Global Economics: PGP: Shekhar Tomar

Global Economics: PGP
SHEKHAR TOMAR
Session 4: Money, Inflation,

Banking and Money Creation
1
topics
• What is Money?
• Quantity Theory of Money
• Interest and Money Demand
• Fractional Reserve Banking
• Bank Failures
2
What is
4.1 Money?
What is Money?
• Money refers to any asset which can be used:

• Medium of exchange
• Unit of account
• Store of value
• Historically, economies had commodity money. Now economies have

fiat money (the only reason it has value, is on account of government
decree).
• The government has a monopoly over the supply of money. The

authority to control money supply is delegated to an (almost)
independent institution called the central bank. In the US, it is the
Federal Reserve Bank (the Fed). In India, it is the Reserve Bank of
India (RBI).
September 6, 2021 4
What is Money?
• Currency is not the only form of money
• Any instrument that is liquid can be counted as part of money.

There are several measures of money, and depending on the
application at hand, one particular measure is used
• Measures of money: (US: April 2018)

CU Currency $ 1.564 T
M1 CU + demand & checking deposits $ 3.691 T
M2 M1 + saving & time deposits $14.047 T
September 6, 2021 5
US Monetary Aggregates
Source: ABC
September 6, 2021 6
How Central Banks create
money?
Open Market Operations
• ↑ Money Supply: Use newly minted currency to buy financial

assets, government bonds
• ↓ Money Supply: Sell government bonds in exchange for

currency
September 6, 2021 7
Quantity
Theory of
4.2 Money
Velocity
Neutrality of Money
Quantity Theory - I
• The starting point for this analysis is the quantity equation or

transactions identity:
MV=PY
• where, M is a monetary aggregate such as M1 (or M2)

• P is the general price level (of goods)
• Y is the real output (GDP)
• V is the income velocity of money (# of times a dollar changes hands
in carrying out transactions to generate PY, the nominal GDP)
September 6, 2021
9
Quantity Theory - II
• The quantity identity becomes a theory

by assuming the velocity is constant at
V. What does this assumption buy?
• Two predictions:
• Money demand
• How M affects P
September 6, 2021 10
Quantity Theory - II
• First define real balances as the quantity of goods and services

money can buy (purchasing power)
• Real balances = Md / P
• Using M = Md (money market clearing), quantity theory states:
Md / P = k Y,
where “k” is a constant (=1/V)
• Higher the income, higher the demand for money
Quantity Theory - III
• In M V = P Y, the real GDP, Y, is determined by the production

function and the level of factor inputs.
• Money supply is controlled by the Central Bank
• This implies a general price level P
Key implication of the Quantity Theory
• An increase in the money supply (by the Central Bank) shows up

as a one-to-one increase in the price level (inflation). That is, the
Central Bank has ultimate control over the rate of inflation.
Velocity of M1 and M2
Source: FRED database of the Federal Reserve Bank of St. Louis, https://fred.stlouisfed.org.
Quantity Theory - IV
• To see this, note that M V = P Y in % change form is:

∆M/M + ∆V/V = ∆P/P + ∆Y/Y
• Growth in output Y comes from input and TFP growth, and constant
velocity implies that change in V = 0.
∆P/P = ∆M/M
• Therefore, a 1% increase in the money supply by the Fed will show
up as a 1% increase in the price level (the rate of inflation)
• This prompted Friedman to observe: “Inflation is always and

everywhere a monetary phenomenon.”
Money and Inflation: Long run
Source: Money growth rates and consumer price inflation from International Financial Statistics, February 2003, International Monetary Fund. Figure
shows European countries in transition for which there are complete data.
The Neutrality of Money
• Increase in money supply directly maps into inflation
• Clear separation of monetary and real variables
• The irrelevance of money for real variables is called money

neutrality
• In the long run, most economists agree on money neutrality,

but in the short run some believe in non-neutrality
Interest and
4.3 Money Demand
Nominal Interest Rate and Money
Demand
• Thus far we have considered money demand to be a function of income

alone.
• In reality, the demand for money would depend on the nominal interest
rate “i” as well, since it is the opportunity cost of holding a dollar in cash
• A more general money demand specification:
Md / P = L(i,Y)
where L is a function that is ↑ in Y (more transactions require more money),

and ↓ in i (higher the interest rate, higher the cost of holding money, lower the
money demand)
Cont …
• The real interest rate is given by: r = i - πe, where πe is the expected
inflation rate
Md/P = M/P = L(r + πe, Y)
• In the Quantity Theory, current money supply alone determines

current prices (for a given level of real output)
• In the more general specification, future money growth affects

inflation expectations, and therefore the nominal interest rate, and
through it current money demand
Cont …
• This implies that an announcement by the Central Bank on future

increases in money supply will increase the current price level.
How does this happen?
•  in future money supply  inflation expectations, πe, today,

• which  nominal interest rate, i, today.
• This  the real demand for money (Md/P = M/P) today.
• Since today’s money supply, M, is fixed, the only way this

adjustment can take place is via an increase in the price level, P,
today.
Fractional
Reserve
4.4 Banking (FRB)
Bank Balance Sheets
FIRST NON-UNION BANK SECOND NON-UNION BANK
Assets Liabilities Assets Liabilities
Reserves: res ($0.10) Dep: 1 ($1) Reserves: res(1-res) Dep: (1-res)

($0.09) ($0.90)
Loan: (1-res) ($0.90)

Loan: (1-res)2 ($0.81)
THIRD NON-UNION BANK
Assets Liabilities
… and so on and on and on

Reserves: res(1-res)2 Dep: (1-res)2
($0.08) ($0.81)
Loan: (1-res)3 ($0.73)
FRB and Money Creation
• Under the fractional-reserve system, a dollar of cash

injected by the central bank will increase as it propagates
through the banking system
• A dollar injected becomes:

1 + (1-res) + (1-res)2 + (1-res)3 + … = 1/res
• Since 1/res > 1, the banking system creates money. It does

not create wealth
• This assumes people deposit all the money they get. In

reality, preference for cash vs deposits captured by
currency-deposit ratio (cu)
Balance Sheet
CENTRAL BANK
ASSETS LIABILITIES
Government Bonds Currency
Reserves Held by
Banks
COMMERCIAL BANKS
ASSETS LIABILITIES
Reserves at CENTRAL Deposits

BANK
Loans
FRB
• Functions of banks: match borrowers and lenders, create

money
• If we had 100% reserve banking: banks are required to hold all

deposits as reserves (RES = DEP). Banks do not affect money
supply
• Fractional reserve banking: banks are required to hold a

fraction (res) of deposits as reserves. Banks may hold excess
reserves
The Monetary Base, the Money
Multiplier, and the Money Supply in
the United States
The Monetary Base, the Money
Multiplier, and the Money Supply
in the United States
• We saw M = CU + DEP, and BASE = CU + RES. Use these to
get: M = m BASE, where m is the money multiplier.
m = (cu + 1)/(cu + res)
• Therefore, money supply is affected by:
• BASE: Directly controlled by the Fed. Higher the base, higher

the money supply, M
• res: Low res yields high m. Fed policy and bank behavior
determine reserve-to-deposit ratio
• cu: Lower cu implies higher m. Determined by household and

firm behavior
Crisis and
4.5 Money
Bank Failures
Bank Failures
• Banks cannot satisfy simultaneous withdrawal demands from everyone

(Why?). This happens when depositors lose confidence in banks.
• As people withdraw deposits, cu ↑, Banks hold excess reserves, so res ↑. Both ↓ m,

and hence the money supply. A precipitous drop in m and M occurred during the
great depression.
• Establishment of the Federal Deposit Insurance Corporation (FDIC) helped

shore up confidence in banks, and has reduced bank failures (at least until now!).
Currency-Deposit and Reserve-
Deposit ratio in the Great
Depression
Source: ABC
Source: ABC
Monetary Variables in the Great

Depression
CPI in the Great Depression
• Goods prices fell with money supply
Currency-Deposit and Reserve-
Deposit ratio in the 2008 crisis
Banks wanted to hold

more reserves because
the Fed began paying
interest on reserves and
because the Fed
increased the monetary
base significantly and
banks had few good
lending opportunities
Source: ABC
Monetary Variables in the 2008
crisis
Source: ABC Source: ABC
• Money multiplier ↓ but the Fed continued to increase the monetary base,
ensuring that the money supply keeps growing
The COVID Period
The price index for American consumer spending (PCE index),

rising at a rate of 4.2% in the year ended July, its highest level in
almost 30 years.
The S&P/Case-Shiller index, which measures home prices

across 20 major U.S. cities, rose 19.1% year on year in June,
the largest jump in the series’ history going back to 1987.
The Federal Reserve and many economists maintain that

the recent spike in inflation will be “transitory,”
Inflation could repeat the 1960s, when the Fed lost

control, Niall Ferguson says
Source: https://www.cnbc.com/2021/09/03/niall-ferguson-inflation-could-repeat-the-1960s-when-the-fed-lost-control.html
https://www.forbes.com/sites/greatspeculations/2021/08/31/stocks-to-pick-as-us-inflation-soars-to-near-30-year-highs/?sh=1eb58e9f3656
35
4.6 Hyperinflation
Hyperinflation
• A very high level of inflation (50% or more per month) is

called hyperinflation. It is usually caused by the government
printing huge amounts of money to make up for insufficient
tax revenues
• Costs of high inflation:

• Huge costs involved with economizing on cash holdings.
• Makes it hard for customers to shop around for best
prices and distorts efficient resource allocation.
• Redistributes wealth from creditors to debtors since
debtors repay loan with less valuable dollars. (Who is the
biggest debtor and what are its incentives to engineer an
inflation?)
Major episodes of hyper-inflation
Average Average Maximum

monthly monthly monthly
growth growth in rise in
of money prices prices
Russia 49.3% 57.0% 213%
(Dec.1921-Jan.1924) Jan. 1924
Germany 314% 322% 32,000%
(Aug.1922-Nov.1923) Oct. 1923
Hungary 12,200% 19,800% 4,200,000%
(July 1945-July 1946) July 1946
• Mid-November 2008 monthly inflation of 79,600,000,000%
The case of • Second highest after Hungary (1946)
Zimbabwe
• Over-reliance on printing money to cover operations (e.g.), in Nov ’08,
compared to previous month:
• M1 increased by 57,871%
• M3 increased by 51,769%
Comparing Zimbabwe to Germany
in 1920s
Exchange Rate
Currency in Circulation
Source: Hanke 2008
40
Further Readings
• The Ascent of Money by Niall Fergusson
• A Monetary History of the United States, 1867-1960 by

Friedman and Schwartz
41
Glossary
• CU Currency
• RES Reserves
• BASE Monetary Base (= CU + RES)
• DEP Deposits
• M1 Currency + Deposits (= CU + DEP)
• M2 M1 + time deposits
• M Money supply (usually M1)
• Md Money demand
• P General price level
• V Money velocity (V when fixed)
• k Constant in simple money demand fn (1/V).
• i Nominal interest rate
• r Real interest rate
• пe Expected inflation
• L General money demand function
• res Reserve ratio
• cu Currency-Deposit ratio
• m Money multiplier

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Global Economics: PGP

Session 4: Money, Inflation,

• Quantity Theory of Money

• Interest and Money Demand

• Fractional Reserve Banking

• Money refers to any asset which can be used:

• Historically, economies had commodity money. Now economies have

• The government has a monopoly over the supply of money. The

• Currency is not the only form of money

• Any instrument that is liquid can be counted as part of money.

• Measures of money: (US: April 2018)

M1 CU + demand & checking deposits $ 3.691 T

M2 M1 + saving & time deposits $14.047 T

Open Market Operations

• ↑ Money Supply: Use newly minted currency to buy financial

• ↓ Money Supply: Sell government bonds in exchange for

• The starting point for this analysis is the quantity equation or

• where, M is a monetary aggregate such as M1 (or M2)

• The quantity identity becomes a theory

• First define real balances as the quantity of goods and services

• Higher the income, higher the demand for money

• In M V = P Y, the real GDP, Y, is determined by the production

Key implication of the Quantity Theory

• An increase in the money supply (by the Central Bank) shows up

• To see this, note that M V = P Y in % change form is:

• This prompted Friedman to observe: “Inflation is always and

• Increase in money supply directly maps into inflation

• Clear separation of monetary and real variables

• The irrelevance of money for real variables is called money

• In the long run, most economists agree on money neutrality,

• Thus far we have considered money demand to be a function of income

• A more general money demand specification:

where L is a function that is ↑ in Y (more transactions require more money),

Md/P = M/P = L(r + πe, Y)

• In the Quantity Theory, current money supply alone determines

• In the more general specification, future money growth affects

• This implies that an announcement by the Central Bank on future

•  in future money supply  inflation expectations, πe, today,

• Since today’s money supply, M, is fixed, the only way this

Reserves: res ($0.10) Dep: 1 ($1) Reserves: res(1-res) Dep: (1-res)

Loan: (1-res) ($0.90)

… and so on and on and on

Loan: (1-res)3 ($0.73)

• Under the fractional-reserve system, a dollar of cash

• A dollar injected becomes:

• Since 1/res > 1, the banking system creates money. It does

• This assumes people deposit all the money they get. In

Government Bonds Currency

Reserves at CENTRAL Deposits

• Functions of banks: match borrowers and lenders, create

• If we had 100% reserve banking: banks are required to hold all

• Fractional reserve banking: banks are required to hold a

• Therefore, money supply is affected by:

• BASE: Directly controlled by the Fed. Higher the base, higher

• cu: Lower cu implies higher m. Determined by household and

• Banks cannot satisfy simultaneous withdrawal demands from everyone

• As people withdraw deposits, cu ↑, Banks hold excess reserves, so res ↑. Both ↓ m,

• Establishment of the Federal Deposit Insurance Corporation (FDIC) helped

Monetary Variables in the Great

• Goods prices fell with money supply

Banks wanted to hold

Source: ABC Source: ABC

The price index for American consumer spending (PCE index),