than 3% of total revenue
Mo
=federal reserve notes+US notes+coins -basically the total of all physical currency
Costs of Inflation: Reduced international competitiveness
A relatively higher inflation rate will make US goods less competitive, leading to a fall in exports. However this may be offset by a decline in the exchange rate. But, if a country is in the Euro (e.g. Greece, Ireland and Spain) they can't devalue. Therefore, high inflation can be very damaging as it leads to a decline in competitiveness.
Cost of inflation: Misallocation of resources from relative-price variability
Firms don't all raise prices at the same time, so relative prices can vary... which distorts the allocation of resources.
Anticipated and unanticipated inflation
If inflation is unanticipated (e.g. people expect a lower inflation rate) then the costs will be more serious than if the inflation rate was expected. It is unanticipated inflation that can negatively impact on a firm's costs.
Cost of inflation: Confusion & inconvenience
Inflation changes the yardstick we use to measure transactions. Complicates long-range planning and the comparison of dollar amounts over time.
Precautionary motive
People often demand money as a precaution against an uncertain future. Unexpected expenses, such as medical or car repair bills, often require immediate payment. The need to have money available in such situations is referred to as the precautionary motive for demanding money
Quantity Theory in 5 steps
Start with quantity equation: MxV=PxY 1. V is stable. 2. So, a change in M causes nominal GDP (P x Y) to change by the same percentage. 3. A change in M does not affect Y: money is neutral, Y is determined by technology & resources 4. So, P changes by same percentage as P x Y and M. 5. Rapid money supply growth causes rapid inflation.
Transactions motive
The transactions motive for demanding money arises from the fact that most transactions involve an exchange of money. Because it is necessary to have money available for transactions, money will be demanded. The total number of transactions made in an economy tends to increase over time as income rises. Hence, as income or GDP rises, the transactions demand for money also rises
Theory 1 of inflation: Demand-pull
This theory can be summarized as "too much money chasing too few goods". In other words, if demand is growing faster than supply, prices will increase. This usually occurs in growing economies.
Theory 2 of inflation: cost-push
When companies' costs go up, they need to increase prices to maintain their profit margins. Increased costs can include things such as wages, taxes, or increased costs of imports
Hyperinflation
is unusually rapid inflation (at least 50% a month). In extreme cases, this can lead to the breakdown of a nation's monetary system. One of the most notable examples of hyperinflation occurred in Germany in 1923, when prices rose 2,500% in one month!
Quantity of money is determined by...
the Fed, the banking system, and consumers
Stagflation
the combination of high unemployment and economic stagnation with inflation. This happened in industrialized countries during the 1970s, when a bad economy was combined with OPEC raising oil prices.
relative price
the price of one good relative to (divided by) another
Monetary neutrality
the proposition that changes in the money supply do not affect real variables
Classical dichotomy
the theoretical separation of nominal and real variables
If real GDP is growing
then inflation rate < money growth rate
If real GDP is constant
then inflation rate = money growth rate
Inflation
when general (average) prices are rising
Deflation
when the general level of prices is falling. This is the opposite of inflation