Inflation, Monetary Policy, and the Financial System: A Comprehensive Guide
Some Costs of Expected Inflation
1. Shoe leather cost: the costs and inconveniences of reducing money balances to avoid the inflation tax.
- Remember: In the long run, inflation doesn’t affect real income or real spending. So, the same monthly spending but lower average money holdings means more frequent trips to the bank to withdraw smaller amounts of cash.
2. Menu costs: the costs of changing prices. Examples:
- Print new menus
- Print & mail new catalogs
- The higher the inflation, the more frequently firms must change their prices and incur these costs.
3. General inconvenience: Inflation makes it harder to compare nominal values from different time periods.
4. Unfair tax treatment: Some taxes are not adjusted to account for inflation, such as the capital gains tax.
Monetary Policy in the Multiplier Model
To stabilize the economy, the central bank stimulates investment by lowering the real interest rate. This shifts the aggregate demand curve upward.
Monetary Policy: Limitations
1. The short-term nominal interest rate (policy rate) cannot go below zero (“zero lower bound”)
- When the economy is in a slump, a nominal interest rate of zero may not be low enough to stabilize the economy
- Quantitative easing = Central bank purchases of financial assets aimed at increasing investment by reducing yields.
2. A country without its own currency does not have its own monetary policy
- E.g. countries of the eurozone
Demand Shocks
Demand shock = An unexpected change in aggregate demand
Governments can use both fiscal and monetary policy to stabilize the economy:
- Monetary policy – decreasing the nominal interest rate
- Fiscal policy – tax cuts and increased government spending
Why is There Inflation?
The QTM
“Inflation is always and everywhere a monetary phenomenon” – Milton Friedman (1912–2006) University of Chicago Nobel Prize, 1976
A Common Misperception About Inflation
Common misperception: Inflation reduces real wages
Only in the short run, when nominal wages are fixed by contracts. In the long run (Solow model), the real wage is determined by labor supply and the marginal product of labor, not the price level or inflation rate.
The Classical View of Inflation
A change in the price level is merely a change in the units of measurement.
So Why, Then, is Inflation a Social Problem?
The social costs of inflation fall into two categories:
- Costs when inflation is expected
- Additional costs when inflation is different than people had expected
The Classical View of Inflation
A change in the price level is merely a change in the units of measurement.
So Why, Then, is Inflation a Social Problem?
The social costs of inflation fall into two categories:
- Costs when inflation is expected
- Additional costs when inflation is different than people had expected
Central Bank
Base money/high-powered money = notes and coins. Money as legal tender. Legal tender has to be accepted as payment by law. The central bank is the only bank that can create legal tender.
- The central bank is usually owned by the government.
- Acts as the banker for the commercial banks, who have accounts at the central bank that hold legal tender.
- By crediting these accounts, the central bank can create money.
Bank Money
Commercial banks create money by making loans
- This is called bank money ≠ legal tender
- It is a liability to the bank, not an asset
- Banks earn profits by charging interest on bank money
→ Broad money = base money + bank money
Banking Crisis
Banks make money by lending much more than they hold in legal tender. Bank run = situation when all depositors demand their money at once; may result in bank failure. Banks can also fail by making bad investments, such as by giving loans that do not get paid back. The government may intervene because, unlike the failure of a firm, a banking crisis can bring down the financial system.
The Money Market
Banks need enough base money to cover their net transactions. They borrow base money on the money market at the short-term interest rate.
- The demand for base money depends on how many transactions commercial banks have to make.
- The supply of base money is a decision by the central bank.
The Financial System
Policy interest rate = The interest rate on base money set by the central bank.
Bank lending rate = The average interest rate charged by commercial banks to firms and households.
Policy Rate
The central bank’s policy rate affects the level of spending in the economy because households and firms borrow to spend. A higher interest rate → low spending today
Monetary Policy: Transmission Mechanisms Market Interest Rates
To set the policy rate, the central bank will work backward:
- Choose the desired level of aggregate demand, based on the labor market equilibrium and the Phillips curve
- Estimate the real interest rate, which will produce this level of aggregate demand (using the multiplier model)
- Calculate the nominal policy rate that will produce the appropriate market interest rate.
A Common Misperception About Inflation
Common misperception: Inflation reduces real wages
Only in the short run, when nominal wages are fixed by contracts. In the long run (Solow model), the real wage is determined by labor supply and the marginal product of labor, not the price level or inflation rate.