MACROECONOMICS
cover art ROW 1 (90)
C H A P T E R
© 2008 Worth Publishers, all rights reserved
SIXTH EDITION
PowerPoint® Slides by Ron Cronovich
N. GREGORY MANKIW
Money and Inflation
4

Chapter 4 is longer than average.  If you omit anything from this chapter to save time, I recommend
that you NOT omit the following, which I think are the most important concepts from this chapter:
•the Quantity Theory of Money’s implication that inflation in the long run equals money growth
minus real GDP growth
•the money demand function L(i,Y), which will be used in the IS-LM model and other parts of the
rest of this book
•the Classical Dichotomy and Neutrality of Money (which includes the Fisher effect and the Layman’s
view of the costs of inflation)
In addition to those three critical topics, Chapter 4 covers many other topics, such as:
•the 3 functions and 2 types of money – these will likely be review if your students have
previously taken an introductory economics course; hence, to save time, you can ask your students
to read these on their own
•the social costs of inflation (here, I think the Shoeleather cost is a good candidate for cutting
– it just does not seem very relevant in a world with ATMs in most grocery stores and online bank
account management)
•ex ante vs. ex post real interest rate
•seigniorage
•the causes and costs of hyperinflation

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
In this chapter, you will learn…
§The classical theory of inflation
§causes
§effects
§social costs
§“Classical” – assumes prices are flexible & markets clear
§Applies to the long run

U.S. inflation and its trend, 1960-2007
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0%
3%
6%
9%
12%
15%
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
long-run trend
% change in CPI from 12 months earlier

In this chapter, we learn about the long-run trend behavior of prices and inflation.  The factors
that make inflation deviate from its trend in the short run will be studied in chapter 13 (on
Aggregate Supply and the Phillips Curve).
source:  BLS
obtained from http://research.stlouisfed.org/fred2/

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
The connection between
money and prices
§Inflation rate = the percentage increase
in the average level of prices.
§Price = amount of money required to
buy a good.
§Because prices are defined in terms of money, we need to consider the nature of money,
the supply of money, and how it is controlled.

>

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Money:  Definition
§Money is the stock
of assets that can be readily used to make transactions.
BTE086

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Money:  Functions
§medium of exchange
we use it to buy stuff
§store of value
transfers purchasing power from the present to the future
§unit of account
the common unit by which everyone measures prices and values

If your students have taken principles of economics, they will probably  be familiar with the
material on this slide.
It might be worthwhile, though, to take an extra moment to be sure that students understand that
the definition of store of value (an item that transfers purchasing power from the present to the
future) simply means that money retains its value over time, so you need not spend all your money
as soon as you receive it.  The idea should be familiar, even though Mankiw’s wording is a bit more
sophisticated than most other texts.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Money:  Types
§1. fiat money
§has no intrinsic value
§example:  the paper currency we use
§2. commodity money
§has intrinsic value
§examples:
   gold coins,
   cigarettes in P.O.W. camps

Again, this material should be review for most students.
Note:  Many students have seen the film The Shawshank Redemption starring Tim Robbins and Morgan
Freeman.  Most of this film takes place in a prison.  The prisoners have an informal “underground
economy” in which cigarettes are used as money, even by prisoners who don’t smoke.  Students who
have seen the film will better understand “commodity money” if you mention this example.  Also, the
textbook (p.79) has a case study on cigarettes being used as money in POW camps during WWII.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Discussion Question
§Which of these are money?
§a. Currency
§b. Debit cards
§c. Deposits in checking accounts
(“demand deposits”)
§d. Credit cards
§e. Certificates of deposit
(“time deposits”)

You might want to ask students to determine, for each item listed, which of the functions of money
it serves.
Answers:
a - yes
b - no, not the checks themselves, but the funds in checking accounts are money.
c - yes (see b)
d - no, credit cards are a means of deferring payment.
e - CDs are a store of value, and they are measured in money units.  They are not readily
spendable, though.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
The money supply and
monetary policy definitions
§The money supply is the quantity of money available in the economy.
§Monetary policy is the control over the money supply.

Again, this is mostly review.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
The central bank
§Monetary policy is conducted by a country’s central bank.
§In the U.S.,
the central bank
is called the
Federal Reserve
(“the Fed”).
The Federal Reserve Building Washington, DC

Again, this is mostly review.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Money supply measures, May 2007
$7227
M1 + small time deposits,
savings deposits,
money market mutual funds,
money market deposit accounts
M2
$1377
C + demand deposits,
travelers’ checks,
other checkable deposits
M1
$755
Currency
C
amount
($ billions)
assets included
symbol

Source:  Federal Reserve Board, H.6 release. http://www.federalreserve.gov/releases/h6/Current/
Figures are seasonally adjusted.
This table is an updated version of Table 4-1 on p.82 of the textbook, with one change:  This slide
excludes M3, which the Federal Reserve discontinued in March 2006. For more info, see
http://www.federalreserve.gov/releases/h6/discm3.htm
The most important thing that students should get from this slide is the following:
Each successive measure of the money supply is BIGGER and LESS LIQUID than the one it follows.
I.e.,
•checking account deposits (in M1 but not C) are less liquid than currency.
•Money market deposit account and savings account balances (in M2 but not M1) are less liquid than
demand deposits.
Whether you require your students to learn the definitions of every component of each monetary
aggregate is up to you.  Most professors agree that students should learn the definitions of M1,
M2, demand deposits, and time deposits.  Some professors feel that, since the quantity of
information students can learn in a semester is finite, it is not worthwhile to require students to
learn such terms as “repurchase agreements.”  However, you might verbally state the definitions of
such terms to help students better understand the nature of the monetary aggregates.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
The Quantity Theory of Money
§A simple theory linking the inflation rate to the growth rate of the money supply.
§Begins with the concept of velocity…

>

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Velocity
§basic concept:  the rate at which money circulates
§definition:  the number of times the average dollar bill changes hands in a given time period
§example:  In 2007,
§$500 billion in transactions
§money supply = $100 billion
§The average dollar is used in five transactions in 2007
§So, velocity = 5

In order for $500 billion in transactions to occur when the money supply is only $100b, each dollar
must be used, on average, in five transactions.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Velocity, cont.
§This suggests the following definition:
where
V = velocity
T = value of all transactions
M = money supply

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Velocity, cont.
§Use nominal GDP as a proxy for total transactions.
§ Then,
where
 P = price of output  (GDP deflator)
 Y = quantity of output (real GDP)
P ´Y = value of output (nominal GDP)

You might ask students if they know the difference between nominal GDP and the value of
transactions.
Answer:  nominal GDP includes the value of purchases of final goods; total transactions also
includes the value of intermediate goods.
Even though they are different, they are highly correlated.  Also, our models focus on GDP, and
there’s lots of great data on GDP.  So from this point on, we’ll use the income version of
velocity.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
The quantity equation
§The quantity equation
M ´V = P ´Y
follows from the preceding definition of velocity.
§It is an identity:
it holds by definition of the variables.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Money demand and the quantity equation
§M/P = real money balances, the purchasing power of the money supply.
§A simple money demand function:
(M/P )d = k Y
where
k = how much money people wish to hold for each dollar of income.
    (k  is exogenous)

>

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Money demand and the quantity equation
§money demand: (M/P )d = k Y
§quantity equation: M ´V = P ´Y
§The connection between them:  k = 1/V
§When people hold lots of money relative
to their incomes (k  is high),
money changes hands infrequently (V  is low).

>

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Back to the quantity theory of money
§starts with quantity equation
§assumes V  is constant & exogenous:
§With this assumption, the quantity equation can be written as

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
The quantity theory of money, cont.
§How the price level is determined:
§With V  constant, the money supply determines nominal GDP (P ´Y ).
§Real GDP is determined by the economy’s supplies of K  and L  and the production function (Chap
3).
§The price level is
P = (nominal GDP)/(real GDP).

It’s worthwhile to underscore the order (logical order, though not necessarily chronological order)
in which variables are determined in this model (as well as the other models students will learn in
this course).
First, real GDP is already determined outside this model (real GDP is determined by the model from
chapter 3, which was completely independent of the money supply or velocity or other nominal
variables).
Second, the Quantity Theory of money determines nominal GDP.
Third, the values of nominal GDP (PY) and real GDP (Y) together determine P
(as a ratio of PY to Y).
If, on an exam or homework problem, students forget the logical order in which endogenous variables
are determined --- or on a more fundamental level, forget which variables are endogenous and which
are exogenous --- then they are much less likely to earn the high grades that most of them desire.
[Note the similarity between the way P is determined and the definition of the GDP deflator from
chapter 2.]

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
The quantity theory of money, cont.
§Recall from Chapter 2:
The growth rate of a product equals
the sum of the growth rates.
§The quantity equation in growth rates:

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
The quantity theory of money, cont.
§p  (Greek letter “pi”)
denotes the inflation rate:
The result from the
preceding slide was:
Solve this result
for p to get

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
The quantity theory of money, cont.
§Normal economic growth requires a certain amount of money supply growth to facilitate the growth
in transactions.
§Money growth in excess of this amount leads to inflation.

The text on this slide is an intuitive way to understand the equation.
For students that are more comfortable with concrete numerical examples, you could offer the
following:
Suppose real GDP is growing by 3% per year over the long run.  Thus, production, income, and
spending are all growing by 3%.  This means that the volume of transactions will be growing as
well.
The central bank can achieve zero inflation (on average over the long run) simply by setting the
growth rate of the money supply at 3%, in which case exactly enough new money is being supplied to
facilitate the growth in transactions.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
The quantity theory of money, cont.
§DY/Y  depends on growth in the factors of
production and on technological progress
(all of which we take as given, for now).
Hence, the Quantity Theory predicts
a one-for-one relation between
changes in the money growth rate and
changes in the inflation rate.

Note:  the theory doesn’t predict that the inflation rate will equal the money growth rate.  It
*does* predict that a change in the money growth rate will cause an equal change in the inflation
rate.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Confronting the quantity theory with data
§The quantity theory of money implies
§1. countries with higher money growth rates
should have higher inflation rates.
§2. the long-run trend behavior of a country’s inflation should be similar to the long-run trend in
the country’s money growth rate.
§Are the data consistent with these implications?

>

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
International data on inflation and money growth
Singapore
U.S.
Switzerland
Argentina
Indonesia
Turkey
Belarus
Ecuador

Figure 4-2, p.89
Each variable is measured as an annual average over the period 1996-2004.
The strong positive correlation is evidence for the Quantity Theory of Money.
Source:  International Financial Statistics.

U.S. inflation and money growth,
1960-2007
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0%
3%
6%
9%
12%
15%
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
inflation rate
M2 growth rate
Over the long run, the inflation and money growth rates move together,
as the quantity theory predicts.

The quantity theory of money is intended to explain the long-run relation of inflation and money
growth, not the short-run relation.  In the long run, inflation and money growth are positively
related, as the theory predicts.
(In the short run, however, inflation and money growth appear highly negatively correlated!  One
possible reason is that the causality is reversed in the short run:  when inflation rises – or is
expected to rise – the Fed cuts back on money growth.  If the economy slumps and inflation falls,
the Fed increases money growth.  It might be appropriate to discuss this when covering the chapters
on short-run fluctuations.)
sources:
CPI - BLS
Money supply - Board of Governors of the Federal Reserve
obtained from http://research.stlouisfed.org/fred2/

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Seigniorage
§To spend more without raising taxes or selling bonds, the govt can print money.
§The “revenue” raised from printing money
is called seigniorage
   (pronounced SEEN-your-idge).
§The inflation tax:
Printing money to raise revenue causes inflation.   Inflation is like a tax on people who hold
money.

Introduction of abbreviation “govt” for “government”
It’s quicker and easier for students to write “govt” in their notes.
In the U.S., seigniorage accounts for only about 3% of total government revenue.  In Italy and
Greece, seigniorage has often been more than 10% of total revenue.  In countries experiencing
hyperinflation, seigniorage is often the government’s main source of revenue, and the need to print
money to finance government expenditure is a primary cause of hyperinflation.
See Case Study on p.90 “Paying for the American Revolution.”

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Inflation and interest rates
§Nominal interest rate, i
not adjusted for inflation
§Real interest rate, r
adjusted for inflation:
r  =  i  - p

This is probably review, if your students have taken an introductory course in economics.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
The Fisher effect
§The Fisher equation:    i  = r  + p
§Chap 3:   S  = I   determines r .
§Hence, an increase in p
causes an equal increase in i.
§This one-for-one relationship
is called the Fisher effect.

Note that S and I are real variables.  In chapter 3, we learned about the factors that determine S
and I.  These factors did not include the money supply, velocity, inflation, or other nominal
variables.
Hence, in the classical (long-run) theory we are learning, changes in money growth or inflation do
not affect the real interest rate.  This is why there’s a one-for-one relationship between changes
in the inflation rate and changes in the nominal interest rate.
(Again, the Fisher effect does not imply that the nominal interest rate EQUALS the inflation rate.
It implies that CHANGES in the nominal interest rate equal CHANGES in the inflation rate, given a
constant value of the real interest rate.)

Inflation and nominal interest rates in the U.S., 1955-2007
percent per year
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inflation rate
nominal interest rate
-3%
0%
3%
6%
9%
12%
15%
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005

A replica of Fig 4-3, p.92
The data are consistent with the Fisher effect:  inflation and the nominal interest rate are very
highly correlated.  However, they are not perfectly correlated, which absolutely does not
invalidate the Fisher effect.  Over time, the saving and investment curves move around, causing the
real interest rate to move, which, in turn, causes the nominal interest rate to change for a given
value of inflation.
About the data:
The inflation rate is the percentage change in the (not seasonally adjusted) CPI from 12 months
earlier.
The nominal interest rate is the (not seasonally adjusted) 3-month Treasury bill rate in the
secondary market.
Data obtained from http://research.stlouisfed.org/fred2/

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Inflation and nominal interest rates across countries
Switzerland
Germany
Brazil
Romania
Zimbabwe
Bulgaria
U.S.
Israel

Fig 4-4, p.93
The nominal interest rate is the rate on short-term government debt.  Inflation and interest rates
are measured as annual averages over the period 1996-2004.
The strong positive relation is evidence for the Fisher effect.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Exercise:
§Suppose V  is constant, M is growing 5% per year,
Y  is growing 2% per year, and r = 4.
§a. Solve for i.
§b. If the Fed increases the money growth rate by
2 percentage points per year, find Di.
§c. Suppose the growth rate of Y  falls to 1% per year.
§What will happen to p ?
§What must the Fed do if it wishes to
keep p constant?

>

This exercise gives students an immediate application of the Quantity Theory of Money and the
Fisher effect.  The math is not difficult.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Answers:
§a. First, find  p  = 5 - 2 = 3.
§ Then, find i  = r + p = 4 + 3 = 7.
§b. Di  = 2, same as the increase in the money growth rate.
§c. If the Fed does nothing, Dp = 1.
§ To prevent inflation from rising,
Fed must reduce the money growth rate by
1 percentage point per year.
V  is constant, M  grows 5% per year,
Y  grows 2% per year, r  = 4.

>

                                      Answers---the details:
a.  First, we need to find .  Constant velocity implies  = (M/M) - (Y/Y) = 5 - 2 = 3.   Then, i
= r +  = 4 + 3 = 7.
b.  Changes in the money growth rate do not affect real GDP or its growth rate.  So, a two-point
increase in money growth causes a two-point increase in inflation.  According to the Fisher effect,
the nominal interest rate should rise by the increase in inflation:  two points (from i=7 to i=9).
c.  = (M/M) - (Y/Y).  If (Y/Y) falls by 1 point, then  will increase by 1 point; the Fed can
prevent this by reducing (M/M) by 1 point.   Intuition:  With slower growth in the economy, the
volume of transactions will be growing more slowly, which means that the need for new money will
grow more slowly.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Two real interest rates
§p  = actual inflation rate
 (not known until after it has occurred)
§p e = expected inflation rate
§i  – p e  = ex ante  real interest rate:
the real interest rate people expect
at the time they buy a bond or take out a loan
§i  – p  = ex post  real interest rate:
the real interest rate actually realized

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Money demand and
the nominal interest rate
§In the quantity theory of money,
the demand for real money balances
depends only on real income Y.
§Another determinant of money demand:
the nominal interest rate, i.
§the opportunity cost of holding money (instead of bonds or other interest-earning assets).
§Hence, i  Þ ¯ in money demand.

>

The concept of “money demand” can be a bit awkward for students the first time they learn it.  A
good way to explain it is to imagine that a consumer has a certain amount of wealth, which is
divided between money and other assets.  The other assets typically generate some type of income
(e.g. interest income in the case of bonds), but are much less liquid than money.  There is
therefore a trade-off:  the more money the consumer holds in his portfolio, the more interest
income he foregoes;  the less money he holds, the more interest income he makes, but the less
liquid is his portfolio.
With this for background, a consumer’s “money demand” refers to the fraction of his wealth he would
like to hold in the form of money (as opposed to less-liquid income-generating assets like bonds).

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
The money demand function
§(M/P )d  =  real money demand, depends
§negatively on i
§i  is the opp. cost of holding money
§positively on Y
§higher Y  Þ more spending
§ Þ so, need more money
§(“L” is used for the money demand function because money is the most liquid asset.)

An increase in the nominal interest rate represents the increase in the opportunity cost of holding
money rather than bonds, and would motivate the typical consumer to hold less of his wealth in the
form of money, and more in the form of bonds (or other interest-earning assets).
An increase in real income (other things equal) causes an increase in the consumer’s consumption
and therefore spending.  To facilitate this extra spending, the consumer will require more money.
Thus, the consumer would like a larger fraction of his wealth to be in the form of money (rather
than bonds, etc).  This might involve redeeming some of his bonds.  Or it might simply involve
holding the additional income in the form of money rather than putting it into bonds.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
The money demand function
§When people are deciding whether to hold money or bonds, they don’t know what inflation will turn
out to be.
§Hence, the nominal interest rate relevant for money demand is  r  + p e.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Equilibrium
The supply of real money balances
Real money demand

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
What determines what
§variable how determined (in the long run)
§ M exogenous (the Fed)
§ r adjusts to make S = I
§ Y
§ P adjusts to make

Again, it is very important for students to learn the logical order in which variables are
determined.  I.e., you do NOT need to know P in order to determine Y.  You DO need to know Y in
order to determine L, and you need to know L and M in order to determine P.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
How P  responds to DM
§For given values of r, Y, and p e,
§ a change in M causes P  to change by the same percentage – just like in the quantity theory of
money.

>

This slide shows the connection between the money market equilibrium condition and the (simpler)
Quantity Theory of Money, presented earlier in this chapter.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
What about expected inflation?
§Over the long run, people don’t consistently
over- or under-forecast inflation,
§ so p e = p  on average.
§In the short run, p e may change when people
get new information.
§EX:  Fed announces it will increase M  next year.  People will expect next year’s P  to be higher,
so p e rises.
§This affects P  now, even though M  hasn’t changed yet….

>

This slide and the next correspond to the subsection of Chapter 4 entitled “Future Money and
Current Prices,” appearing on pp.96-97.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
How P  responds to Dp e
§For given values of r, Y, and M ,

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Discussion question
§Why is inflation bad?
§What costs does inflation impose on society?  List all the ones you can think of.
§Focus on the long run.
§Think like an economist.

>

Many of the social costs of inflation are not hard to figure out, if students “think like an
economist.”
Suggestion:  After you pose the question, don’t immediately ask for students to volunteer their
answers.  Instead, tell them to think about the question for a moment, jot down their answers, and
THEN ask for volunteers.  You will get more participation (quantity & quality) this way, especially
from students who don’t consider themselves fast thinkers.
After presenting the following slides (which describe the costs), see how many of the costs
presented here were anticipated by the students’ responses to the question on this slide.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
A common misperception
§Common misperception:
inflation reduces real wages
§This is true only in the short run, when nominal wages are fixed by contracts.
§(Chap. 3)  In the long run,
the real wage is determined by
labor supply and the marginal product of labor,
not the price level or inflation rate.
§Consider the data…

Average hourly earnings and the CPI, 1964-2007
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$0
$2
$4
$6
$8
$10
$12
$14
$16
$18
$20
1965
1970
1975
1980
1985
1990
1995
2000
2005
0
50
100
150
200
250
wage in current dollars
wage in 2007 dollars
CPI (right scale)
slide 45

First, note that the CPI has risen tremendously over the past 40 years.
However, nominal wages have risen by a roughly similar magnitude.
If the common misperception were true, then the real wage should show exactly the opposite behavior
as the CPI.  It doesn’t.  The real wage is not constant - it varies within the range of $15 to $19
- but there is no downward trend in the real wage over the long term.
Note:  We wouldn’t expect the real wage to be constant over the long run – we would expect it to
change in response to shifts in the labor supply and MPL curves.
source:  BLS
Obtained from:
http://research.stlouisfed.org/fred2/

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
The classical view of inflation
§The classical view:
A change in the price level is merely a change in the units of measurement.
So why, then, is inflation a social problem?

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
The social costs of inflation
§…fall into two categories:
§1. costs when inflation is expected
§2. costs when inflation is different than people had expected

>

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
The costs of expected inflation:
1. Shoeleather cost
§def:  the costs and inconveniences of reducing money balances to avoid the inflation tax.
§p  Þ  i
§ Þ  ¯ real money balances
§Remember:  In long run, inflation does not
affect real income or real spending.
§So, same monthly spending but lower average money holdings means more frequent trips to the bank
to withdraw smaller amounts of cash.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
The costs of expected inflation:
 2. Menu costs
§def:  The costs of changing prices.
§Examples:
§cost of printing new menus
§cost of printing & mailing new catalogs
§The higher is inflation, the more frequently firms must change their prices and incur these
costs.
§

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
The costs of expected inflation:
3. Relative price distortions
§Firms facing menu costs change prices infrequently.
§Example:
A firm issues new catalog each January.
As the general price level rises throughout the year, the firm’s relative price will fall.
§Different firms change their prices at different times, leading to relative price distortions…
§ …causing microeconomic inefficiencies
in the allocation of resources.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
The costs of expected inflation:
 4. Unfair tax treatment
§Some taxes are not adjusted to account for inflation, such as the capital gains tax.
§Example:
§Jan 1:  you buy $10,000 worth of IBM stock
§Dec 31:  you sell the stock for $11,000,
so your nominal capital gain is $1000 (10%).
§Suppose p = 10% during the year.
Your real capital gain is $0.
§But the govt requires you to pay taxes on your $1000 nominal gain!!

In the 1970s, the income tax was not adjusted for inflation.  There were a lot of people who
received nominal salary increases large enough to push them into a higher tax bracket, but not
large enough to prevent their real salaries from falling in the face of high inflation. This led to
political pressure to index the income tax brackets.
If inflation had been higher during 1995-2000, when lots of people were earning high capital gains,
then there might have been more political pressure to index the capital gains tax.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
The costs of expected inflation:
 5. General inconvenience
§Inflation makes it harder to compare nominal values from different time periods.
§This complicates long-range financial planning.
§

Examples:
•Parents trying to decide how much to save for the future college expenses of their (now) young
child.
•Thirty-somethings trying to decide how much to save for retirement.
•The CEO of a big corporation trying to decide whether to build a new factory, which will yield a
revenue stream for 20 years or more.
•Your grandmother claiming that things were so much cheaper when she was your age.
A silly digression:  My grandmother often has these conversations with me, concluding that the
dollar just isn’t worth what it was when she was young.
I ask her “well, how much is a dollar worth today?”.  She considers the question, and then offers
her estimate: “About 60 cents.”  I then offer her 60 cents for every dollar she has.  She doesn’t
accept the offer.  :)

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Additional cost of unexpected inflation:
Arbitrary redistribution of purchasing power
§Many long-term contracts not indexed,
but based on p e.
§If p  turns out different from p e,
then some gain at others’ expense.
§ Example:  borrowers & lenders
§If p > p e, then  (i - p) < (i - p e)
and purchasing power is transferred from lenders to borrowers.
§If p < p e, then purchasing power is transferred from borrowers to lenders.

Ask students this rhetorical question:  Would it upset you off if somebody arbitrarily took wealth
away from some people and gave it to others?
   Well, this in effect is what’s happening when inflation turns out different than expected.
   Furthermore, it’s impossible to predict when inflation will turn out higher than expected, when
it will be lower, and how big the difference will be.  So, these redistributions of purchasing
power are arbitrary and random.
The text gives a simple numerical example starting on the bottom of p.100.
(In the short run, when many nominal wages are fixed by contracts, there are transfers of
purchasing power between firms and their employees whenever inflation is different than expected
when the contract was written and signed.)

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Additional cost of high inflation:
Increased uncertainty
§When inflation is high, it’s more variable and unpredictable:
p  turns out different from p e  more often,
and the differences tend to be larger
(though not systematically positive or negative)
§Arbitrary redistributions of wealth
become more likely.
§This creates higher uncertainty,
making risk averse people worse off.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
One benefit of inflation
§Nominal wages are rarely reduced, even when the equilibrium real wage falls.
This hinders labor market clearing.
§Inflation allows the real wages to reach equilibrium levels without nominal wage cuts.
§Therefore, moderate inflation improves the functioning of labor markets.

>

Students will better appreciate this point when they learn chapter 6 (the natural rate of
unemployment).  In this chapter, we will see how the failure of wages to adjust contributes to a
long-term unemployment problem.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Hyperinflation
§def:  p  ³ 50% per month
§All the costs of moderate inflation described
above become HUGE under hyperinflation.
§Money ceases to function as a store of value, and may not serve its other functions (unit of
account, medium of exchange).
§People may conduct transactions with barter or a stable foreign currency.

Page 104 has an excellent example of life during a hyperinflation, which involves beer, a commodity
with which your students may be somewhat familiar.  See also the excellent case study on
pp.104-105.
Note:  On p.103, the text states “Hyperinflation is often defined as inflation that exceeds 50
percent per month.”   I’ve included this definition at the top of this slide, to be consistent with
the textbook.  However, some professors are a bit uncomfortable assigning a specific number (such
as 50% per month) to the definition of hyperinflation, because, for example, most would agree that
49% per month inflation is high enough to be considered hyperinflation.  The definition I like to
use in my own teaching is this:
    hyperinflation:  a really, really, really high rate of inflation
Feel free to edit the definition of “hyperinflation” on this slide if you wish.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
What causes hyperinflation?
§Hyperinflation is caused by excessive money supply growth:
§When the central bank prints money, the price level rises.
§If it prints money rapidly enough, the result is hyperinflation.

>

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
A few examples of hyperinflation
money growth (%)
inflation (%)
Israel, 1983-85
295
275
Poland, 1989-90
344
400
Brazil, 1987-94
1350
1323
Argentina, 1988-90
1264
1912
Peru, 1988-90
2974
3849
Nicaragua, 1987-91
4991
5261
Bolivia, 1984-85
4208
6515

Examples of hyperinflation from the textbook:
1.  interwar Germany (data and discussion)
2.  Bolivia in 1985 (Case Study)
This table provides data on Bolivia’s hyperinflation, and some additional examples.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Why governments create hyperinflation
§When a government cannot raise taxes or sell bonds, it must finance spending increases by printing
money.
§In theory, the solution to hyperinflation is simple:  stop printing money.
§In the real world, this requires drastic and painful fiscal restraint.

Before revealing the contents of this slide, you might consider asking students the following
question:
“Solving the problem of hyperinflation is easy.  Why, then, do governments allow hyperinflation to
occur?”

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
The Classical Dichotomy
§Real variables: Measured in physical units – quantities and relative prices, for example:
§quantity of output produced
§real wage:  output earned per hour of work
§real interest rate:  output earned in the future
by lending one unit of output today
§Nominal variables:  Measured in money units, e.g.,
§nominal wage:  Dollars per hour of work.
§nominal interest rate:  Dollars earned in future
by lending one dollar today.
§the price level:  The amount of dollars needed
to buy a representative basket of goods.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
The Classical Dichotomy
§Note:  Real variables were explained in Chap 3, nominal ones in Chapter 4.
§Classical dichotomy:
the theoretical separation of real and nominal variables in the classical model, which implies
nominal variables do not affect real variables.
§Neutrality of money:  Changes in the money supply do not affect real variables.
§ In the real world, money is approximately neutral in the long run.

Chapter Summary
§Money
§the stock of assets used for transactions
§serves as a medium of exchange, store of value, and unit of account.
§Commodity money has intrinsic value, fiat money does not.
§Central bank controls the money supply.
§Quantity theory of money assumes velocity is stable, concludes that the money growth rate
determines the inflation rate.
CHAPTER 4   Money and Inflation
slide 62
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>

Chapter Summary
§Nominal interest rate
§equals real interest rate + inflation rate
§the opp. cost of holding money
§Fisher effect:  Nominal interest rate moves
one-for-one w/ expected inflation.
§Money demand
§depends only on income in the Quantity Theory
§also depends on the nominal interest rate
§if so, then changes in expected inflation affect the current price level.
CHAPTER 4   Money and Inflation
slide 63
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>

Chapter Summary
§Costs of inflation
§Expected inflation
shoeleather costs, menu costs,
tax & relative price distortions,
inconvenience of correcting figures for inflation
§Unexpected inflation
all of the above plus arbitrary redistributions of wealth between debtors and creditors
CHAPTER 4   Money and Inflation
slide 64
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>

Chapter Summary
§Hyperinflation
§caused by rapid money supply growth when money printed to finance govt budget deficits
§stopping it requires fiscal reforms to eliminate
govt’s need for printing money
CHAPTER 4   Money and Inflation
slide 65
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>

Chapter Summary
§Classical dichotomy
§In classical theory, money is neutral--does not affect real variables.
§So, we can study how real variables are determined w/o reference to nominal ones.
§Then, money market eq’m determines price level and all nominal variables.
§Most economists believe the economy works this way in the long run.
§
CHAPTER 4   Money and Inflation
slide 66
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>

MACROECONOMICS
cover art ROW 1 (90)
C H A P T E R
© 2008 Worth Publishers, all rights reserved
SIXTH EDITION
PowerPoint® Slides by Ron Cronovich
N. GREGORY MANKIW
Money Supply and Money Demand
18

This chapter is particularly good for students with interests in money and banking and finance.
The first half of this chapter covers money supply, including money creation in the banking system,
and how the central bank controls the money supply.  Much of this material is review for most
students who took a macro principles course.   However, this chapter presents a model of the money
multiplier that is more realistic than the models found in most principles texts.
The second half of the chapter presents several theories of money demand.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
In this chapter, you will learn…
§how the banking system “creates” money
§three ways the Fed can control the money supply, and why the Fed can’t control it precisely
§Theories of money demand
§a portfolio theory
§a transactions theory:  the Baumol-Tobin model

>

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Banks’ role in the money supply
§The money supply equals currency plus
demand (checking account) deposits:
§ M  =  C  +  D
§Since the money supply includes demand deposits, the banking system plays an
important role.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
A few preliminaries
§Reserves (R ):  the portion of deposits that banks have not lent.
§A bank’s liabilities include deposits,
§ assets include reserves and outstanding loans.
§100-percent-reserve banking:  a system in which banks hold all deposits as reserves.
§Fractional-reserve banking:
a system in which banks hold a fraction of their deposits as reserves.

It might be worthwhile at this point to explain why deposits are liabilities and why reserves and
loans are assets.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
SCENARIO 1:
No banks
§With no banks,
D  = 0   and   M  =  C  =  $1000.

>

In this and the following examples, we assume there is $1000 in currency circulating in the
economy.
We then compare the size of the money supply in different scenarios about the banking system:  no
banks, 100% reserve banking, and fractional reserve banking.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
SCENARIO 2:
100-percent reserve banking
§After the deposit,
  C = $0,
  D = $1,000,
  M = $1,000.
§100%-reserve banking has no impact on size of money supply.
FIRSTBANK’S
balance sheet
Assets
Liabilities
reserves  $1,000
deposits  $1,000
§Initially    C = $1000,  D = $0,  M = $1,000.
§Now suppose households deposit the $1,000 at “Firstbank.”

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
FIRSTBANK’S
balance sheet
Assets
Liabilities
reserves  $1,000
reserves  $200
loans  $800
SCENARIO 3:
Fractional-reserve banking
§The money supply now equals $1,800:
§Depositor has $1,000 in
demand deposits.
§Borrower holds $800 in currency.
deposits  $1,000
§Suppose banks hold 20% of deposits in reserve, making loans with the rest.
§Firstbank will make $800 in loans.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
SCENARIO 3:
Fractional-reserve banking
FIRSTBANK’S
balance sheet
Assets
Liabilities
reserves  $200
loans  $800
deposits  $1,000
Thus, in a fractional-reserve
banking system, banks create money.
The money supply now equals $1,800:
§Depositor has $1,000 in
demand deposits.
§Borrower holds $800 in currency.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
SECONDBANK’S
balance sheet
Assets
Liabilities
reserves  $800
loans  $0
reserves  $160
loans  $640
SCENARIO 3:
Fractional-reserve banking
§Secondbank will loan 80% of this deposit.
deposits  $800
§Suppose the borrower deposits the $800 in Secondbank.
§Initially, Secondbank’s balance sheet is:

Maybe the borrower deposits the $800 in the bank.  Or maybe the borrower uses the money to buy
something from someone else, who then deposits it in the bank.  In either case, the $800 finds its
way back into the banking system.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
SCENARIO 3:
Fractional-reserve banking
THIRDBANK’S
balance sheet
Assets
Liabilities
deposits  $640
§If this $640 is eventually deposited in Thirdbank,
§then Thirdbank will keep 20% of it in reserve,
and loan the rest out:
reserves  $640
loans  $0
reserves  $128
loans  $512

Again, the person who borrowed the $640 will either deposit it in his own checking account, or will
use it to buy something from somebody who, in turn, deposits it in her checking account.  In either
case, the $640 winds up in a bank somewhere, and that bank can then use it to make new loans.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Finding the total amount of money:
§ Original deposit = $1000
§ + Firstbank lending = $ 800
§ + Secondbank lending = $ 640
§ + Thirdbank lending = $ 512
§ + other lending…
Total money supply = (1/rr ) ´ $1,000
   where rr  = ratio of reserves to deposits
In our example, rr  = 0.2, so  M  =  $5,000

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Money creation in the banking system
Plaid
A fractional reserve banking system creates money, but it doesn’t create wealth:
Bank loans give borrowers some new money
and an equal amount of new debt.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
A model of the money supply
§Monetary base,  B  =  C  + R
§controlled by the central bank
§Reserve-deposit ratio,  rr  =  R/D
§depends on regulations & bank policies
§Currency-deposit ratio,  cr = C/D
§depends on households’ preferences
exogenous variables

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Solving for the money supply:
where

The point of all this algebra is to express the money supply in terms of the
three exogenous variables described on the preceding slide.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
The money multiplier
§If rr < 1,  then m  > 1
§If monetary base changes by DB,
then   DM  =  m  ´ DB
§m  is the money multiplier,
the increase in the money supply resulting from a one-dollar increase
in the monetary base.
where

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Exercise
§Suppose households decide to hold more of their money as currency and less in the form of demand
deposits.
1. Determine impact on money supply.
2. Explain the intuition for your result.
where

>

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Solution to exercise
§Impact of an increase in the currency-deposit ratio
Dcr > 0.
1.An increase in cr  increases the denominator
of m  proportionally more than the numerator. So m  falls, causing M to fall.
2.If households deposit less of their money,
then banks can’t make as many loans,
so the banking system won’t be able to
“create” as much money.

>

Note:
An increase in cr  raises both the numerator and denominator of the expression for m.  But since rr
< 1, the denominator is smaller than the numerator, so a given increase in cr will increase the
denominator proportionally more than the numerator, causing a decrease in m.
If your students know calculus, they can use the quotient rule to see that (dm/dcr) < 0.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Three instruments of
monetary policy
§1. Open-market operations
§2. Reserve requirements
§3. The discount rate

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Open-market operations
§definition:
The purchase or sale of government bonds by the Federal Reserve.
§how it works:
If Fed buys bonds from the public,
it pays with new dollars, increasing B  and therefore M.

>

Why it’s called “open market operations”:
The “operations” are the buying and selling.  The market in which U.S. Treasury bonds are traded is
“open” in the sense that anyone---you, me, your Aunt Zelda, the Fed---can buy or sell in this
market.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Reserve requirements
§definition:
Fed regulations that require banks to hold a minimum reserve-deposit ratio.
§how it works:
Reserve requirements affect rr and m:
If Fed reduces reserve requirements,
then banks can make more loans and
“create” more money from each deposit.

>

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
The discount rate
§definition:
The interest rate that the Fed charges on loans it makes to banks.
§how it works:
When banks borrow from the Fed, their reserves increase, allowing them to make more loans and
“create” more money.
§ The Fed can increase B  by lowering the discount rate to induce banks to borrow more reserves
from the Fed.

>

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Which instrument is used most often?
§Open-market operations:
most frequently used.
§Changes in reserve requirements:
least frequently used.
§Changes in the discount rate:
largely symbolic.
The Fed is a “lender of last resort,”
does not usually make loans to banks
on demand.

>

Why not reserve requirements?
Making them too low creates a risk of bank runs.  Making them too high makes banking unprofitable.
In addition, banking would be difficult if the Fed changed reserve requirements frequently.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Why the Fed can’t precisely control M
§Households can change cr,
causing m and M  to change.
§Banks often hold excess reserves
(reserves above the reserve requirement).
§ If banks change their excess reserves,
then rr, m, and M change.
where

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
CASE STUDY:
Bank failures in the 1930s
§From 1929 to 1933,
§Over 9,000 banks closed.
§Money supply fell 28%.
§This drop in the money supply may have caused the Great Depression.
§ It certainly contributed to the severity of the Depression.

>

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
CASE STUDY:
Bank failures in the 1930s
§Loss of confidence in banks
Þ cr  Þ ¯m
§Banks became more cautious
Þ rr  Þ ¯m
where

>

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
CASE STUDY:
Bank failures in the 1930s
March 1933
% change
0.41
0.21
2.3
141.2
50.0
–37.8
0.17
cr
0.14
rr
3.7
m
2.9
5.5
8.4
–9.4
41.0
18.3
3.2
R
3.9
C
7.1
B
13.5
5.5
19.0
–40.3
41.0
–28.3%
22.6
D
3.9
C
26.5
M
August 1929

Table 18-1, p.517. Source:  Adapted from Milton Friedman and Anna Schwartz, A Monetary History of
the United States, 1867-1960 (Princeton, NJ:  Princeton University Press, 1963), Appendix A.
To the table, I have added an extra column with the percent changes.
I have animated the table so that the rows appear in three groups.
•First group:  M, C, and D, because M = C + D
•Second group:  B, C, and R, because B = C + R
•Third group:  m and its components, rr and cr
The base rises, yet the money multiplier falls so much that the money supply falls.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Could this happen again?
§Many policies have been implemented since the 1930s to prevent such widespread bank failures.
§E.g., Federal Deposit Insurance,
to prevent bank runs and large swings in the currency-deposit ratio.

>

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Money Demand
§Two types of theories
§Portfolio theories
§emphasize “store of value” function
§relevant for M2, M3
§not relevant for M1.   (As a store of value,
M1 is dominated by other assets.)
§Transactions theories
§emphasize “medium of exchange” function
§also relevant for M1

>

Why portfolio theories are not relevant for M1:
As a store of value, M1 is dominated by other assets:  other assets serve the store of value
function as well as M1, but offer a better risk/return profile, so there is no reason why anybody
would hold M1 for a store of value.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
A simple portfolio theory
§where
§rs  = expected real return on stocks
§rb  = expected real return on bonds
§p e = expected inflation rate
§W = real wealth

Intuition for the signs:
Stocks and bonds are alternatives to money.  An increase in their expected returns makes money less
attractive, and thus reduces desired money holdings.
The real return to holding money is -^e.  An increase in ^e  is a decrease in the real return to
holding money, which would cause a decrease in desired money balances.
And finally, an increase in wealth causes an increase in the demand for all assets.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
The Baumol-Tobin Model
§a transactions theory of money demand
§notation:
§Y = total spending, done gradually over the year
§i  = interest rate on savings account
§N = number of trips consumer makes to the bank
   to withdraw money from savings account
§F = cost of a trip to the bank
   (e.g., if a trip takes 15 minutes and
    consumer’s wage = $12/hour, then F = $3)

>

In the Baumol-Tobin model, we assume for simplicity that the consumer’s wealth is divided between
cash on hand and savings account deposits.  The savings account pays interest rate i, while cash
pays no nominal interest.
Alternatively, we can think of “money” in the Baumol-Tobin model as representing all monetary
assets, including some that pay interest.  Then, i  in the model would be the interest rate on
non-monetary assets (e.g. stocks & bonds) minus the interest rate on monetary assets
(interest-bearing checking & money market deposit accounts).  F would be the cost of converting
non-monetary assets into monetary ones, such as a brokerage fee.  The decision about how often to
pay the brokerage fee is analogous to the decision about how often to make a trip to the bank.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Money holdings over the year
§N = 1
Y
Money holdings
Time
1
Average
= Y/ 2

Figure 18-1 on p.521.
Our first step:  compute average money holdings as a function of N.
(Then, we will find the optimal value of N.)
If N=1, then the consumer withdraws $Y from her savings account at the beginning of the year.  As
she spends it gradually throughout the year, her money holdings fall.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Money holdings over the year
Money holdings
Time
1
1/2
Average
= Y/ 4
Y/ 2
Y
N = 2

Figure 18-1 on p.521.
If N = 2, consumer makes one trip at the beginning of the year, withdraws half of the money she
will spend throughout the year.  She spends it gradually over the first half of the year until it
runs out.  Then she makes another trip, withdrawing enough money to last her the second half of the
year, and spends it down gradually.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Money holdings over the year
Average
= Y/ 6
1/3
2/3
Money holdings
Time
1
Y/ 3
Y
N = 3

Figure 18-1 on p.521.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
The cost of holding money
§In general, average money holdings = Y/2N
§Foregone interest = i ´(Y/2N )
§Cost of N  trips to bank = F ´N
§Thus,
§Given Y, i, and F,
consumer chooses N  to minimize total cost

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Finding the cost-minimizing N
N*

Figure 18-2 on p.523.
(For any value of N, the height of the red line equals the height of the blue line plus the height
of the green line at that N.)
This slide shows the graphical derivation of N*.
The following slide uses basic calculus to derive an expression for N*.   It is “hidden” and can be
omitted without loss of continuity.  If you display it, then before leaving this slide you might
point out that the slope of the cost function (red line) equals zero at N*.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Finding the cost-minimizing N
§Take the derivative of total cost with respect to N, set it equal to zero:
§Solve for the cost-minimizing N*

This slide uses calculus to derive N*.   Since a calculus background is not assumed, I have
“hidden” this slide.  If you wish to include it in your presentation, click on the Slide Show
drop-down menu, and unselect “Hide Slide”.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
The money demand function
§The cost-minimizing value of N :
§To obtain the money demand function,
plug N*  into the expression for average money holdings:
§Money demand depends positively on Y  and F, and negatively on i.

If you did not show your students the slide with the calculus derivation of the expression for N*,
then you can just say
“it turns out that N* is equal to this expression….”

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
The money demand function
§The Baumol-Tobin money demand function:
How this money demand function differs from
previous chapters:
§B-T shows how F  affects money demand.
§B-T implies:
income elasticity of money demand = 0.5,
interest rate elasticity of money demand = -0.5

Page 523 of the text contains a very nice paragraph discussing
things that alter F, and hence money demand:
•automatic teller machines
•internet banking
•wages (higher wages increase the opportunity cost of time spent visiting the bank)
•bank or brokerage fees

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
EXERCISE:
The impact of ATMs on money demand
§During the 1980s,
automatic teller machines became widely available.
§How do you think this affected N*  and money demand?  Explain.
RF5060297

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Answer:
(From p.523)
“The spread of automatic teller machines reduces F by reducing the time it takes to withdraw
money.”
Lower F increases N* and decreases money demand - you can see this from the expressions N* and
money demand.
A decrease in the cost of withdrawing money allows consumers to hold lower real money balances
relative to their spending, so they can keep more of their money in interest-bearing bank
accounts.  Of course, they will need to make more trips to the bank now, but doing so is less
costly.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Financial Innovation, Near Money, and
the Demise of the Monetary Aggregates
§Examples of financial innovation:
§many checking accounts now pay interest
§very easy to buy and sell assets
§mutual funds are baskets of stocks that are easy to redeem - just write a check
§Non-monetary assets having some of the liquidity of money are called near money.
§Money & near money are close substitutes,
and switching from one to the other is easy.

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CHAPTER 4   Money and Inflation
CHAPTER 4   Money and Inflation
Financial Innovation, Near Money, and
the Demise of the Monetary Aggregates
§The rise of near money makes money demand less stable and complicates monetary policy.
§1993:  the Fed switched from targeting monetary aggregates to targeting the Federal Funds rate.
§This change may help explain why the U.S. economy was so stable during the rest of the 1990s.

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Chapter Summary
§1. Fractional reserve banking creates money because each dollar of reserves generates many dollars
of demand deposits.
§2. The money supply depends on the
§monetary base
§currency-deposit ratio
§reserve ratio
§3. The Fed can control the money supply with
§open market operations
§the reserve requirement
§the discount rate
CHAPTER 18   Money Supply and Money Demand
slide 108
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Chapter Summary
§4. Portfolio theories of money demand
§stress the store of value function
§posit that money demand depends on risk/return of money & alternative assets
§5. The Baumol-Tobin model
§a transactions theory of money demand,
stresses “medium of exchange” function
§money demand depends positively on spending, negatively on the interest rate,
and positively on the cost of converting
non-monetary assets to money
CHAPTER 18   Money Supply and Money Demand
slide 109
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