Mishkin 05

Chapter 5
Money and
Inflation
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

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• To understand the meaning of money and

how it is measured
• To examine the link between money,
inflation, and the interest rate
• To understand the costs of inflation for
households and businesses
5-2
What is Money?
• Economists define money as an asset that

is generally accepted in payment for goods
and services or in the repayment of debts
• When people talk about money, they usually
refer to currency
• Money is not the same as:
– Wealth: the total collection of property that
serves as a store of value
– Income: a flow of earnings per unit of time
(money is a stock)
5-3
Box: Unusual Forms of Money
• Beads (wampum) used by American Indians

• Tobacco and whisky used by early American
colonists
• Big stone wheels used by residents on the
island of Yap
• Cigarettes used by prisoners of war in a
POW camp during World War II
5-4
Functions of Money
• Money has three primary functions:

– Medium of exchange
– Unit of account
– Store of value
5-5
Functions of Money (cont’d)
• Money as a medium of exchange:

– Without money, people would barter, which
requires a “double coincidence of wants”
– Money promotes economic efficiency by
minimizing transaction costs
5-6
• Money as a unit of account:

– we measure the value of goods and services in
terms of money as we measure weight in pounds
and distance in miles
5-7
• Money as a store of value:

– Money saves purchasing power from the time
income is received until the time it is spent
– Money as a medium of exchange makes money
the most liquid of all assets: It does not have to
be converted into a medium of exchange to
immediately make purchases
5-8
The Federal Reserve System and
the Control of the Money Supply
• The money supply is the amount of money
in the economy
• The key player in the money supply process
is the Federal Reserve System (Fed), which
consists of:
– 12 Federal Reserve Banks
– Board of Governors
5-9
Federal Reserve Banks
• Federal Reserve Banks are involved in

monetary policy:
– 5 of the 12 bank presidents (on rotation basis)
each have a vote in the Federal Open Market
Committee (FOMC)
5-10
FIGURE 5.1 Federal Reserve System
5-11
Board of Governors of the Federal
Reserve System
• As head of the Federal Reserve System

• Has 7 members
• Headquartered in Washington, D.C.
• Each governor is appointed by the president
of the United States and confirmed by the
Senate
• The chairman of the Board of Governors
serves a 4-year, renewable term
5-12
Federal Open Market Committee
(FOMC)
• Usually meets 8 times a year

• Makes decisions on open market operations
• Consists of 7 members of the Board of
Governors, the president of the Federal
Reserve Bank of New York, and the
presidents of 4 other Federal Reserve banks
• Chairman of the Board of Governors
presides as the FOMC chairman
5-13
Box: The European Central Bank
• European Central Bank (ECB) patterns its

central banking system after the Fed:
• Run by an Executive Board similar in structure
to the Board of Governors of the Fed
• National Central Banks (NCBs) have similar
functions to the Federal Reserve Banks
• Its Governing Council, comprised of the
Executive Board and presidents of the National
Central Banks, is similar to the FOMC
5-14
Control of the Money Supply
• The Fed controls the money supply through

open market operations, which are
purchases or sales of government bonds
– When the Fed buys government bonds, the
money supply increases
– When the Fed sells government bonds, the
money supply decreases
5-15
Measuring Money
• The Fed’s monetary aggregates:

– M1
• The Fed’s narrowest measure of money
• Includes only the most liquid assets
• Consists of currency, traveler’s checks, demand
deposits, and checking account deposits.
– M2
• Consists of M1 plus money market deposit accounts,
money market mutual fund shares with check-writing
features, savings deposits, and certificates of deposit in
denominations of less than $100,000
5-16
TABLE 5.1 Measures of the Monetary
Aggregates
5-17
Macroeconomics in the News: The
Monetary Aggregates
• Every week on Thursday, the Federal

Reserve publishes the data for M1 and M2 in
its H-6 release and these numbers are often
reported on in the media
• The H-6 release can be found at
http://www.federalreserve.gov/releases/h6/
current/h6.htm
5-18
The Fed’s Use of M1 Versus M2 in
Practice
• It’s not obvious whether M1 or M2 is a

better measure of money
• The growth rates of M1 and M2 move in
tandem through the 1980s but then diverge
since then
• Because the two monetary aggregates give
different stories about the course of
monetary policy in recent years, the Fed
now focuses on interest rates rather than
money supply in conducting monetary policy
5-19
FIGURE 5.2 Growth Rates of M1 and
M2, 1960-2010
5-20
Box: Where Is All the U.S. Currency?
• The $872 billion in outstanding U.S.

currency in 2010 means, on average, a U.S.
citizen holds $2800 in cash
• Who actually have so much of U.S. dollars?
– People engaging in illegal activities
– Foreigners, especially those living in countries
with high inflation
5-21
Quantity Theory of Money
• The quantity theory of money is the product

of the classical economists, also known as
classicals, who assumed that wages and
prices were completely flexible
• American economist Irving Fisher gave a
clear exposition of this theory in his
influential book, The Purchasing Power of
Money, published in 1911
5-22
Velocity of Money and the Equation of
Exchange
• The link between the total quantity of

money (M) and the total amount of
spending on goods and services produced
(P x Y) is the velocity of money (V):
P Y
V
M
5-23
Exchange (cont’d)
• The equation of exchange relates nominal

income to the quantity of money and
velocity:
M V  P  Y
5-24
Exchange (cont’d)
• The demand for money (Md) is the

quantity of money that people want to hold
• Md can be obtained from dividing the
equation of exchange by V:
1
M   PY
V
5-25
Exchange (cont’d)
• Assuming V is constant, the demand for real

money balances:
Md
 k Y
P
where k=1/V
5-26
From the Equation of Exchange to the
Quantity Theory of Money
• According to Fisher, V is fairly constant at V in the

short run
• This transforms the equation of exchange into the
quantity theory of money—nominal income is
determined solely by movements in the quantity of
money:
P  Y  M V
5-27
The Classical Dichotomy
• Classical economists viewed wages and

prices as flexible, so that prices of goods
and service and factor prices would fully
adjust to the level that equates the supply
and demand for a particular good or service
in the long run
5-28
The Classical Dichotomy (cont’d)
• Classical dichotomy:
– In the long run there is a complete separation
between the real side of the economy and the
nominal side
– The amounts of goods and services produced in
an economy in the long run is not affected by the
price level
5-29
Quantity Theory and the Price Level
• Assuming that Y is fixed at Y so that in the price

level in the quantity theory of money becomes:
M V
P
Y
• This implies that, in the long run, changes in the

quantity of money lead to proportional changes in
the price level
• This view is also known as the neutrality of money
—the money supply has no impact on real variables
5-30
Quantity Theory and Inflation
• A theory of inflation can be obtained by rewriting the

equation of exchange as:
%M  %V  %P  %Y

• If V is constant, the inflation rate ( )becomes:
  %P  %M  %Y

• The quantity theory of inflation indicates that the
inflation rate equals the growth rate of the money
supply minus the growth rate of aggregate output
5-31
Application: Testing the Quantity
Theory of Money
• Because the quantity theory of money provides

a long-run theory of inflation, it explains
differing long-run inflation rates across
countries
• However, the relationship between inflation and
money growth on an annual basis is not strong
at all
• The conclusion: Milton Friedman’s statement
that “inflation is always and everywhere a
monetary phenomenon” is accurate in the long
run, but is not supported by the data for the
short run
5-32
FIGURE 5.3 Relationship Between
Inflation and Money Growth (a)
5-33
FIGURE 5.3 Relationship Between
Inflation and Money Growth (b)
5-34
FIGURE 5.4 Annual U.S. Inflation and
Money Growth Rates, 1965-2010
5-35
Hyperinflation
• Hyperinflation occurs when a country

experiences extremely rapid price increases
of more than 50 percent per month (over
1000 percent per year)
• Except for the United States, many
economies – both poor and developed –
have experienced hyperinflation over the
last century
5-36
Policy and Practice: The Zimbabwean
Hyperinflation
• In 2000s, the Zimbabwean government paid

for its excessive spending by raising its
money supply rapidly
• As predicted by the quantity theory, the
surge in the money supply led to a rapidly
rising price level: The inflation rate hit over
1,500 percent in March 2007, over 2 million
percent by 2008
5-37
Inflation and Interest Rates
• The Fisher equation in Chapter 2 states that the

nominal interest rate i equals the real interest rate
r plus the expected rate of inflation e :
i  r  e
• The Fisher effect occurs at a result of the Fisher
equation and the classical dichotomy: When
expected inflation rises, interest rates will rise
5-38
Application: Testing the Fisher Effect
• The U.S. evidence demonstrates that the

Fisher effect prediction that nominal rates
rise along with expected inflation is accurate
in the long run, but over shorter time
periods, expected inflation and nominal
interest rates do not always move together
5-39
FIGURE 5.5 Expected Inflation and
the Nominal Interest Rate (a)
5-40
FIGURE 5.5 Expected Inflation and
the Nominal Interest Rate (b)
5-41
The Cost of Inflation
• Costs from anticipated inflation

– Shoe-leather costs
– Menu costs
– Tax distortions
– Increased Variability of Relative Prices
– Loss of the dollar yardstick
5-42
The Cost of Inflation (cont’d)
• Costs from unanticipated inflation

– Increased uncertainty
– Increased variability of relative prices
– Higher inflation uncertainty when the level of
inflation is higher
5-43
Chapter 5
Appendix
The Money
Supply Process

The Fed’s Balance Sheet
• Liabilities
– Currency in circulation: in the hands of the public
– Reserves: bank deposits at the Fed and vault cash
• Assets
– Government securities: holdings by the Fed that affect
money supply and earn interest
– Discount loans: bank borrowings from the Fed, i.e.,
borrowed reserves, at the discount rate
5-45
The Fed’s Balance Sheet (cont’d)
• Monetary base is the sum of the Fed’s monetary

liabilities and the U.S. Treasury’s monetary
liabilities (Treasury currency in circulation, mostly
coins)
• Reserves consist of deposits at the Fed plus
currency that is held in bank vaults (or vault cash)
• Total reserves = required reserves + excess
reserves
5-46
Control of the Monetary Base
• The monetary base equals currency in circulation

(C) plus the total reserves in banking system (R):
MB = C + R
• MB is also called high-powered money because

the Fed exercises control over it through open
market operations, and through its extension of
discount loans to banks.
5-47
Federal Reserve Open Market
Operations
• An open market purchase is a purchase of

bonds by the Fed
• An open market sale is a sale of bonds by the
Fed
• Suppose that the Fed purchases $100 of bonds
from a bank and pays for them with a $100 check.
How does this transaction affect the monetary
base? Let’s look at a T-account.
5-48
Federal Reserve Open Market
Operations (cont’d)
• Reserves increase by $100

• Monetary base increases by $100
5-49
Shifts from Deposits into Currency
• A shift from $100 deposits to currency affects the

reserves in the banking system, but the shift will have
no net effect on the monetary base
5-50
Discount Loans
• A $100 discount loan to a bank increases the monetary

base by $100
5-51
Discount Loans (cont’d)
• If the bank pays off the $100 discount loan, then borrowings
from the Fed and the monetary base will reduce by $100
5-52
Overview of the Fed’s Ability to
Control the Monetary Base
• The monetary base has two components:

1. Nonborrowed monetary base
• Created through open market operations
• The Fed can control completely
2. Borrowed reserves
• Created through banks’ borrowings from the Fed
(discount loans)
• The Fed has less control over
5-53
Multiple Deposit Creation: A
Simple Model
• An increase in the monetary base leads to
a multiple expansion of the money supply
• The money supply process is multiple
deposit creation: For each $1 additional
reserves that the Fed supplies the banking
system, deposits increase by a multiple of
this amount
5-54
Deposit Creation: The Single Bank
• Suppose the Fed buys $100 bonds from the First National
Bank
5-55
Deposit Creation: The Single Bank
(cont’d)
• A bank cannot safely make loans for an

amount greater than the excess reserves it
has before it makes the loan
• The First National Bank’s final T-account is:
5-56
Deposit Creation: The Banking
System
• Assumptions:
– The $100 deposits created by the First National
Bank is deposited at Bank A
– no excess reserves
– Required reserve ratio (rr) = 10%
5-57
System (cont’d)
5-58
System (cont’d)
• If the money spent by the borrower to

whom Bank A lent the $90 is deposited in
Bank B, then:
5-59
System (cont’d)
• If Bank A had taken its excess reserves

and purchased securities instead of making
loans, then:
• Whether a bank chooses to use its excess

reserves to make loans or to purchase
securities, the effect on deposit expansion
is the same
5-60
TABLE 5A1.1 Creation of Deposits
(assuming 10% reserve requirement
and a $100 increase in reserves)
5-61
Critique of the Simple Model
• In reality, the multiple deposit creation may

be smaller than that implied by the model
because:
1. Borrowers hold loan proceeds as cash and never
deposit them, so there is no multiple deposit
expansion
2. Banks choose not to use all their excess
reserves to buy securities or make loans
5-62
Factors that Determine the
Money Supply
• Changes in the nonborrowed monetary base

– The money supply is positively related to the
non-borrowed monetary base MBn
• Changes in borrowed reserves from the Fed

– The money supply is positively related to the
level of borrowed reserves, BR, from the Fed
5-63
Factors that Determine the
Money Supply (cont’d)
• Changes in the required reserves ratio

– The money supply is negatively related to the
required reserve ratio rr
• Changes in currency holdings
– The money supply is negatively related to
currency holdings
• Changes in excess reserves
– The money supply is negatively related to the
amount of excess reserves
5-64
TABLE 5A1.2 Money Supply
Response
5-65
Application: The Great Depression Bank
Panics and the Money Supply, 1930-1933
• In 1930, the U.S. experienced a bank

panic, in which there were simultaneous
failures of multiple banks
• Depositors who anticipated substantial
losses on deposits sought to shift their
deposit holdings into currency
• For a relatively constant MB, the money
supply decreased due to the fall of the
money multiplier
5-66
FIGURE 5A1.1 Excess Reserves Ratio
and Currency Ratio, 1929–1933
5-67
FIGURE 5A1.2 M1 and the Monetary
Base, 1929–1933
5-68
The Money Multiplier
• Define money as currency plus checkable

deposits: M1
• The money multiplier (m) tells us how
much the money supply (M) changes for a
given change in the monetary base (MB):
M  m  MB
5-69
Deriving the Money Multiplier
• Assume that the desired holdings of currency

(C) and excess reserves (ER) grow
proportionally with checkable deposits (D),
then:
c = {C/D} = currency ratio
e = {ER/D} = excess reserves ratio
5-70
(cont’d)
The total amount of reserves (R) equals the sum of

required reserves (RR) and excess reserves (ER ).
R = RR + ER
The total amount of required reserves equals the required
reserve ratio times the amount of checkable deposits
RR = rr × D
Subsituting for RR in the first equation
R = (rr × D) + ER
The Fed sets rr to less than 1
5-71
(cont’d)
• Because the monetary base MB equals

currency (C) plus reserves (R):
MB = R + C= (rr x D) + ER + C
• This equation reveals the amount of the

monetary base needed to support the
existing amounts of checkable deposits,
currency and excess reserves.
5-72
(cont’d)
c = {C / D}  C = c  D
e = {ER / D}  ER = e  D
Substituting in the previous equation:
MB  ( rr  D)  (e  D)  (c  D )  (r  e  c)  D
Divide both sides by the term in parentheses:
1
D  MB
r ec
Because M  D  C and C  c  D :
M  D  (c  D )  (1  c )  D
Substituting again:
1 c
M  MB
r ec
The money multiplier is therefore:
1 c
m
r ec
5-73
Intuition Behind the Money Multiplier
• What is the value of the money multiplier

given the following information?
rr  required reserve ratio = 0.10

C  currency in circulation = $400 billion
D  checkable deposits = $800 billion
ER  excess reserves = $0.8 billion
M  money supply (M1) = C  D = $1,200 billion
5-74
Intuition Behind the Money Multiplier
(cont’d)
$400 billion
c  0.5
$800 billion
$0.8 billion
e  0.001
$800 billion
1  0.5 1.5
m   2.5
0.1  0.001  0.5 0.601
• The money multiplier is less than the multiple

deposit expansion of 10 in the simple model.
• Although there is multiple expansion of deposits,
there is no such expansion for currency
5-75
Money Supply Response to Changes
in the Factors
• Because the monetary base (MB) is the sum

of nonborrowed base (MBn) and borrowed
reserves (BR):
MB=MBn+BR
• A rise in MBn or BR raises the money supply

by m
5-76
Money Supply Response to Changes
in the Factors (cont’d)
• If rr increases from 10% to 15%, then m falls to:

1  0.5 1.5
m   2.3
0.15  0.001  0.5 0.651
• If c rises from 0.5 to 0.75, then m falls to:

1  0.75 1.75
m   2.06
0.1  0.001  0.75 0.851
• If e rises from 0.001 to 0.005, then m falls to:

1  0.5 1.5
m   2.48
0.1  0.005  0.5 0.605
5-77

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Chapter 5

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

• To understand the meaning of money and

• Economists define money as an asset that

• Beads (wampum) used by American Indians

• Money has three primary functions:

• Money as a medium of exchange:

• Money as a unit of account:

• Money as a store of value:

• Federal Reserve Banks are involved in

• As head of the Federal Reserve System

• Usually meets 8 times a year

• European Central Bank (ECB) patterns its

• The Fed controls the money supply through

• The Fed’s monetary aggregates:

• Every week on Thursday, the Federal

• It’s not obvious whether M1 or M2 is a

• The $872 billion in outstanding U.S.

• The quantity theory of money is the product

• The link between the total quantity of

• The equation of exchange relates nominal

• The demand for money (Md) is the

• Assuming V is constant, the demand for real

• According to Fisher, V is fairly constant at V in the

• Classical economists viewed wages and

• Assuming that Y is fixed at Y so that in the price

• This implies that, in the long run, changes in the

• A theory of inflation can be obtained by rewriting the

%M  %V  %P  %Y

  %P  %M  %Y

• Because the quantity theory of money provides

• Hyperinflation occurs when a country

• In 2000s, the Zimbabwean government paid

• The Fisher equation in Chapter 2 states that the

• The U.S. evidence demonstrates that the

• Costs from anticipated inflation

• Costs from unanticipated inflation

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

• Monetary base is the sum of the Fed’s monetary

• The monetary base equals currency in circulation

• MB is also called high-powered money because

• An open market purchase is a purchase of

• Reserves increase by $100

• A shift from $100 deposits to currency affects the

• A $100 discount loan to a bank increases the monetary

• The monetary base has two components:

• A bank cannot safely make loans for an

• If the money spent by the borrower to

• If Bank A had taken its excess reserves

• Whether a bank chooses to use its excess

• In reality, the multiple deposit creation may

• Changes in the nonborrowed monetary base

• Changes in borrowed reserves from the Fed

• Changes in the required reserves ratio

• In 1930, the U.S. experienced a bank

• Define money as currency plus checkable

• Assume that the desired holdings of currency

The total amount of reserves (R) equals the sum of

• Because the monetary base MB equals

• This equation reveals the amount of the

• What is the value of the money multiplier

rr  required reserve ratio = 0.10

• The money multiplier is less than the multiple