Lecture 18

MoneyWhat is money?

Anything people will accept in place of the goods they seek to obtain. Trust is critical.

Examples from history: salt in Egypt; rice in Japan; dried fish in Iceland; cotton cloth in Africa; cigarettes in Romania in the 1970s; liquor in Germany after World War II; QQ coin in China; rocks such as gold and silver

Roles of Money

Account keepingStore of ValueMedium of Exchange

More efficient than barterIf people do not trust official money,

they use other things

Money Creation

Governments create moneyRole of central banks

Independence from politics importantMany views on how the banks should

manage money creation — fixed rules versus flexibility

Inflation

What is inflation? It is a general rise in prices —not an increase in one price, such as higher price for wheat one year due to bad crops causing a short supply.

Usually it is caused by more money in the hands of people who are trying to buy the same quantity of goods in an economy.

Inflation Is Not an Increase in One PriceIf the price of one good rises, it does not

cause inflation. It is a change in relative prices.

People have no more money to spend than before, they change spending mix.

Example: Price of gasoline up in U.S. 2006: 4.6% of personal expenditures on gas; in 1997: 2.6%

Where does the extra money spent on gas (2% of personal income) come from? Less spending on other goods.

MV = PTThe quantity theory of money is:MV = PTM = money in circulationV = velocity (number of times money

spent per year)P = average price levelT = number of transactionsNote: this is national income.

Price of Gas RisesMV = PTAssume M and V constant.P of gasoline rises; T constantIf Demand for gasoline constant (T not

changing), since more spent on gas, other transactions must fall (and their prices may too as a result).

Gas Goes Up —What Goes Down?Consumers do not make money, so M constant.Velocity rarely changes in stable economies.Price of gas goes up; but Demand constant, so

something gives—in U.S. the drop occurred in spending at higher class stores and nicer restaurants. Spending on luxury goods dropped (boat sales and jewelry). Lower income people cut spending at Wal-Mart.

Same thing from increase in mortgage rates—consumers must cut back in other areas.

It hurts, but it is not inflation.

So What Causes Inflation?

In general, inflation is caused by more money (M) chasing the same quantity of goods.

If M rises and V constant then PT must rise to balance equation.

People have more money so make more purchases (T rises) increase in T means more demand for same level of goods, so prices (P) bid higher.

Origins of Inflation

So why do we get inflation? The government creates more money. Why? Not stupidity. It is deficit

spending.1. Print money.2. Borrow money from Central Bank or

from foreigners.

Destructive Effects

When inflation rising (and is expected to continue to rise):

▲ spending and borrowing▼ savings and investment▲ incentive to inflate currency even

more, depending on political forces

Real vs. Nominal Interest Rate

Suppose inflation averages 10% per year (the value of the currency falls by 10% each year).

If interest rate paid is 12%, that is the nominal interest rate.

What is real (after inflation) interest rate?

12% – 10% = 2%

Inflation Hurts People,Business, and Society

Businesses have a difficult time planning for future — which means less investment.

How do you time payments?Do you accept currency?There are winners and losers in every

transaction just due to changes in the value of the currency — up or down.

Real World Example

Assume a person in the U.S. invested $10,000 in 1971 for their retirement in 1991 when the investment is worth $35,000 — a normal rate of return.

What is the gain? Due to inflation, $10,000 in 1971 = $34,000 in 1991. So gain is only $1,000. But the entire “gain” of $25,000 is subject to taxes of about $7,000, leaving $28,000 in 1991 — less than the original investment in real spending power.

So if people think there will be inflation—what actions do they rationally take?

Rational Decision Makers

People try to avoid losses imposed by inflation:● invest in hard assets● invest in other countries● avoid currency of own country

Due to international flows of currency, inflation is punished in the market. Local people with few options suffer the most. Political instability more likely if currency unstable.