Macroeconomics

Chapter 7:
The Asset Market, Money, and Prices

ECON2220 Intermediate Macroeconomics

Jinglun Yao
Autumn 2025

Copyright © 2020 Pearson Education Ltd. 1

Overview
• First half: Long-run economic growth

• Second half: Short-run economic fluctuations (business cycles)

• Chapter 7 (Money/Asset market)

2
Overview
• So far, in Chapter 3, 4, and 6, we focused on models with real
variables
• Output, employment, consumption, savings, investment

• All prices were real prices (measured in the unit of goods like oranges).

• No money, so no nominal prices (measured in the unit of dollars)

• We introduce money in this chapter.

3
Chapter Outline
• What Is Money?
• Portfolio Allocation and the Demand for Assets
• The Demand for Money
• Asset Market Equilibrium
• Money Growth and Inflation in the Long Run

4
What Is Money?
• Money
• Assets that are widely used and accepted as payment
• Matter of degree
• Currency (coin/paper money), check, gold, bank deposit (checking/saving
account), Octopus card, etc.

• Three functions of money

• Medium of exchange
• Unit of account
• Store of value

5
What Is Money?
• The functions of money
• Medium of exchange
• Barter is inefficient—double coincidence of wants (i.e. both parties have to agree
with the trade)
• e.g., You want to sell oranges and want to buy apples. Without money, you
need to find someone who wants to sell apples and buy oranges.
• Money allows people to trade their labor for money, then use the money to buy
goods and services in separate transactions
• Money permits people to trade with less cost in time and effort
• Facilitates the division of labor in society

6
What Is Money?
• The functions of money
• Unit of account
• Money is the basic unit for measuring economic value
• Prices in the Hong Kong dollar (HKD)
• Simplifies comparisons of prices, wages, and incomes

7
What Is Money?
• The functions of money
• Store of value
• Money can be used to hold wealth
• Most people use money only as a store of value for a short period and for small
amounts, because it earns less interest than money in the bank

8
What Is Money?
• The distinguishing economic feature of money is its medium-of-
exchange role
• There are other assets such as stocks, bonds, and housing that serve the
store-of-value role that is served by money
• However, there are difficulties in using these other assets in exchange
• Imperfect information: difficult to get the clerk in a convenience store to
accept a stock certificate in exchange for a candy bar, as the clerk does not
know the market value of the stock certificate
• Some assets come in large denominations and are difficult to use for small
purchases (smallest denomination of treasury bills : $1000)
• It takes time to sell assets at their market value

9
What Is Money?
• Brief history of money
• 1st stage: Money as a commodity
• Gold, silver or other valuable items
• Government issued coins
• Money has intrinsic value (fundamental/objective value)
• 2nd stage: Paper money
• “Gold certificates”: People could exchange government/bank issued certificates
with actual gold
• Fiat money: No intrinsic value, not backed by any commodity
• 3rd stage: E-money (Electronic/digital money)
• Stored in computers/in digital forms
• Bank deposits, Octopus card
• No dollar bills, coins, gold

10
What Is Money?
• Measuring money
• Distinguishing what is money from what isn’t money is sometimes difficult
• Cash (coin, paper money)
• Saving account, checking account, time deposits

• There’s no single best measure of money

• Definitions are different across countries and have changed over time

11
What Is Money?
• The M1 monetary aggregate
• Currency (coins and paper money) held by the public
• Demand deposits
• Deposits in your bank account that you can withdraw anytime without notice
• Checking accounts
• Saving accounts
• Pay (low) interest
• Saving accounts were added to M1 in 2021

12
What Is Money?
• The M2 monetary aggregate
• M2 = M1 + less money like assets

• Additional assets in M2
• Small (< $100,000) time deposits
• A type of bank account where you deposit money for a fixed period and
receive an interest rate (penalty for early withdrawal)
• Individual money market funds
• A type of mutual fund (pooled investment fund) that invests your money in low-
risk, short-term securities, cash, and cash-equivalents
• You can invest through a brokerage or investment account (not a deposit account
offered by a bank)
• You can liquidate your investment within a day or two

13
What Is Money?
• Monetary base (MB)
• Currency held by the public
• Reserves (reserve balances)
• Banks have an account at the central bank in which they hold deposits.
• Not included in M1 and M2

• Narrow definition of money

• The Fed can directly control this

14
FRED Graph
MB, M1, and M2 in the U.S.
• MB (blue solid),
M1(red dot),
M2(green dash)
• All as a fraction of
GDP (100 = 100%)

Saving accounts
added to M1

15
What Is Money?
• Next, we consider money market equilibrium
• Money supply
• Money demand
• Money supply = money demand

• The money supply

• A central bank (or the government) controls money supply
• The US central bank is the Federal Reserve System
• Sometimes called the Federal Reserve, or the Fed

16
What Is Money?
• How does the central bank increase money supply?
• Conventional procedure: Open market operations
• Use newly printed money to buy financial assets from the public—an open-
market purchase
• Usually, the Fed buys short-term Treasury securities (government bonds in
the US) from banks
• Example
• The Fed buys U.S. Treasury securities from Citibank ($100)
• Reserve balance held by Citibank increase by $100
• Overall, MB increased by $100

17
What Is Money?
• To reduce the money supply, sell financial assets to the public to
remove money from circulation—an open-market sale

• How does the MB affect the money supply (M1/M2)?

• Can the central bank control M1/M2?
• Money multiplier
• How much the money supply increases when the MB increases by $1
𝑀 = 𝑚 × 𝑀𝐵

• 𝑀: Money supply; this might be M1 or M2

• 𝑚: Money multiplier
• 𝑀𝐵: Monetary base
18
What Is Money?
• By definitions,
• 𝑀𝐵 = 𝐶 + 𝑅
•𝑀 = 𝐶 + 𝐷
• 𝐶: Currency, 𝑅: Reserves, 𝐷: Deposits

• Money multiplier 𝑚 is
𝐶
𝑀 𝐶+𝐷 𝐷+1
𝑚≡ = =
𝑀𝐵 𝐶 + 𝑅 𝐶 + 𝑅
𝐷 𝐷
𝐶 𝑅
• : Currency deposit ratio, : Reserve ratio
𝐷 𝐷

19
What Is Money?
𝑅
• A central bank can control 𝑀𝐵 and (to some extent)
𝐷
• Banks are required to have a certain fraction of deposits as reserves
• This is called required reserve ratio
• The Fed did not pay interest on reserves before 2008. So, banks try to make
loans as much as possible to earn more interest.
𝑅
• If the required reserve ratio is 10%, can be as low as 0.1.
𝐷
• How can 𝐷 > 𝑅 happen? Banks can increase the amount of your deposit without
having actual cash/reserves.
• From 2020, 0% required reserve ratio in the US

20
FRED Graph
M1 Money Multiplier in the US
• Money multiplier =
M1/MB

21
What Is Money?
• The central bank cannot directly control 𝑀
• 𝑀 = 𝑚 × 𝑀𝐵, but 𝑚 may change.

• After the Great Recession, the way the Fed conducts monetary policy
has changed
• Now, the Fed sets the interest on reserve balances (IORB) rate
• No reserve balance requirement
• Interest-rate-focused policy
• More on this later

22
Portfolio Allocation and the Demand for Assets
• Next, let’s consider money demand
• How do people allocate their wealth among various assets? The
portfolio allocation decision

• You have 1m HKD worth wealth and want to allocate it across

different assets
• Money vs other assets(Bonds/Stocks/Houses, etc.)

• We can derive money demand function

23
Portfolio Allocation and the Demand for Assets
• How is the demand for money determined?

• Determinants of the demand for assets

• Expected return
• Risk
• Liquidity
• Time to maturity

24
Portfolio Allocation and the Demand for Assets
• Expected return
• Expected gain/loss of your investment per unit of time
• Saving account: interest rate
• Stock: dividend yield + percent increase in stock price

• Investors want assets with the highest expected return (other things equal)

• Returns are not known in advance, so people estimate their expected return

25
Portfolio Allocation and the Demand for Assets
• Risk
• Risk is the degree of uncertainty in an asset’s return

• People don’t like risk, so they prefer assets with low risk (other things equal)

• Money has low risk compared to stocks and bonds

• Risk premium: the amount by which the expected return on a risky asset
exceeds the return on an otherwise comparable safe asset
• e.g., government bonds vs. corporate bonds

26
Portfolio Allocation and the Demand for Assets
• Liquidity
• Liquid asset: An asset that can be traded quickly and easily without much cost

• Money is very liquid

• Assets like houses/apartments are very illiquid— long time and large
transaction costs to trade them

• Stocks and bonds are fairly liquid

• Investors prefer liquid assets (other things equal)

27
Portfolio Allocation and the Demand for Assets
• Time to maturity
• Time to maturity (maturity of bonds): the remaining period until a bond
matures (expires)

• For simply, you can assume the maturity of a bond is one year in a model.
• e.g., 1-year government bond

28
Portfolio Allocation and the Demand for Assets
• Types of assets and their characteristics
• People hold many different assets, including money, bonds, stocks, houses,
and consumer durable goods
• Money has a low return, but low risk and high liquidity

• Bonds and stocks have a higher return than money, but have more risk and less
liquidity

• Housing provides housing services and the potential for capital gains, but is quite
illiquid

• Households must consider what mix of assets they wish to own

29
Table 7.2: Household Assets, 2006, 2009, and 2021

30
Portfolio Allocation and the Demand for Assets
• Asset Demands
• Trade-off among expected return, risk, liquidity, and time to maturity
• The sum of asset demands equals total wealth
• You allocate your wealth (e.g., 1m HKD) across different assets

• How much money do people want to hold in their portfolios?

• Money demand

31
The Demand for Money
• The demand for money
• As an asset, money demand depends on expected return, risk, and liquidity

• Money is the most liquid asset

• Money pays a low return (0 nominal return on currency)

• People’s money-holding decisions depend on how much they value liquidity

against the low return on money

32
The Demand for Money
• Key macroeconomic variables that affect money demand

• Liquidity (for transactions)

• Price level
• Real income

• Return (as an asset)

• Interest rate on other assets

33
The Demand for Money
• Price level
• The higher the price level, the more money you need for transactions

• Prices are 10 times as high today as 65 years ago, so it takes 10 times as much
money for equivalent transactions

• Nominal money demand is thus proportional to the price level

• Price of one orange 65 years ago = $1
• Price of one orange today = $10
• You need 10 times more money to buy an orange today

34
The Demand for Money
• Real income
• The more transactions you conduct, the more money you need

• Real income is a prime determinant of the number of transactions you

conduct

• So, money demand rises as real income (real GDP) rises

35
The Demand for Money
• Real income
• Money demand is proportional/less than proportional to real income.

• Higher-income individuals may use money more efficiently, and since a

country’s financial sophistication grows as its income rises (use of credit and
more sophisticated assets)
• Robinson’s income = 1m HKD
• Friday’s income = 10m HKD
• Suppose Robinson holds 10% (0.1m HKD) as money (currency + checking and
saving accounts). Friday may hold 10% or less (1m HKD or less) as money.

• Money demand rises 1 for 1 or less than 1 for 1 with a rise in real income

36
The Demand for Money
• Interest rates
• An increase in the interest rate or return on nonmonetary assets decreases
the demand for money
• Nonmonetary assets: Bonds, stocks, etc.

• Though there are many nonmonetary assets with many different interest
rates, because they often move together, we assume that for nonmonetary
assets there’s just one nominal interest rate, 𝑖

• For simplicity, assume there is no interest on money

• It’s easier to understand if you assume money is cash and nonmonetary assets
are government bonds/saving accounts

37
The Demand for Money
• The money demand function
𝑀𝑑 = 𝑃 × 𝐿 𝑌, 𝑖
• 𝑀𝑑 is nominal money demand
• 𝑃 is the price level
• 𝐿 is the real money demand function
• 𝑌 is real income (GDP)
• 𝑖 is the nominal interest rate on nonmonetary assets

• Nominal money demand is proportional to the price level

• A rise in 𝑌 increases money demand
• A rise in 𝑖 reduces money demand
• This type of money demand function is called liquidity preference theory
(developed by Keynes)
38
The Demand for Money
• The money demand function
• Alternative expression
𝑀𝑑
= 𝐿 𝑌, 𝑖
𝑃
𝑀𝑑
• In terms of real money demand =
𝑃

39
The Demand for Money
• Other factors affecting money demand
• Wealth: A rise in wealth may increase money demand
• Risk
• Increased riskiness in the economy may increase money demand (risk in stock
market)
• Liquidity of alternative assets: Deregulation, competition, and innovation
have given other assets more liquidity, reducing the demand for money
• Now quite easy to trade stocks
• Payment technologies: Credit cards, ATMs, and other financial innovations
reduce money demand
• In general,
𝑀𝑑 = 𝑃 × 𝐿 𝑌, 𝑖, 𝑤𝑒𝑎𝑙𝑡ℎ, 𝑟𝑖𝑠𝑘, . . .
• We consider 𝑌 and 𝑖 as the most important factors for money demand
• So, we use 𝑀𝑑 = 𝑃 × 𝐿 𝑌, 𝑖

40
The Demand for Money
• Zero lower bound (ZLB) of the nominal interest rate
• The nominal interest rate cannot go below 0%
• Why?
• Suppose the nominal interest rate is negative 1% (e.g., Saving account interest
rate is -1%). What are you going to do?
• In the model, money demand 𝑀𝑑 = 𝑃 × 𝐿 𝑌, 𝑖 skyrockets when 𝑖 goes to 0.
• This is called a liquidity trap. We discuss this more later.
• In some countries, interest rates became negative
• This can happen if you do not want to or cannot withdraw your deposit
• Sometimes, the lower bound is called the effective lower bound (ELB) instead of
ZLB as the lower bound is not exactly 0%

• Q: Can the real interest rate become negative?

41
 Nominal and real interest rates in the United States
• Nominal interest
FRED Graph

rate (blue), real

interest rate
(red)
• 1-year
government
bond interest
rate

42
The Demand for Money
• How strong are the effects of changes in (𝑃, 𝑌, 𝑖) on money demand?
𝑀𝑑 = 𝑃 × 𝐿 𝑌, 𝑖

• Example
2
𝑀𝑑 𝑌3
= 1
𝑃
1+𝑖 5

• Let’s do “growth accounting”

• The functional form is similar to Cobb-Douglas production function

43
The Demand for Money
• Take the natural log on both sides of the equation
𝑑
2 1
log 𝑀 − log 𝑃 = log 𝑌 − log(1 + 𝑖)
3 5
• Take the first order difference
𝑑 𝑀𝑑 𝑑𝑃 2𝑑𝑌 1 𝑑𝑖 2𝑑𝑌 1
− = − ≈ − 𝑑 𝑖
𝑀𝑑 𝑃 3 𝑌 5 1+𝑖 3 𝑌 5
where the approximation comes from 𝑖 being close to 0
• In other words,
Δ 𝑀𝑑 Δ 𝑃 2 Δ 𝑌 1
𝑑
= + − Δ𝑖
𝑀 𝑃 3 𝑌 5

44
The Demand for Money
∆𝑀𝑑 ∆𝑃 2 ∆𝑌 1
𝑑
= + − ∆𝑖
𝑀 𝑃 3 𝑌 5
• What is the effect of price change on money demand?
• When price level goes up by 1%, money demand goes up by 1%.
• This is called the price elasticity of money demand.
• Elasticity measures the percent change in money demand caused by a one
percent change in some factor
• Why percent change? Unit free. If you measure money demand in millions or
billions, percent changes are the same.
• 1,000m HKD
• 1% increase of 1,000m HKD= 10m HKD
• 1b HKD
• 1% increase of 1b HKD = 10m HKD
45
The Demand for Money
∆𝑀𝑑 ∆𝑃 2 ∆𝑌 1
𝑑
= + − ∆𝑖
𝑀 𝑃 3 𝑌 5
2
• When income level goes up by 1%, money demand goes up by %.
3
2
• The income elasticity of money demand is .
3

46
The Demand for Money
∆𝑀𝑑 ∆𝑃 2 ∆𝑌 1
𝑑
= + − ∆𝑖
𝑀 𝑃 3 𝑌 5
• When the interest rate goes up by one percentage point, money
demand goes down by 1/5
1 ∆𝑖
• Notice it is NOT − . As 𝑖 is already in %, we prefer ∆𝑖 (change in
5 𝑖
percentage points).
∆𝑖 0.01
• For example, 5% to 6% means ∆𝑖 = 0.01. However, = = 0.2 and it is
𝑖 0.05
not intuitive.
• 1/5 above is often called semi-elasticity

47
The Demand for Money
• Empirical studies on the money demand function
• For simplicity, assume the income elasticity is 1. Then,
𝑀𝑑 𝑌
= 𝜂𝑖
𝑃 1+𝑖
• Dividing both sides by 𝑌 yields
𝑀𝑑 1
= 𝜂𝑖
𝑃𝑌 1+𝑖
• Does this equation explain data well?
• In percent changes,
∆𝑀𝑑 ∆𝑃 ∆𝑌
𝑑
= + − 𝜂𝑖 ∆𝑖
𝑀 𝑃 𝑌
• What is the estimated value of 𝜂𝑖 ? Is it positive?

48
The Demand for Money
• Money demand
function in the US
𝑀
• X-axis: where 𝑀 is M1
𝑃𝑌
• Y-axis: 𝑖, 3 months T-bill
interest rate (government
bond interest rate)
• Estimated 𝜂𝑖 = 8 between
1900 and 1976, and 1.69
between 1977 and 2006
• Dai and Serletis (2019)

49
Asset Market Equilibrium
• Next let’s think about equilibrium as usual

• Asset market equilibrium

• Assume that all assets can be grouped into two categories, money and
nonmonetary assets
• Money includes currency (and deposits)
• Supply is fixed at 𝑀
• Nonmonetary assets include bonds, stocks, land, etc.
• Pays interest rate 𝑖
• Supply is fixed at 𝑁𝑀

50
Asset Market Equilibrium
• Entire asset market (both money and nonmonetary asset markets) is
in equilibrium when money supply = money demand
• 𝑚𝑑 + 𝑛𝑚𝑑 = total nominal wealth of an individual
• 𝑀𝑑 + 𝑁𝑀𝑑 = aggregate nominal wealth (1)
(from adding up individual wealth)
• 𝑀 + 𝑁𝑀 = aggregate nominal wealth (2)
(supply of assets)
• Subtracting Eq. (2) from Eq. (1) gives
𝑀𝑑 − 𝑀 + 𝑁𝑀𝑑 − 𝑁𝑀 = 0

51
Asset Market Equilibrium
• So, excess demand for money 𝑀𝑑 − 𝑀 plus excess demand for
nonmonetary assets 𝑁𝑀𝑑 − 𝑁𝑀 equals 0

• If money market is in equilibrium (money supply equals money

demand), nonmonetary asset market is in equilibrium; then entire
asset market is in equilibrium

• We can focus on the money market equilibrium

52
Asset Market Equilibrium
• Asset market equilibrium condition
𝑀 = 𝑀𝑑 = 𝑃 × 𝐿 𝑌, 𝑖
• 𝑀 is (indirectly) controlled by the central bank
• Remember 𝑖 = 𝑟 + 𝜋 𝑒
• 𝑟: real interest rate, 𝜋 𝑒 : expected inflation
• Assume expected inflation rate 𝜋 𝑒 is given (for now)

• Let’s consider the long run first.

• We often assume the neutrality of money for the long-run analysis
• Money supply does not affect real variables such as output 𝑌 and the real
interest rate 𝑟.
• Money supply only affects nominal variables such as the price level.
• This is why we did not have money in the Solow model
53
Asset Market Equilibrium
• Interpretation
• Suppose the Solow model determines 𝑌
• Given 𝑌, the goods market equilibrium condition determines 𝑟
• Given (𝑌, 𝑟), the asset market equilibrium condition determines the price
level
𝑀
𝑃=
𝐿 𝑌, 𝑟 + 𝜋 𝑒
• The price level is the ratio of nominal money supply to real money demand

54
Asset Market Equilibrium
• Is this reasonable?
• Example
• Suppose there are 100 oranges in this classroom and money supply is 1,000
HKD. If everybody spends money, the price of one orange is 10 HKD.
• Suddenly, money supply becomes 2,000 HKD. It is likely that the price of one
orange will be 20 HKD.
• People still buy 100 oranges (no change in quantities).
• The price level increased in proportion to money supply.

• This may not hold if prices are fixed, which is often assumed for the
short-run analysis.

55
Money Growth and Inflation
• Let’s rewrite the equilibrium condition in growth rates as we often
focus on inflation (growth rate of the price level)
𝑀
= 𝐿 𝑌, 𝑖
𝑃
• Growth rate form
• Use the natural log as usual
∆𝑀 ∆𝑃 ∆𝐿
= +
𝑀 𝑃 𝐿
∆𝐿
• The neutrality of money implies money supply does not affect
𝐿
• Notice 𝐿 𝑌, 𝑖 = 𝐿 𝑌, 𝑟 + 𝜋𝑒
• The key determinant of inflation in the long run is money supply
growth

56
Money Growth and Inflation
• Alternative theory of money for the long-run analysis
• Quantity theory of money
• Velocity of money
• What’s velocity?
• Velocity (𝑉) measures how many times money is used each period

𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 𝑃𝑌
𝑉≡ =
𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑚𝑜𝑛𝑒𝑦 𝑠𝑡𝑜𝑐𝑘 𝑀

• 100 HKD money, nominal GDP=1000. What’s velocity?

𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 1000
•𝑉= = = 10
𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑚𝑜𝑛𝑒𝑦 𝑠𝑡𝑜𝑐𝑘 100

57
FRED Graph
Velocity of M2 in the US
• Velocity
measured as
M2/Nominal
GDP for the U.S.

58
Money Growth and Inflation
• In the long run, the velocity of M2 is stable
• Assume constant velocity 𝑉, where velocity isn’t affected by 𝑀, 𝑌, and 𝑖.
Then,
𝑀𝑡 𝑉 = 𝑃𝑡 𝑌𝑡
𝑀𝑡 1
→ = 𝑌𝑡
𝑃𝑡 𝑉
• This implies the real money demand is proportional to real income.
𝑀𝑡𝑑 1
= 𝑌𝑡
𝑃𝑡 𝑉
𝑀𝑑 1
• Special case of money demand = 𝐿 𝑌, 𝑖 where 𝐿 𝑌, 𝑖 = 𝑌
𝑃 𝑉
𝑀𝑑
• The liquidity preference theory with = 𝐿 𝑌, 𝑖 emphasizes the role of
𝑃
interest rate and liquidity, and is used for short-run analysis
59
Money Growth and Inflation
• In growth rates, 𝑀𝑡 𝑉 = 𝑃𝑡 𝑌𝑡 becomes
∆𝑀 ∆𝑃 ∆𝑌
= +
𝑀 𝑃 𝑌
• Assuming the neutrality of money, same implications as before.
∆𝑃 ∆𝑀 ∆𝑌
• Inflation is mostly determined by money growth if is stable
𝑃 𝑀 𝑌
• “Inflation is always and everywhere a monetary phenomenon.” –
Milton Friedman
• This may be true in the long run.

60
Money growth and inflation around the world, 1990-
2011

61
Money growth and inflation in the US, 1870-2012

62
Money Growth and Inflation
• Example
• In 10 years, assume
∆𝑀 ∆𝑉 ∆𝑌
= 0.5, = 0, = 0.1
𝑀 𝑉 𝑌
∆𝑀 ∆𝑃 ∆𝑌
• As = + , the inflation rate is
𝑀 𝑃 𝑌
∆𝑃 ∆𝑀 ∆𝑌
= − = 0.5 − 0.1 = 0.4
𝑃 𝑀 𝑌
∆𝑀
• If the central bank sets = 1 instead,
𝑀
∆𝑃 ∆𝑀 ∆𝑌
= − = 1 − 0.1 = 0.9
𝑃 𝑀 𝑌

63
Money Growth and Inflation
• Question
• Stabilization of inflation is the main goal for many central banks
• The Fed has two mandates, stable inflation (2% inflation) and maximum
employment
• Suppose money is neutral and money supply determines inflation in the long
run.
• Why is it difficult to stabilize inflation, at least in the long run?
• Why would a central bank print too much money if it knows that high inflation
will result?
• We still observe hyperinflation.
• Data (IMF): Link

64
Hyperinflations in History

65
Money Growth and Inflation
• Possible reasons
• Seigniorage revenue
• Government has an incentive to print more money to pay its bills (this revenue is
called seigniorage)
• Small for the US now (less than 1% of the government revenue)
• If the government cannot finance spending with taxes or borrowing, printing
money may be only alternative
• Especially during and after wars and major economic disasters
• Collecting tax may be difficult in developing countries (tax avoidance).

• Reducing real debt burden

• Higher price level decreases the real value of debt
• E.g., you need to pay back $100, and the price level increases

66
Money Growth and Inflation
• Possible reasons
• Higher tax revenue
• If marginal tax rate goes up as nominal income goes up, tax revenue can go up
with higher inflation

• “Persistent high inflation is always and everywhere a fiscal

phenomenon” – Tom Sargent
• Need a sound fiscal policy to avoid persistent high inflation

67
Money Growth and Inflation
• What kind of policy approaches have been taken to have stable
inflation?

• Fixed exchange rate to commodities (e.g., gold) or other currencies

• Restrict the government’s ability to print money freely
• These do not always work in history
• Prices of commodities are not always stable
• People need to believe the government to pay gold/other currencies (Risk of
devaluation/default).

68
Money Growth and Inflation
• Gold standard system
• The value of currency is pegged to a specific amount of gold
• E.g., 1 gram = 1 USD
• The US was on a pure gold standard system between 1873 and 1933
• Halted convertibility domestically and devalued the USD about 41% in 1933.
• Convertibility for international transactions ended in 1971.
• Before 1873, both gold and silver

• Was the price level stable?

69
US and UK Price Levels, 1865-1914
• Price levels in the US
and UK
• Friedman (1994)

70
Money Growth and Inflation
• Persistent deflation
• Why?
• Production of gold did not keep up with increased demand for gold
• Under the gold standard, inflation is dictated by world production of gold (supply
of gold = M), relative growth in world economy (=Y that determines demand for
gold as money) and other demand for gold

𝑀
= 𝐿 𝑌, 𝑖
𝑃
Or
𝑀𝑉 = 𝑃𝑌

• Not clear why we want supply of gold to dictate inflation

71
Gold Production

72
 Price of Goods in Gold and US dollar
FRED Graph

• Price of goods in US
dollar (red): Personal
consumption
expenditure deflator
• Price of goods in gold
(blue): Personal
consumption
expenditure deflator/
Price of gold in US
dollar
• Normalized to be 100
at the beginning

73
Money Growth and Inflation
• Stable price level in the U.S.
• Fixed exchange rate against the US dollar

• Monetary system in Hong Kong

• Hong Kong Monetary Authority (HKMA)
• De facto central bank
• Ensure the stability of HKD and the banking system
• Linked exchange rate system (LERS)
• Established in 1983
• Fixed exchange rate: 1 USD at 7.8 HKD (between 7.75 and 7.85)
• Monetary base 100% backed by USD
• HKMA authorizes note-issuing banks (three commercial banks below) to issue
new banknotes, but they need to deposit an equivalent value of USD with HKMA
• HSBC, Standard Chartered Bank, Bank of China
74
Money Growth and Inflation
• Implications of LERS
• The interest rate in Hong Kong is determined by the interest rate in the US
• If not, arbitrage opportunity
• No independent monetary policy
• Monetary policy cannot be used to stimulate the economy during a recession

• The price level in Hong Kong is affected by the price level in the US (in the
long run)
• If not, arbitrage opportunity
• The price of iPhone in Hong Kong and the US
• However, arbitrage is not easy for goods and services unlike assets (interest
rates)
• Transaction cost can be large
• Some goods and services are not/cannot be traded internationally

75
Currency System (Exchange Rate Regimes) in the World
• Floating: No
fixed exchange
rate
• Peg to US
dollar: Fixed
exchange rate
against US
dollar

76
Money Growth and Inflation
• Other approaches to stabilize inflation

• Money supply targeting

• Increase money supply at a pre-specified rate
• Friedman’s 𝑘-percent rule
• Based on the quantity theory of money
• In the 1970s, many central banks including the Fed used this type of approach
to reduce the elevated inflation
• Instability of money demand function (velocity) makes it hard to use this
approach

77
Money Growth and Inflation
• Inflation targeting
• Set an explicit target for inflation rate (e.g. 2%)
• Everybody can evaluate the performance of central bank easily
• A central bank takes responsibility for this goal
• To this end, it is given some degree of independence from the government
• Limit the ability of the government to influence the central bank’s decision
• It often uses a short-term interest rate as a policy tool
• Need credibility

78
Money Growth and Inflation
• The Fed’s policy
• Sets the short-term interest rate
• Federal funds rate: Overnight interbank interest rate
• The Fed targets 2% average inflation in the long run
𝑖 = 𝑟 + 𝜋𝑒
• In the short run, the Fed also tries to keep employment high
• We will discuss this later

79
Central bank independence and inflation 1955-1988
• More independent central
banks produced lower
inflation
• Y-axis: Average inflation
between 1955-1988
• X-axis: Index of central
bank independence from
the rest of the government.
Higher values of the index
imply that the central bank
is more independent. The
index is based on factors
such as the ease with
which the government can
dismiss the head of the
central bank or reverse
central bank decisions.

80
Inflation rates and inflation targets
• First two countries
that adopted inflation
targeting
• They have significantly
reduced inflation rate

81
Summary
• Money
• Means of transaction
• Unit of account, store of value
• M1, M2
• Money supply
• Exogenous
• Will discuss how policy makers decide later
• Money demand function
• Portfolio allocation problem
• Money vs. nonmonetary assets
• Price level, interest rate and income

82
Summary
• Velocity of money
• M2
• Long run relatively stable
• Quantity theory of money
• Long-run determination of price level
• Neutrality of money
• Inflation
• Long-run
• Monetary phenomenon
• Financing expenditure
• Short-run
• Will study later

83
Review
• Assume the money demand function discussed before
∆𝑀𝑑 ∆𝑃 2 ∆𝑌 1
𝑑
= + − ∆𝑖
𝑀 𝑃 3 𝑌 5

• Suppose the central bank wants to achieve 2% inflation rate

• Assume the changes in output and the nominal interest rate are given
as follows and are not affected by money supply
∆𝑌
• = 0.03, ∆𝑖=0.05
𝑌

• What should be the growth rate of money supply?

84
Review
• 2% inflation rate target
∆𝑃
= 0.02
𝑃
• In equilibrium, money supply = money demand
∆𝑀 ∆𝑀𝑑 ∆𝑃 2 ∆𝑌 1 2 1
= 𝑑 = + − ∆𝑖 = 0.02 + 0.03 − 0.05
𝑀 𝑀 𝑃 3 𝑌 5 3 5
• In the end, we get
∆𝑀
= 0.03
𝑀

85