Economics - Macro - Money, Price Level and Inflation

Start 11:00 am

Money, Price Level and Inflation

Functions of money

• Medium of exchange or means of payment
• Unit of account
• Store of value

Measures of money in US

• M1 - all currency NOT held at banks, traveler's checks, and checking account deposits of individuals and firms (but not govt checking accts)
• M2 - all of M1 plus time deposits, savings deposits, and mmmf balances
• Note: checks and credit cards are not money, they are just transfers

Institutions

• Commercial banks - intermediary between savers and borrowers
• Thrifts - savings banks, credit unions, and S&Ls
• Money mkt mutual fund - an investment company - offer slightly less liquidity than other two

Economic functions of institutions

• Create liquidity - make loans or purchase debt securities
• Financial intermediary - lower cost of funds for borrowers
• Monitor risk of loans
• Pool default risk

Regulation of banks and their balance sheets

• Minimum amount of equity must be maintained to align incentives
• Reserve requirements (portion in cash/US Fed deposits)
• Restrictions on types of deposits various institutions may accept
• Rules about proportions of various loan types institutions can make

There has been lots of financial innovation - overall has led to a shift from checking accounts at commercial banks to checking accounts at thrifts, and from savings accounts to mmmfs

Role of the US Federal Reserve - keep inflation low, promote growth and employment, reduce business cycles

• Federal funds rate - rate at which banks loan to each other on an overnight basis
• Fed influences this rate through the supply of money
• Policy tools (3)
• Discount rate - rate at which banks can borrow from Fed - lower rate encourages lending and decreases interest rates
• Reserve requirements - increasing this decreases supply of money
• Only works well if banks willing to lend and customers willing to borrow the additional funds made available
• Open Market Operations - buying/selling Treasuries by Fed on open market - buying means more money in the market.  Most commonly used tool.

Fed Balance Sheet

• Assets - gold, deposits of other central banks, SDR at IMF, US treasuries (90%), loans to banks
• Liabilities - mostly cash (90%).  Bank reserve deposits are a small portion.

Creation of money

• In fractional reserve system, excess reserves can be loaned
• Multiplier effect as money is spent and deposited and respent
• If reserve ratio is 25%, each $1 in excess reserve will become $4
• When fed uses open market ops, it increases/decrease bank reserves
• Expansion of money is dampened by amount of proceeds held in cash
• Money multiplier therefore accounts for this:
• Multiplier = (1+c) / (r+c)
• c = currency as % of deposits, r = required reserve ratio
• Change in quantity of money = change in monetary base * money multiplier

Demand for Money

• That is, demand for balances held in form of ready cash
• Demand for money is driven by interest rates - higher interest rates, less money demand
• Rise in real GDP increases demand for real money - shifts up
• Technology has overall reduced the demand for money

Supply of Money

• Determined by Fed and therefore independent of interest rate - vertical
• Equilibrium interest rate equates the supply and demand for money
• Usually talk about this in real terms - i.e. inflation does not increase demand for real money

Determination of interest rates

• Interest rate is equilibrium between supply and demand for money
• Central bank can shift money supply left and right

Impact on GDP

• More money/lower interest means
• Businesses invest more and households increase durable consumption - so C and I both increase
• Investment less attractive to foreigners - exchange rate decreases - exports increase
• This is compounded by the multiplier effect
• Increase in demand will increase real GDP and price level
• If economy is at full-employment, the increase in real GDP must be temporary
• Increase in demand makes demand for wages rise, than SAS falls
• Thus long run effect of increase in money supply is just a rise in prices
• Increase in price level offsets the increase in money supply

Quantity of Money: MV = PY

• Quantity theory of money:
• M = money supply, V = velocity, P = price, Y = real output
• MV = PY
• P = M(V/Y)
• V and Y both change very slowly, so change in M results in proportional change in Y
• Monetarists think you should only increase M with Y so as to maintain a stable P
• Can estimate inflation with GDP and money supply growth
• Inflation = money supply growth - GDP growth

End

12:00 pm

1 hour