Lecture 18 Money

1
Lecture 18 Money

• What is money?
• Anything people will accept in place of the
  goods they seek to obtain.
• Trust is critical.
• Examples from history salt in Egypt rice in
  Japan dried fish in Iceland cotton cloth in
  Africa cigarettes in Romania in the 1970s
  liquor in Germany after World War II QQ coin in
  China rocks such as gold and silver

2
Roles of Money

• Account keeping
• Store of Value
• Medium of Exchange
• More efficient than barter
• If people do not trust official money, they use
  other things

3
Money Creation

• Governments create money
• Role of central banks
• Independence from politics important
• Many views on how the banks should manage money
  creation fixed rules versus flexibility

4
Inflation

• What is inflation? It is a general rise in prices
  not an increase in one price, such as higher
  price for wheat one year due to bad crops causing
  a short supply.
• Usually it is caused by more money in the hands
  of people who are trying to buy the same quantity
  of goods in an economy.

5
Inflation Is Not an Increase in One Price

• If the price of one good rises, it does not cause
  inflation. It is a change in relative prices.
• People have no more money to spend than before,
  they change spending mix.
• Example Price of gasoline up in U.S. 2006 4.6
  of personal expenditures on gas in 1997 2.6
• Where does the extra money spent on gas (2 of
  personal income) come from? Less spending on
  other goods.

6
MV PT

• The quantity theory of money is
• MV PT
• M money in circulation
• V velocity (number of times money spent per
  year)
• P average price level
• T number of transactions
• Note this is national income.

7
Price of Gas Rises

• MV PT
• Assume M and V constant.
• P of gasoline rises T constant
• If Demand for gasoline constant (T not changing),
  since more spent on gas, other transactions must
  fall (and their prices may too as a result).

8
Gas Goes Up What Goes Down?

• Consumers do not make money, so M constant.
• Velocity rarely changes in stable economies.
• Price of gas goes up but Demand constant, so
  something givesin U.S. the drop occurred in
  spending at higher class stores and nicer
  restaurants. Spending on luxury goods dropped
  (boat sales and jewelry). Lower income people cut
  spending at Wal-Mart.
• Same thing from increase in mortgage
  ratesconsumers must cut back in other areas.
• It hurts, but it is not inflation.

9
So What Causes Inflation?

• In general, inflation is caused by more money (M)
  chasing the same quantity of goods.
• If M rises and V constant then PT must rise to
  balance equation.
• People have more money so make more purchases (T
  rises) increase in T means more demand for same
  level of goods, so prices (P) bid higher.

10
Origins of Inflation

• So why do we get inflation?
• The government creates more money.
• Why? Not stupidity. It is deficit spending.
• Print money.
• Borrow money from Central Bank or from foreigners.

11
Destructive Effects

• When inflation rising (and is expected to
  continue to rise)
• ? spending and borrowing
• ? savings and investment
• ? incentive to inflate currency even more,
  depending on political forces

12
Real vs. Nominal Interest Rate

• Suppose inflation averages 10 per year (the
  value of the currency falls by 10 each year).
• If interest rate paid is 12, that is the nominal
  interest rate.
• What is real (after inflation) interest rate?
• 12 10 2

13
Inflation Hurts People,Business, and Society

• Businesses have a difficult time planning for
  future which means less investment.
• How do you time payments?
• Do you accept currency?
• There are winners and losers in every transaction
  just due to changes in the value of the currency
  up or down.

14
Real World Example

• Assume a person in the U.S. invested 10,000 in
  1971 for their retirement in 1991 when the
  investment is worth 35,000 a normal rate of
  return.
• What is the gain? Due to inflation, 10,000 in
  1971 34,000 in 1991. So gain is only 1,000.
  But the entire gain of 25,000 is subject to
  taxes of about 7,000, leaving 28,000 in 1991
  less than the original investment in real
  spending power.
• So if people think there will be inflationwhat
  actions do they rationally take?

15
Rational Decision Makers

• People try to avoid losses imposed by inflation
• ? invest in hard assets
• ? invest in other countries
• ? avoid currency of own country
• Due to international flows of currency, inflation
  is punished in the market. Local people with few
  options suffer the most. Political instability
  more likely if currency unstable.