Title: CHAPTER Money, Inflation, and Exchange Rates in the Long Run
1 CHAPTER Money, Inflation, and
Exchange Rates in the Long Run
7
2Money, 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
3Money, 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
4What 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
5Measuring 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.
6Measures of Money M1
- Currency
- Coins and bills
- Checkable deposits
- Deposits in checking accounts
- Travelers checks
- Checks issued by banks and accepted as cash
7Measures 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
8Measures 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.
9Measures of Money M4
- M3 plus
- Highly liquid bonds
- Short-term Treasury securities, commercial paper,
savings bonds, and bankers acceptances
10Where 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.
11Open 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
12The 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
13Quantity 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.
14The 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
15Does 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
16From 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
17Assumption 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
18Assumption 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.
19Velocity of Money in the U.S.
20Assumption 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
21Assumption 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.
22Inflation 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
23Inflation and Money Growth
24Correlation 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.
25Policy 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
26Long-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.
27Exchange 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.
28Exchange Rates
29Exchange Rate Determination by Market Forces
Currency supply gt currency demand
Decrease in Currency Price
Currency supply lt currency demand
Increase in Currency Price
30Demand 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
31Government 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.
32Flexible 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
33Changes 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.
34The Value of the Dollar
35The 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.
36The 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
37The Balance of Payments Account
38The 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
39The 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)
40Private 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).
41Official 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.
42Balance 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.
43Price 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.
44Price 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.
45Price 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
46The 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
47The 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.
48The 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
49Purchasing 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)
50Purchasing Power Parity and the Price of Big Macs
51Purchasing 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.
52The Nominal Exchange Rate and Inflation
53Policy 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