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CHAPTER Money, Inflation, and Exchange Rates in the Long Run

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Title: CHAPTER Money, Inflation, and Exchange Rates in the Long Run


1
CHAPTER Money, Inflation, and
Exchange Rates in the Long Run
7
2
Money, Inflation, and Exchange Rates in the Long
Run
  • What is Money?
  • Where does Money Come From?
  • From the Equation of Exchange to a Theory of
    Inflation
  • Policy Implications of the Quantity Theory of
    Money
  • The Long-Run Dichotomy

3
Money, Inflation, and Exchange Rates in the Long
Run
  • Exchange Rates and Inflation
  • Exchange Rate Determination
  • The Balance of Payments Account
  • Balance of Payments Forces
  • Price Levels
  • Exchange Rates
  • Real Exchange Rates
  • Purchasing Power Parity

4
What is Money?
  • Money is a financial asset.
  • Money is
  • a unit of account
  • everything is priced in the units of money
  • a store of value
  • money holds its value over time
  • a medium of exchange
  • money is universally accepted in transactions

5
Measuring Money
  • The Federal Reserve Bank is the agency
    responsible for measuring money.
  • The Fed defines several measures of money based
    on liquidity.
  • Liquidty is the ability to easily exchange one
    financial asset for another.
  • M1 is the most liquid measure.
  • L is the broadest and least liquid measure.

6
Measures of Money M1
  • Currency
  • Coins and bills
  • Checkable deposits
  • Deposits in checking accounts
  • Travelers checks
  • Checks issued by banks and accepted as cash

7
Measures of Money M2
  • M1 plus
  • Savings deposits
  • Deposits in accounts with no checking privileges
  • Small time deposits
  • Deposits of less than 100,000 that have an
    explicit maturity and a penalty for early
    withdrawal
  • Money market mutual fund shares
  • Short-term securities that come with
    check-writing privileges

8
Measures of Money M3
  • M2 plus
  • Large time deposits
  • Deposits of greater than 100,000 that have an
    explicit maturity and a penalty for early
    withdrawal
  • Institutional money market fund shares
  • Shares, held by corporations, of a fund that
    invests in short-term securities that come with
    check-writing privileges
  • Repurchase agreements (RPs)
  • Sales of securities with the agreement to
    repurchase
  • Eurodollars
  • Dollars or other currency depostied in banks
    outside the currencys country of origin.

9
Measures of Money M4
  • M3 plus
  • Highly liquid bonds
  • Short-term Treasury securities, commercial paper,
    savings bonds, and bankers acceptances

10
Where Does Money Come From?
  • The U.S. Treasury prints the currency that
    circulates.
  • The Fed supplies most of the money supply through
    the financial system.
  • The Fed influences the money supply mainly
    through open market operations.
  • Open market operations are the Feds purchase and
    sale of government securities.

11
Open Market Operations and Monetary Policy
  • Expansionary policy
  • The Fed wants to expand the money supply
  • The Fed purchases government securities and puts
    money in circulation when it pays for them
  • Contractionary policy
  • The Fed wants to contract the money supply
  • The Fed sells government securities and payment
    for them takes money out of circulation

12
The Long-Run Dichotomy
  • The long-run dichotomy is the separation of the
    real and nominal sectors.
  • In the long-run
  • Labor, capital, and technology determine real
    output
  • Money determines the price level and nominal
    output

13
Quantity Theory of Money
  • The quantity theory of money is the long-run
    theory of money supply and demand.
  • The quantity theory suggests that the price level
    varies in direct proportion with the price level.
  • For example, if the money supply increases by 5,
    the price level will also increase by 5.

14
The Equation of Exchange
The quantity theory of money is expressed in the
equation of exchange
MV PY
M the money supply V the velocity of money,
the number of times per year a dollar is
spent P average price of a transaction Y real
income
15
Does the Fed Control Interest Rates or the Money
Supply?
The Fed changes interest rates by changing the
money supply.
Interest Rates Decrease
Reserves Increase
Fed purchases bonds
Borrowing Decreases
16
From the Equation of Exchange to a Theory of
Inflation
  • The equation of exchange assumes
  • velocity of money (V) is constant
  • real output (Y) is determined independently of
    the money supply
  • the direction of causation is from money to
    prices
  • Since MV PY, with V constant and Y independent
    of M, changes in M determine changes in P

17
Assumption Velocity is Constant
  • The amount of money people want to hold depends
    on
  • how much they spend
  • ease of conversion of other financial assets to
    money
  • Ease of conversion depends on institutional
    features of the financial system
  • how frequently people are paid
  • costs of converting assets to cash
  • brokerage fees
  • banking convenience

18
Assumption Velocity is Constant
  • Since these institutional factors dont change
    very often, M/PY, is also constant.
  • Rewriting the equation of exchange as M/PY 1/V,
    if M/PY is constant, V is also.
  • With V constant, the equation of exchange shows
    the relationship between the money supply and
    nominal income.
  • If velocity is 5 and the money supply is 200,
    nominal income is 1000.

19
Velocity of Money in the U.S.
20
Assumption Real Output Depends on the Factors of
Production
  • In the long-run, real output is determined by the
    factors of production
  • labor
  • capital
  • technology
  • Real output is exogenous
  • Determined by factors outside the quantity theory
    of money

21
Assumption Causation Goes from Money to Prices
  • Changes in the money supply cause changes in the
    price level.
  • The direction of causation goes from the money
    supply to the price level.
  • Changes in the money supply are exogenous, they
    are not in response to price level changes.

22
Inflation is a Monetary Phenomenon
The equation of exchange MV PY can be also
written as
? M ?V ?P ?Y
If V is constant and Y is determined by factors
of production, then
proportional ?P
?M
23
Inflation and Money Growth
24
Correlation Between Money Growth and Inflation
  • Data show that there is a correlation between
    large changes in the money supply and changes in
    prices.
  • For small changes in the money supply, the
    connection may not exist.
  • Causation may go from prices to money.
  • When inflation political pressure may force the
    central bank to increase the money supply.

25
Policy Implications of the Quantity Theory of
Money
  • To control inflation, control the money supply.
  • Political Problems in Controlling the Money
    Supply
  • Inflation Tax
  • Printing money reduces the purchasing power of
    money
  • Printing money produces government revenue,
    seigniorage, the difference between the cost of
    printing money and the value of the money
  • Central Bank Independence
  • Allows the Fed to make unpopular political
    decisions to protect the long-run health of the
    economy

26
Long-Run Dichotomy
  • The long-run dichotomy states that in the
    long-run the real sector, where real output is
    determined, and the nominal sector, where prices
    are determined can by analyzed separately.
  • Relative prices, not absolute prices, are
    important in the real sector.
  • Relative price changes are important in the
    long-run because they affect demand and supply
    decisions, while absolute changes do not.

27
Exchange Rates and Inflation
  • Changes in the price level of a country will
    affects its economic relationships with other
    countries.
  • If prices in Mexico increase by 14 and prices in
    the U.S. stay constant, Mexican goods will be
    more expensive compared to U.S. goods.
  • People will buy more U.S. goods and fewer Mexican
    goods.
  • Adjustments will occur in exchange rates and/or
    price levels in both countries.

28
Exchange Rates
29
Exchange Rate Determination by Market Forces
Currency supply gt currency demand
Decrease in Currency Price
Currency supply lt currency demand
Increase in Currency Price
30
Demand and Supply of Currencies
  • The demand for dollars by Mexicans is to
  • pay for imported goods and services exported from
    the U.S. to Mexico
  • buy assets in the U.S.
  • The supply of dollars by the U.S. is to
  • pay for goods and services imported to the U.S.
    from Mexico
  • buy assets in Mexico

31
Government Intervention in Exchange Rates
  • Governments choose whether their currency is
    convertible.
  • Convertible currencies can be traded freely with
    no restriction.
  • Nonconvertible currencies are not traded freely.
  • Governments buy and sell currencies to affect
    their value.
  • Countries that keep exchange rates at a
    predetermined level have a fixed exchange rate.
  • Countries that let the market determine its
    exchange rates have a flexible exchange rate.

32
Flexible and Fixed Exchange Rates
Fixed
Flexible
10
10
S
S
9
9
Pesos per
D
Pesos per
D
4
6
8
4
6
8
Quantity of s
Quantity of s
33
Changes in Exchange Rate Values
  • For flexible exchanges rates
  • A currency depreciates if its value decreases
    relative to another currency.
  • A currency appreciates if its value increases
    relative to another currency.
  • For fixed exchange rates
  • A currency is devalued if the country allows it
    to depreciate.
  • A currency is revalued if the country allows it
    to appreciate.

34
The Value of the Dollar
35
The Balance of Payments Account
  • The balance of payments account shows
    transactions of goods and assets between the U.S.
    and the rest of the world.
  • Behind each purchase or sale of a good or an
    asset in the balance of payments, there is also a
    purchase or sale of foreign currency.
  • The balance of payments tells whether there is a
    net inflow or outflow of currency.

36
The Balance of Payments Account
  • Changes in a countrys balance of payments change
    the demand and supply of its currency and,
    therefore, its exchange rate.
  • The balance of payments account is comprised of
  • the current account
  • the private capital account
  • the official reserves transactions account

37
The Balance of Payments Account
38
The Current Account
  • Trade Balance (3)
  • The difference between exports, which cause a
    dollar inflow, and imports, which cause a dollar
    outflow
  • Net Investment Income (4)
  • Income the U.S. receives from holdings of foreign
    assets less income foreigners receive from their
    holdings of U.S. assets
  • Official transfers
  • Payments of foreign aid
  • Current account balance 3 4 5

39
The Private Capital Account
  • The private capital account is a summary of
    currency flows resulting from the purchase and
    sale of assets between a country and the rest of
    the world.
  • Comprised of
  • Foreign purchases of U.S. assets ( inflow)
  • U.S. purchases of foreign assets ( outflow)

40
Private Balance of Payments
  • The private balance of payments is the sum of the
    current account and the capital account balance.
  • The private balance of payments equals zero when
    a countrys exchange rate is determined only by
    market forces because the quantity of dollars
    supplied (inflows) must equal the quantity
    demanded (outflows).

41
Official Reserve Transactions Account
  • The official reserve transactions account is a
    record of government purchases and sales of
    currencies.
  • When the government buys its own currency, an
    inflow () results.
  • When the government sells its own currency, an
    outflow (-) results.

42
Balance of Payments Relationships
  • The balance of payments measures the flow of a
    countrys currency, which is the demand and
    supply of the currency.
  • Quantity demanded quantity supplied for
    convertible currencies.
  • Private balance of payments (current account
    balance capital account balance statistical
    discrepancy) deficit must be offset by government
    purchases of its currency.

43
Price Levels and Flexible Exchange Rates
  • Suppose that the price level in Mexico
    increases by 14 while the price level in the
    U.S. remains constant.

Value of pesos
Demand for pesos
Decrease continues until the peso has
depreciated by the difference in the inflation
rates (14).
The amount of imports and exports in both
countries remain the same.
44
Price Levels and Fixed Exchange Rates
  • Suppose that prices in Mexico increase by 14 and
    prices in the U.S. remain constant.
  • Mexican exports decrease and imports increase
    causing a balance of payments deficit.
  • Mexico and the U.S. can offset the deficit by
    buying pesos.

45
Price Levels and Fixed Exchange Rates
Mexico must buy pesos.
1/8
S
S
Pesos per dollar
Dollars per peso
8
D
D
U.S. must sell dollars
Quantity of Dollars
Quantity of Pesos
46
The Real Exchange Rate
The real exchange rate (ER) is the nominal
exchange rate adjusted for price level
differences.
ER E x (PU.S./Pforeign)
Where ER the real exchange rate E the
nominal exchange rate (foreign
currency/dollar) PU.S the U.S. price level
Pforeign the foreign price level
47
The Real Exchange Rate
  • Suppose that the euro-to-dollar exchange rate is
    1.5 euros per dollar.
  • A movie ticket costs 7 in the U.S. and 10.5
    euros in the European Union.
  • ER 10.5x(7/10.5) 1
  • Goods, adjusted for price levels, cost the same
    in both countries.
  • The real exchange rate measures the amount of
    goods your money buys in another country.

48
The Real Exchange Rate
  • The equation for the real exchange rate written
    as percent changes is
  • ??ER ??E ?? PU.S - ?Pforeign
  • Where
  • ?? PU.S U.S. inflation rate
  • ?Pforeign foreign inflation rate
  • If inflation is 14 in Mexico and 0 in the U.S
    and the dollar appreciated 14
  • ??ER 14 0 -14 0

49
Purchasing Power Parity
  • Purchasing power parity says that the amount of
    goods and services a currency can buy (its
    purchasing power) should be the same in all
    countries.
  • Exchange rates and/or prices will adjust so that
    the same good sells for the same price in
    different countries.
  • The real exchange rate will be 1 if purchasing
    power parity holds.
  • ER 1 E(PU.S./Pforeign)

50
Purchasing Power Parity and the Price of Big Macs
51
Purchasing Power Parity
  • Since the change in real exchange rates is
  • ??ER ??E ?? PU.S - ?Pforeign
  • And since according to purchasing power parity ER
    1
  • ??E ?Pforeign - ?? PU.S
  • The dollar will appreciate when foreign inflation
    is greater than U.S. inflation.

52
The Nominal Exchange Rate and Inflation
53
Policy Perspective Exporting Inflation
  • When inflation rates are different between
    countries, adjustment occurs in
  • the price level if exchange rates are fixed
  • nominal exchange rates if exchange rates are
    flexible
  • In both cases the real exchange rate does not
    change, but is determined by
  • Labor
  • Capital
  • Technology
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