Economics 3rd ch07

Economics
THIRD EDITION

By John B. Taylor
Stanford University

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Chapter 22 (Macro 9)
Money and Inflation
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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.

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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.

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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

relative values of goods.

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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.

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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.

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Figure 22.1
(Macro 9)
Channeling Funds from Savers to Investors

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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.

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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.

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2. The Fed and the Banks: Creators of Money

• 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.

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Figure 22.2 (Macro 9)
The Twelve Districts of the Fed

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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.

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Figure 22.3 (Macro 9)
The Structure of the Fed

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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.

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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

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3. How the Fed Controls the Money Supply

CU =k D , where k is the currency to deposit
ratio
MB =CU +BR , where MB is the monetary base
Substitution yields M = (k + 1)D and MB =(k +r
)D so that the money multiplier is:
M /Mb = (k + 1)/(r +k )

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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.
 

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3. How the Fed Controls the Money Supply

Some values of k for this period are:
April 1928: k = .091 (prior to financial
crisis)
March 1933: k = .225 (bank holiday
declared)
May 1941: k = .251 (World War II)

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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.

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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

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Figure 22.4
(Macro 9)
The Relation Between Money Growth and
Inflation

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Figure 22.5 (Macro 9)
German Hyperinflation of 1923

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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.

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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.

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