lecture 4 money and inflation. example: zimbabwe hyperinflation

Lecture 4

Money and inflation

Example: Zimbabwe hyperinflation

What happened?

A dramatic increase in government expenditure.

For example, in 2006: Soldiers salary was raised by 300% Police’ salary was raised by 200%

Government had no money to do that – they print money.

Right now

Since April 2009, all transactions are done in foreign currencies, such as the US dollar or South Africa’s Rand.

Price of a daily newspaper

Jan 1921: 0.30 mark May 1922: 1 mark Oct 1922: 8 marks Feb 1923: 100 marks Sep 1923: 1,000 marks Oct 1, 1923: 2,000 marks Oct 15, 1923: 1 million marks Nov 17, 1923: 17 million marks

This lecture

Quantity theory of money how inflation is determined.

Demand for money a link between output and money

Fisher equation

Why could this happen?

What is money?

A store of value

A medium of exchange

A unit of account

Money supply measure

C Currency $715.4 billion

M1 Currency + demand deposits + Checking accounts $1363.4 billion

M2 M1 + retail money market mutual fund +Saving deposits $6587.9 billion

M3 M2 + repurchase agreements $9976.2 billion

Note: US GDP is 14.256 trillion

Money supply in US

Open market operations Sell bond decrease money supply Buy bond increase money supply

Reserve requirement

The discount rate

Money supply in USM1 Money Supply (08/08 -- 07/10)

08/08

1350

1400

1450

1500

1550

1600

1650

1700

1750

Month

Bill

ion

s o

f U

S$

Banks borrowing from Fed

2008 Banks borrowing from Fed

0

100

200

300

400

500

600

700

800

0 2 4 6 8 10 12 14

Month

Bil

lio

ns

US money supply

Changes in Fed Discount Rate

2006-6-29

2007-8-17

2007-9-182007-10-31

2007-12-11

2008-1-22

2008-1-302008-3-17

2008-3-182008-4-30

2008-10-8

2008-10-29

2008-12-16

0

1

2

3

4

5

6

7

3-24-06 7-2-06 10-10-06 1-18-07 4-28-07 8-6-07 11-14-07 2-22-08 6-1-08 9-9-08 12-18-08 3-28-09

Velocity

Basic concept: the rate at which money circulates.

Example: In 2009, US GDP: $14000 billion Money supply = $700 billion (M1) The average dollar is used 20 times. So velocity = 20

Quantity theory of money

V = velocity T = value of all transactions (T = PY) M = money supply.

Money * Velocity = Price * Output M * V = P * Y


Take the log of previous equation: (1)

Since it works for time t, it also works for time t-1: (2)

Equations (1) – (2), we have:

(3)

tttt YPVM loglogloglog

1111 loglogloglog tttt YPVM

tttt YPVM loglogloglog


Equation (3) says: % change in M + % change in V = % change in P + % change in Y

Inflation and money supply

Demand for money

Consider the “trip to the bank” story:

People would have some of their income in their pocket, and the rest in a bank.

When the money in his pocket is lower than some number, he would take a trip to the bank to “refill” his pocket.

Therefore, factors that affect the number of the trips would affect his demand for money.

Demand for money

Income effect: When a person has a higher income, it

is more costly for him to go to the bank (opportunity cost is high).

When a person has a higher income, he would typically consume more – therefore he needs more money in his pocket.

Demand for money

Interest effect: When the nominal interest rate is

higher, putting money in the bank would earn more interests less money in his pocket.

Price effect: Higher price would require more money

in the pocket.

Demand for money

Money demand equation

α and β are two positive numbers: α represents the relationship between

money demand and the income β represents the relationship between

money demand and nominal interest rate.

iYYiLP

Md

,

Discussion:

If, because of increasing popularity of credit use, people carry almost no cash in their pockets, regardless of their income. What would happen to the money demand equation?

The value of α would be reduced to almost zero -- people’s income levels would no longer have any effects on their demand for money in their pockets.

Fisher equation

At the beginning of a year, Bill has 1 million dollars. Two options:

Option #1: Deposit into a bank to earn a preset nominal interest. At the end of the year, he would have:

$ (1 + i) million

Fisher equation

Option #2: Invest.

At the current price p, he would buy 1/p million units machines.

Each unit of machine would produce (1+r) units of output. At the end of the year, he would produce total output:

1/p x (1+r)

Fisher equation:

Option #2 (continued):

At the end of the year, the new price is px(1+π )

He would sell the output at the new price to get money:

1/p x (1 + r) x px(1+π) = (1+r) x(1+π)

Fisher equation:

Two options should generate exact same amount of money:

(1 + i) = (1+r) x(1+π) 1 + i = 1 + r + π + r x π

Since r x π is generally very small, we have the Fisher equation:

i ≈ r + π

Fisher equation

Since at the beginning of the year we do not know the inflation, so we use expected inflation:

eri

Discussions:

Since real interest rate does not vary much across time, nominal interest rate and the inflation should be highly correlated. See graphs next.

The Fisher equation: time series evidence

The Fisher equation: cross country evidence

Cost of expected inflation

Cost of expected inflation

Menu cost: first may have to change their posted prices more often.

Tax laws: many provision of the tax code do not account for the inflation.

Cost of unexpected inflation

Unexpected redistribution.

Summary

Quantity theory suggests that inflation is almost entirely due to the money supply.

Demand for money depends on income, price level, and nominal interest rate.

Fisher equation suggests that nominal interest = real interest + expected inflation

lecture 4 money and inflation. example: zimbabwe hyperinflation

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