The big picture marcoeconomics 12e parkin chapter 08

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W H AT I S E C O N O M I C S ? 19 C h a p t e r MONEY, THE PRICE LEVEL, AND INFLATION** The Big Picture Where we have been: Chapters and focused on the markets for labor and capital, both real resources used in the production of real GDP This chapter now shifts gears to study money and how money impacts markets Because Chapter is the first chapter on money, it introduces a lot of new material The discussion of the market for money relates back to the supply and demand model in Chapter Where we are going: Chapter is the first of two chapters that examine money and the economy This chapter defines money, introduces the Federal Reserve, explains the money creation process, and then concentrates on the long run effects (the quantity theory) of changes in the quantity of money Chapter 14 returns to these topics to study monetary policy Chapter also is the 3rd of chapters that cover the economy in the long run The next chapter looks at the exchange rate and balance of payments N e w i n t h e Tw e l f t h E d i t i o n An At Issue feature discusses fractional reserve requirements and the history of supporters of 100 percent reserve banking The data and figures in the chapter are updated to reflect 2014 data The section “What Do Depository Institutions Do” has been slightly modified to more clearly define commercial bank assets The Economics In The News feature has a 2014 article about banks preparing for deposit outflows in 2015 with the Fed relaxing quantitative easing The Worked Problem at the end of the chapter gives data about the amount of currency, checkable deposits, savings deposits, time deposits, and money market mutual funds and other deposits in June 2014 The students are asked to calculate of M1, M2, the monetary base, the currency drain and banks’ reserve ratio, and the M1 and M2 money multipliers To include the new Worked Problem without lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications These problems are in the MyEconLab and are called Extra Problems 19 Lecture Notes Money, the Price Level, and Inflation • • • • Money is anything that is used as a means of payment Banks play a major role in creating money but this process is ultimately controlled by the Federal Reserve In the short run, equilibrium in the money market determines the nominal interest rate In the long run, an increase in the growth rate of the quantity of money leads to a higher inflation rate I What Is Money? The contrast between money in economics and money in everyday language It can be helpful to emphasize that “money” is a technical term in economics that has a precise meaning and that differs from its looser usages in everyday language For example, an economist would not say “Bill Gates makes a lot of money.” Rather, the economist would say “Bill Gates earns a large income.” An interesting exercise is to have students think of statements containing the word “money” that make complete sense in normal language but that misuse the word in its precise economic sense, and to get them to explain why • Money is any commodity or token that is generally acceptable as a means of payment A means of payment is a method of settling a debt Money has three functions: • Medium of exchange • Unit of account • Store of value Medium of Exchange A medium of exchange is any object that is generally accepted in exchange for goods and services Money acts as a medium of exchange As a result, money eliminates the need for barter, which is the exchange of goods and services directly for other goods and services The defining characteristic of money Adam Smith wrote, “Money is a commodity or token that everyone will accept in exchange for the things they have to sell.” Most people have interpreted this statement as defining money as the medium of exchange That interpretation is wrong Smith is defining money as the means of payment Money is a commodity or token that everyone will accept as payment for the things they have to sell When Michael Parkin was a young economist, he had the enormous good fortune to meet Anna Schwartz, Milton Friedman, and a group of other leading monetary economists It was during the late 1960s when the monetarist debate was alive and well and people were still arguing about whether the demand for money was interest inelastic (as the monetarists claimed) or almost perfectly elastic (as the Keynesians claimed) Anna made a remark that for Michael was one of those defining moments She said money is the means of payment Nothing else performs this function It is unique to money Many things serve as a medium of exchange, unit of account, or store of value, but money alone serves as the means of payment—the means of settling a debt so that there is no remaining obligation between the parties to a transaction Get the class involved in figuring out what money is To involve the students in the process of determining what money is, after noting its definition and three functions, ask M O N E Y , T H E P R I C E L E V E L , A N D I N F L AT I O N them what they think should be counted as money List the suggestions on the board before commenting on them Coins and currency will certainly be mentioned Usually each class has a few members who have read the text and will suggest checkable deposits Almost always you will obtain some not-so-excellent answers, ranging from gold to shares of stock to credit cards The point of this exercise is to obtain these incorrect answers because they give you a chance to discuss why these items are not money Without ridiculing the wrong answers, you might point out that students rarely pay for books by giving the bookstore shares of IBM stock and asking for change in AT&T stock By being involved and having to think, the students emerge with a stronger grasp of why money is measured as it is 75 76 CHAPTER Unit of Account Money serves as a unit of account, which is an agreed measure for stating the prices of goods and services Store of Value Money serves as a store of value because it can be held and exchange later for goods and services During the Great Depression there was deflation so the real return on money was positive Thus, many people held money as an asset and did not immediately use it to spend on goods and services This is the idea behind Keynes’ concern that people were stuffing money in their mattresses instead of spending it Concerns about deflation have been revived in recent years Japan has had deflation on and off for the past decade and many other countries have very low rates of inflation One of the more interesting suggestions by Fed economists in thinking how to avoid the problem of money serving so well as a store of value is to have money which expires like a coupon It is not clear whether such a form of money is feasible from a political or psychological point of view, but the suggestion is interesting Money in the United States Today • • • • Money consists of currency (the notes and coins held by individuals and businesses) and deposits at banks and other depository institutions Deposits are also money because they can be converted into currency and because they are used to settle debts M1 consists of currency and traveler’s checks plus checking deposits owned by individuals and businesses M2 consists of M1 plus time deposits, saving deposits, and money market mutual funds and other deposits M2 is much larger than M1, $11,423 billion versus $2,857 billion in June, 2014 M2 includes liquid assets that are not means of payment Liquidity is the property of being instantly convertible into a means of payment with little loss in value The assets in M2 are generally quite liquid Checks are not money—they are instructions to transfer money from one person’s deposits to another person’s deposits Credit cards are not money—they are IDs that allow an instant loan Fiat money Pull out a dollar bill, wave it at the class and ask, “What backs our currency?” You should get someone to state gold Tell them, “Yes, I have heard about all the gold stored in Fort Knox, but none of it is there for a trade-in value We went off the gold standard with Nixon If you look closely at the bill you’ll find your backing, “In God we trust,” That’s it! The dollar has value because of your faith that someone else will accept it for something else you want Alternatively (or additionally) take a green piece of paper and cut it to the same size as a dollar bill Then take the paper into class along with a dollar bill Ask the students why one piece of paper has value and the other does not Is there anything intrinsically more valuable about the dollar bill? If not, why won’t someone in class exchange his or her old wrinkled piece of green paper with writing on it for the nice new piece you offer? II Depository Institutions • A firm that takes deposits from households and firms and makes loans to other households and firms is called a depository institution There are three types of depository institutions whose deposits are money: commercial banks, thrift institutions, and money market mutual funds M O N E Y , T H E P R I C E L E V E L , A N D I N F L AT I O N Commercial Banks • • A commercial bank is a firm that is licensed to receive deposits and make loans In 2014 there are about 6,800 commercial banks but that number has been trending downward The deposits of commercial banks account for 50 percent of M1 and 71 percent of M2 Banks accept deposits and then divide these funds into reserves (cash in the vault plus its deposits at the Federal Reserve), liquid assets (such as Treasury bills and commercial bills), securities (such as U.S government bonds and mortgage-backed securities), and loans (made primarily to corporations for purchases of capital equipment and to households to finance homes, consumer durable goods, and credit cards) Loans are the riskiest of a bank’s assets As a percentage of deposits, on June 30, 2014 cash assets were 28.0 percent, securities were 27.6 percent, and loans were 75.4 percent (The percentages sum to more than 100 percent because deposits are just one source of funds; borrowing and the banks’ own capital are other sources of funds and are equal to about 50 percent of deposits.) Because of concerns about the financial crisis and bank runs, banks increased their reserves from the more typical 0.6 percent of deposits in June 2008 to 14.3 percent in June, 2010 and to 28.0 percent in June, 2014 Thrift Institutions The thrift institutions are savings and loan associations, savings banks, and credit unions Money Market Mutual Funds A money market mutual fund is a fund operated by a financial institution that sells shares in the fund and holds liquid assets such as U.S Treasury bills and short-term commercial bills The Economic Functions of Depository Institutions • Depository institutions make a profit from the spread on the interest rate at which they lend over the interest rate they pay on deposits The spread reflects four services provided by depository institutions: • Create Liquidity: Most assets are less liquid than liabilities, so depository institutions turn less-liquid funds into more liquid funds A bank run is a liquidity crisis in the sense that banks can have the deposits backed by assets such as mortgage loans, but the assets are less liquid than the deposits This scenario should be familiar to anyone who has seen It’s a Wonderful Life with Jimmy Stewart As suggested by the movie, bank runs were a big problem in the 1930s and many economists believe they made the Great Depression much worse than other recessions Indeed, banks runs were feared by the Federal Reserve during the financial crisis of 2008 and this fear likely accounted one reason why the Fed responded so strongly to the crisis • • • Lower the Cost of Borrowing Obtaining Funds: Depository institutions lower transaction costs of matching borrowers and lenders Lower the Cost of Monitoring Borrowers: Depository institutions lower transaction costs by specializing in monitoring risky loans Pool Risk: The costs of defaults on loans are spread across all depositors, instead of being borne by individual lenders What banks do? Students usually have bank accounts, but often they have never fully thought through what banks do, how they it, or what the differences are between banks and other deposit-taking institutions, so what tends to strike instructors as rather dry descriptive material can be interesting to students It is worth being explicit about the fact, 77 78 CHAPTER which students tend to be very aware of, that in practice commercial banks earn income not only by the spread between their deposit and lending rates, but also by charging fees for their services The text focuses on the role of depository institutions as a source of credit creation; for most students, like most customers, their most important function is actually facilitating the payment process, and a little discussion on that (and how relatively cheap it is) can also engage students Financial Innovation • The development of new financial products is called financial innovation Some innovation has been a response to economic circumstances such as high inflation and high interest rates in the 1970s Others, such communications networks which have spread the use of credit cards, are the result of advances in technology Still others, such as sub-prime mortgages, were developed during the 2000s M O N E Y , T H E P R I C E L E V E L , A N D I N F L AT I O N III The Federal Reserve System The central bank of the United States is the Federal Reserve System A central bank is a bank’s bank and a public authority that regulates a nation’s depository institutions and controls the quantity of money The Fed conducts the nation’s monetary policy, which means that it adjusts the quantity of money in circulation By adjusting the quantity of money, the Fed can change interest rates Conspiracy theory of the Fed Some students will have heard about a “conspiracy theory of the Fed.” This theory, advanced by the ignorant, the misinformed, or the deceitful, is that the commercial banks own the Fed, which is run solely to benefit the banks to ensure that they earn large profits Point out that commercial banks indeed own the Fed—they own all the stock issued by the Fed But Fed stock is not like shares in General Electric or Microsoft The dividend on the Fed’s stock is fixed at percent of the purchase price, and the stock cannot be sold in a marketplace So this stock is a lousy investment What privileges come with the stock? Commercial banks elect six of the nine directors of their Federal Reserve Regional bank; each commercial bank has the same number of votes regardless of the amount of stock it owns But the directors of the regional banks are hardly key players in the Federal Reserve System Essentially, the most important task they perform is nominating a president for the regional bank The regional banks’ presidents are important The directors, however, not get much freedom in this choice because their nominee must be approved by the Board of Governors, which does not hesitate to veto anyone considered unacceptable Regional bank presidents gain their power from sitting on the FOMC But there they are a minority because the voting members of the FOMC consist of five regional bank presidents and seven members of the Board of Governors Because the board members are appointed by the president and approved by the Senate, the government thus wields the ultimate power in the Federal Reserve The regional bank presidents must be approved by the publicly appointed board members and the board members constitute a majority on the FOMC The Structure of the Fed • • • The Board of Governors has seven members, including the chairman (currently Ben Bernanke) There are 12 regional Federal Reserve banks The Federal Open Market Committee (FOMC) is the main policy-making group of the Fed It is comprised of the members of the Board of Governors and the Presidents of the regional Federal Reserve Banks The Board of Governors, the President of the Federal Reserve Bank of New York, and, on a rotating basis, the presidents of four other regional Federal Reserve Banks, vote on monetary policy In practice, the chairman has the largest influence on policy The Fed’s Balance Sheet • • The Fed’s two main assets are U.S government securities and loans to depository institutions The Fed’s two main liabilities are Federal Reserve notes (currency) and banks’ deposits The Economics in Action detail discusses how the Fed’s balance sheet changed dramatically as a result of the financial crisis in 2008 U.S government securities soared from less than $1,000 billion to approximately $2,500 billion and currency from less than $1,000 trillion to approximately $1,300 trillion Banks now hold almost $3,000 billion reserves The monetary base quadrupled in size! 79 80 CHAPTER • The monetary base is the sum of coins, Federal Reserve notes, and depository institution deposits at the Fed The major parts of the monetary base, Federal Reserve notes and depository institution deposits, are liabilities of the Federal Reserve Changes in the monetary base lead to changes in the quantity of money The Fed’s Policy Tools • • • Required Reserve Ratios: The minimum percentage of deposits that depository institutions must hold as reserves are the required reserve ratios The Fed sets the required reserve ratio A decrease leads to an increase in the quantity of money and an increase leads to an increase in the quantity of money Last Resort Loans: The Fed is the lender of last resort, which means that if depository institutions are short of reserves, they can borrow from the Fed The interest rate charged on these loans is the discount rate In 2008 the Fed changed its policy and encouraged depository institutions to borrow from it A decrease in the discount rate leads to an increase in the quantity of money and an increase in the discount rate leads to a decrease in the quantity of money Open Market Operation: An open market operation is the purchase or sale of government securities by the Federal Reserve System in the open market The Fed does not directly purchase bonds from the federal government because it would appear that the government was printing money to finance its expenditures An open market purchase leads to an increase in the money supply IV How Banks Create Money Creating Deposits by Making Loans When a bank makes a loan, it makes a deposit to finance the loan Because deposits are money, the bank has created money For example, if you use a credit card to buy $50 at Walgreens, loans to you increase and Walgreens deposits increase The increase in deposits increases the quantity of money Three factors limit the amount of deposits that the banking system can create: • • • • The monetary base: Banks have a desired amount of reserves they want to hold and people have a desired amount of currency The monetary base sets a limit on the sum of these two Both of these desired holdings depend on the quantity of money, and so the monetary base limits the amount of money that can be created Alternatively, the monetary base limits the amount of the banking systems’ reserves Desired reserves: A bank’s actual reserves are the coin and currency in its vault and its deposits at the Federal Reserve The fraction of a bank’s total deposits that are held in reserves is called the reserve ratio The desired reserve ratio is the ratio of reserves to deposits that banks want to hold Actual reserves minus desired reserves are excess reserves Excess reserves can be loaned and can thereby create money Desired currency holding: The other use of the monetary base involves the public’s holding it as currency When banks create new money by creating new deposits, the public wants to hold some of this money as currency As a result, currency leaves the banking system when banks increase their loans, which limits the overall increase in loans The currency drain is the ratio of currency to deposits Banks use excess reserves to make loans In the process, banks create money • For each dollar deposited, a bank keeps a fraction as reserves and lends out the rest When a bank makes a loan, it creates a new deposit (new money) equal to the value of the loan After the loan is spent by the borrower, the new money eventually ends up back as a new deposit in a bank As new deposits are made, the process of money creation begins again, albeit with a smaller amounts each time because banks keep a fraction of each deposit in the form of reserves M O N E Y , T H E P R I C E L E V E L , A N D I N F L AT I O N • The total of amount of new money created by the entire banking system depends on the fraction of the deposits that banks loan at each step in the process The Money Creation Process • • • • • The monetary base increases and banks have excess reserves Banks lend the excess reserves and thereby create new deposits, that is, create new money The new money is used to make payments Some of the new money remains in the banking system as deposits and some of it is drained out of the banking system via the currency drain The funds that stay within the banking system are reserves for the banks Because deposits have increased, banks’ desired reserves have increased But the actual reserves have increased by more than desired reserves, so banks still have excess reserves to loan Banks lend these excess reserves and the process continues Eventually the money creation process comes to a stop when the sum of additional currency holdings plus additional desired reserves equals the initial increase in the monetary base and banks’ reserves The money multiplier is the ratio of the change in the quantity of money to the change in the monetary base It determines the change in the quantity of money that results from a given change in the monetary base A change in the monetary base has a multiplied effect on the quantity of money because banks’ loans are deposited in other banks where they are loaned once again The formula for the money multiplier is derived in the Mathematical Note to the chapter (see the end of these lecture notes) A money creation experiment The process through which banks “create money” can be a dark and mysterious secret to the students Indeed, even though the text contains a superb description of the process, students still manage to end up confused The first prerequisite to students understanding the process is that they be comfortable with balance sheets shown in the form of T-accounts, and it is well worth spending time on them to make sure students understand what they are and what they show This will be the first time some students have ever had to interpret a balance sheet, and it is key that they understand that assets are what are owned, liabilities are what are owed, by the institution for which the balance sheet is constructed; and that the two sides must balance Mark Rush (our study guide author and supplements czar) tackles the problem of getting students to understand bank money creation head-on by (again) involving the class in a demonstration Prepare by decorating a piece of green paper with currency-like symbols (For instance, Mark draws a seal and around it writes “In Rush We Trust.” You may write the same slogan, but substituting your name for his probably will be more effective; an alternative is to use “play money.”) Label this piece of paper a “$100 bill.” In class use one of the students by handing him the bill Tell him that he has decided to deposit it in his bank and ask him his bank’s name On the chalkboard draw a balance sheet for the bank with deposits of $100, reserves of $10, and loans of $90 Tell the students that the required reserve ratio is 10 percent, so this bank currently has no excess reserves Now, instruct the student to deposit the money in his bank, which coincidentally happens to be run by the student next to him Show the class what happens to the balance sheet and how the bank now has excess reserves of $90 Clearly the “banker” will loan these reserves to the next student in the class, who wants a $90 dollar loan so she can take a bus ride to some nearby dismal location (Being located in Gainesville, Florida, Mark picks on the city of Stark, home to Florida’s electric chair and a town with an apt name.) When the loan takes place, rip the $100 bill so that only about nine tenths of it is given as the loan This student pays the money to Greyhound— coincidentally the next student Ask the name of Greyhound’s bank and draw an initial 81 82 CHAPTER balance sheet for this bank identical to the initial balance sheet of the first bank Greyhound deposits the money in the bank—the next student in the row Work with the balance sheets to show what happens to the first bank and what happens to the second bank Clearly the first one no longer has excess reserves but the second bank now has $81 of excess reserves ($90 of additional deposits minus $9 of required reserves) The second bank will make a loan, which you can act out with more students in the class, again ripping off nine tenths of the remaining bill Work through the point where the second loan winds up deposited in a third bank and then stop to take stock At this point the quantity of money has increased by $90 in the second bank and $81 in the third, for a total increase—so far—of $171 The students will see that this loaning and reloaning process is not yet over and that the quantity of money will increase by still more Moreover (and more important) the students will grasp how banks “create money.” An Economics in the News detail defines, describes, and analyzes QE2, that is, the second round of quantitative easing the occurred in 2011 M O N E Y , T H E P R I C E L E V E L , A N D I N F L AT I O N V The Money Market A picky point The textbook is careful to not use the term “money supply” in this chapter Instead, it talks about the “quantity of money.” The term “money supply” is reserved for the relationship between the quantity of money and the interest rate, other things remaining the same It parallels the demand for money Although this point might seem picky, you can help your students by using this same language convention The Influences on Money Holding The demand for money refers to the choice to hold an inventory of money, not to the desire to receive money The quantity of money that people plan to hold depends on: • • • • The Price Level: The quantity of nominal money demanded is proportional to the price level so that, for example, when the price level doubles, the quantity of nominal money demanded doubles • Real money is the quantity of money measured in constant dollars and equals nominal money divided by the price level The quantity of real money demanded is independent of the price level The Nominal Interest Rate: The nominal interest rate is the opportunity cost of holding money, so an increase in the nominal interest rate decreases the quantity of real money demanded Real GDP: An increase in real GDP increases the quantity of money people plan to hold Financial Innovation: Some financial innovation decreases the quantity of money people plan to hold (ATM machines) and other financial innovation increases it (interest paid on checking accounts) The Demand for Money Curve The demand for money curve is the relationship between the quantity of real money demanded and the interest rate, holding all else equal As the figure shows, the negative relationship between the interest rate and the quantity of money demanded means the demand for money curve is downward sloping Shifts in the Demand for Money Curve • A change in real GDP or financial innovation changes the demand for money and shifts the demand for money curve An increase in real GDP increases the demand for money and shifts the demand for money curve rightward The Demand for Money Students are often confused by the phrase “demand for money” and it is worth tackling it head-on by emphasizing this does not equate to “wanting to be rich,” but refers to how much of total wealth (assets) the public want to hold in the particular form of “money.” Students often find it straightforward to think about their behavior and the quantity of cash they hold in their wallet when dealing with the factors that change the demand for money and shift the demand for money curve But they frequently get confused about the effect the interest rate has on the quantity of money demanded, probably because their holdings of money are not large So tell your students 83 84 CHAPTER to imagine themselves in the job of treasurer of a corporation with large liquid resources and to think how their behavior with respect to those funds might differ according to the short-term interest rates available on non-money alternatives, such as bonds It is easier for them to see that a treasurer will surely shift $5 million dollars into non-money assets in order to reap the higher interest-rate reward when the interest rate rises M O N E Y , T H E P R I C E L E V E L , A N D I N F L AT I O N Money Market Equilibrium Money market equilibrium occurs when the quantity of money demanded equals the quantity of money supplied The quantity of money supplied is determined by the Federal Reserve • • • Short Run: On any given day, the quantity of real money is fixed, so the supply of money curve is vertical The nominal interest rate adjusts to establish equilibrium in the money market The equilibrium nominal interest rate equates the quantity of real money demanded with the fixed quantity of real money In the figure, the equilibrium interest rate is percent The Short-Run Effect of a Change in the Supply of Money: Starting from a short-run equilibrium, if the Fed increases the quantity of money, people hold more money than the quantity demanded With a surplus of money holding, people enter the loanable funds market and buy bonds The increase in demand for bonds raises the price of a bond and lowers the interest rate Long Run: In the long run, supply and demand in the loanable funds market determines the equilibrium real interest rate That, plus the expected inflation rate determines the nominal interest rate, so the nominal interest rate cannot adjust to restore equilibrium in the money market The factor that adjusts in the long run is the price level: The price level adjusts to make the real quantity of money equal to the real quantity of money demanded In the long run, an increase in the quantity of money raises the price level by the same proportion VI The Quantity Theory of Money • • • The quantity theory of money is the proposition that in the long run, an increase in the quantity of money brings an equal percentage increase in the price level The velocity of circulation is the average number of times a dollar of money is used annually to buy the goods and services that make up GDP Nominal GDP equals real GDP, Y, multiplied by the price level, P, or GDP=PY So the velocity of circulation, V, is given by V = PY/M The equation of exchange states that the quantity of money, M, multiplied by the velocity of circulation, V, equals GDP: MV = PY The equation of exchange is a definition and so is always true It becomes the quantity theory of money by adding two assumptions: • The velocity of circulation is not influenced by the quantity of money • Potential GDP is not influenced by the quantity of money A 4:33 minute Youtube video that shows how Keynesians and Monetarists view the equation of exchange On Youtube, search “Economics: New Keynesians versus Monetarists” and select the video created by Mindbites • The equation of exchange can be rearranged as P = M(V/Y) This equation, together with the assumptions about velocity and potential GDP, implies that in the long run, the price level is determined by the quantity of money • In growth rates, the equation of exchange is: (Money growth rate) + (Growth rate of velocity) = (Inflation rate) + (Real GDP growth rate) Rearranging this equation gives (Inflation rate) = (Money growth rate) + (Growth rate of velocity) − (Real GDP growth rate) If velocity does not grow, then in the long run the inflation rate 85 86 CHAPTER equals the growth rate of the quantity of money minus the growth rate of potential GDP Historical Insight When Milton Friedman’s quantity theory of money was brought to the attention of policymakers during the 1960s, he was labeled an ivory tower academic with his head in the clouds When his predictions of inflation came true in the 1970s, he was crowned king of monetary theory Evidence on the Quantity Theory of Money The predictions of the quantity theory can be tested using evidence on money growth and inflation across time On the average, the money growth rate and the inflation rate are correlated, supporting the quantity theory The predictions of the quantity theory also can be tested using the evidence on money growth and inflation across countries As predicted, rapid money growth is correlated with high inflation The idea that growth in the quantity of money causes inflation sounds obvious enough to students that they might miss just how controversial the idea is, at least outside of the economics profession In an economy suffering from inflation, many observers blame “special circumstances,” such as hikes in the price of oil, bad crop harvests, import prices, or whatever Economists from the central bank often lend their support to these assertions The fact that central bank employees wish to divert attention away from their role in creating inflation is understandable if not commendable But why other observers go astray? Most often it is because they look at only their economy and not consider what data from other economies indicates or data from their own economy over a long period of time shows When looking at only one economy and one time period, it is always possible to find some price-increasing factor other than growth in the quantity of money and blame inflation on it But when looking across economies or across time, the paramount role growth in the quantity of money plays in creating inflation is immediately apparent So, contrary to the assertions emanating from the central banks and other analysts in nations with high inflation, almost surely their inflation is the result of high monetary growth and not some other “special, unique to them, unique to this time period circumstance!” The Economics in the News section deals with banks preparing for deposit outflows in 2015 with the Fed relaxing quantitative easing It uses the demand for M2 money to derive an estimate of what will be the deposit outflow when interest rates return to more normal levels MATHEMATICAL NOTE The mathematical note derives the formula for the money multiplier • Money is M, deposits is D, and currency is C M=D+C • The monetary base is MB and banks’ reserves is R MB = C + R • The money multiplier, mm, is equal to mm = M/MB = (D + C)/(R + C) • Divide all the variables on the right side of the money multiplier equation by D: mm = (1 + C/D)/(R/D + C/D) • • C/D is the currency drain ratio and R/D is the banks’ reserve ratio The formula shows that the size of the money multiplier depends on the reserve ratio and the currency drain In 2008, when times were more “normal,” for M1 the currency drain ratio, C/D, was • M O N E Y , T H E P R I C E L E V E L , A N D I N F L AT I O N equal to 1.24 and the reserve ratio, R/D, was equal to 0.28, so the money multiplier for M1 was +1.24 = 1.47 In 2008, for M2 the currency drain ratio was equal 0.28 + 1.24 to 0.12 and the reserve ratio was equal to 0.03, so the money multiplier for M2 was • + 0.12 = 7.5 0.03 + 0.12 In 2014, when banks are holding substantially more reserves than in past decades, for M1 the currency drain ratio, C/D, is equal to 0.81 and the reserve ratio, R/D, is equal to 1.69, so the money multiplier for M1 was +0.81 = 0.72 In 2014, for 1.69 + 0.81 M2 the currency drain ratio is equal to 0.13 and the reserve ratio is equal to 0.26, so the money multiplier for M2 was +0.13 = 2.90 0.126 + 0.13 87 88 CHAPTER Additional Problems Higher Reserve Requirement China’s central bank raised its reserve ratio requirement by one percentage point to 17.5 percent by June 25 China’s action was an attempt to decrease lending growth People’s Daily Online, June 11, 2008 a Compare the required reserve ratio in China and in the United States d Explain how raising the required reserve ratio changes the interest rate in the short run and draw a graph to illustrate the change In Zimbabwe the growth rate of the quantity of money increased from 52 percent a year to 66,700 percent a year in 2007 Accordingly the inflation rate in Zimbabwe skyrocketed, from 56 percent a year in 2000 to 24,000 percent a year in 2007 The growth rate of real GDP between these years is harder to measure but was probably −30 percent per year a How we know that Zimbabwe’s reported inflation between 2003 and 2007 is almost certainly below the true inflation rate? b What must be done to stop Zimbabwe’s inflation? c Zimbabwe’s government frequently responded to its inflation by changing its currency to “knock off” zeros on the currency At one point it was proposed to knock off ten zeros from the currency (so that an old 10,000,000,000 denomination bill would become a new domination bill) Why will knocking ten zeroes off all prices not stop Zimbabwe’s inflation? Solutions to Additional Problems a The required reserve ratios in China are much higher than those set by the Federal Reserve The required reserve ratio is 17.5 percent in China In the United States, the required reserve ratio is percent of checking deposits between $10.3 million and $44.4 million and 10 percent of these deposits in excess of $44.4 million The required reserve ratio on other types of deposits is zero b Figure 8.1 shows the effect of the boost in the required reserve ratio The increase in the required reserve ratio decreases the quantity of money supplied and the money supply curve shifts leftward from MS0 to MS1 As a result, the interest rate rises, in the figure from percent to percent M O N E Y , T H E P R I C E L E V E L , A N D I N F L AT I O N a We know that the reported inflation rate is too low because the velocity of circulation calculated with it fell The (true) velocity of circulation rises during hyperinflations as people strive to spend money as rapidly as possible If the true velocity of circulation rose, then the true inflation rate is higher (probably much higher) than the reported inflation rate b To stop Zimbabwe’s inflation, the central bank must stop or drastically lower the growth rate of the quantity of money c Knocking ten zeros off of all prices will not stop Zimbabwe's inflation because it just changes the units in which prices are measured Prices will continue to grow as long as the quantity of money grows Additional Discussion Questions 11 Why is the use of money in the exchange of goods and services less costly than using barter? Barter requires a “double coincidence of wants.” For instance, suppose the first person has good A and wants good B The person must find a second person with good B and who wants good A Barter requires that the first person must undertake costly search for his or her trade partner Use of money, on the other hand, breaks the necessity for the double coincidence of wants The first person who has good A and wants good B can trade with anyone who wants good A and has money After exchanging good A for money, the first person can now search for anyone who has good B and wants something else That person will be willing to accept money in exchange for his or her good B because that person knows that the money can then be exchanged for whatever he or she wants Therefore money has eliminated the need for the time-consuming and costly search needed with barter 12 “Everyone knows that true money is issued by the government; that is, the only real form of money is the nation’s currency.” Comment on this assertion This assertion is false Money is anything that can be used as a medium of exchange Funds in checking accounts clearly qualify because they can be used as a medium of exchange Therefore funds in checking accounts are definitely money Other sources of funds, such as funds in savings accounts, also come close to be money because they can be used with only slight difficulty as a medium of exchange Therefore money includes many assets beyond government-issued currency 13 Define the monetary base The monetary base is equal to the sum of coins, Federal Reserve notes, and depository institutions’ deposits at the Federal Reserve Except for coins, which are a small part of the monetary base, the monetary base is made up of liabilities of the Federal Reserve 14 “Ask anyone if he or she has enough money No one ever has enough money, that is, everyone demands more money Thus theorizing about the demand for money makes no sense because this demand obviously is infinite.” Correct and comment on the error in this assertion This assertion makes a fundamental error by confusing money with income Money is M1 The demand for money is the amount of M1 people want to hold People have a finite amount of M1 that they want to hold; that is, no one wants to hold an infinite amount of M1 Income, however, is a different story: people would like to receive infinite income because that means that they could have infinite consumption But infinite income is not the same as holding an infinite quantity of M1! 89 90 CHAPTER 15 If the price level was already doubling every month and inflation accelerating, what would you expect to happen to the velocity of circulation and why? How close would you expect the relation between the quantity of money and the price level to be? The velocity of circulation would increase People would try to spend the money they receive as rapidly as possible in order to avoid suffering the loss that comes from higher prices In this case, which occurs in hyperinflations, the inflation rate exceeds the growth rate of the quantity of money In a hyperinflation with accelerating inflation, the inflation rate equals the growth rate of the quantity of money plus the growth rate of velocity 16 How does a currency drain affect the money multiplier? [Requires Mathematical Note] A currency drain decreases the magnitude of the money multiplier The money multiplier exists because some of the proceeds of the loans that one bank makes are deposited in other banks where it can be loaned once again The more of the proceeds that are deposited in banks, the larger will be the next round of loans and hence the larger will be the money multiplier A currency drain decreases the amount of the loans that is deposited back in banks Because the faction of the loans that is deposited is less, the ultimate increase in the quantity of money—and hence the money multiplier—is smaller ... Conspiracy theory of the Fed Some students will have heard about a “conspiracy theory of the Fed.” This theory, advanced by the ignorant, the misinformed, or the deceitful, is that the commercial... increase in the monetary base and banks’ reserves The money multiplier is the ratio of the change in the quantity of money to the change in the monetary base It determines the change in the quantity... across time On the average, the money growth rate and the inflation rate are correlated, supporting the quantity theory The predictions of the quantity theory also can be tested using the evidence
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