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Chapter 4
Money and Inflation
CHAPTER 4
Money and Inflation
slide 0
In this chapter, you will learn…
 The classical theory of inflation
 causes
 effects
 social costs
 “Classical” – assumes prices are flexible &
markets clear
 Applies to the long run
CHAPTER 4
Money and Inflation
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U.S. inflation and its trend, 1960-2006
15%
% change in CPI from
12 months earlier
12%
long-run trend
9%
6%
3%
0%
1960 1965
1970 1975
1980 1985
1990 1995
2000 2005
slide 2
Turkish inflation and its trend,
2001-2011
Source: CBT
CHAPTER 4
Money and Inflation
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The connection between
money and prices
 Inflation rate = the percentage increase
in the average level of prices.
 Question: How would you calculate the inflation
rate if you know the GDP deflator or the CPI?
CHAPTER 4
Money and Inflation
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The money supply and
monetary policy definitions
 The money supply is the quantity of money
available in the economy.
 Monetary policy is the control over the money
supply.
 Expansionary MP
 Contractionary MP
CHAPTER 4
Money and Inflation
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The central bank
 Monetary policy is conducted by a country’s
central bank.
 In the U.S.,
the central bank
is called the
Federal Reserve
(“the Fed”).
The Federal Reserve Building
Washington, DC
CHAPTER 4
Money and Inflation
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In Turkey, the central
bank is called the
“Central Bank of
Turkey (CBT)” or
TCMB.
CHAPTER 4
Money and Inflation
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Money supply measures, April 2006
symbol assets included
C
amount
($ billions)
Currency
$739
M1
C + demand deposits,
travelers’ checks,
other checkable deposits
$1391
M2
M1 + small time deposits,
savings deposits,
money market mutual funds,
money market deposit accounts
$6799
CHAPTER 4
Money and Inflation
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 Why do we care about these various measures?
 Because an increase Money demand reflects an
increase in demand for goods and services 
Inflation?
 keeping output constant,  demand  P 
 Watching the right quantity is important for policy
making.
CHAPTER 4
Money and Inflation
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The Quantity Theory of Money
 A simple theory linking the inflation rate
to the growth rate of the money supply.
 Begins with the concept of velocity…
CHAPTER 4
Money and Inflation
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Velocity
 basic concept: the rate at which money circulates
 definition: the number of times the average dollar
bill changes hands in a given time period
 example: In 2007,
 $500 billion in transactions
 money supply = $100 billion
 The average dollar is used in five transactions
in 2007
 So, velocity = 5
CHAPTER 4
Money and Inflation
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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
Money and Inflation
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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
Y
= quantity of output
P Y = value of output
CHAPTER 4
Money and Inflation
(GDP deflator)
(real GDP)
(nominal GDP)
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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.
CHAPTER 4
Money and Inflation
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 M in the quantity equation refers to Money
Supply.
 What is Money Demand?
CHAPTER 4
Money and Inflation
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Money demand and the quantity
equation
 M/P = real money balances, the purchasing
power of the money supply.
 A simple money demand function:
(M/P )d = kY
where
k = how much money people wish to hold for
each dollar of income.
(k is exogenous)
CHAPTER 4
Money and Inflation
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Money demand and the quantity
equation
 money demand:
 quantity equation:
(M/P )d = kY
M V = P Y
 (M/P)s = Y/V
 In equilibrium: (M/P)d = (M/P)s
 k = 1/V
 When people hold lots of money relative
to their incomes (k is high),
money changes hands infrequently (V is low).
CHAPTER 4
Money and Inflation
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Back to the quantity theory of
money
 starts with quantity equation
 assumes V is constant & exogenous: V V
 With this assumption, the quantity equation can
be written as
M V  P Y
CHAPTER 4
Money and Inflation
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The quantity theory of money,
cont.
M V  P Y
How the price level is determined:
 With V constant, the money supply determines
nominal GDP (P Y ).
 Real GDP is determined by the economy’s
supplies of K and L and the production
function (Chap 3).
 The price level is
P = (nominal GDP)/(real GDP).
CHAPTER 4
Money and Inflation
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The quantity theory of money,
cont.
 Re-write the quantity equation as:
%  in M  %  in V  %  in P  %  in Y


 

 


0
InflationRate
0
 % ∆ in Y: 0 (unless there is a ∆ in tech. or factors
of production)
 The Central Bank (by adjusting the level of M)
has control over inflation rate.
CHAPTER 4
Money and Inflation
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Confronting the quantity theory
with data
The quantity theory of money implies
1. countries with higher money growth rates
should have higher inflation rates.
2. the long-run trend behavior of a country’s
inflation should be similar to the long-run trend
in the country’s money growth rate.
Are the data consistent with these implications?
CHAPTER 4
Money and Inflation
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International data on inflation and
money growth
100
Turkey
Inflation rate
Ecuador
Indonesia
(percent,
logarithmic scale)
Belarus
10
Argentina
U.S.
1
Singapore
Switzerland
0.1
1
10
100
Money Supply Growth
(percent, logarithmic scale)
CHAPTER 4
Money and Inflation
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Inflation and interest rates
 Nominal interest rate, i , is not adjusted for
inflation
 Real interest rate, r , is adjusted for
inflation:
r = i 
CHAPTER 4
Money and Inflation
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The Fisher effect
 The Fisher equation: i = r + 
 Chap 3: S = I determines r.
 Hence, an increase in  causes an equal
increase in i.
 This one-for-one relationship is called the
Fisher effect.
CHAPTER 4
Money and Inflation
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Inflation and nominal interest rates
in the U.S., 1955-2006
percent
per year
15
nominal
interest rate
10
5
0
inflation rate
-5
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
CHAPTER 4
Money and Inflation
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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
Money and Inflation
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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
Money and Inflation
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Two real interest rates
 When the borrower and the lender sign a contract, it
specifies the nominal interest rate.
 Q: Do the borrower and the lender know the real interest
rate over the duration of the contract?
 A: They do not know the actual  but they have a guess.
 Ex-ante real interest rate: expected real interest rate
before the contract is signed
 Ex-post real interest rate: realized interest rate
CHAPTER 4
Money and Inflation
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Two real interest rates
  = actual inflation rate
(not known until after it has occurred)
  e = expected inflation rate
 i –  e = ex ante real interest rate:
the real interest rate people expect
at the time they buy a bond or take out a loan
 i –  = ex post real interest rate:
the real interest rate actually realized
CHAPTER 4
Money and Inflation
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