Money and inflation

1
Money and inflation
2
Overview

• What is money?
• The Reserve bank and the control of the money
  supply
• Money and inflation
• The costs of inflation

3
What is money?

• Money as
• A medium of exchange
• A unit of account
• A store of value
• Commodity v fiat money
• Different definitions of money

4
The relationship between narrow and broad money
the money multiplier

• Suppose there is 1m in currency. This is
  narrow money. Let broad money be currency plus
  bank deposits. How much broad money do we get
  given the amount of currency?
• Suppose people keep no cash on hand
• Then all money will end up as bank reserves
• But suppose that banks only keep fractional
  reserves equal to x of total deposits
• Then broad money will expand to equal (1/x)m.
• The money multiplier is R (1/x)

5
Controlling the money supply

• Money targeting in the late 1970s
• Did not work because when the RBA targeted one
  definition of money it tended to lose control
  of others.
• Targeting interest rates
• The RBA now controls the money supply by
  targeting the overnight cash interest rate. It
  stands in the market and buys or sells government
  bonds to help achieve its target (open market
  operations)
• In other countries, central banks also use
  reserve requirements

6
Money and inflation

• Inflation is the long term rate of change in the
  general price level (e.g. CPI or GDP deflator)
• Short-term price changes are often called
  inflation, but strictly speaking are often just
  once off changes (e.g. when the GST was
  introduced).
• In the long run, inflation is caused by
  increasing the money supply (and this is the only
  cause in the long term)
• Why because if P is the general price level
  then 1/P is the price of money in terms of
  goods and services

7
The demand and supply of money
Notes The supply of money is fixed by the
Reserve Bank The demand for money depends on
transactions Equilibrium determines the general
price level If the money supply increases (1/P)
falls so the general price level rises
8
The quantity theory of money

• V(PY)/M so VM PY
• Velocity of money depends on transacting
  institutions and tends to be fairly stable over
  time it does not depend on the quantity of
  money
• In the long term, Y depends on technology and
  inputs
• So in the long term, if M increases faster than Y
  then P increases.

9
The costs of inflation

• The neutrality of money in a fully indexed
  economy
• Costs due to nominal variables
• Shoe leather cost and the inflation tax
• Menu costs
• Tax and pension distortions
• The costs of unexpected inflation

10
Lessons

• There is not a single money supply rather
  there re assets that differ in liquidity
• The RBA imperfectly controls the money supply
  through interest rate targeting
• In the long term, inflation arises because of
  increases in the money supply
• Inflation has real economic costs