A PowerPoint Tutorial

to Accompany macroeconomics, 5th ed.

N. Gregory Mankiw

CHAPTER FOUR
Money and Inflation

Mannig J. Simidian

Chapter 1
Four
 Stock of assets
Money Used for transactions
A type of wealth

Self-sufficiency
Without Money
Barter economy

Chapter 2
Four
 Functions of Money

Store of value
Unit of account
Medium of exchange

The ease with which money is converted into other things--

goods and services-- is sometimes called moneys liquidity.

Chapter 3
Four
Chapter 4
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 5
Four
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 Bank Indonesia, or the BI.

Chapter 6
Four
How does the BI control the money supply?

1) Open Market Operations

2) Reserve Requirements

3) Discount rate at which member banks can

borrow from the CB.

Chapter 7
Four
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 output (Y):
Money Velocity = Price Output
M V = P Y
Because Y is also total income, V in the quantity equations is called the
income velocity of money. This tells us the number of times a dollar
bill changes hands in a given period of time.

Chapter 8
Four
Chapter 9
Four
 M=C+D
Money Supply Currency Demand Deposits

In this chapter, well see that the money supply is determined not onl
by the Federal Reserve, but also by the behavior of households
(which hold money) and banks (where money is held).

Chapter 10
Four
The
Thedeposits
depositsthat
thatbanks
bankshave
havereceived
receivedbut
buthave
havenotnotlent
lentout
outare
arecalled
called
reserves.
reserves. Consider
Considerthe
thecase
casewhere
whereall
alldeposits
depositsare
areheld
heldas
asreserves:
reserves:
banks
banksaccept
acceptdeposits,
deposits,place
placethe
themoney
moneyininreserve,
reserve,and
andleave
leavethe
themoney
money
there
thereuntil
untilthe
thedepositor
depositormakes
makesaawithdrawal
withdrawalor orwrites
writesaacheck
checkagainst
against
the
thebalance.
balance.

In
Inaa100%
100%reserve
reservebanking
bankingsystem,
system,all
alldeposits
depositsare
areheld
heldin
inreserve
reserve
and
andthus
thusthe
thebanking
bankingsystem
systemdoes
doesnot
notaffect
affectthe
thesupply
supplyof
ofmoney.
money.

Chapter 11
Four
As
Aslong
longas
asthe
theamount
amountofofnew
newdeposits
depositsapproximately
approximatelyequals
equalsthe
the
amount
amountof ofwithdrawals,
withdrawals,aabank
bankneed
neednot
notkeep
keepall
allits
itsdeposits
depositsin
in
reserves.
reserves.Note:
Note:aareserve-deposit
reserve-depositratio
ratioisisthe
thefraction
fractionofofdeposits
depositskept
kept
in
inreserve.
reserve.Excess
Excessreserves
reservesare
arereserves
reservesabove
abovethe
thereserve
reserve
requirement.
requirement.

Fractional-reserve
Fractional-reservebanking,
banking,aasystem
systemunder
underwhich
whichbanks
bankskeep
keep
only
onlyaafraction
fractionof
oftheir
theirdeposits
depositsin
inreserve.
reserve. In
Inaasystem
systemof
of
fractional
fractionalreserve
reservebanking,
banking,banks
bankscreate
createmoney.
money.

Chapter 12
Four
Assume each bank maintains a reserve-deposit ratio (rr) of 20% and that the initial deposit is
$1000.
Firstbank Secondbank Thirdbank
Balance Sheet Balance Sheet Balance Sheet
Assets Liabilities Assets Liabilities Assets Liabilities
Reserves $200 Deposits $1,000 Reserves $160 Deposits $800 Reserves $128 Deposits $640
Loans $800 Loans $640 Loans $512

Mathematically, the amount of money the original $1000 deposit creates is:
Original Deposit =$1000
Firstbank Lending = (1-rr) The
$1000process
The processofoftransferring
transferringfunds
funds
Secondbank Lending = (1-rr)2 $1000 from savers to borrowers is called
from savers to borrowers is called
Thirdbank Lending = (1-rr)3 $1000
Fourthbank Lending
financial intermediation.
=. (1-rr)4 $1000 financial intermediation.
..
Total Money Supply = [1 + (1-rr) + (1-rr)2 + (1-rr)3 + ] $1000
= (1/rr) $1000
Chapter
= (1/.2) $1000 13
Four = $5000 Money
Moneyand andLiquidity
LiquidityCreation
Creation
Three exogenous variables:
The monetary base B is the total number of dollars held by the
public as currency C and by the banks as reserves R.
The reserve-deposit ratio rr is the fraction of deposits D that banks
hold in reserve R.
The currency-deposit ratio cr is the amount of currency C
people hold as a fraction of their holdings of demand deposits D.
Definitions of the money supply and the monetary base:
M=C+D
B =C+R
Solving for M as a function of the 3 exogenous variables:
M/B = C/D + 1
C/D + R/D
Making the substitutions for the fractions above, we obtain:
cr + 1 Lets call this the money multiplier, m.
M= B
cr + rr
Chapter 14
Four
 M m B
M == m B

Money Supply Money multiplier Monetary Base

Because
Becausethe
themonetary
monetarybase
basehas
hasaamultiplied
multipliedeffect
effecton
onthe
themoney
moneysuppl
supp
the
themonetary
monetarybase
baseisissometimes
sometimescalled
calledhigh-powered
high-poweredmoney.
money.

Chapter 15
Four
Lets go back to our three exogenous variables to see how
their changes cause the money supply to change:
The money supply M is proportional to the monetary base B.
So, an increase in the monetary base increases the money
supply by the same percentage.
The lower the reserve-deposit ratio rr (R/D), the more loans
banks make, and the more money banks create from every
dollar of reserves.
The lower the currency-deposit ratio cr (C/D) , the fewer
dollars of the monetary base the public holds as currency, the
more base dollars banks hold in reserves, and the more
money banks can create. Thus a decrease in the currency-
deposit ratio raises the money multiplier and the money
supply.
Chapter 16
Four
 Classical Theory of Money Demand
According to the Quantity Theory of Money, (M/P)d = kY, where k is a constant
measuring how much people want to hold for every dollar of income.
Keynesian Theory of Money Demand
Later we adopted a more realistic money demand function where the demand for
real money balances depends on i and Y: (M/P)d = L(i, Y).
Portfolio Theories of Money Demand
They emphasize the role of money as a store of value; people hold money as a part
of their portfolio of assets. Key insight: money offers a different risk and return
than other assets. Money offers a safe nominal return, while other investments may
fall in both real and nominal terms.
Transactions Theories of Money Demand
They emphasize the role of money as a medium of exchange; they acknowledge
that money is a dominated asset and stress that people hold money, unlike other
assets, to make purchases. They explain why people hold narrow measures of money
like currency or checking accounts.

Chapter 17
Four
Near money consists of assets that have acquired the liquidity of mone
(e.g. checks that can be written against mutual fund accounts).

Near money causes instability in money demand and can give faulty
signals about aggregate demand.

One response to this problem is to use a broad definition of money tha

includes near money however, it is hard to choose what kinds of asset
should grouped together.

Chapter 18
Four
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 what determines
the quantity 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 19
Four
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 Chapter
are
Four
opposite sides of the same coin. 20
The Assumption of Constant Velocity

The
Thequantity
quantityequation
equationcan
canbe
beviewed
viewedasasaadefinition:
definition:
ititdefines
definesvelocity
velocityVVasasthe
theratio
ratioof
ofnominal
nominalGDP,
GDP,PY,PY,
to
tothe
thequantity
quantityofofmoney
moneyM. M. But,
But,ififwe
wemake
makethethe
assumption
assumptionthat thatthe
thevelocity
velocityofofmoney
moneyisisconstant,
constant,
then
thenthethequantity
quantityequation
equationMV=PY
MV=PYbecomes
becomesaauseful
useful
theory
theoryof ofthe
theeffects
effectsof
ofmoney.
money.

MV = PY So, lets hold it constant!

Chapter 21
Four
Three building blocks that determine the economys overall level
of prices:

1) The factors of production and the production function determine

the level of output Y.
2) 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.
3) The price level P is then the ratio of the nominal value of output,
PY, to the level of output Y.

Chapter 22
Four
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 23
Four
 The
Therevenue
revenueraised
raisedthrough
throughthe
theprinting
printingofofmoney
moneyisiscalled
called
seigniorage.
seigniorage. When
Whenthethegovernment
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 24
Four
Chapter 25
Four
Economists
Economistscallcallthe
theinterest
interestrate
ratethat
thatthe
thebank
bankpays
paysthe
thenominal
nominal
interest
interestrate
rateand
andthe
theincrease
increaseininyour
yourpurchasing
purchasingpower
powerthe
the
real
realinterest
interestrate.
rate.

r=i

This
Thisshows
showsthe therelationship
relationshipbetween
betweenthethenominal
nominalinterest
interestraterate
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
thatisissimply
that simplythe
thepercentage
percentagechange
changeof ofthe
theprice
pricelevel
levelP.P.

Chapter 26
Four
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)
Nominal rate of Real rate Inflation
interest of 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 27
Four
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 28
Four
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
moreChapter
precise version of the the Fisher effect. 29
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 30
Four
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 demanded the 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 31
Four
 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 32
Four
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 inflation many economists say that some

inflation may make labor markets work better. They say it
greases the wheels of labor markets.

Chapter 33
Four
 Hyperinflation is defined as inflation that exceeds
50 percent per month, which is just over 1% a day.

Costs such as shoe-leather and menu costs are much

worse with hyperinflation and 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
becomes prevalent.
Chapter 34
Four
 Economists call the separation of the determinants of real
and nominal variables the classical dichotomy. 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
issues-- monetary neutrality is approximately correct.

Chapter 35
Four
Inflation Central Bank Seigniorage
Hyperinflation Federal Reserve Nominal and
Money Open-market operations real interest rates
Store of value Currency Fisher equation
Unit of account Demand deposits Fisher effect
Medium of exchange Quantity equation Ex ante and ex post
Fiat money Transactions velocity real interest rates
Commodity money of money Shoeleather costs
Gold Standard Income velocity Menu costs
Money supply of money Real and nominal
Monetary policy Real money balances variables
Money demand function Classical dichotomy
Quantity theory of money Monetary neutrality
Chapter 36
Four