EC114 Core Lecture, Week 9

Introduction

• Today: Chapters 12–14: Money, Prices, Monetary and Fiscal Policy.
• Rest of term:
  • Week 10:
    • Tuesday: Classes: What should we expect from the budget?
    • Wednesday: The Budget!
    • Thursday: Applications Lecture: The Budget!
    • Friday: Chapters 17–18: Banking, Debt and (Sovereign) Default.
  • Week 11:
    • Thursday: Claire Macallan from the Bank of England.
    • Friday: Chapters 19–21: Exchange Rates (guaranteed question).
• Unable to cover chapters in full detail.
• Reading all the chapters will be beneficial.

Essay

• Due Friday March 27 4pm.
• Word limit: 2000, strict (no 10%).
  • Words after 2000th will not be counted (it’s electronic submission).
    • Ability to write succintly and clearly an acquired skill.
  • Footnotes do not count (but no obligation to read footnotes).
  • Tables and figures do not count (but do not abandon them).
  • Harvard style referencing (copy style in academic papers).
• Question Choose one of the guest lectures by Joe Grice, John Redwood and Sam Juthani and answer the following questions:
  1. Summarise the lecture given by your chosen guest.
  2. Identify which economic theories covered in lectures that the lecturers referred to. Was the lecturer in agreement with the theory?
  3. Explain whether you agree with the lecturer.
• All parts equally weighted.

Debates in Class

• Thanks for participating!
• Tutors gave me very positive feedback.
• Attendance low again, but suspect those who fail to attend classes fail to attend lectures.
• Next week:
  • I’ll provide some reading material ahead of class on budget.
  • Debate on what we should expect from the budget.

Clarification

• More than happy to answer questions.
  • No obligation to review your scripts step by step.
  • But happy to answer questions about exam.
  • Exam marks not up for debate.
• Midterm tests were marked as midterm tests.
  • What I mentioned last week was an analysis of exam marks against class attendance.
  • Attending more classes was consistent with getting higher marks.

Chapter 12: Money and Prices: Prices in the Very Long Run

Inflation = Percentage Change in Prices

Most Countries Show Similar Broad Patterns…

… even more so recently

Oil Prices Tend to Influence Inflation

Cumulative High Inflation Takes its Toll

How to Measure Inflation?

People Prefer Low Inflation to Low Unemployment

But Economists Less Decided

People Fear Costs of Inflation

Higher Inflation is More Volatile…?

Money Illusion Another Cost

Deflation Matters… Because Real Wages Increase

The Nature of Money

• What is money? What determines acceptability of something as money?
  • Medium of exchange.
  • Unit of account.
  • Store of value.
• Historically if something satisfied these properties, became money:
  • Precious metals.
  • Cigarettes.
• Today: By legal mandate.

The (US) Money Supply

• Monetary Base notes and coins and reserve deposits at Fed.
• M1 notes and coins + travellers cheques + demand deposits + other deposits.
• M2 M1 + mutual funds + savings deposits + overnight repos.

The (European) Money Supply

• M1 currency + overnight deposits.
• M2 M1 + deposits with maturity \(<2\) years + deposits \(<3\) months.
• M3 M2 + repos + mutual funds + debt securities \(<2\) years maturity.

The Money Multiplier

• Money base tiny fraction of total (broad) money supply.

  • Function of amount of assets banks required/decide to retain.

\[ \text{Money multiplier} = \frac{1}{\text{Reserve requirement}}. \]

Seignorage: Profit from Making Money

Printing Money Can Have Costs: Hyperinflation

Quantity Theory of Money

• Explicit link between money supply and prices. Quantity equation: \[ M \times V = P \times Y. \]
• Taking logs and differencing gives, approximately: \[ \%\Delta \text{ in money supply} + \%\Delta \text{ in velocity} = \%\Delta \text{ in prices} + \%\Delta \text{ in output}. \]
• But how stable is velocity?
• What moves: \(P\) or \(Y\)? Neutrality of money.

Inflation Always and Everywhere a Monetary Phenomenon?

Inflation Always and Everywhere a Monetary Phenomenon??

Inflation Always and Everywhere a Monetary Phenomenon???

What else causes inflation?

• Demand for money need not be solely income based:
  • Transactions demand for money.
• Precautionary demand:
  • Money people hold in case of emergency.
• Speculatory demand:
  • Money people hold to take advantage of investment opportunities that may arise.
• Despite this, inflation may not be a monetary phenomenon:
  • Excess demands all across the economy can cause inflation.
  • Excess demand for (demand-pull):
    • Labour: Wages increase causing excess demand elsewhere.
    • Goods: Product shortages.
    • Financial sector: Demand for financial assets/commodities.
  • Supply shortages (cost-push) can cause inflation also:
    • Product chain hold-ups.
    • Cartel decisions, e.g. OPEC.
  • Not always straightforward to tell the difference…

Chapter 13: Monetary Policy. The rise of the Central Banker…

A Central Bank’s Balance Sheet

Instruments and Targets

Monetary Policy and the LM Curve

• IS Curve: Interest rate and income combinations s.t. goods mkt in equilibrium.
• Need LM curve: Interest rate and income combinations s.t. money mkt in equilibrium.
• Recall: \[ MV = PY. \]
• In equilibrium \(M=M^s=M^d\) and rearranging: \[ \frac{M^d}{P} = \frac{Y}{V}. \]
• Demand for real balances depends on income and velocity.
  • Velocity depends on interest rate: Opportunity cost of holding money.

If Income Increases, Interest Rate Increases

The LM Curve

Central Bank Influences LM Curve Via \(M^s\)

Increase \(M^s\) Shifts LM Curve

The IS-LM Model: Equilibrium in Good and Money Markets

Different Targets

Possible Targets

• Money supply.
• Interest rates.
• Exchange rate.
• Inflation rate.

Which Money Supply?

And What About Velocity?

Inflation Targetting

• Explicit target (gold, exchange rate, etc) binding— leads to constraints.
• Inflation targetting: Central Bank targets particular rate at particular time.
  • Tool used is interest rate (not money supply). Set by Central Bank.
  • Sets rate via manipulation of inter-bank lending. Open market operations.
• Target range usually quite broad, Central Bank has lots of discretion.
• Usually see increased transparency alongside inflation targetting.

Targetting Money Supply Causes Volatility

Targetting Interests Rates Less So…

The Transmission Mechanism: Policy to Real Economy

% ## % % % %

The Taylor Rule

• Taylor rule (John B Taylor) simplified version of Central Bank behaviour.
• Interest rates should be set as function of inflation and output gap: \[ r_t = r_0 + \lambda (y_t-\overline{y}) + \alpha(\pi_t- \pi^*_t), \] where \(\overline{y}\) is trend output, and \(\pi^*_t\) is inflation target.
  • Taylor suggested \(\lambda=0.5\) and \(\alpha=1.5\).

Quantitative Easing: When Negative Rates Required

The Impact of QE

Chapter 14: Fiscal Policy and the Role of Government

It Hasn’t Always Been This Way…

Different Governments Have Different Priorities

Rationale for Intervention

• Invisible hand and efficient markets hypothesis:
  • Market ensures resources go to their most productive use. Pareto efficiency.
• But efficiency relies on conditions holding:
  • Perfect competition, perfect information, low cost of mistaken choice.
  • Private costs and benefits equal social costs and benefits.
• Justifications for government:
  • Traditionally: Public good provision.
  • Social insurance provision.
  • Paternalism: People can’t look after themselves.
• But how big…?

Taxation Funds the Machine…

But Taxes Distort…

Cost of Taxes is Square of Taxes

More Taxes, More Distortion

The Laffer Curve

But No Relationship Between Govt Size and Growth…?

Other Sources of Finance for Govt Spending

The UK Debt Situation

Global Phenomenon of Large Budget Deficits

The Debt League Table

The Optimal Budget Deficit

• Deficit financing investments can be profitable.
• Deficit financing ensures taxation is smoother:
  • Instead of tax hikes to pay for wars or greater benefits, deficits used.
• Sustainable? Borrowing against future income, borrowing in own currency.

The Argument for Tax Smoothing

Concluding

• Today:
  • Chapter 12: Money and Prices.
  • Chapter 13: Monetary Policy.
  • Chapter 14: Fiscal Policy.
• For week 10 classes: The Budget— what should we expect?
• Reading material:
  • Guardian Budget articles
  • Telegraph Budget articles
  • FT Budget articles
  • Yahoo Finance articles
• Next Thursday: The Budget aftermath.
• Next Friday: Chapters 17–18: Banking, Debt and (Sovereign) Default.