Lecture 6 - Money, Inflation and Interest Rates

Introduction

See graph of inflation in industrial countries. It peaked in 70s at 8.7%, but has subsided since then to less than 3%.

Greenspan kept interest rates low in 2002 and 2003. Fueled the housing bubble. Interest rates were way below what the Taylor Rule would indicate.

Money supply is directly related to interest rate. Low interest rates require more money supply which leads to inflation.

Fed mandate: control inflation and control business cycle (overheating). European Central Bank (ECB) is more obsessed with maintaining a low (~2%) inflation rate because that is their sole objective.

Discussion of two types of bonds: nominal (which don't adjust for inflation, but are purchased at a discount) and TIPS inflation-adjusted bonds. The gaps between them represents what the public anticipates in inflation. (??)

What is the function of money?

(1) Medium of exchange. Without it, we only have barter which requires a "double coincidence of wants".
(2) Store of value. non-perishable.
(3) Unit of account. It makes it easy to compare prices. It's a common good against which all other goods are valued.

Other things can be a store of value (#2), but these are not equally easily exchangeable for other goods.

Therefore economists measure the liquidity of an asset = ease and speed with which an asset can be traded for other goods.

The Measures of Money (in the US)

Very liquid assets = cash or anything "close" to cash should be considered as money

C = currency
M1 = currency + demand deposits + traveler's checks + other checkable deposits
M2 = M1 + money market mutual funds shares (checking acct against mutual fund shares) + savings and small time deposits (<$100k CDs) + overnight repurchase agreements (overnight loans collateralized by treasury bonds)
M3 = M2 + large time deposits + term repurchase agreements
(+ Euro dollars - i.e. dollars circulating outside the US, not just Europe) short discussion of regulation Q.
L = M3 + short-term Treasury Securities + other liquid assets