Chapter Overview This chapter completes the long-run part of macroeconomics with an introduction to money and inflation. The discussion of
the money creation and control process involves a description of banks and the Federal Reserve System. Money growth and inflation are related through the quantity equation of money. The inflation-unemployment tradeoff and natural rate proposition of Phelps and Friedman are presented in their historical context, including a discussion of the original Phillips curve. The chapter concludes with a brief discussion of why inflation is not zero and the bias in measuring inflation.
Teaching Objectives 1. Introduce money into the macroeconomy and discuss its creation and control. 2. Describe the structure of the Federal Reserve System. 3. Relate money to inflation through the quantity equation of money. 4. Discuss the inflation-unemployment tradeoff and the natural rate proposition.
1. What Is Money? • 1a. Commodity money has taken a variety of forms. Since commodity money is a commodity, it is susceptible to changes in supply, and so its relative price is altered, leading to inflation or deflation. • 1b. Money has three functions. • It is a medium of exchange, a quid pro quo process that replaced barter. • It is a convenient store of value from one period to the next. • It is a unit of account in order to represent the
1. What Is Money? • 1c. The evolution from commodity money to coins to paper money reflects a movement to more efficient forms of money. The potential for over issue of paper fiat money has at times led to requirements that currency be convertible into some commodity like gold that is in relatively fixed supply. Governments now serve as the sole issuer of currency, but checking deposits are also a part of money.
1. What Is Money? • 1d. Narrowly defined, money is M1, or, roughly, currency plus checking deposits.Less liquid forms of money such as a savings deposit are included in M2. These forms of money and their magnitudes for 1996 are given in Table 22.1.
2. The Fed and the Banks: Creators of Money • 2a. Banks and other financial intermediaries are involved in the translation of the funds of savers into an asset sold to investors or borrowers. Bank liabilities, such as deposits are loaned to borrowers, creating assets, such as loans. The basic balance sheet of a commercial bank is given in Table 22.2. • For example, a deposit account is an asset for the customer but a liability for the bank, while a customer's auto loan is a liability for the customer but an asset for the bank.
2. The Fed and the Banks: Creators of Money • 2b. The Federal Reserve System is structured under the Federal Reserve Act of1913. • 2b.1 Under this act, the overall supervision of the Fed rests with a seven-person Board of Governors, appointed for fourteen-year terms. A chairman is appointed by the president for a four-year term that is renewable; most chairmen serve more than four years. The board is responsible for monetary policy as well as the regulation and supervision of certain aspects of banking.
• 2b.2 The twelve district banks carry out a number of tasks related to the money supply process, banking regulation and supervision, and the analysis of economic conditions in their region. In addition the presidents of the district banks participate in the formulation of monetary policy. The geographical distribution of Fed districts is given in Figure 22.2.
2. The Fed and the Banks: Creators of Money • 2b.3 The Federal Open Market Committee (FOMC) consists of the seven governors and twelve district bank presidents, five of whom have votes on the committee.The chairman is the most powerful member of the FOMC, and his influence is so extensive that he is viewed by many as the second most powerful person in America. The relationship among the board, the district banks, and the FOMC is summarized in Figure 22.3.
2. The Fed and the Banks: Creators of Money • 2c. Banks are an integral part of the moneycreation process due to the fractional value of the reserve requirement. • 2c.1 Deposit expansion occurs as a bank-by-bank process and is treated in detail in Tables 24.3, 24.4, and 24.5. 2c.2 The simple reserve multiplier in a system with only deposits as money is given by: Deposits= (1/reserve ratio) x reserves.
3. How the Fed Controls the Money Supply: Currency Plus Deposits
3a. The money supply and bank reserves are related through the usual set of definitions: M =CU +D , where is the money stock,CU is currency, and is deposits BR =rD ,where BR is bank reserves and r the reserve ratio
3. How the Fed Controls the Money Supply • The currency to deposit ratio (k ) reflects the decisions of the public in terms of transaction habits, the state of the economic environment, and the like and is ordinarily not subject to large changes. The reserve ratio r is a Fed decision variable that remains fairly fixed. The implication for control is clear: The Fed can alter M by changes in the base,MB .However,r and especially k will change as conditions change, as in the early years of the Great Depression and again with the onset of World War II.
4. Money Growth and Inflation • 4a. The relationship between money and nominal GDP that reflects the transactions of the economy is the quantity equation of money, MV = PY or, in terms of velocity, V = PY / M . So for V, a constant, the growth in M is reflected in the growth in nominal GDP, PY . In growth form, g P + g Y = g M +gV.
4. Money Growth and Inflation • 4b. Figure 22. 4 plots inflation and money growth for the G-7 economies. Persistent inflation is a post-World War II phenomenon, especially since 1965. 4c. Hyperinflation occurs when the government prints money to finance spending, as in Germany in 1923 or Argentina in the early 1990s. See Figure 22.5
5. Inflation: Effects on Unemployment and Productivity Growth
• The effect of inflation on long-run growth in the economy is potentially felt through its effects on unemployment and on capital accumulation and technology. • 5a. The Phillips curve, Figure 22.8, was the first attempt to quantitatively link inflation and unemployment. The apparent negative relationship between inflation and unemployment implied a tradeoff in the long run.
5. Inflation: Effects on Unemployment and Productivity Growth
• 5b. The Friedman-Phelps natural rate argument showed that the Phillips curve was a short-run relation. In the long run, the Phillips curve is vertical at the natural rate, as indicated by Figure 22.9.
5c. Inflation affects investment and technological change because it affects the level of uncertainty about relative prices, in particular, uncertainty about future real returns. A similar argument holds for technological change.