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Macroeconomics & The global
economy
Ace Institute of Management
Chapter 4: Money and Inflation
Instructor
Sandeep Basnyat
Sandeep_basnyat@yahoo.com
9841 892281
Money
Stock of assets
Used for transactions
A type of wealth
• 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 money’s liquidity.
• Measures economic transactions like
yardsticks. Without it, we would be
forced to barter.
• Problem with barter: requires the double
coincidence of wants.
Fiat money is money by declaration.
It has no intrinsic value.
Commodity money is money that
has intrinsic value.
Eg. Gold or cigarettes in P.O.W. camps
When people use gold as money, the
economy is said to be on a gold standard.
• The money supply: quantity of money available in an economy.
• Monetary policy: The control over the money supply (increasing
or decreasing).
• Central Bank: Institution that conduct monetary policy.
• Open Market Operation: Primary way of controlling Money
Supply
To expand the money supply:
Central banks buys government bonds and pays for them
with new money.
To reduce the money supply:
Central banks sells government bonds and receives the
existing money and then destroys them.
Other instrument 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.)
• Currency
• Demand Deposits
• M1, M2, M3
For Nepal:
• Broad Money (M2) and Narrow
Money (M1)
Monetary Statistics for US and Nepal for 2008/2009
Nepal
US
Rs. 18307
million or $1.99
Monetary Base (M1)
Approx. $250 trillion
million
M2
Reserve Requirements
Rs. 67644
million or $8.36
Approx. $926 trillion
million
5.50%
10%
FYI: Prepare a list of countries with their Money Supply, Reserve
Requirements and Central Banks monetary instruments in
monetary policy operations.
Equilibrium in Money Market
Value of
Money, 1/P
(High)
Price
Level, P
Money supply
1
1
3
1.33
/4
12
/
Equilibrium
value of
money
(Low)
A
(Low)
2
Equilibrium
price level
14
4
/
Money
demand
0
Quantity fixed
by the Central Bank
Quantity of
Money
(High)
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.
– 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.
– Money is like any other commodity: increases in its supply
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.
Quantity Theory of Money-Derivation
• Md = T x P
– T = Number of transactions in an economy
– P = General price Level. It is the nominal GDP
• Ms = M x V
– M = Amount of Money in circulation
– V = Velocity of money (the number of times
money changes hands)
From Equilibrium condition, Md = Ms
TxP=MxV
The Quantity Theory of Money
• Transactions calculation not easy
• Replaces with Total Output (Transactions and output are related as
the more the economy produces, the more goods are bought and sold).
Money  Velocity = Price  Output
M 
V
= P  Y
Fixed Y = as K, L are fixed, and
Fixed V : supposed constant over time
MV = PY
MαP
Price Level is directly proportional to the Quantity of
Money in the Economy.
The Quantity Theory of Money
MV = PY
MαP
Price Level is directly proportional to the Quantity of Money in
the Economy.
or in percentage change form:
% 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 % Changes in P.
The quantity theory of money states that the central bank, which
controls 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.
• The revenue raised through the printing of money is called
seigniorage.
• When the government prints money to finance expenditure,
it increases the money supply. The increase in the money
supply, in turn, causes inflation. Printing money to raise
revenue is like imposing an inflation tax.
The Effects of Monetary Injection
Value of
Money, 1 /P
(High)
MS1
MS2
1
1
1. An increase
in the money
supply . . .
3
2. . . . decreases
the value of
money . . .
Price
Level, P
/4
12
/
1.33
A
2
B
14
/
(Low)
3. . . . and
increases
the price
level.
4
Money
demand
(High)
(Low)
0
M1
M2
Quantity of
Money
Money and Prices During Four Hyperinflations
(a) Austria
(b) Hungary
Index
(Jan. 1921 = 100)
Index
(July 1921 = 100)
100,000
100,000
Price level
Price level
10,000
10,000
Money supply
1,000
100
Money supply
1,000
1921
1922
1923
1924
1925
100
1921
1922
1923
1924
1925
Money and Prices During Four Hyperinflations
(c) Germany
(d) Poland
Index
(Jan. 1921 = 100)
100,000,000,000,000
1,000,000,000,000
10,000,000,000
100,000,000
1,000,000
10,000
100
1
Index
(Jan. 1921 = 100)
10,000,000
Price level
Money
supply
Price level
1,000,000
Money
supply
100,000
10,000
1,000
1921
1922
1923
1924
1925
100
1921
1922
1923
1924
1925
• Nominal interest rate: interest rate that the bank pays
• Real interest rate: increase in purchasing power
• The relationship between the nominal interest rate and the rate
of inflation:
r=i-π
r = real interest rate; I = nominal interest rate; and,
p = inflation rate of inflation
Fisher Equation: i = r + p
The one-to-one relationship
between the inflation rate
and the nominal interest
rate is the Fisher effect.
Actual (Market)
Inflation
Real
rate
nominal rate of
of interest
interest
It shows that the nominal interest can change for two reasons:
because the real interest rate changes or because the inflation rate
changes.
i=r+p
• According to the quantity theory, a 1% increase in the
money supply causes a 1% increase in inflation.
• According to the Fisher equation, a 1% increase in the
rate of inflation in turn causes a 1% increase in the
nominal interest rates.
• Simplified:
r = i -p
Adjustment to Fisher Effects
• People have expectation of the inflation rate.
Let
p = actual future inflation and
pe = expectation of future inflation.
• Actual inflation is not known when the nominal interest rate is
set. But people can adjust to expected inflation.
i=r+
e
p
• The nominal interest rate i moves one-for-one with changes in
expected inflation pe.
Shoe-leather cost of inflation:
walking to the bank more often induces one’s
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 consideration
inflationary effects on income.
• Unanticipated inflation is unfavorable because it arbitrarily
redistributes wealth among individuals. For example, it hurts
individuals on fixed pensions.
• There is a benefit of inflation—many economists say that some
• inflation may make labor markets work better. They say it
“greases the wheels” of labor markets.
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 hyperinflation—and tax systems
are grossly distorted. Eventually, when costs
become too great with hyperinflation, the money
loses its role as store of value, unit of account and
medium of exchange. Bartering or using
commodity money becomes prevalent.
• Separation of the determinants of real and nominal
variables: changes in the money supply do not influence
real variables.
• This irrelevance of money for real variables is called
monetary neutrality. For the purpose of studying long-run
issues--monetary neutrality is approximately correct.
The Classical dichotomy
Y
Y
No Change in Output
N
W/P
P
W
No Change in Level of Employment
N
Increase in Wage Level
Increase in Price
P
There is a dichotomy between real and monetary sector.
Thank You