Lecturer: Dr. Edward Asiedu, UGBS Contact Information ......Inflation Dr. Edward Asiedu Slide 19 Figure 1 Relationship Between Inflation and Money Growth Sources: For panel (a), Milton

College of Education

Department of Distance Education 2017/2018

Lecturer: Dr. Edward Asiedu, UGBS Contact Information: [email protected]

Session Overview

By the end of this session students should be able to:

• Illustrate the market for reserves and demonstrate how changes in monetary policy can affect the policy rate.

• Assess the relationship between money growth and inflation in the short run and the long run, as implied by the quantity theory of money.

• Identify the circumstances under which budget deficits can lead to inflationary monetary policy.

Dr. Edward Asiedu Slide 2

Session Outline

The key topic to be covered in the session is the demand

for money:

More specifically:

• How Changes in the Tools of Monetary Policy Affect

the Policy Rate

• Quantity theory of money

• Inflation


Reading List

• Frederic S. Mishkin, The Economics of Money, Banking, and Financial Markets, 7th or 9th edition (Addison Wesley: New York).

• Walsh, Carl E. Monetary theory and policy. MIT press, 2010

Dr Edward Asiedu Slide 4

HOW CHANGES IN THE TOOLS OF MONETARY POLICY AFFECT THE POLICY RATE

Topic One

Dr. Edward Asiedu

Slide 5

How Changes in the Tools of Monetary Policy

Affect the Policy Rate

• Effects of open an market operation depends on whether

the supply curve initially intersects the demand curve in its downward sloped section versus its flat section.

• An open market purchase causes the policy rate to fall whereas an open market sale causes the policy to rise (when intersection occurs at the downward sloped section).

• Open market operations have no effect on the policy rate when intersection occurs at the flat section of the demand curve.

Dr. Edward Asiedu

Slide 6

How Changes in the Tools of Monetary Policy Affect the Policy Rate

• If the intersection of supply and demand occurs on

the vertical section of the supply curve, a change in

the discount rate will have no effect on the policy

rate.

• If the intersection of supply and demand occurs on

the horizontal section of the supply curve, a change

in the discount rate shifts that portion of the supply

curve and the policy rate may either rise or fall

depending on the change in the discount rate

Dr. Edward Asiedu

Slide 7


Figure 3 Response to a Change in the Discount Rate

Dr. Edward Asiedu

Slide 8


• When the Central Bank raises reserve requirement,

the policy rate rises and when the Central Bank

decreases reserve requirement, the policy rate falls.

Dr. Edward Asiedu

Slide 9


Figure 4 Response to a Change in Required Reserves

Dr. Edward Asiedu

Slide 10

QUANTITY THEORY OF MONEY Topic Two


Quantity theory of money

Velocity of Money and The Equation of Exchange:


M = the money supply

P = price level

Y = aggregate output (income)

P ´ Y = aggregate nominal income (nominal GDP)

V = velocity of money (average number of times per year that a dollar is spent)

V =P ´ Y

M

Equation of Exchange

M ´V = P ´ Y



• Velocity fairly constant in short run

• Aggregate output at full-employment level

• Changes in money supply affect only the price level

• Movement in the price level results solely from change in the quantity of money

Dr. Edward Asiedu

Slide 13



• Demand for money: To interpret Fisher’s quantity theory in terms of the demand for money…

• Divide both sides by V

When the money market is in equilibrium • M = Md

Let • Because k is constant, the level of transactions generated by a fixed

level of PY determines the quantity of Md. • The demand for money is not affected by interest rates.

Dr. Edward Asiedu

Slide 14

PYV

M 1

Vk

1

PYkM d



• From the equation of exchange to the quantity theory of

money:

Fisher’s view that velocity is fairly constant in the short

run, so that , transforms the equation of exchange into the

quantity theory of money, which states that nominal

income (spending) is determined solely by movements in

the quantity of money M.

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Slide 15

P Y M V



• Because the classical economists (including Fisher)

thought that wages and prices were completely

flexible, they believed that the level of aggregate

output Y produced in the economy during normal

times would remain at the full-employment level .

Dividing both sides by , we can then write the price level as follows:

Dr. Edward Asiedu

Slide 16

Y

M VP

Y

Quantity theory of money and Inflation


• Percentage Change in (x ✕ y) = (Percentage Change in x) + (Percentage change in y)

• Using this mathematical fact, we can rewrite the equation of

exchange as follows:

• Subtracting from both sides of the preceding equation, and

recognizing that the inflation rate, is the growth rate of the price level,

• Since we assume velocity is constant, its growth rate is zero, so

the quantity theory of money is also a theory of inflation:

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Slide 17

% % % %M V P Y

% % % %P M V Y

% %M Y

INFLATION Topic Three

Dr. Edward Asiedu

Slide 18

Inflation

Dr. Edward Asiedu

Slide 19

Figure 1 Relationship Between Inflation and Money Growth

Sources: For panel (a), Milton Friedman and Anna Schwartz, Monetary Trends in the United States and the United Kingdom: Their Relation to Income, Prices, and Interest Rates, 1867–1975; Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed .org/fred2/. For panel (b), International Financial Statistics. International Monetary Fund, http://www.imfstatistics.org/imf/.

Inflation

Dr. Edward Asiedu

Slide 20

Figure 2 Annual U.S. Inflation and Money Growth Rates, 1965–2015

Sources: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2/.

Inflation

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Slide 21

Budget Deficits and Inflation

• There are two ways the government can pay for spending: raise revenue or borrow

Raise revenue by levying taxes or go into debt by issuing government bonds

The government can also create money and use it to pay for the goods and services it buys

Inflation

Dr. Edward Asiedu

Slide 22

Budget Deficits and Inflation

• The government budget constraint thus reveals two important facts:

If the government deficit is financed by an increase in bond holdings by the public, there is no effect on the monetary base and hence on the money supply.

But, if the deficit is not financed by increased bond holdings by the public, the monetary base and the money supply increase.

Inflation

Dr. Edward Asiedu

Slide 23

Hyperinflation

• Hyperinflations are periods of extremely high inflation of more than 50% per month.

• Many economies—both poor and developed—have experienced hyperinflation over the last century, but the United States has been spared such turmoil.

• One of the most extreme examples of hyperinflation throughout world history occurred recently in Zimbabwe in the 2000s.

Documents

Lecturer: Dr. Edward Asiedu, UGBS Contact Information ......Inflation Dr. Edward Asiedu Slide 19 Figure 1 Relationship Between Inflation and Money Growth Sources: For panel (a), Milton