Money, Money Growth, and Inflation PDF

MONEY, MONEY GROWTH, AND INFLATION  LESSON OBJECTIVE: Understand the Mechanisms of Money Supply and Growth Analyze the Causes and Effects of Inflation Evaluate the Costs Associated with Inflation Explore the Relationship Between Money Growth and Inflation Estimate the economic costs through...

MONEY, MONEY GROWTH, AND INFLATION  LESSON OBJECTIVE: Understand the Mechanisms of Money Supply and Growth Analyze the Causes and Effects of Inflation Evaluate the Costs Associated with Inflation Explore the Relationship Between Money Growth and Inflation Estimate the economic costs through computational analysis  WHAT IS MONEY? -It is any item or medium used for exchange that represents perceived value. It exists in different forms, such as currency, coins, and bank deposits. It is widely accepted for purchasing goods and services and for repaying debts. Economies depend on money to enable transactions and drive financial growth. BARTER SYSTEM - parties trade products and services directly with one another without the use of cash or any other kind of monetary medium.  FOUR TYPES OF MONEY Currency Fiat Currency Definition: Physical bills and coins issued by Money that is not backed by a physical commodity governments. but by the trust and authority of the government. Characteristics: Tangible, widely accepted for Examples: US Dollar, Euro. transactions. Money Substitutes Commodity Money Definition: Financial instruments that can be A type of money that is based on a commodity's exchanged for currency easily. intrinsic value (e.g., gold or silver). Examples: Checks, debit cards.  VALUE OF MONEY Acceptability - Currency and checkable deposits function as money due to widespread acceptance. Confidence in exchangeability for goods and services supports the use of paper money. Legal Tender - Government designates currency as legal tender. Each bill states it is "legal tender for all debts, public and private." Private firms and the government can specify non-cash payment forms. Relative Scarcity - Money's value depends on the supply and demand. Value derived from scarcity relative to its utility (exchange power). Demand for money influenced by transaction volume and future needs.  WHAT IS MONEY SUPPLY? The money supply is the total amount of cash and cash equivalents, such as savings account balances, circulating in an economy at a given time. a. Open Market Operations - changing the quantity of money banks have on hand to lend by purchasing or disposing of government securities. b. Interest Rate Adjustments - are made to either promote or discourage borrowing and expenditure by altering the federal funds rate or discount rate.  EFFECT OF THE MONEY SUPPLY ON THE ECONOMY Increased Decreased Money Money Supply Money Supply Supply Changes ·Lowers interest rates. ·Raises interest rates. ·Stimulates investment ·Significantly ·Slows investment and and consumer consumer spending. impact economic spending. performance and ·Reduces business ·Boosts business activity activity and job cycles. and job demand. demand.  THE COMPONENTS OF MONEY SUPPLY M1 (NARROW MONEY) - The most liquid Formula : components of the money supply, used for Money, M1 = immediate CURRENCY + transactions. It reflects CHECKABLE DEPOSITS the money available for day-to-day transactions. M1 SAMPLE PROBLEM In a small economy, the following components of the M1 money supply are known: Currency in circulation: $300,000 Checkable deposits (demand deposits): $700,000 Calculate the total M1 money supply in this economy M2 (BROAD MONEY) -Includes M1 and adds Formula : savings and time deposits that are less liquid but still M2 = M1 + Small Time accessible. Its purpose is Deposits + Savings to track the money Deposits + Money supply available for spending or saving in the Market Mutual Funds short-to-medium term. M2 SAMPLE PROBLEM In a hypothetical economy, the following data is provided: Currency in circulation: $300 million Checkable deposits: $200 million Traveler’s checks: $50 million Small time deposits: $100 million Savings deposits: $400 million Money market mutual funds: $150 million Calculate the M2 money supply.  WHAT IS MONEY DEMAND? -It refers to the amount of money individuals desire to hold for their daily transactions and activities, influenced by the level of income and the cost of holding money, which is the interest rate.  THE THREE MAIN REASONS TO HOLD MONEY Transactions Precautionary Speculative related reason reason reason The citizens’ Held to moderate the It involves a trade-off impact of unexpected propensity to between holding spending needs that money and earning spend. can occur in the returns from financial future. instruments. KEY CONCEPTS OF VALUE OF MONEY Inflation - A general increase in prices reduces the purchasing power of money. For instance, if inflation rates are high, a dollar today buys less than a dollar did a decade ago. Deflation - A decrease in the general price level of goods and services increases the purchasing power of money. Supply and Demand - The value of money is also influenced by the principles of supply and demand. When more money is printed (increasing the money supply) without a corresponding growth in economic productivity, it can lead to inflation, decreasing the value of money. THE KEYNESIAN THEORY OF MONEY AND PRICE Aggregate Demand -At the heart of Keynesian economics is the concept of aggregate demand, which encompasses total spending in the economy at a given price level. -Keynes proposed that fluctuations in demand could lead to economic instabilities, such as recession or inflation. When aggregate demand is low, businesses reduce production, leading to unemployment and further decrease in demand. Money Supply and Interest Rates -Keynes argued that the money supply plays a critical role in determining aggregate demand. By controlling the money supply and interest rates, central banks can influence consumption and investment. -Lower interest rates make borrowing cheaper, which can stimulate spending and economic growth, whereas higher interest rates can dampen economic activity. Price Levels -Unlike classical economists who viewed prices as flexible and self- adjusting, Keynesian theory asserts that prices, particularly in the short term, can be sticky. This stickiness can lead to situations where the economy does not reach equilibrium quickly, causing prolonged periods of unemployment and underutilization of resources. The Phillips Curve -The Phillips Curve, which illustrates the inverse relationship between inflation and unemployment, is also a key element of Keynesian economics. Keynesians argue that during periods of high demand, inflation may rise, leading to lower unemployment. Conversely, in times of low demand, unemployment may rise while inflation falls. KEYNESIAN THEORY OF MONEY AND PRICES VELOCITY AND QUANTITY EQUATION Velocity of money - refers to the speed at which the typical dollar bill travels around the economy from wallet to wallet. Quantity equation - can be used to support the theory that increases in the money supply cause inflation. Velocity and Quantity Equation: MV=PY Where: V = velocity P = the price level Y = the quantity of output M = the quantity of money SAMPLE PROBLEM SUPPOSE THE INITIAL VALUES ARE: - M = 500 billion -V=4 - Y = 1000 units 1. What is the initial price level P? 2. If the money supply increases to 600 billion and the velocity of money decreases to 3.5, while real output remains constant, what will be the new price level P? MONEY MULTIPLIER -Amplifies money creation through fractional reserve Formula : banking. Central banks inject reserves into the MONEY MULTIPLIER = banking system. Commercial banks lend 1/Reserver Ratio multiples of these reserves. This process expands the initial injection, increasing the overall money supply. SAMPLE PROBLEM Example: Suppose the central bank requires commercial banks to hold 10% of their deposits as reserves. If the central bank injects $1,000 into the banking system, the money multiplier will be:  WHAT IS INFLATION? ·Inflation is the rate at which the general level of prices for goods and services in an economy rises over a period of time, leading to a decrease in the purchasing power of money. ·Essentially, it means that as prices increase, each unit of currency buys fewer goods and services. CAUSES OF INFLATION Inflation arises when the general price level in an economy increases over time, and its root causes can vary based on economic conditions and external factors. Excess Money Supply -When the central bank prints too much money or injects liquidity Into the economy without a corresponding increase in production, it leads too much money chasing too few goods. Global Factors -Events beyond domestic control can also cause inflation. Taxation Policies -Increases in taxes on goods and services can lead to higher prices for consumers. Demand Pull Inflation -This happens when the demand for goods and services exceeds the economy's ability to produce them. Cost-Push Inflation -This occurs when the cost of production increases, forcing businesses to raise prices to maintain profitability. Built-In Inflation -This type of inflation results from the expectations of businesses and workers that prices will continue to rise in the future. THE COSTS OF INFLATION -Inflation is a significant economic phenomenon that affects both individuals and the broader economy, leading to various costs that can have far-reaching implications. Understanding these costs is crucial for comprehending how inflation impacts purchasing power and economic stability. RELATIVE PRICE VARIABILITIES -Refers to the amount of changes in the prices of different goods and services in an economy, showing how much the price of one good or service changes in relation to others over time. EXAMPLE TAX DISTORTION ·Tax distortion occurs when taxes alter the behavior of individuals and businesses, leading to inefficient allocation of resources in the economy. ·It arises from the inherent nature of taxes, which can influence people's decisions regarding work, investment, consumption, and saving. MENU COST ·Menu cost are the costs of adjusting prices. ·During inflationary times, it is necessary to update price lists and other posted prices. ·This is a resource-consuming process that takes away from other productive activities. CONFUSION AND INCONVENIECE ·When the Fed increases the money and supply and creates inflation, it erodes the real value of the unit of account. ·Inflation causes dollars at different times to have a different real values. ·Therefore, with rising prices, it is more difficult to compare real revenues, costs, and profits over time. Thank you very much!