CHAPTER 7 – MONEY AND INFLATION IN THE LONG RUN (What determines the long run rate of

inflation?)

Money and inflation: what is money?

 What functions does money have?

 Means of payment
 Unit of measurement
 Store of value that does not yield interest
 Who prints money?
 the Central Bank (usually independent from the government)
 Can banks “create” money?
 Yes, but regulations put a limit on this
 If households deposit 100 dollars that the CB gave them, and the bank needs to keep r=10% in
reserves, total lending is equal to 100/r=1000
 “fractional reserve banking”
 Money supply and inflation
 Money is related to inflation: more money for a given level of production means price have to
increase
 CB needs to understand/adjust to the behavior of banks and households if they want to control the
money supply
 How can the CB control the money supply in a digital world? –cash in circulation in Sweden has almost
halved in 10 years. Swish and credit cards.

Average value of bills and coins in circulation in Sweden (billions of SEK).

However, money is not necessarily cash. In fact, bills and coins only made up 1.7% of our “widest”
measure of money, M3.

Money and inflation: Money

 Monetary base: bills and coins in circulation plus deposits that banks have in the central bank (we will
use this as our measure of “money”)
 The central bank can perfectly control of the monetary base using ‘outright’ open market
operations and repurchase agreements.
 M1: bills and coins among the general public plus ‘demand deposits’ (‘immediately available funds’)
 M2: M1 plus deposits that cannot be immediately withdrawn (deposits tied for a certain time etc.)
 M3: M2 plus money market fund shares and certain debt securities
 Note that the money supply has increased despite lower demand for cash

Money and inflation: money and inflation in the long run

 How is money supply related to inflation?

 Intuition: if more money “chases” the same goods, prices have to increase
 The quantity theory helps us understand this
 The quantity equation: M*V=P*Y
 M is the supply of money in circulation
 V is the turnover speed of money
 How often the money changes owner is important. If a 100-dollar bill is used 10 times it is used
to purchase goods at a total value of 1000 dollars. Had it been used only twice, the total value
would be 200 dollars
 P is the price level
 Y is production

 Assume that production is at the natural level in the long run:

 Inflation is determined by the change in money supply, velocity and real GDP
 If ΔV/V=0 and ΔYn/Y=0, an increase in money supply will lead to inflation
 If ΔM/M=0 and ΔYn/Y=0, an increase in the velocity will lead to inflation
 If we assume that velocity is constant, inflation should be related to money growth?
 Seems to the case, but not when the money growth is low


 According to our formula, the velocity might also impact inflation. Why?
 When the interest rate is high, people do not want to hold cash (high opportunity cost)
 Affects the demand for cash
 

Money and inflation: demand for money

 Our theory says that ceteris paribus increased money supply growth leads to increased inflation.  the
central bank can control long run (average) inflation if they want to
 But a theory that assumes that V is constant in the short run is not useful for predicting inflation 
assume that V is an increasing function of the nominal interest rate: V=V(i)


 The real demand for money, i.e. the amount of money households, firms and banks want to carry out
their transactions:
 Increases with Y (more things to buy)
 Decreases with i (opportunity cost)

Money and inflation: money and inflation in the long run

 What happen if the central bank increases the money supply M? Depends on whether we look at the
long or short run
 The long run
 Production is given by Yn and the nominal interest rate is given by i=r n+π
 Equilibrium condition
 Money growth leads to inflation  decrease in real money holdings. A high nominal interest rate
means that velocity is high (people do not want to hold cash)
 In the long run, inflation does not affect real variables (the classical dichotomy) – money is neutral
 Milton Friedman: ‘inflation is always and everywhere a monetary phenomenon’ – yes, in the long
run!
 The short run
 Prices and wages are rigid/fixed (P does not change (fully))
 The real interest rate is affected (key difference)
 If i gets lower and π is unchanged, the real interest rate falls  stimulates production (Y)

Money and inflation: seignorage and inflation tax

 Can we finance government expenditure by “printing money” (increasing the monetary base)?

 Seignorage is defined as .
 
 It is reasonable that velocity is constant when money growth is higher?
 no, it is likely to increase as well since nominal interest rate is higher
 Seignorage only possible to some extent – risk of hyperinflation!

Money and inflation: how high should inflation be?

 Problems with too high inflation:

 ‘menu costs’
 More difficult to compare prices when price observations quickly become out of date
 Inefficient changes of relative prices when prices change at different times
 Unintended redistribution via on tax and transfer systems which remain fixed in nominal terms
 Unexpected inflation: wealth redistribution associated with long-term contracts (wages, loans)
 Problems with low inflation:
 Obstructs real wage adjustment if nominal wages are sluggish downwards
 Monetary policy may be constrained because the interest rate cannot be lower than zero (liquidity
trap)
 Conclusions:
 Very high inflation leads to substantial losses
 Zero inflation can cause problems
 Some positive rate of inflation is optimal but hard to say exactly what rate
 Many central banks have an inflation targets in range 2-3 per cent and manage to keep inflation
close to this
 In the short run they decide about the interest rate rather than the money supply