12 chapter d ynamic p ower p oint ™ s lides by s olina l indahl inflation and the quantity theory...

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DYNAMIC POWERPOINT™ SLIDES BY SOLINA LINDAHL

Inflation and the Inflation and the QuantityQuantity

Theory of MoneyTheory of Money

CHAPTER OUTLINE

Defining and Measuring Inflation

The Quantity Theory of Money

The Costs of Inflation

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Some good blogs and other sites to get the juices flowing:

Food for Food for Thought….Thought….

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"Americans are getting stronger. Twenty years ago, it took two people to carry ten dollars worth of groceries. Today, a five-year-old can do it."

- Henny Youngman

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In this chapter:

How is inflation defined and measured?

Introduction

The costs and benefits of inflation?

What causes inflation?

Why do governments sometimes resort to inflation?

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Inflation:Inflation: an increase in the average level of prices.

Measured using the following formula:

Inflation is the average change of all prices.

Some prices go up and some go down.

Think of an elevator containing many prices that change relative to each other. As the elevator rises, all of the prices rise.

100P

PPrate Inflation

1

12

Where P2 is the index value in year 2 and P1

is the index value in year 1


Try it!Try it!Year CPI Value

2005 100

2006 107

2007 1132008 121

2009 129

What was the approximate inflation rate over the period 2007 to 2008?a)6.6% b)8% c)21% d)7.1%

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In which year was the inflation rate the highest?a)2006 b)2007 c)2008 d)2009

Year CPI Value

2005 100

2006 107

2007 113

2008 121

2009 129


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Price Indexes are used to measure inflation.

An index is a number that compares the price level in one period relative to the prices in some base year.

An index is only a number; it is not expressed in dollars.

There are several price indexes:

Consumer price index (CPI)

GDP deflator

Producer price index (PPI)

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1.CPI: The average price of goods bought by a typical American consumer.

Covers 80,000 goods.

Weighted so that major items (housing) count more.

2.GDP deflator: Measures the average price of all final goods and services.

3.Producer price indexes (PPI): The average price received by producers.

Includes intermediate goods as well as final goods.

PPI’s exist for different industries.

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The Inflation Rate in the United States, 1950–2010

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The Effect of Inflation on the Price of a Basket of Goods

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Inflation in the U.S. and Around the World

Using the CPI to calculate real prices

Real priceReal price is the price of a good that has been corrected for inflation.

Example:

1982 price of gasoline was $1.25/gal.

2006 it was double that at $2.50/gal.

CPI was 100 in 1982 and 202 in 2006.

Conclusion: The real price of gasoline was about the same in 2006 as it was in 1982.

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Inflation in the United States and Around the World

Hyperinflation:Hyperinflation: extremely high rates of inflation

Many governments have fallen into the trap of inflating their currency in order to pay debts.


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Inflation in the United States and Around the WorldHungary’s hyperinflation is the highest on

record.What cost 1 Hungarian pengo in 1945 cost 1.3

septillion pengos at the end of 1946. Prices doubled every 15 hours!

World's highest denomination banknote: Hungary (1946) 100 Quintillion pengo

100,000,000,000,000,000,000 Pengo


The worthless Hungarian Pengo, 1946

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Causes of Inflation

Take a look…..Take a look…..

“Commanding Heights” (PBS) looks at prices. The first few minutes of the clip focus on Germany’s hyperinflation, the second half of the 8-minute clip focuses on the U.S. Great Depression

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The quantity theory of money does two things:

1. Sets out the general relationship between inflation, money, real output, and prices.

2. Presents the critical role of the money supply in regulating the level of prices.

For the nation as a whole…

M x v = P x YR

Where M = Money supply, v = Velocity of money, P = Price level and YR = Real GDP


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Velocity (Velocity (vvaverage number of times that a dollar is spent on goods and services in a year.

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The quantity theory of money depends on two assumptions…

1.Real GDP is stable compared to the money supply.

Real GDP is fixed by the real factors of production—capital, labor, and technology.

The growth rate of real GDP is limited by how fast these factors can increase.


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2.The velocity of money, v, is stable compared to the money supply.

It is determined by various factors such as: Whether workers are paid monthly or

biweekly. How long it takes to clear a check or

electronic transaction. How easy it is to find an ATM.

Factors like these may change, but slowly.


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The Cause of InflationThe quantity theory: a theory of inflation.

If YR is fixed by real factors of production

and v is stable, then it follows that inflation is caused by an increase in the supply of money.

The quantity theory of money can also be written in terms of growth rates:

Which translates as:Growth rate of money + growth rate of v equals the rate of inflation + growth rate of real GDP.

RYPvM


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Important implication: If the growth rates of v and YR are small compared to the growth rate of M, the rate of inflation will be approximately equal to the increase in money supply.

v RYMP Inflation, of Rate

MPOr more generally:


SEE THE SEE THE INVISIBLEINVISIBLE HANDHAND

SEE THE SEE THE INVISIBLEINVISIBLE HANDHAND

“Inflation is always and everywhere a monetary phenomenon.”

Milton Friedman (1912-2006), Nobel Prize Winner , Leader of the “Chicago school of economics”

Source: www.freetochoosemedia.org

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How well does the theory hold up?

In Peru, very well….

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More money means more inflation.

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Some Important Caveats:

1. If M and v grow more slowly than YR,

prices will fall; this is called deflation.

2. Changes in velocity will affect prices.

Hyperinflation: People will spend their money faster (increase v) → even faster increase in prices.

Great Depression: Fear → ↓spending (decreased v) → deflation → worse depression.

3. In the long run, money is neutral.


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Deflation and Disinflation

Don’t be confused:

Deflation: Deflation: a decrease in the average level of prices (negative inflation)

E.g. if the CPI falls from 100 to 95, the inflation rate is negative.

Disinflation: Disinflation: a reduction in the inflation rate

E.g. if the CPI rose from 100 to 110, and the next year to 112, the inflation rate is positive but slowing down.

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Year Inflation Rate (Annual Percent Change)

1985 15.1%

1990 585.8%

1999 7.3%

2002 1.9%

2003 0.8%

This table shows actual inflation data for different periods of Polish history. Which year can you identify as deflationary?a)1990 b)1999 c)2003 d)No year was deflationary.


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An Inflation Parable

Under some circumstances, changes in M can temporarily change YR. Let’s see how…

Consider a mini-economy consisting of a baker, tailor, and carpenter who buy and sell products among themselves. Government prints money to pay army

Soldiers buy frombaker, tailor, and carpenter

All three work harder to increase output and raise theirprices.

When the baker, tailor, and carpenter go to buy from each other, they find they are no better off than before because of higher prices

Eventually they catch on and stopworking harder to produce more output.

Conclusion: Increase in M can boost the economy in the short run but as firms and workers come to expect and adjust to the influx of new money, output (real GDP) will not grow any faster than normal.


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If all prices (including wages) are going up, then why is inflation a problem?

Four problems with inflation:

1. Inflation causes price confusion and money illusion.

2. Inflation redistributes wealth.

3. Inflation interacts with other taxes.

4. Inflation is painful to stop.


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1.Price Confusion and Money IllusionPrice confusion:

Inflation makes price signals more difficult to interpret.A consumer may not know if the price of a product is increasing…

Because of increased demand? orAs a result of all prices going up with inflation.

The Costs of Inflation: Price Confusion and Money Illusion

Making sense of prices…

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Money Illusion:Money Illusion: when people mistake changes in nominal prices for changes in real prices.

Example: Mary receives a 10% increase in salary and takes on a higher mortgage payment. The rate of inflation is 10%: she is no better off in terms of real salary. She now has a higher house payment and is in danger of losing her home.Result: resources are wasted in unprofitable activities.

The Costs of Inflation: Price Confusion and Money Illusion

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2. Inflation Redistributes WealthInflation is type of tax. It transfers wealth to the government.

Even tax cheats can’t avoid this tax!

Governments that print money to pay their bills are using this type of tax.

Inflation redistributes wealth among the public.

The real rate of return for a lender is given by:

ractual = i –

where ractual = actual rate of return, i = nominal interest rate and = inflation rate

The Costs of Inflation: Wealth Redistribution

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Example:

Suppose a bank makes a 30-year home loan at an interest rate of 7%. If inflation is 3% over that period: bank’s actual rate of return = 7% - 3% = + 4%

If inflation rises unexpectedly to 13% (as it did in late 1970s), the actual rate of return = 7% - 13% = -6%!

The lender is now losing money on the loan.

The borrower gains.


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What happens if people expect inflation to go up?

Lenders will increase nominal rates of interest.

Fisher effect:Fisher effect: the tendency for nominal interest rates to rise with expected inflation.

The nominal rate of interest will be equal to expected inflation rate plus the equilibrium rate of return.


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Nominal Interest Rates Tend to Increase with Inflation Rates

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The actual rate of return: determined in large part by the difference between expected inflation and actual inflation.

From earlier equations we have:(2) mequilibriu and (1) actual rEiπir

mequilibriuactual rEr )(

Substituting i from equation (2) into equation (1) we get:


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Using the inflation data in the table above, assume that all loan contracts matured after one year, and that they all had fixed nominal interest rates of 10%. In which of the years given below did lenders gain relative to borrowers?a)2000 b)2002 c)2003 d)2004


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Monetizing the debt:Monetizing the debt: when the government pays off its debts by printing money.

Why don’t they always inflate their debt away? Two reasons:

1.The Fisher effect: if banks know the government is doing this, they will simply raise interest rates.

2.Political cost: People who buy government bonds usually vote.


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Workers and firms are affected by inflation.

Wage agreements are often made several years in advance.

Underestimating inflation → wages are too low → supply of labor: too low.

Overestimating inflation → wages are too high → demand for labor: too low.

Conclusion: errors in estimating the rate of inflation → a misallocation of resources → lower economic growth.


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Hyperinflation and the Breakdown of Financial Intermediation

If inflation is moderate and stable:

Lenders and borrowers can forecast well.

Loans can be signed with rough certainty regarding the value of future payment.

If inflation is high and volatile:

Long-term risk becomes high and loans may not be signed at all.

Financial intermediation breaks down.


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Peru (1987-1992)

Private loans virtually disappeared.

Investment fell and the economy collapsed.

Mexico

1980s: Inflation rate at times exceeded 100%.

Long-term loans were hard to get.

As recently as 2002, 90% of debt matured within one year.

Since the 1990s: inflation has been tamed.

Result: rapidly growing capital markets and increased investment: Economic growth


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Conclusions:1. Unexpected inflation redistributes

wealth throughout society in arbitrary ways.

2. When inflation is high and volatile

Unexpected inflation is difficult to avoid.

Long-term contracting grinds to a halt.

Result: economic growth suffers.


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Unanticipated high inflation always means:a)a loss in purchasing power for lenders.b)a decrease in the amount of real taxes paid by citizens and firms.c)a redistribution of wealth from the rich to the poor.d)All of the answers are correct. To next To next

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3. Inflation Interacts with Other TaxesInflation will produce tax burdens and tax liabilities that do not make economic sense.

People pay taxes on illusory capital gains.

Example: Taxes are collected on nominal capital gains (e.g. not real gains)

Results:

Longer-run effect is to discourage investment in the first place.

Inflation increases the costs of complying with the tax system.

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4. Inflation is Painful to StopSlowing down the money supply can create a recession.A good lesson:

Inflation in 1980 was 13.5%.Tough monetary policy reduced the rate of inflation to 3%, but the consequence was…The worst recession since the Great Depression.Unemployment rate over 10%.The unemployment rate didn’t return to near 5.5% until 1988.

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The average number of times a dollar is spent on final goods and services during a year is:a)the velocity of money.b)the consumption rate.c)the money supply.d)the quantity theory of money.

12 chapter d ynamic p ower p oint ™ s lides by s olina l indahl inflation and the quantity theory...

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