Money And Inflation Part 2 Flashcards
3 instruments of monetary policy
Policy rate
Open market operations
Reserve requirements
Why borrow from central bank
If need funds, it acts as lender of last resort. It is safe, it wont go bust
Policy rate/base rate relationship with commercial bank rate
Positive. Policy rate is an input cost for commercial banks, so they increase their interest rates too
Higher policy rate on money supply and AD
Withdrawal from circular flow (more saving)
Fall in AD
Open market operations
Refer to the purchase and sale of non monetary assets to/from the banking sector by the central bank.
I.e the bank can manipulate money supply by buying or selling to commercial banks e.g bonds.
Issuing bonds decrease money supply, increase interest rate
Reserve requirements
Commercial banks must hold money in reserve.
Thus limiting extent to which banks can give out loans. Less money circulating.
Expansionary characteristics (3)
Decrease policy rate
Create money and buy bonds (open market operations)
Lower reserve requirements (commercials have to hold less money, more circulation)
All these increase money supply
Contractionary characteristics
Increasing policy rate
Sell bonds
Raise reserve requirements
All these lower money supply
2008 financial crisis approach
Very focused on policy rate. However rate was already near 0 so quantitative easing, and statements of intent to influence economic agents.
Inflation+ Overall price level can be measured through CPI or value of money.
How is the value of money measured.
1/P.
Shows how many goods can be bought with one 1 monetary unit. (Shows purchasing power of each monetary unit=pound)
Higher price=lower purchasing power
Assumption about supply of money and what it looks like on the graph, and name axis
Exogenous. Determined by central bank and so is fixed.
Vertical line. Price/value of money on y axis, quantity on x axis
Demand for money depends on.. (classical view)
Demand depends on prices.
Higher prices=more money required so more demand for money
Positive relationship between demand for money and price.
Relationship between money demand and value of money
Inverse. If value is high, we need less money to purchase so demand low
Time horizons in short run and long run for price
LR-price level adjusts to where MD=MS (Classical view)
SR-prices are less flexible and money demand depends on other things e.g interest rates like in Keynesian, where interest rates influence opportunity cost of holding money
Expansionary monetary policy on value of money
Increases money supply, so value of money decreases and prices increase. (MORE ACTIVITY INCREASES PRICES)
Money supply and price-positive relationship.
Classical dichotomy
Variables can be divided into nominal variable (monetary units) and real variables (physical units) e.g nominal wages and real wages.
What did Hume argue
Determinants of the monetary system influence nominal variable but are irrelevant when it comes to real variables. (See next card)
E.g in Loanable funds market, the determination of real interest rate had nothing to do with money
Monetary neutrality
According to Hume and the classical school of thought, changes in the supply of money have no real effects on the economy.
I.e. although money supply doubles, price level doubles, as does wages. So REAL VARIABLES are unchanged.
Quantity theory
Changes in money supply lead to changes in price level.
Growth in the quantity of money is the primary cause of overall price increases (the money growth rate determines the inflation rate)
Quantity theory equation
M x V = P x Y
M=nominal money supply
V=velocity of money (no. of times the average monetary unit (pound in UK) is used.)
P=price level
Y=output
What is constant in that equation
V-is stable over time so we can cancel out from equation.
And Y is determined by factors of production and tech so it doesn’t change either
What must happen for money supply to increase
Output or Price increase or velocity falls
But we know velocity is constant and output depends on production factors so it can’t be V or Y
Given these assumptions of constant velocity and Y being determined by L and K:
% change in M=% change in P
Nominal interest rate vs real interest rate
Nominal is interest offered by banks
Real is nominal corrected for inflation (minus inflation)
If real>inflation-interest on saving is greater than rise in cost so purchasing power rises
If real<inflation-interest is less than rise in prices so purchasing power falls
What does the real interest rate show+ formula
Purchasing power. (See previous slide)
Nominal-inflation
Why negative REAL rate is useful (cannot have a negative nominal)
If weak economy, incentivise spending.
Because implies inflation>nominal rate. So purchasing power is falling, thus better to spend.
Fisher equation shows what and formula
Shows nominal interest rate can change because real interest changes or inflation rate changes.
I=r+inflation (notated as pie)
Basically just rearranged the real interest rate formula (I-inflation=r)
Classical view on whether inflation is a problem.
Inflation is not a problem, just a change in units of the measurement. E.g prices rise but other variables rise too (monetary neutrality)
Costs of expected inflation (5)
Shoe leather-inconvenience of moving money
Menu costs
Price distortions and misallocation of resources-firms may change prices infrequently or at different times
Inflation-induced tax distortions-e.g fiscal drag (nominal income increased but not real but paying higher tax)
General inconvenience and confusion.
Costs of unexpected inflation
If actual inflation is different than expected inflation, one side of the transaction gains at the others expense
If unexpected (actual) is greater than expected inflation (predicted)-inflation is underestimated so interest received by lenders is worth less so lenders worse off. (Vice versa)
High inflation main problem.
Uncertainty
What is Inflation tax
When government raises money through printing money. Money supply increases so value falls.
Thus, inflation tax is a ‘tax’ on people who hold more money
• Broadly, inflation tax might be regarded as a progressive tax (i.e. the richer you are, the more the tax will affect you) – however we might debate this
• Consider: what kind of people hold money in a liquid form? (Do very rich people have lots of cash?)
Benefits of inflation
Reduce real wages by holding nominal wages constant.
Wages constant (not keeping up with inflation, real costs actually gets cheaper for firms)
What is hyperinflation caused by
Excessive growth in money supply (quantity theory-changes in money supply cause changes in overall price level (inflation))
Inflation targeting example and formula
% change in M= % change in P x % change in Y
E.g if inflation target=2, and change in y=4
Change in M must be 6 (2+4=6)
