Week 8 Money and Inflation

Question 1

Untill now, what havent we introduced in our model full intertemporal model?

Answer 1

Money

Question 2

In real life we use money to do what?

Answer 2

Exchange goods

Question 3

What is Money?

Answer 3

A medium of exchange

Store of value

Units of account.

Question 4

What does it mean that money is a medium of exchange?

Answer 4

you can use money to buy goods, its universally accepted.

Question 5

What does it mean if money is a store of value?

Answer 5

Money has to hold its value to be used for payment. It can be held for a long time without expiring

Question 6

What does Units of account mean?

Answer 6

a value of something is measured in a specific currency.

Question 7

To introduce money into our model, lets first some terms, what is a nominal bond and how is it different to a bond we have used in previous weeks?

Answer 7

Nominal bond - we excahnge an amount of money in the current period, for a promise to deliver an amount of money in the future period.

Bond - we exchange current consumption goods, for a promise for future consumption goods.

Question 8

So what are the 2 assets, in our economy?

Answer 8

Money and a Nominal bond.

Question 9

So we are going to express the prices of any goods we have in the economy in terms of what?

Answer 9

Money ( CPI)

Question 10

What is the price of goods in terms of money?

Answer 10

P ( this is the average level of prices)

Question 11

What is the nominal interest rate and what is Nominal interest rate and how is it different to real interest rate we used in our previous model?

Answer 11

Nominal interest rate = retuurn of the bond in terms of money, this differs in the goofs market where he had r = real interest rate, which is return of the bond in terms of goods.

We denote Nominal interest rate with R and real interest rate with r.

Question 12

What is the fisher’s relation?

Answer 12

Tells you how the real interest rate is linked to the nominal interest rate, by inflation.

Question 13

What is the approximate of the fishers relation?

Answer 13

so the real interest rate is approximately equal to the Nominal interest rate - inflation.

Question 14

Now we are going to look at alternative means of payign for goods via credit card services, when i purchase goods for a price p, what do you have to pay?

Answer 14

When using a credit card you bear a cost q per unit of goods purchased ( transcation fees of credit cards)

Question 15

Do credut card services bare costs when supplying money?

Answer 15

Question 16

What is the diagram for the supply of credit cards services where the transcation cost is a function of the supply of credit?

Answer 16

The higher q the more credit card services i want to serve, because the transcation feees cover the costs.

Question 17

What is the demand for credit card services, ie how do we note the quanitiy of goods purchased with credit cards services?

Answer 17

Question 18

What is the amount of goods that i buy with currency denoted as?

Answer 18

it is the difference between all the transcations in the economy and goods purchased with credit card services.

GDP - goods brought with credit cards.

Question 19

How do i decide to buy goods using cash or credit?

Answer 19

We look at their marginal cost and marginal benefit.

Question 20

If i decide to buy an additional unit of the goods or services by using credit cards, whats the marginal benefit?

Answer 20

It is i dont have to carry an amount P of cash in my hands, meaning i can just use credit cards, So the amount P in my hands can go buy a nominal bond, in the next period.

Question 21

If i buy a nominal bond what will i get

Answer 21

P(1+R) - the marginal benefit if i decide to use all credit cards and not carry cash meaning i can use this P and by a nominal bond to get a return of this.

Question 22

What is the Marginal cost of using a credit card at the end of the period to buy an additonal good?

Answer 22

When i use a credit card i have to pay a transcation cost of q.

So its P(1+q) so P is the cost of good x the transcation cost

Question 23

If 𝑃 (1 + 𝑅) > 𝑃 (1 + 𝑞)?

Answer 23

If the marginal benefit of using credit cards is greater than the marginal cost of using credit cards this means i will not ever use cash, ill purchase all goods with credit cards.

Question 24

If P(1+R)

Answer 24

Then its always convient to use cash, i dont want to use credit cards.

Question 25

If i want to be in a asitutation where i am indifferent in using credit cards or cash, what must happen?

Answer 25

Marginal benefit = Marginal cost

P(1+R) = P(1+q)

or the nominal interest rate = Transcation cost

R = q

Question 26

What is the demand of credit card services displayed on a diagram?

Answer 26

It is horizontal for a certain level of the interest rate.

Question 27

What is the intersection of supply of credit card services and the demand of credit card services?

Answer 27

Tells us the number of transcations using credit card services.

Question 28

If the R nominal interest rate goes up what does this mean?

Answer 28

It is more convient to use credit card services, as the marginal benefit is higher

P(1+R)>P(1+q)

Question 29

What is the nominal demand for money i.e the amount of cash i have to carry in my pocket?

Answer 29

So this tells us the value of goods using cash i buy (P)

Question 30

What is proportional in this equation?

Answer 30

Md and P are proportional as the rest are constants.

Question 31

How can i rewrite this equation?

Answer 31

We can use the approximate fishers equation to rewrite assuming inflation = 0.

L means a function of

Question 32

What is the money demand curve?

Answer 32

Straight linear line that goes through the origin, this is because money demand is proportional to the price level.

Question 33

What are some costs of inflation?

Answer 33

Menu costs ( costs increased by firms changing their prices)

People on fixed incomes lose purchasing power( prices rise while incomes dont )

Uncertainity( inflation affects prices and costs to business making it difficult to plan for the future)

Question 34

What are some costs of deflation?

Answer 34

Confidence and saving : falling asset price such as prices deflation in the housing market hit personal sector wealth and confidence.

The real cost of borrowing increases.

Question 35

What happens when income goes up?

Answer 35

If income goes up, i want to buy more goods, with cash so for the same level of prices, my money demand will be higher.

Use formula

Question 36

What happens when r decreases, assuming inflation is 0 ( interest and nominal interest rate are the same thing)?

Answer 36

Question 37

What is the government budget constraint?

Answer 37

PG = Government purchases x prices of goods

1 + R^-)B^- = we have some nominal debt issued in previous period in which we have to pay back, with interest

This is all funded by tax, issuing nominal bonds, or changing quanitiy of money in circulation

Also the government can change the money supply in the economy.

And also M^- means quanitity of money in circulation in the previous period.

Question 38

How does the money market look in the current period, introducing money supply?

Answer 38

We assume the money supply is a constant amount of money .

When money supply in the economy and demand are equal, this determines money supply and price level in the economy.

Question 39

Now how does the full intertemporal model look like?

Answer 39

Question 40

What are the 3 possibilities to increase the money supply, keeping the government budget constraint satisfied?

Answer 40

1) We reduce taxes, and increase M^- ( we are transferring basically M^- to consumers, known as ‘helicopter drop’)
2) Open market operations - so the fiscal authority will issue some govt bonds and the monetary authority, can purchase some debt by issuing money, thus reducing quanitiy of government bonds in ciruclation.
3) Increase quanitiy of money and government spending, so we are prinitiyn more money to increase govt spending, the govt collect seigniorage ( the revenue the govt gets from priniting money)

Question 41

How does an increase in money supply affect the full intertemporal model?

Answer 41

The money supply shifts to the right, the new equibrium will be were prices are higher.

There is no effect on labour market or output market.

We say the increase in money supply is neutral, as it doesnt affect the reallocation, it only changes nominal variables suxh as prices level, it doesnt change employment, real wage, interest rate etc.

Question 42

In the real world do prices adjust immediately, when there is an increase in money supply?

Answer 42

Prices adjust dont adjust immediately like our model assumes.

Question 43

Now we are going to look at an increase in current TFP how does it affect our intertemporal model?

Answer 43

1) The marginal product of labour is going to be higher, implying labour demand will jump up for the same wage, thus i want to higher more workers.
2) this implies output supply shifts to the right.
3) The interest rate is going to have to adjust as output supply greater than demand, so it will come down to r2.
4) This leads to a higher output and lower interest rate.
5) The labour supply shifts to the left, due to the intertempral subsitiuion effect of lesiure, future lesiure is more expensive, so you want to work less today and more in the future period.
6) This also affects the money demand too, so the interest rate is has fallen, and as we assume inflation is 0 the formula M^d = PL(Y1,r1), Output increases and r decreases meaning that) using that nominal demand formula, i want to buy more goods with cash, so this linear line shifts downwards, rotating around the origin. Thus prices will go down.

Question 44

Now as you can see the prices have gone down and money demand has increased, what can the central bank do, if it wants to keep prices stable?

Answer 44

They can increase the money supply, so that we have the same price level as before the increase in TFP.

Question 45

What is the most important thing central banks do on a day to day basis?

Answer 45

they respond to money demand shocks, these shifts in the demand for money that occur within a day, week or month.

Question 46

Lets say there is a shock to the supply of credit card services ie banks, there cloud services that store data of their clients get burned down. what happens to the supply of credit and money demand and what if the central bank dont do anything ?

Answer 46

The supply of credit card card services, have a sudden reduction. This equibrium,will show a lower demand for credit card services, implying that we want to buy more goods using currency, using for formula Md = PL[Y - X*(R)] we see you take away a smaller constant. Thus there will be an increase in the money demand( not because of output or real interest rate change. )

If the central bank doesnt do anything, there will be a drop in the price level.

Question 47

Lets say there is a shock to the supply of credit card services ie banks, there cloud services that store data of their clients get burned down. what happens to the supply of credit and money demand and what if the central bank do do something ?

Answer 47

If the central bank job is to stabilise prices they wiill provide liqudiity to the market by increasing money supply.

Question 48

Do central banks really control inflation?

Answer 48

Monetarists: inflation is always and only a monetary phenonenom( if we print money, prices rise, if we dont prices fall, it has nothing to do with real variables)

So if you control money supply you control inflation.

Question 49

From the data, do we see a 1 on 1 change in the inflation rate, if we change the money supply growth rate?

Answer 49

The correlation is not one on one but its 0.79 ,

We said from the fishers relation N = r + i

this seems to back it up.

Question 50

What do Modern central banking do insteead of always just adjusting money supply?

Answer 50

adjust with open market operations on a daily basis,

○ set interest rate for banks’ deposits at the central bank (bank reserves)

○ Set interest rate for banks’ borrowing from the central bank, or among themselves ( some banks might have more reserves than they need and trade with other banks, but the central bank sets the interest rate for this trading.

Question 51

What do banks usually do when they get set an interest rate ( Nominal interrest rate) from the central bank, for borrowing?

Answer 51

Banks want to make money, so they charge a higher interest rate than the one they receive from the central bank.

Question 52

Can nominal interest rates be negative and give an example?

Answer 52

No they cannot e.g. lets say you borrow £100 today, and given real interest rate that is negative, tommorow i pay back an amount less than what i borrowed e.g £99, so banks make a profit of £1, so i would be stupid not to borrow more, as i can make a profit and everyone would want to borrow.

Question 53

So to summarise nominal interest rates cannot be negative because of what?

Answer 53

They cannot be zero because, there is no equilbrium, no one wants to lend you money, and everyone would want to borrow.

Question 54

As nominal interest rates cannot be negative, what is there?

Answer 54

A zero lower bound.

Question 55

So we know that the nominal interest rate that cash carries is 0 ( if i have £10 today, i will have £10 tommorow, and with zero lower bound what does it mean for a nominal bond?

Answer 55

The return on the nominal bond is 0, meaning that money and bonds are perfect subsitutes.

Question 56

What is a liquidity trap?

Answer 56

When lower or 0 interest( nominal) rates fail to increase the interest elasticity of demand.

Question 57

When the central bank are trying to do some open market operations and there is a zero lower bound what happens.

Answer 57

It doesnt affect the money supply, money and bonds are the exact same thing for the finanacial markets, so if i buy an equivalent amount of bonds, B goes down by an equivalent amount that the increase in money supply from open market operations is.

Question 58

So now because of the liquidity trap what can the central banks do?

Answer 58

They look at the yield curve ( that tells you the return of an asset of similar , risk in terms of maturity.

Interest rates with for long maturity assets are higher, as you want the money back, and its a risk to loan it out that long.

Question 59

How does the zero lower bound look like on the yield curve?

Answer 59

it will mean very short maturity bonds will have a return of 0. So money policy is useless, as the central bank get 0 or no return.

Question 60

So how does the central bank use quanitative easing and how does this affect the yield curve ?

Answer 60

Instead of exchanging money for short maturity bonds, ill exchange bonds with very long maturity e.g. 10, 20 years?

This affects the yield curve, this will reduce the returns on the longer maturity bonds but let money supply increase.

This will mean the nominal return on them bonds are higher, not like when there is a 0 lower bond, so return is 0.

Question 61

With quanititative easing, how does this affect the money supply on the diagram?

Answer 61

Question 62

In December 1952, the Great Smog descended on London. This was a deep and heavy fog mostly caused by pollution, and it created chaos and several thousand deaths in around 4 days. After the fog disappeared, the prime minister, at the time, Winston Churchill decided to increase the spending on hospitals for respiratory diseases (as most deaths were caused by these types of health problems). At the same time, in a few months, the parliament discussed and passed the first legislation aimed at fighting pollution, imposing regulations and additional costs to companies. Can you predict what these two policy changes will imply in light of our full intertemporal model?

Select one or more:

a. Price level goes up
b. Price level goes down
c. We cannot say what happens to the price level
d. Money supply goes up
e. Money demand goes up

Answer 62

Last week we have seen that these two policies can be interpreted as an increase in government spending accompanied by a reduction in current total factor productivity. The increase in government spending will tend to increase output and interest rates. The reduction of current TFP will tend to reduce output and increase interest rates. We cannot say what happens to output, as it will depend on which effect is stronger as they go in opposite directions. We can say for sure that interest rates will increase. This implies that we cannot really say how the money demand will change. Hence we cannot say what will happen to the price level. The only correct answer is therefore c. Money supply, in particular, is not affected.

Question 63

Which of these shocks or policies will unequivocally increase money demand in equilibrium?

Select one or more:

a. An increase in current government spending
b. An increase in current total factor productivity.
c. A sectoral shock
d. A reduction in current government spending.

Answer 63

An increase in government spending increases both output and the real interest rate, therefore the effect on money demand is ambiguous.

Current total factor productivity increase will get a higher output and reduce the interest rate, therefore increasing the money demand

A sectoral shock reduces output and increases the interest rate, hence decreasing the money demand ( a sectorial shock refers to a fall in labour demand and supply)

As for the increase in G, a reduction in government spending will have an ambiguous effect on the money demand

Question 64

Which of these shocks or policies will unequivocally increase the price level in the new equilibrium?

Select one or more:

a. A new effective cure for COVID-19 is announced by scientists at the end of the first period, and it will become available in the second period.
b. Consumers do not trust credit card companies anymore
c. An increase in money supply.
d. A new regulation introducing additional red tape for companies becomes effective in the current period.

Answer 64

a) a: This is a news shock, which increase output and the interest rate. The effect on money demand is ambiguous, and we cannot say what happens to the price level: can go up or down. ( increase in future tfp)
b) will increase the money demand, as consumers will reduce their demand for credit card services. An increase in money demand reduces the price level.
c. this will defientely raise prices as it says unieqivocally
d: This is a decrease in total factor productivity in the current period, hence it will reduce output and increase the interest rate. Money demand will therefore decrease, pushing prices up.

Question 65

Consumers can pay for their purchases with credit cards or money. Credit cards carry a transaction cost of 𝑞 per unit of consumption goods bought using them. In the aftermath of the coronavirus crisis, the nominal interest rate 𝑅 is now equal to zero.

a. Calculate the equilibrium quantity of goods bought using credit cards, using a diagram similar to the one seen in the lectures. Explain the diagram and comment on your result.

Answer 65

Question 66

Consumers can pay for their purchases with credit cards or money. Credit cards carry a transaction cost of 𝑞 per unit of consumption goods bought using them. In the aftermath of the coronavirus crisis, the nominal interest rate 𝑅 is now equal to zero. b

Answer 66

This result seems quite unrealistic. Many countries had a nominal interest rate in the last few years that was close or even below zero, and yet people kept using credit cards and other means of payment. Why? One reason is convenience: it is easier to carry a credit card rather than a sizeable amount of cash. The other is that cash is easier to steal, while credit cards and the like can easily be blocked therefore avoiding a loss.

Question 67

The economy has been heavily hit by the pandemic, but things start to look brighter. With vaccines being deployed, companies start to be optimistic, and the expectation for the future period is that total factor productivity 𝑧 ′will go up. Assume that expected inflation is zero for the rest of the exercise.

c. Using the monetary intertemporal model, explain how this shock will affect the economy in the current period. Use the 3-diagram graphical representation seen in the lectures. What happens to the price level?

Answer 67

We have to look at what happens in the real markets ( labour and goods) then money market.

An increase in 𝑧 ′ implies an increase in future marginal product of capital 𝑀𝑃𝐾 ′ which will make firms invest more, as now the capital in the future will be more productive. Output demand shifts then to the right (red line)

2. Interest rate will have to rise as a consequence, as there will be an excess of output demand. This will shift the labour supply to the right (green line).

The effect on the money market depends, whether the output or interest rate is stronger. because interest rate increases and output.

Question 68

d. By looking at your answer in question c, do you think that waves of optimism and pessimism (i.e. companies expecting 𝑧 ′ to go up or down) could potentially be a good explanation for economic fluctuations? Compare your findings in c with the main business cycles facts seen in the lectures. (Fast and Dumb)

Answer 68

With this shock, investment increases, but the effect on consumption is ambiguous (income increases and the real interest rate increases). Employment also increases, and the real wage falls. Moreover, the price level could be procyclical or countercyclical. Thus, the model does not match all of the key business cycle facts. Consumption may not be procyclical in the model, and the real wage is countercyclical in the model but procyclical in the data.

Question 69

e. The central bank would like to stabilize the price level. In light of your answer to question c, what is the best course of action for monetary policy? (Fast and Smart)

Answer 69

Question 70

Rishi, which is in charge of fiscal policy, increases government spending in the current period, at the same time as the shock described in question c takes place.

f. Does your answer to question e change? (Fast and Smart)

Answer 70

An increase in government spending will further increase both real interest rate and output, hence the change in money demand will still be ambiguous. The answer in e therefore should not change.