Session 5. Money and Inflation
v What is money? Definitions
v How much money is needed in an economy?
v Introduction to the Long-run Dichotomy
v Central banks and the Process of Money Creation.
v The Money Multiplier
Macroeconomics in the Global Economy Antonio Fatás
Definition of Money?
v Money is a medium of exchange: asset that can be used to buy goods and services (a liquid asset)
v It is the unit of account providing the terms in which prices are quoted.
v It is also a store of value as it transfers purchasing power from the present to the future. Types of Money
v Commodity money and the gold standard v Fiat money
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1 Measuring Money: Monetary Aggregates
v Money supply: the total quantity of money available v The components of money are:
Currency in circulation M1 Checking accounts M2 Savings accounts M3 Small time deposits Large time deposits Money-market funds
Macroeconomics in the Global Economy Antonio Fatás
U.S. Monetary Aggregates April, 2012 (billions $)
M1 2,252
Currency 1,034 Total Checkable Deposits 1,118
M2 9,846
Components of M1 2,252 Savings Deposits 6,242 Small-Denomination Time Deposits 717 Money Market Mutual Funds 634
Macroeconomics in the Global Economy Antonio Fatás
2 Euro area money supply
10000 1700
1500
1300 7000 M3 M2 1100
900 4000 700 M1 Currency in circulation 500 (billions of euros) (billions of euros) (right scale) 1000 300
1997.09 1999.04 2000.11 2002.06 2004.01 2005.08 2007.03 2008.10 2010.05 2011.12 100
-2000 -100
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How much money is need? Currency in circulation
Currency holdings per capita in USD (April 2012)
Euro area $3.318 per person USA $3,530 per person
Are these numbers reasonable?
Who holds the money?
Euro area: total currency in circulation 848 Billions Euro. Out of which 290 Billions are in 500 Euro notes (almost two 500 euro notes per person!!!)
Macroeconomics in the Global Economy Antonio Fatás
3 How much money is needed?
v Nominal GDP in the US is about 14.6 trillion USD, while M1 is about 2.2 trillion. All of the products in GDP must be purchased. How does it happen that 2.2 trillion dollars buy 14.6 trillion dollars worth of goods and services? Velocity is the rate at which money circulates in the economy. v The money supply times its velocity needs to cover the value of all transactions. (Nominal) GDP is a good proxy for the value of transactions. Money x Velocity = Value of Transactions ≈ Nominal GDP
v And Nominal GDP is the product of Real GDP times the Price Level
Money x Velocity = Nominal GDP = Price x Real GDP
Macroeconomics in the Global Economy Antonio Fatás
Money x Velocity = Prices x Real GDP
v In this equation, real GDP is determined by the factors of production and technology. Velocity depends on certain characteristics of the financial system. The central banks is then free to determine the nominal level of prices, value or incomes. Any value for prices is possible as long as you set the Money Supply at the right level. According to the classical dichotomy money supply affects only nominal variables (in the long run).
v The classical dichotomy is best illustrated by transforming the quantity theory equation in growth rates:
% change in Money + % change in Velocity = Inflation + Real growth
Inflation = % change in Money - Real growth + % change in Velocity
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4 Long-run Dichotomy
v The central bank needs a “nominal anchor” to determine the level of prices or inflation. It could be the exchange rate, it could be the price of a commodity (gold) or it could be last year prices plus some “reasonable” inflation.
v One way to understand this “freedom” of central banks is to ask the question: What will happen if money supply grows too fast relative to the needs of the real economy? The answer is inflation.
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Inflation (and the Price Level) in the UK.
Inflation is a recent phenomenon associated to the use of “fiat money”, which allows central banks to choose the inflation rate.
Source: Miles and Scott (2002)
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5 Inflation and Money Growth
Demo cr ati c Re pub l of Co ngo Inflation rate 10,000 Ni car ag ua (percent, Angola logarithmic Georgia Brazil scale) 1,000
Bulgaria 100
Germany 10 K uw ait USA Canada 1 Oman Japan
0.1 0.1 1 10 100 1,000 10,000 Source: Mankiw (Fig.4.2). Averages for the 1990s. Money supply growth (percent, logarithmic scale
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Annual Inflation and Money Growth (Argentina 1970-2001)
400
1989
300
1984
200
100 Money growth (%) growth Money
0
2001
-100 -100 0 100 200 300 400
Inflation (%)
Macroeconomics in the Global Economy Antonio Fatás
6 Highest Monthly Inflation Rates in History
Equivalent Month with Highest Time required Daily Country highest inflation monthly for prices to inflation rate inflation rate Double Rate Hungary July 1946 1.30 x 1016% 195% 15.6 hours Mid-November Zimbabwe 2008 (latest 79,600,000,000% 98.0% 24.7 hours measurable) Yugoslavia January 1994 313,000,000% 64.6% 1.4 days Germany October 1923 29,500% 20.9% 3.7 days Greece November 1944 11,300% 17.1% 4.5 days China May 1949 4,210% 13.4% 5.6 days
Source: Prof. Steve H. Hanke, February 5, 2009.
Macroeconomics in the Global Economy Antonio Fatás
The Creation of Money: Central Banks and the Gold Standard
v Central banks produce bank notes that are backed by the reserves of gold held at the central bank. v The money supply is tied one to one to the supply of gold. v Increases in money supply are related to the size of the Central Bank balance sheet.
Central Bank Balance Sheet
Assets Liabilities Gold Currency (Banknotes) Other Other (Capital)
Macroeconomics in the Global Economy Antonio Fatás
7 The Creation of Money: Central Banks in a Cashless Society
v Imagine a world without bank notes (Currency) where you are required to pay with electronic means (credit cards or wire transfers via your mobile phone). Central Bank Balance Sheet Assets Liabilities Loans to Commercial Banks Deposits of Commercial Banks (Reserves) Other (Gold) Deposits of Bank #1 Deposits of Bank #2 Other
Commercial Bank #1 Commercial Bank #2 Assets Liabilities Assets Liabilities Deposits at Central Deposits of Customers Deposits at Central Deposits of Customers Bank Loans from Central Bank Loans from Central Other Bank Other Bank Other Other
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The Creation of Money: Central Banks Central Bank Balance Sheet Assets Liabilities Loans to Commercial Banks Currency (Banknotes) Securities Reserves (Deposits of Commercial Banks) Other assets (Gold, Foreign) Other Capital
Commercial Banks Balance sheet Assets Liabilities Reserves (Deposits at Central Bank) Deposits Loans Loans from Central Bank Securities Other sources of funding (Bonds) Other assets Capital
Monetary Base = Currency (C) + Reserves (R) Money Supply = Currency (C) + Deposits (D)
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8 From the Monetary Base to the Money Supply Money Creation Most banking systems are fractional-reserve systems. This means that when a bank receives a deposit it does not have to keep the money in its vaults – instead it can lend one part of it. This lending activity gives power to commercial banks to create liquidity, i.e. money. Initial conditions: currency in circulation $10,000 The money is deposited in the bank The balance sheet of Bank The bank keeps Reserves $10,000 Deposit 1 $10,000 50% as cash and Loans lends the rest Reserves $5,000 Deposit 1 $10,000 Loans $5,000
Macroeconomics in the Global Economy Antonio Fatás
Money Creation What does the borrower do with the borrowed money? Buys goods and services. The income paid will end up as a deposit by the seller of the goods in a bank.
Reserves $10,000 Deposit 1 $10,000 Loans $5,000 Deposit 2 $5,000
If the bank sticks to the same 50% rule, how much money can the bank lend now?
Reserves $7,500 Deposit 1 $10,000
Loan 1 $5,000 Deposit 2 $5,000 Loan 2 $2,500
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9 Money Creation This process will continue until the bank exhausts the possibility to lend while keeping 50% as reserves:
Reserves $10,000 Deposits $20,000 Loans $10,000 What happened to money supply?
Before credit expansion: M1 = currency in circulation + deposits = 10,000 + 0 = 10,000
After credit expansion: M1 = currency in circulation + deposits = 0 + 20,000 = 20,000
Notice that the money multiplier process would continue forever if there was no liquidity being kept aside in two forms: reserves and currency.
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The Money Multiplier
The Money Supply is higher than the Monetary Base because commercial banks can magnify the liquidity introduced by the central bank. This is what we call the Money Multiplier.
We can calculate the factor by which commercial banks and the public multiply the currency issued by the central bank in the process of money creation.
Money Supply C + D C/D + 1 = = Monetary Base C + R C/D + R/D
As Long as the ratio R/D is smaller than one, the multiplier is larger than 1.
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10 U.S. Monetary Aggregates What happened in the Fall of 2008?
2500.0
2000.0
1500.0
1000.0
500.0
0.0 1990.01 1990.12 1991.11 1992.10 1993.09 1994.08 1995.07 1996.06 1997.05 1998.04 1999.03 2000.02 2001.01 2001.12 2002.11 2003.10 2004.09 2005.08 2006.07 2007.06 2008.05 2009.04 M1 Monetary Base
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U.S. Monetary Aggregates What happened in the Fall of 2008? Balance sheet of a Central Bank
Assets 2007 2009 2010 Liabilities 2007 2009 2010 Loans to banks Currency Securities Reserves Govt. Agency+MBS
Balance sheet of commercial banks
Assets 2007 2009 2010 Liabilities Securities Deposits Loans Loans from Central Bank Reserves
All figures from US Federal Reserve. End of the year. Billions of USD.
Macroeconomics in the Global Economy Antonio Fatás
11 U.S. Monetary Aggregates What happened in the Fall of 2008? Balance sheet of a Central Bank
Assets 2007 2009 2010 Liabilities 2007 2009 2010 Loans to banks Currency 760 861 915 Securities 755 1,846 2,159 Reserves 43 1,139 1,078 Govt. 755 777 1,010 Agency+MBS 0 1,069 1,149
Balance sheet of commercial banks
Assets 2007 2009 2010 Liabilities Securities Deposits Loans Loans from Central Bank Reserves 43 1,139 1,078
All figures from US Federal Reserve. End of the year. Billions of USD.
Macroeconomics in the Global Economy Antonio Fatás
Session 5. Summary
v Money is the stock of assets used for transactions
v In the long-run money is neutral – it does not affect real variables! But it does affect nominal variables: Inflation is a result of high money growth.
v The Money Supply is ultimately controlled by the Central Bank via de Monetary Base (Currency + Reserves).
v Commercial banks by giving loans and taking deposits they “multiply” the monetary base to produce the Money Supply.
Macroeconomics in the Global Economy Antonio Fatás
12 Appendix: How Do Central Banks Operate? Balance sheet Assets Liabilities Gold Banknotes Loans to depository institutions Deposits of Commercial Banks Government securities Capital Other assets (including foreign)
Total Total
Central banks control the monetary base: Banknotes (Currency) + Deposits of depository institutions (Reserves). This is the ultimate source of liquidity. Changes in the monetary base take place through: 1. Open market operations – buying and selling of government bonds 2. Foreign exchange market interventions 3. Lending to commercial banks 4. Direct credit to the government 5. Changes in reserve requirements
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