Economics Notes
CENTRAL
BANKS &
INFLATION
,Topics covered
• What is money?
• What is inflation?
• Role of the central bank
• How do central banks set interest rates?
• Corridor vs floor systems
• Fisher equation
• Policy rule
• How do central banks choose short-term interest rates?
• How do central banks choose long-term interest rates?
• Deriving an equation for short run inflation
• Taylor rule
• Real world application: what interest rate should the ECB set?
• The yield curve
• Forward guidance
• Quantitative easing
• Central bank balance sheets
• Currency
• Seigniorage
• Quantity theory of money
• Hyperinflation
, What is money?
Money is ultimately a unit of account. It is a social convention used so that we can easily
transact goods and services with each other. It could be anything like rocks or paper. But its
defining feature is that for instance a £1 coin holds a price of £1 in the economy. Hence why it
is just a unit of account. The government requires all transactions with the government to be in
this unit of account. In the UK for example, that would be £s or in the USA the government
requires itself to be paid in US$. Other people in the economy like small business owners could
decide to transact with each other in another unit of account in theory. A construction business
could pay its builders in a currency we could call ‘Boris’s’ and builders would then use their
Boris’s to buy other goods and services as they please. But because the government is using £s
in the UK and it’s the largest employer in the UK and pays all its workers in £s while banks
deposit their money at the central bank in £s etc. it makes sense for everybody else to use £s in
the UK economy. Given people’s indifference between what currency unit they use (so long as
it holds its value) then choosing a central currency is just a coordination device and people will
go with whatever the government is using.
Key takeaway: money is just a unit of account.
What is inflation?
To define inflation, we must first define some other key terms.
• A price: is the value in terms of the unit of account. How much of the unit of account
you must give to get the good or service?
• The price level: is how much money (the unit of account) you must spend to get the
overall set of goods or services in the economy.
We can denote the price level as 𝑃𝑡 .
• Inflation: is the change in the price level.
𝑃
Thus, inflation (𝜋) = 𝑃 𝑡 − 1 ≈ ∆log (𝑃𝑡 )
𝑡−1
I.e. Inflation is the change in the amount of money you must spend to purchase the
overall set of goods in the economy. It also represents a loss in the real value of the unit
of account if inflation is positive. I.e. Positive inflation will reduce consumer
purchasing power.
To represent the overall set of goods in the economy we use representative baskets like in the
consumer prices index (CPI). The CPI is a base-weighted price index or Laspeyres index. It is
therefore a weighted average of proportionate price increases whereby the weight given to a
good is the proportion of expenditure spent on that good. There are other measures of inflation
used. For example, in the UK there is also the RPI, RPIX and GDP deflator. We will not go
into too much detail here, but this is covered in our consumer theory course.
CENTRAL
BANKS &
INFLATION
,Topics covered
• What is money?
• What is inflation?
• Role of the central bank
• How do central banks set interest rates?
• Corridor vs floor systems
• Fisher equation
• Policy rule
• How do central banks choose short-term interest rates?
• How do central banks choose long-term interest rates?
• Deriving an equation for short run inflation
• Taylor rule
• Real world application: what interest rate should the ECB set?
• The yield curve
• Forward guidance
• Quantitative easing
• Central bank balance sheets
• Currency
• Seigniorage
• Quantity theory of money
• Hyperinflation
, What is money?
Money is ultimately a unit of account. It is a social convention used so that we can easily
transact goods and services with each other. It could be anything like rocks or paper. But its
defining feature is that for instance a £1 coin holds a price of £1 in the economy. Hence why it
is just a unit of account. The government requires all transactions with the government to be in
this unit of account. In the UK for example, that would be £s or in the USA the government
requires itself to be paid in US$. Other people in the economy like small business owners could
decide to transact with each other in another unit of account in theory. A construction business
could pay its builders in a currency we could call ‘Boris’s’ and builders would then use their
Boris’s to buy other goods and services as they please. But because the government is using £s
in the UK and it’s the largest employer in the UK and pays all its workers in £s while banks
deposit their money at the central bank in £s etc. it makes sense for everybody else to use £s in
the UK economy. Given people’s indifference between what currency unit they use (so long as
it holds its value) then choosing a central currency is just a coordination device and people will
go with whatever the government is using.
Key takeaway: money is just a unit of account.
What is inflation?
To define inflation, we must first define some other key terms.
• A price: is the value in terms of the unit of account. How much of the unit of account
you must give to get the good or service?
• The price level: is how much money (the unit of account) you must spend to get the
overall set of goods or services in the economy.
We can denote the price level as 𝑃𝑡 .
• Inflation: is the change in the price level.
𝑃
Thus, inflation (𝜋) = 𝑃 𝑡 − 1 ≈ ∆log (𝑃𝑡 )
𝑡−1
I.e. Inflation is the change in the amount of money you must spend to purchase the
overall set of goods in the economy. It also represents a loss in the real value of the unit
of account if inflation is positive. I.e. Positive inflation will reduce consumer
purchasing power.
To represent the overall set of goods in the economy we use representative baskets like in the
consumer prices index (CPI). The CPI is a base-weighted price index or Laspeyres index. It is
therefore a weighted average of proportionate price increases whereby the weight given to a
good is the proportion of expenditure spent on that good. There are other measures of inflation
used. For example, in the UK there is also the RPI, RPIX and GDP deflator. We will not go
into too much detail here, but this is covered in our consumer theory course.
