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Econ 100b

Created 4/30/1996
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Lecture Eight

Money and Inflation
(Economics 100b; Spring 1996)

Professor of Economics J. Bradford DeLong
601 Evans, University of California at Berkeley
Berkeley, CA 94720
(510) 643-4027 phone (510) 642-6615 fax
delong@econ.berkeley.edu
http://www.j-bradford-delong.net

February 5, 1996


Feedback
What Is "Money"?
The "Quantity" of "Money"
Nominal Spending as Determined by the Quantity of Money

Feedback

Feedback, necessity of, in such a large course...
Still a few bugs in the system: apology for handout error...

What Is "Money"?

You have already encountered the phenomenon that economists use familiar words in unfamiliar, technical ways: if I buy a share of Apple Computer from you, and you take the money and use it to buy xerox paper, then that is not an "investment" as economists use the word. But if I buy a newly-issued share of, say, Visioneer Corporation, and if the money then flows into Visioneer's corporate accounts and is used not to build a factory but to add to the pile of scannersin Visioneer's warehouse, that is investment--investment in inventories.

Economists use the word "money" in a similar, technical, not very intuitive way. To an economist, "money" is wealth in the form of ready purchasing power. To the world at large, "money" is much closer to being a synonym for "wealth" or "income". Beware of this definitional, technical phenomenon. If you forget it, you may well get tripped up.

Almost every economics textbook refers to three functions of money:


Store of value. You want to put your wealth in the form of "money" because you are pretty certain that "money" will not decline in value between now and next week (or next year).

Unit of account. You (and everyone else) quotes prices and reckons debts and contracts in "money" for convenience and transparency. Double coincidence of wants

Medium of exchange
. You (and everyone else) are willing to accept "money" as payment when you sell something. Legal tender. Digression on gold clauses?

Commodity money/ gold/ gold standard/ fiat money. Why use fiat money? A lot cheaper to produce. The people who would otherwise be producing commodity money can be employed doing something more useful...

Why use commodity money? Fear of inflation/default. Change in yardstick...

Natural resolution? Use fiat money as a means of payment, but commodity money as a unit of account/store of value. However, we almost never see this arrangement, especially not today...

Digression on indexed bonds. Tesebonos...

The coincidence of the medium of exchange function with the unit of account function can lead to trouble, in the form of inflation, as we will see...


The "Quantity" of "Money"

The "quantity" of "money" is a medium-of-exchange function. (Amounts as of December 1994)

High-powered money:

Demand deposits:

High-powered money plus demand deposits = "M1" ($1,147 billion (note double counting))

"Amphibians"


M1 plus amphibians = "M2" ($3,293 billion)

To get to "M3" ($3,451 billion) add:


To get to "L" ($4,409 billion), add:


And I'm sorry, I have forgotten what "other liquid assets" means. Bankers' acceptances; commercial paper; and something else..

You will see that none of these have much relevance for "unit of account"; but all have relevance for "medium of exchange"


Nominal Spending as Determined by the Quantity of Money

Why pay attention to this forest of "Ms"? Because there is a very real sense in which all of these assets are held to spend. No one keeps money in their checking account--or no one should keep money in their checking account--if they are not going to spend it. At the moment my wife and I have a--rather large--sum in our checking account because this spring we are planning to buy a car and a house.

And so when people pile up their wealth into the form of these "Ms", they do so because they are planning to spend it. And spend it they do, at a more-or-less constant rate.

The quantity equation:

M V = P Y

V is the income velocity of money. Different Vs for each M concept...

Quantity equation an identity. Quantity "theory" is the quantity equation plus the prediction that velocity V is not going to change much.

Implication is that if you know M, and if you can forecast V, then you know nominal GDP--you know P times Y.

Is velocity that stable? Well, look and see...





Goodhart's law
Alan Blinder and Janet's attempt to get the FOMC to take their monetary targets seriously...
The Volcker deflation; Henry Wallich and Charles Schultze on the benefits and dangers of switching from targetting i's to targetting M's.


>

Econ 100b

Created 4/30/1996
Go to
Brad De Long's Home Page


Professor of Economics J. Bradford DeLong, 601 Evans
University of California at Berkeley
Berkeley, CA 94720-3880
(510) 643-4027 phone (510) 642-6615 fax
delong@econ.berkeley.edu
http://www.j-bradford-delong.net/