Economics 3307

Main Points of Mankiw, Chapter 7: Money and Inflation

1. Inflation is the percentage change in the price level: p_t = (P_t - P_t-1)/P_t-1

2. Average inflation rates (over 10 year time periods, say) vary widely across time in any given country and across countries at any given time. Inflation was much higher in the U.S. in the 1970s than in the 1980s, for example. Also, inflation in Germany since World War II has been lower on average than inflation in the U.S.

3. Basic Points in this chapter: (i) The average price level (P) is determined by the money supply (M), and (ii) Inflation (the percentage increase in P) is determined primarily by the money supply growth (the percentage increase in M).

4. The 3 functions of money are: (i) store of value, (ii) unit of account, and (iii) medium of exchange.

5. Types of money include:

(i) Fiat money, which has no intrinsic value

(ii) Commodity money, which has the intrinsic value of the commodity used as money. Gold and silver are the 2 commodities that have been most widely used as money.

6. All countries now have fiat money, but in the past (the late 1800s, say), commodity money was common. Commodity money evolves to fiat money as follows:

Gold Gold Gold Fiat

Bullion ==> Coins ==> Certificates ==> Money

7. The quantity of money in the economy is controlled by the central bank. The U.S. central bank (which is actually a system of banks) is called the Federal Reserve System. The German central bank is the Bundesbank. The Japanese central bank is the Bank of Japan.

8. In developed economies, central banks influence the money supply by open market operations: purchases and sales of assets such as government bonds or foreign currencies. When a central bank purchases an asset in the open market, it in effect creates the money to pay for the asset. It creates money electronically through the banking system in a way that is rather involved, but the effect is the same as it would be if the central bank simply printed up new currency to buy the asset. Thus an open market purchase increases the money supply, and when a central bank increases the money supply it is sometimes said to be "printing money". When a central bank sells an asset in the open market, it takes money out of circulation and the money supply decreases.

9. There are several possible measures of the money supply, but the precise definition we use is not especially important. M1 includes all currency and checking account balances in the economy, and it thereby corresponds most closely to the "medium of exchange" function that is the unique property of money. M2 is M1 + savings accounts, and M3 is M2 + large negotiable certificates of deposit. When we speak of "the money supply," we will always mean M1 or M2.

10. The Transactions Equation of Exchange is given by M·V_T = P·T, where V_T is the transactions velocity of money. The Income Equation of Exchange is given by M·V_Y = P·Y, where V_Y is the income velocity of money.

11. The Quantity Theory of Money assumes that V and Y are constant, or at least exogenous. The income equation of exchange implies %DM + %DV_Y = %DP + %DY. If %DV_Y and %DY are zero, or small, then %DM is the primary determinant of %DP = p.

12. Inflation is caused by increases in the money supply. When M increases and money becomes less scarce relative to goods. Normally when something becomes less scarce, its price falls. The price of money, however, if fixed at 1 because of the unit of account function of money. Thus the only way money can lose value is for the prices of all other goods and services to rise.

13. Historical and cross-country evidence support the quantity theory of money as an explanation of differences in average inflation rates. During those periods in U.S. history when money growth has been rapid, inflation has been high. During those periods in U.S. history when money growth has been low, inflation has been low. Countries with high average money growth tend to have high average inflation, and countries with low average money growth tend to have low average inflation.

14. The creation of money serves as a source of revenue for governments. The purchasing power a government achieves in this way is known as seigniorage.

15. The Fisher equation says that i = r + p^e, where p^e is the expected inflation rate. The nominal interest rate (i) changes point-for-point with changes in p^e. Changes in p^e therefore have no effect on the real interest rate (r). Historical and cross-country evidence shows that nominal interest rates tend to increase and decrease with increases and decreases in inflation.

16. The nominal interest rate is the rate of return on bonds, and is therefore one measure of the opportunity cost of holding wealth in the form of money. Other things equal, the lower the nominal interest rate, the more wealth people will want to hold in the form of money.

17. In equilibrium, the desired holding of wealth in the form of money (which we call money demand) must equal the supply of money. If (M/P)^d is real money demand, then (M/P) = (M/P)^d is the equilibrium condition.

18. The central bank controls the nominal money supply M, so we treat M as exogenous. If (M/P)^d is not equal to (M/P), the price level (P) adjusts to bring the economy into equilibrium. If (M/P)^d > (M/P), then P will fall. If (M/P)^d < (M/P), then P will rise. (Lecture will elaborate on this point.)

19. When (M/P)^d ¹ (M/P) with a given M, P must adjust. Thus we can say that (M/P)^d is a determinant of P. (M/P)^d depends on the nominal interest rate i, which in turn depends on expected inflation p^e. Expected inflation depends on expected future nominal money growth. If people expect higher nominal money growth in the future, this will increase current p^e and thereby increase the nominal interest rate, which reduces money demand and thereby increases the price level. Thus the current price level depends on expectations about future monetary policy.

20. If the nominal money growth rate increases, this leads to higher inflation, higher expected inflation, higher nominal interest rates, and lower real money demand. The lower money demand means that the equilibrium real money supply (M/P) must decrease, which in turn implies that for a while P must rise even faster than the new higher rate of money growth. Conversely, a decrease in the rate of nominal money growth causes an increase in the equilibrium level of (M/P), because the lower inflation causes lower p^e, and the lower p^e causes higher (M/P)^d.

21. Analysis of hyperinflations provides strong support for the idea that higher nominal money growth causes a decrease in the equilibrium real money supply (M/P).

22. The social costs of higher inflation that is accurately anticipated include: (i) Shoeleather costs, (ii) menu costs, (ii) more relative price variability, (ii) distortions caused by the tax system, and (v) inconvenience.

23. Unexpected inflation redistributes wealth between borrowers and lenders. Higher-than-expected inflation helps borrowers and hurts lenders. Lower-than-expected inflation helps lenders and hurts borrowers. Higher inflation also hurts people on fixed nominal incomes, such as retirees whose nominal pensions do not increase with the higher prices. (In the U.S., social security payments to retirees are indexed to the CPI.)

24. The Classical Dichotomy says that the determination of real variables (quantities and relative prices) in the economy occurs independently of the determination of nominal variables. Real variables are determined according to the theories discussed in Chapters 3 and 4. For given real variables, nominal variables are determined by the money supply.

25. The concept of Monetary Neutrality says that changes in the money supply affect only nominal variables and not real variables. Virtually all economists believe that money is neutral in the long-run, but many also believe that money is not neutral in the short-run. We'll consider short-run monetary non-neutrality in Chapter 8.