CHAPTER 4

Money and Inflation

A PowerPoint Tutorial
To Accompany

MACROECONOMICS, 7th. Edition

N. Gregory Mankiw
Tutorial written by:

Mannig J. Simidian

B.A. in Economics with Distinction, Duke University

Chapter
1
M.P.A.,
Harvard
University
Kennedy
School
of
Government
Four
M.B.A., Massachusetts Institute of Technology (MIT) Sloan School of Management

Money

Stock of assets
Used for transactions
A type of wealth

As a medium of exchange, money is used to buy goods and

services. The ease at which an asset can be converted into a
medium of exchange and used to buy other things is sometimes
called an assets liquidity. Money is the economys most liquid
asset.
Chapter
Four

Inflation is an increase in the average level of prices, and a price

is the rate at which money is exchanged for a good or service.
Here is a great illustration of the power of inflation:
In 1970, the New York Times cost 15 cents, the median price of a
single-family home was $23,400, and the average wage in
manufacturing was $3.36 per hour. In 2008, the Times cost
$1.50, the price of a home was $183,300, and the average wage
was $19.85 per hour.

Chapter
Four

It serves as a store of value, unit of account, and a medium of

exchange. The ease with which money is converted into other things
such as goods and services--is sometimes called moneys liquidity.

Chapter
Four

Money is the yardstick with which we measure

economic transactions. Without it, we would be
forced to barter. However, barter requires the
double coincidence of wantsthe unlikely
situation of two people, each having a good that
the other wants at the right time and place to make
an exchange.

Chapter
Four

Fiat money is money by declaration.

It has no intrinsic value.

Commodity money is money that

has intrinsic value.
When people use gold as money, the
economy is said to be on a gold standard.

Chapter
Four

Chapter
Four

The government may get involved in

the monetary system to help people
reduce transaction costs. Using gold as
a currency is costly because the purity
and weight has to be verified. Also,
coins are more widely recognized than
gold bullion.
The government then accepts gold from the public
in exchange for gold-certificates pieces of paper
that can be redeemed for actual gold. If people trust
that the government will give them the gold upon
request, then the currency will be just as valuable as
the gold itselfplus, it is easier to carry around the
paper than the gold. The end result is that because
no one redeems the gold anymore and everyone
accepts the paper, they will have value and serve as
7
money.

The money supply is the quantity of money available in an economy.

The control over the money supply is called monetary policy.
In the United States, monetary policy is conducted in a partially
independent institution called the central bank. The central bank in the
U.S. is called the Federal Reserve, or the Fed.

Chapter
Four

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Chapter
Four

To expand the money supply:

The Federal Reserve buys U.S. Treasury Bonds
and pays for them with new money.
To reduce the money supply:
The Federal Reserve sells U.S. Treasury Bonds
and receives the existing dollars and then destroys
them.
9

The Federal Reserve controls

the money supply in 3 ways:
Conducting Open Market Operations
(buying and selling U.S. Treasury bonds).

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Chapter
Four

Changing the Reserve requirements

(never really used).
Changing the Discount rate which
member banks (not meeting the reserve
requirements) pay to borrow from the
Fed.
10

The quantity equation is an identity: the definitions of the four

variables make it true. If one variable changes, one or more of the
others must also change to maintain the identity. The quantity
equation we will use from now on is the money supply (M) times the
velocity of money (V) which equals price (P) times the number of
transactions (T):
Money Velocity = Price Transactions
M
V
= P
T
V in the quantity equation is called the transactions velocity of money.
This tells us the number of times a dollar bill changes hands in a given
period of time.
Chapter
Four

11

Transactions and output are related, because the more the

economy produces, the more goods are bought and sold.
If Y denotes the amount of output and P denotes the price of one
unit of output, then the dollar value of output is PY. We
encountered measures for these variables when we discussed
the national income accounts.
Money Velocity = Price Output
M
V
= P
Y
This version of the quantity equation is called the income
velocity of money, which tells us the number of times a dollar
bill enters someones income in a given time.
Chapter
Four

12

Lets now express the quantity of money in terms of the quantity of

goods and services it can buy. This amount, M/P is called real money
balances. Real money balances measure the purchasing power of the
stock of money.
A money demand function is an equation that shows the determinants
of real money balances people wish to hold. Here is a simple money
demand function:
(M/P)d = k Y
where k is a constant that tells us how much money people want to hold
for every dollar they earn. This equation states that the quantity of real
money balances demanded is proportional to real income.
Chapter
Four

13

The money demand function is like the demand function for a

particular good. Here the good is the convenience of holding real
money balances. Higher income leads to a greater demand for real
money balances. The money demand equation offers another way
to view the quantity equation (MV= PY) where V = 1/k.
This shows the link between the demand for money and the
velocity
of money. When people hold a lot of money for each dollar of
income (k is large), money changes hands infrequently (V is small).
Conversely, when people want to hold only a little money (k is
small), money changes hands frequently (V is large). In other
words, the money demand parameter k and the velocity of money V
14
areChapter
opposite
sides
of
the
same
coin.
Four

The
Thequantity
quantityequation
equationcan
canbe
beviewed
viewedas
asaadefinition:
definition:
ititdefines
definesvelocity
velocityVVas
asthe
theratio
ratioof
ofnominal
nominalGDP,
GDP,PY,
PY,
to
tothe
thequantity
quantityof
ofmoney
moneyM.
M. But,
But,ififwe
wemake
makethe
the
assumption
assumptionthat
thatthe
thevelocity
velocityof
ofmoney
moneyisisconstant,
constant,
then
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thequantity
quantityequation
equationMV
MV==PY
PYbecomes
becomesaauseful
useful
theory
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ofthe
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ofmoney.
money.The
Thebar
barover
overthe
theVV
means
meansthat
thatvelocity
velocityisisfixed.
fixed.
MV = PY
Chapter
Four

So, lets hold it constant! Remember

a change in the quantity of money causes
a proportional change in nominal GDP.
15

Three building blocks that determine the economys overall level

of prices:
The factors of production and the production function determine
the level of output Y.
The money supply determines the nominal value of output, PY.
This follows from the quantity equation and the assumption that
the velocity of money is fixed.
The price level P is then the ratio of the nominal value of output,
PY, to the level of output Y.
Chapter
Four

16

In other words, if Y is fixed (from Chapter 3) because it depends

on the growth in the factors of production and on technological
progress, and we just made the assumption that velocity is constant,

MV = PY
or in percentage change form:
%
%Change
Changein
inM
M++%
%Change
Changein
inVV==%
%Change
Changein
inPP++%
%Change
Changein
inYY
if V is fixed and Y is fixed, then it reveals that % Change in M is what
induces % Changes in P.
The quantity theory of money states that the central bank, which
controls the money supply, has the ultimate control over the inflation
rate. If the central bank keeps the money supply stable,the price level
will be stable. If the central bank increases the money supply rapidly,
the price level will rise rapidly.
Chapter
Four

17

The
Therevenue
revenueraised
raisedthrough
throughthe
theprinting
printingof
ofmoney
moneyisiscalled
called
seigniorage.
seigniorage. When
Whenthe
thegovernment
governmentprints
printsmoney
moneyto
tofinance
finance
expenditure,
expenditure,ititincreases
increasesthe
themoney
moneysupply.
supply. The
Theincrease
increasein
in
the
themoney
moneysupply,
supply,in
inturn,
turn,causes
causesinflation.
inflation.Printing
Printingmoney
moneyto
to
raise
raiserevenue
revenueisislike
likeimposing
imposingan
aninflation
inflationtax.
tax.

Chapter
Four

18

Chapter
Four

19

Economists
Economistscall
callthe
theinterest
interestrate
ratethat
thatthe
thebank
bankpays
paysthe
the
Nominal
Nominalinterest
interestrate
rateand
andthe
theincrease
increasein
inyour
yourpurchasing
purchasingpower
powerthe
the
real
realinterest
interestrate.
rate.

r=i-
This
Thisshows
showsthe
therelationship
relationshipbetween
betweenthe
thenominal
nominalinterest
interestrate
rate
and
andthe
therate
rateof
ofinflation,
inflation,where
whererrisisreal
realinterest
interestrate,
rate,iiisisthe
the
nominal
nominalinterest
interestrate
rateand
andisisthe
therate
rateof
ofinflation,
inflation,and
andremember
remember
that
thatisissimply
simplythe
thepercentage
percentagechange
changeof
ofthe
theprice
pricelevel
levelP.
P.
Chapter
Four

20

The Fisher Equation illuminates the distinction between

the real and nominal rate of interest.

Fisher Equation: i = r +

The one-to-one relationship

between the inflation rate and
the nominal interest rate is
the Fisher effect.
Actual (Market)
Real rate
Inflation
nominal rate of
of interest
interest
It shows that the nominal interest can change for two reasons: because
the real interest rate changes or because the inflation rate changes.
Chapter
Four

21

The quantity theory and the Fisher equation together tell us how money
growth affects the nominal interest rate. According to the quantity
theory, an increase in the rate of money growth of one percent causes a
1% increase in the rate of inflation.
According to the Fisher equation, a 1% increase in the rate of inflation
in turn causes a 1% increase in the nominal interest rates.
Here is the exact link between our two familiar equations: The quantity
equation in percentage change form and the Fisher equation.
% Change in M + % Change in V = % Change in P + % Change in Y
% Change in M + % Change in V =

+ % Change in Y

i=r+
Chapter
Four

22

The real interest rate the borrower and lender expect when a loan is
made is called the ex ante real interest rate. The real interest
rate that is actually realized is called the ex post real interest rate.
Although borrowers and lenders cannot predict future inflation with
certainty, they do have some expectation of the inflation rate. Let
denote actual future inflation and e the expectation of future inflation.
The ex ante real interest rate is i - e, and the ex post real interest rate is
i - The two interest rates differ when actual inflation differs from
expected inflation e.
How does this distinction modify the Fisher effect? Clearly the nominal
interest rate cannot adjust to actual inflation, because actual inflation
is not known when the nominal interest rate is set. The nominal interest
rate can adjust only to expected inflation. The next slide presents a
23
moreChapter
precise version of the the Fisher effect.
Four

ii =
= rr +
+ EE
The ex ante real interest rate r is determined by equilibrium in the
market for goods and services, as described by the model in
Chapter 3. The nominal interest rate i moves one-for-one with
changes in expected inflation E.

Chapter
Four

24

The quantity theory (MV = PY) is based on a simple money demand

function: it assumes that the demand for real money balances is
proportional to income. But, we need another determinant of the
quantity of money demandedthe nominal interest rate.

The nominal interest rate is the opportunity cost of holding money:

it is what you give up by holding money instead of bonds. So, the new
general money demand function can be written as:
(M/P)d = L(i, Y)
This equation states that the demand for the liquidity of real money
balances is a function of income (Y) and the nominal interest rate (i).
The higher the level of income Y, the greater the demand for real
money balances.
Chapter
Four

25

Inflation & the Fisher Effect

Money Supply & Money Demand

As the quantity theory of money explains, money supply and money

demand together determine the equilibrium price level. Changes in
the price level are, by definition, the rate of inflation. Inflation, in
turn, affects the nominal interest rate through the Fisher effect.
But now, because the nominal interest rate is the cost of holding
money, the nominal interest rate feeds back into the demand for money.
Chapter
Four

26

The inconvenience of reducing money

holding is metaphorically called the
shoe-leather cost of inflation, because
walking to the bank more often induces
ones shoes to wear out more quickly.
When changes in inflation require printing
and distributing new pricing information,
then, these costs are called menu costs.
Another cost is related to tax laws. Often
tax laws do not take into consideration
inflationary effects on income.
Chapter
Four

27

Unanticipated inflation is unfavorable because it arbitrarily

redistributes wealth among individuals.
For example, it hurts individuals on fixed pensions. Often these
contracts were not created in real terms by being indexed to a
particular measure of the price level.
There is a benefit of inflationmany economists say that some
inflation may make labor markets work better. They say it
greases the wheels of labor markets.

Chapter
Four

28

Hyperinflation is defined as inflation that exceeds

50 percent per month, which is just over 1percent a
day.

Chapter
Four

Costs such as shoe-leather and menu costs are much

worse with hyperinflationand tax systems are
grossly distorted. Eventually, when costs become too
great with hyperinflation, the money loses its role as
store of value, unit of account and medium of
exchange. Bartering or using commodity money
29
becomes prevalent.

Economists call the separation of the determinants of real

and nominal variables the classical dichotomy. A
simplification of economic theory, it suggests that changes in
the money supply do not influence real variables.
This irrelevance of money for real variables is called
monetary neutrality. For the purpose of studying long-run
issuesmonetary neutrality is approximately correct.

Chapter
Four

30

Inflation
Hyperinflation
Money
Store of value
Unit of account
Medium of exchange
Fiat money
Commodity money
Gold Standard
Money supply
Monetary policy

Chapter
Four

Central bank
Federal Reserve
Open-market operations
Currency
Demand deposits
Quantity equation
Transactions velocity
of money
Income velocity
of money
Real money balances
Money demand function
Quantity theory of money

Seigniorage
Nominal and
real interest rates
Fisher equation
Fisher effect
Ex ante and ex post
real interest rates
Shoeleather costs
Menu costs
Real and nominal
variables
Classical dichotomy
Monetary neutrality
31