Money and Inflation

February 25, 2024

Money and Inflation February 25, 2024 1 / 17

Money

Money is the stock of assets that can be readily used to make

transactions.
Functions of money:
store of value
unit of account
medium of exchange
Types of money
Commodity Money Money with intrinsic value (i.e., gold standard)
Fiat Money Money with NO intrinsic value

Money and Inflation February 25, 2024 2 / 17

The Role of Banks in the Monetary System

M=C+D
100 Percent Reserve Banking If banks hold 100 percent of deposits
in reserve, the banking system does not affect the money supply.
Fractional Reserve Banking In a system of fractional reserve
banking, banks create money.
Bank Capital The equity of the bank owners.
Leverage The use of borrowed money to supplement existing funds
for investment. Leverage ratio is the ratio of a bank’s total asset to bank
capital.
Capital Requirement It ensures that the banks will be able to pay off
their depositors and other creditors.

Money and Inflation February 25, 2024 3 / 17

A Model of the Money Supply

One dollar is issued by CB and held as currency: money supply goes up

by only one dollar (100 percent reserve banking)
One dollar is issued by CB and deposited in the bank account, and a
fraction of the deposit is kept in the reserve: money supply goes up by
more than a dollar (Fractional reserve banking)
Fractional reserve banking depends on 3 decisions:
CB’s decision about dollar creation
Bank’s decision about holding deposits as loan or reserve
Household’s decision about holding money in terms of currency or
demand deposits.

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Building the Model

Three exogenous variables:

Monetary Base, B: sum of currency held by public C and by the banks
as reserve R. It is controlled by CB.
Reserve-Deposit Ratio, rr: Fraction of deposit banks hold as reserve. It
is decided by the business policies of banks.
Currency-Deposit Ratio, cr: Amount of currency C people hold as a
fraction of the demand deposit D. Household preferences drive the
decision regarding this one.
Algebraic manipulation provides
cr + 1
M= ×B= m ×B
cr + rr |{z}
money multiplier

Interpretation each dollar of monetary base produces m dollar of

money

Money and Inflation February 25, 2024 5 / 17

Building the Model (continued)

Key takeaways:
M ∝ B ⇒ %∆B = %∆M
↓ rr ⇒↓ R ⇒↑ Loans ⇒↑ m ⇒↑ M
↓ cr ⇒↓ C, ↑ R ⇒↑ money creation ⇒↑ m ⇒↑ M

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The Instruments of Monetary Policy
CB controls the MP indirectly using two broad groups:
1. influencing B
2. influencing rr
How the CB Changes the B
Open-market operations (purchases and sales of government bonds)
How?
US FED conducts open-market operations in NY bond markets almost
every weekday.
CB can lend reserve to the commercial banks. (Current situation of
Bangladeshi banking sector). CB is the lender of last resort.
Discount rate (repo rate) is the interest rate the CB charges on this
loan.
↓ Repo rate ⇒↑ borrowing from reserves ⇒↑ B ⇒↑ M
Bangladesh Bank is currently raising repo rate (policy rate). Why?
Money and Inflation February 25, 2024 7 / 17
Instruments of Monetary Policy (continued)

How the CB Changes the rr

Reserve Requirements: CB regulations that impose a minimum rr
on banks.
↑ Reserve Requirements ⇒↑ rr ⇒↓ m ⇒↓ M
Less effective strategies in the recent year as most banks hold more
reserves than are required.
How about Shariah controlled banks of Bangladesh?
Interest on Reserves: CB pays bank interest if a bank holds reserves
on deposit at the CB.
↑ Interest on Reserves ⇒↑ R ⇒↑ rr ⇒↓ m ⇒↓ M

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Quantity Theory of Money

Proposed by David Hume (1711-1776)

Quantity equation

M×V =P ×T

T is the total number of transactions during a period. The number of

times in a year that goods or services are exchanged for money.
P is the price level.
What is the meaning of PT then?
M is the quantity of money.
V is the transaction velocity of money- the rate at which money
circulates in the economy.

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The Quantity Theory of Money (continued)

It is difficult to quantify T .
Transactions and output are related, but NOT the same. (e.g., buying
and selling of a used car)
Dollar value of transaction is ROUGHLY proportional to dollar value of
output.
New quantity equation

M×V =P ×Y

Y is the real output.

V is now income velocity of money- the number of times dollar bills
enter into someone’s income in a given period.

Money and Inflation February 25, 2024 10 / 17

Money Demand Function

M
P:Real money balance (i.e., the purchasing power of the stock of
money). This a money supply equation as well.
Simple money demand function is
 d
M
= kY
P

k is a constant that tells how much money people want to hold for

d
every dollar of income. (i.e., M
P ∝ Y ).
Money market equilibrium condition restores the quantity equation
with V = k1 .
What is the intuition behind the inverse relation between V and k?

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Assumption of Constant V

V can be expressed as the ratio between nominal GDP and quantity of

money.
V is assumed to be FIXED for the expositional convenience.
Quantity theory of money can be written as

M × V̄ = P × Y

If V is fixed, M determines the dollar value of the economy’s output

(i.e., GDP).
Re-writing the above equation

%∆M + %∆V
| {z } = %∆P + %∆Y
| {z }
=0 =0(Why?)

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Seigniorage

A revenue that a government raises by printing money.

It is like an imposition of inflation tax.
It is like a tax on holding money.

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Inflation and Interest Rates

What should be the relationship between nominal interest rate?

How can you connect nominal interest rate and money supply?
Irving Fisher provided the answer!
Fisher equation can be written as

i =r +π

ex-ante real interest rate: i − Eπ

ex-post real interest rate: i − π

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The Nominal Interest Rate and the Demand for Money

What is the opportunity cost of holding money?

The answer is Nominal Interest Rate. (Why?)
How can we determine this nominal interest rate? (Fisher equation).
The general money demand equation
 d
M
= L (i, Y )
P

L stands for liquidity as money is the most liquid asset.

Li < 0 and LY > 0.

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Future Money and Current Prices

Relation between money, prices, and interest rate:

Money supply and money demand determine the price level.
Change in price level is the rate of inflation
Inflation influences the nominal interest rate through the Fisher effect.
The nominal interest rate affects the real money demand.
It is like a vicious cycle.
Equilibrium condition provides
M M
= L (i, Y ) ⇒ = L (r + Eπ, Y )
P P
All the fancy equations are meaningless without proper explanation.

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Practice Problem (Taken from the problem set of Chapter
5)
An economy has the following demand function
 d
M 0.2Y
= 1
P i2

Derive an expression for the velocity of money. What does the velocity
depend on? Explain why this dependency may occur.
Calculate velocity if the nominal interest rate is 4 percent.
If real output is 1000 and the money supply is 1200, what is the price
level?
Suppose the the new governor of BB decides to increase the expected
inflation by 5 percentage point. What is the new nominal interest rate?
What is the new velocity of money?
After the announcement, if Y and M are unchanged, what will happen
to the price level? Explain in plain English.
What should be the new money supply if the governor of BB plans to
keep the price level same after
Moneythe announcement? February 25, 2024
and Inflation 17 / 17