Module 2:

Money Creation and

Inflation
 IN THIS MODULE, YOU WILL LEARN:

▪ the definition, functions, and types of money

▪ how banks “create” money
▪ what a central bank is and how it controls the money
supply
▪ The classical theory of inflation
▪ causes
▪ effects
▪ social costs
▪ “Classical” – assumes prices are flexible & markets clear

slide 1
 Money: Definition

Money is the stock

of assets that can be
readily used to make
transactions.

slide 2
 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

slide 3
 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

slide 4
NOW YOU TRY
Discussion Question
Which of these are money?
a. Currency
b. Checks
c. Deposits in checking accounts
(“demand deposits”)
d. Credit cards
e. Certificates of deposit
(“time deposits”)

slide 5 5
 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.

slide 6
 The central bank and monetary
control
▪ Monetary policy is conducted by a country’s
central bank.

▪ The U.S.’
central bank
is called the
Federal Reserve
The Federal Reserve Building
(“the Fed”).
Washington, DC
▪ To control the money supply, the Fed uses
open market operations, i.e. the purchase and
sale of government bonds.
slide 7
 The central bank and monetary
control
▪ Monetary policy is conducted by a country’s
central bank.

▪ Vietnam’s
central bank
is called the
State Bank
The State Bank of Vietnam Building
of Vietnam (SBV)

▪ To control the money supply, the SBV uses

discount window, interest rates, exchange
rates, reserve requirements, and open market
operations slide 8
 Money supply measures

Symbol Assets included

C Currency
B=C+R C + banks’ reserves
M1 = C + D C + demand deposits,
travelers’ checks,
other checkable deposits
M2 = M1 + SD M1 + small time deposits,
savings deposits,
money market mutual funds,
money market deposit accounts

slide 9
 Banks’ role in the monetary
system
▪ Let M denote the money supply being equal to
currency plus demand (checking account)
deposits:
M = C + D
▪ Since the money supply includes demand
deposits, the banking system plays an
important role.

slide 10
 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.
slide 11
 Banks’ role in the monetary
system
▪ To understand the role of banks, we will consider
three scenarios:
1. No banks
2. 100-percent-reserve banking
(banks hold all deposits as reserves)
3. Fractional-reserve banking
(banks hold a fraction of deposits as reserves,
use the rest to make loans)
▪ In each scenario, we assume C = $1,000.
slide 12
 SCENARIO 1:
No banks

With no banks,
D = 0 and M = C = $1,000.

slide 13
 SCENARIO 2:
100-percent-reserve banking
▪ Initially C = $1000, D = $0, M = $1,000.
▪ Now suppose households deposit the $1,000 at
“Firstbank.”
▪ After the deposit:
C = $0,
FIRSTBANK’S
D = $1,000,
balance sheet
M = $1,000
Assets Liabilities
▪ LESSON:
reserves $1,000 deposits $1,000
100%-reserve
banking has no
impact on size of
money supply.
slide 14
 SCENARIO 3:
Fractional-reserve banking
▪ Suppose banks hold 20% of deposits in reserve,
making loans with the rest.
▪ Firstbank will make $800 in loans.
The money supply
FIRSTBANK’S
now equals $1,800:
balance sheet
Assets Liabilities ▪ Depositor has
$1,000 in
$200 deposits $1,000
reserves $1,000 demand deposits.
loans $800 ▪ Borrower holds
$800 in currency.

slide 15
 SCENARIO 3:
Fractional-reserve banking
▪ Suppose banks hold 20% of deposits in reserve,
LESSON: in a fractional-reserve
making loans with the rest.
banking system, banks create money.
▪ Firstbank will make $800 in loans.
The money supply
FIRSTBANK’S
now equals $1,800:
balance sheet
Assets Liabilities ▪ Depositor has
$1,000 in
$200 deposits $1,000
reserves $1,000 demand deposits.
loans $800 ▪ Borrower holds
$800 in currency.

slide 16
 SCENARIO 3:
Fractional-reserve banking
▪ Suppose the borrower deposits the $800 in
Secondbank.
▪ Initially, Secondbank’s balance sheet is:
SECONDBANK’S The money supply
balance sheet now equals $2,440:
Assets Liabilities ▪ $1,800 in
demand deposits.
reserves $160
$800 deposits $800
▪ $640 in currency.
loans $0
$640

slide 17
 SCENARIO 3:
Fractional-reserve banking
▪ If this $640 is eventually deposited in Thirdbank,
▪ then Thirdbank will keep 10% of it in reserve
and loan the rest out:

THIRDBANK’S The money supply

balance sheet now equals $2,952:
Assets Liabilities ▪ $2,440 in
demand deposits.
reserves $128
$640 deposits $640
▪ $512 in currency.
loans $0
$512

slide 18
 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

slide 19
 Extended Example

▪ 90% of currency is deposited

▪ Banks hold 20% of deposits in reserve
▪ What is the money supply? Compare with the
previous scenario.

slide 20
 Extended Example

The money supply

FIRSTBANK’S
now equals $1,720:
balance sheet
Assets Liabilities ▪ $900 in demand
deposits
$180 deposits $900
reserves $1,000 ▪ $720+$100 in
loans $720 currency

slide 21
 Extended Example

▪ The borrower deposits $648 in Secondbank and

holds $72 in currency
▪ Secondbank’s balance sheet is:
SECONDBANK’S The money supply
balance sheet now equals $2,238.4:
Assets Liabilities ▪ $900+$648 in
demand deposits
reserves $800 deposits $648
reserves $129.6
▪ $518.4+$100+$72
loans
loans $518.4
$0 in currency

slide 22
 Extended Example

▪ The borrower deposits $466.56 in Secondbank

and holds $51.84 in currency
▪ Thirdbank’s balance sheet is:
THIRDBANK’S The money supply now
balance sheet equals $2,611.648:
Assets Liabilities ▪ $900+$648 + 466.56
in demand deposits
reserves $800 deposits $466.56
reserves$93.312
▪ $373.248+$100+$72
loans
loans $373.248
$0 +$51.84 in currency

slide 23
 Money creation in the banking
system

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.

slide 24
 A model of the money supply
exogenous variables

▪ 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

slide 25
 Solving for the money supply:
C +D
M = C +D = B = m B
B
where
C +D
m =
B
C +D
=
(C D ) + (D D )
=
cr + 1
=
C +R (C D ) + (R D ) cr + rr

slide 26
 Two versions of the money
multiplier
Are the following money multipliers identical?
𝑐𝑟+1
▪ 𝑚= 𝑐𝑟+𝑟𝑟
where cr=C/D, rr=R/D

1
▪ 𝑚= 𝑐+𝜃(1−𝑐)
where c=C/M and θ=R/D

slide 27
 The money multiplier
cr + 1
M = m B, where m =
cr + rr
▪ If rr < 1, then m > 1
▪ If monetary base changes by B,
then M = m  B
▪ m is the money multiplier,
the increase in the money supply
resulting from a one-dollar increase
in the monetary base.
slide 28
NOW YOU TRY
The money multiplier
cr + 1
M = m B, where m =
cr + rr
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.

29
slide 29
SOLUTION
The money multiplier
Impact of an increase in the currency-deposit ratio
cr > 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.

30
slide 30
 The instruments of monetary
policy
The CB can change the monetary base using
▪ open market operations (the CB’s preferred
method of monetary control)
▪ To increase the base, the CB could buy
government bonds, paying with new dollars.
▪ the discount rate: the interest rate the CB
charges on loans to banks
▪ To increase the base, the CB could lower the
discount rate, encouraging banks to borrow
more reserves.

slide 31
 The instruments of monetary
policy
The CB can change the reserve-deposit ratio using
▪ reserve requirements: CB regulations that
impose a minimum reserve-deposit ratio
▪ To reduce the reserve-deposit ratio, the CB
could reduce reserve requirements
▪ interest on reserves: the CB pays interest on
bank reserves deposited with the CB
▪ To reduce the reserve-deposit ratio, the CB
could pay a lower interest rate on reserves

slide 32
 Why the CB can’t precisely control
M
cr + 1
M = m  B , where m =
cr + rr
▪ 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.

slide 33
What are causes of inflation? Is
inflation good or bad?

slide 34
Inflation in Vietnam and its trend,
1996–2020

annual inflation rate (%)

25

20

15

10

0
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
-5

Source: The World Bank

slide 35
 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…

slide 36
 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 2012,
▪ $500 billion in transactions
▪ money supply = $100 billion
▪ The average dollar is used in five transactions
in 2012
▪ So, velocity = 5
slide 37
 Velocity, cont.

▪ This suggests the following definition:

𝑷𝑻
𝑽=
𝑴
where
V = velocity
P = price of a typical transaction
T = total number of transactions
M = money supply

slide 38
 Velocity, cont.

▪ Use nominal GDP as a proxy for total

transactions.
P Y
V=
Then, M
where
P = price of output (GDP deflator)
Y = quantity of output (real GDP)
P  Y = value of output (nominal GDP)

slide 39
 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.

slide 40
 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 = kY
where
k = how much money people wish to hold for
each dollar of income.
(k is exogenous)

slide 41
 Money demand and the quantity
equation
▪ money demand: (M/P )d = kY
▪ 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 large), money changes
hands infrequently (V is small).

slide 42
 Back to the quantity theory of
money
▪ starts with quantity equation
▪ assumes V is constant & exogenous: V = V
Then, quantity equation becomes:

M V = P Y

slide 43
 The quantity theory of money,
cont.
M V = P Y
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
▪ The price level is P = (nominal GDP)/(real
GDP).

slide 44
 The quantity theory of money,
cont.
▪ Hint: The growth rate of a product equals
the sum of the growth rates.
▪ The quantity equation in growth rates:

M V P Y
+ = +
M V P Y

The quantity theory of money assumes

V
V is constant, so = 0.
V
slide 45
 The quantity theory of money,
cont.

 (Greek letter pi ) P
denotes the inflation rate:  =
P
The result from the M P Y
= +
preceding slide: M P Y

Solve this result M Y

for :  = −
M Y

slide 46
 The quantity theory of money,
cont.
M Y
 = −
M Y

▪ 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.

slide 47
 The quantity theory of money,
cont.
M Y
 = −
M Y

Y/Y depends on growth in the factors of

production and on technological progress
(all of which we take as given, for now).
Neutrality of money?

Hence, the quantity theory predicts

a one-for-one relation between
changes in the money growth rate and
changes in the inflation rate.
slide 48
 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 in a country’s inflation rate
should be similar to the long-run trend in the
country’s money growth rate.
Are the data consistent with these implications?

slide 49
 International data on inflation and
money growth
40
Belarus
35
30
Zambia
Inflation rate

25 Iraq
Turkey
(percent)

Serbia
20 Suriname
Mexico
15
U.S. Russia
10 Malta
5
0
Cyprus China
-5
-10 0 10 20 30 40 50
Money supply growth
(percent) slide 50
 U.S. inflation and money growth,
1960–2012
14%

M2 growth rate
12%
% change from 12 mos. earlier

10%

8%

6%

4%

2%
inflation
rate
0%
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
slide 51
 U.S. inflation and money growth,
1960–2012
Inflation and money growth
14%
have the same long-run trends,
12%
as the quantity theory predicts.
% change from 12 mos. earlier

10%

8%

6%

4%

2%

0%
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
slide 52
 10
20
30
40
70

50
60

-10
0
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007

money growth
2008
2009
2010
growth, 1996-2020

2011
2012
inflation 2013
2014
2015
2016
2017
2018
Vietnam’s inflation and money

2019
2020
slide 53
 Inflation and interest rates

▪ Nominal interest rate, i, not adjusted for inflation

▪ Real interest rate, r, adjusted for inflation:
r = i −
▪ This is ex post real interest rate
▪ Ex ante real interest rate is given by
r = i − E
where E is expected inflation

slide 54
 The Fisher effect

▪ The Fisher equation: i = r + 

▪ Hence, an increase in  causes an equal
increase in i.
▪ This one-for-one relationship is called the Fisher
effect.

slide 55
 U.S. inflation and nominal interest
rates, 1960–2012
18%

14% nominal
interest rate
10%

6%

2%

inflation rate
-2%
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
slide 56
 Inflation and nominal interest rates
in
40
96 countries
Nominal Turkey
interest rate 35
(percent) 30
Georgia Malawi
25
Ghana
Mexico
20
Brazil
15
Poland
10 Iraq
U.S.
5
Japan Kazakhstan
0
-5 0 5 10 15 20 25
Inflation rate
(percent) slide 57
NOW YOU TRY
Applying the theory
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 SBV increases the money growth rate by
2% per year, find i.
c. Suppose the growth rate of Y falls to 1% per
year.
▪ What will happen to  ?
▪ What must the SBV do if it wishes to keep 
constant?
58
slide 58
ANSWERS
Applying the theory
V is constant, M grows 5% per year,
Y grows 2% per year, r = 4%.
a. First, find  = 5% − 2% = 3%.
Then, find i = r +  = 4% + 3% = 7%.
b. i = 2%, same as the increase in the money
growth rate.
c. If the SBV does nothing,  = 1%.
To prevent inflation from rising, the SBV must
reduce the money growth rate by 1% per year.
59
slide 59
 A common misperception
▪ Common misperception:
inflation reduces real wages
▪ This is true only in the short run, when nominal
wages are fixed by contracts.
▪ 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…

slide 60
 The CPI and Average Hourly Earnings,
1965–2012
900
Real average hourly earnings

Hourly wage in May 2012 dollars

800 in 2012 dollars, right scale $20

700

600 $15
1965 = 100

500

400 $10
Nominal average
300 hourly earnings,
(1965 = 100)
200 $5

100 CPI (1965 = 100)

0 $0
1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 slide 61
 The classical view of inflation

▪ The classical view:

A change in the price level is merely a change
in the units of measurement.

Then, why is inflation

a social problem?

slide 62
 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

Please read the textbook!

slide 63
 Group discussion

1. Read the following text and comment on the

causes of inflation
Causes of Inflation | Explainer | Education | RBA
▪ Demand-full inflation
▪ Cost-push inflation
▪ Inflation expectations
2. Is all of this consistent with the quantity theory
of money?
slide 64