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Economics: Theory Through Applications

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Chapter 26Inflations Big and Small

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Learning Objectives

• What is the quantity theory of money?

• What is the classical dichotomy?

• According to the quantity theory, what determines the rate of inflation in the long-run?

• What does it mean to say that “inflation is always and everywhere a monetary phenomenon”?

• What do we know about inflation and money growth in the United States?

• What happened during past and recent hyperinflations?

Learning Objectives

• What is the inflation tax?

• How is inflation caused by the central bank’s commitment problem?

• What happens if there are multiple regions (states, countries) independently choosing how much money to print?

• What are the costs of an excessive inflation tax?

• When does inflation cause a redistribution?

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Learning Objectives

• What actions can government’s take to prevent excessive inflation?

• How can hyperinflations be ended?

• How do governments overcome the commitment problem?

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Figure 26.1- Button: Whip Inflation Now

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The Quantity Theory of Money

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nominal spending nominal GDP

nominal spendingvelocity of money

money supply

nominal GDP

money supply

price level real GDPvelocity of money

money supply

Figure 26.2 - Labor Market Equilibrium

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Figure 26.3 - Credit Market Equilibrium

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The Classical Dichotomy

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money supply velocity of money price level real GDP

Long Run Inflation

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money supply velocity of money price level real GDP

growth rate of money supply growth rate of money velocity inflation rate growth rate of output

inflation rate growth rate of money suppl

y growth rate of velocity

growth rate of output growth rate of money supply growth rate of output

Figure 26.4 - Inflation and Money Growth in the Short Run

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Figure 26.5 - Inflation and Money Growth in the Long Run

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Figure 26.6 - Inflation and Money Growth in Different Countries

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Table 26.1 - Prices in Germany

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Figure 26.7 - Money Growth and Inflation in Germany

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Figure 26.8 - The Use of Money in a Hyperinflation

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Table 26.2 - The Start of the Hyperinflation in Zimbabwe

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The Inflation Tax

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deficit change in government debt change in money supply

government purchases transfers tax receipts change in government debt

change in money supply

Figure 26.9 - The Gains to Inflation

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Closing the Output Gap

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inflation on rate autonomous inflation inflation sensitivity output gap

Figure 26.10 - The Price Level in Argentina

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Uncertainty and Real Interest Rates

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real interest rate nominal interest rate inflation rate

expected real interest rate nominal interest rate expected inflation rate

Figure 26.11 - Central Bank Independence and Inflation

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Key Terms

• Quantity Theory of Money: The Quantity Theory of Money is a relationship between money, output and prices that is used to study inflation

• Quantity equation: The quantity equation states that the supply of money times the velocity of money equals nominal GDP

• Circular flow of income: The circular flow of income measures the money flows among the different sectors of the economy as individuals and firms buy and sell goods and services

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Key Terms

• Classical dichotomy: According to the classical dichotomy, real variables are determined independently of nominal variables

• Aggregate expenditure model: The aggregate expenditure framework studies the relationship between planned spending and output

• Long-run neutrality of money: The fact that changes in the money supply have no long-run effect on real variables is called the long-run neutrality of money

• Nominal variable: A nominal variable is defined and measured in terms of money

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Key Terms

• Real variable: A real variable is defined and measured in terms other than money, often in terms of real GDP

• Monetary transmission mechanism: The monetary transmission mechanism explains how the actions of the Federal Reserve Bank affect aggregate economic variables, and in particular real GDP

• Hyperinflation: A hyperinflation is a period of very large, often escalating, inflation

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Key Terms

• Inflation tax: An inflation tax occurs when the government prints money to finance its deficit

• Commitment problem: A government suffers from a commitment problem when it is not able to make credible promises to pursue actions regardless of how others respond to those actions

• Taylor rule: A rule for monetary policy in which the target real interest rate increases when inflation is too high and decreases when output is too low

• Risk premium: The risk premium is part of the interest rate needed to compensate the lender for the risk of default 26-29

Key Terms

• Externality: An externality occurs when one person’s actions impose uncompensated costs or benefits on others

• Prisoner’s dilemma: In a prisoners’ dilemma game, there is a cooperative outcome that both players would prefer to the Nash equilibrium of the game

• Fisher equation: According to the Fisher equation, the real interest rate is approximately equal to the nominal interest rate minus the rate of inflation

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Key Terms

• Fixed exchange rate: In a fixed exchange rate regime, a central bank uses it tools to target the value of the domestic currency in terms of a foreign currency

• Inflation targeting: Under a policy regime of inflation targeting, the central bank uses its tools to set the rate of inflation as close as possible to a target

• Currency board: A fixed exchange rate regime in which each unit of domestic currency is backed by holding the foreign currency, valued at the fixed exchange rate

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Key Takeaways

• The quantity theory of money states that the supply of money times the velocity of money equals nominal GDP

• According to the classical dichotomy, real variables, such as real GDP, consumption, investment, the real wage, the real interest rate, etc., are determined independently of nominal variables, such as the money supply

• Using the quantity equation along with the classical dichotomy, in the long run the inflation rate equals the rate of money growth minus the growth rate of output

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Key Takeaways

• The quote by Milton Friedman that “inflation is always and everywhere a monetary phenomenon” points out the connection between money growth and price growth (inflation)

– From this perspective, the source of inflation is money growth

• Over long periods of time, inflation and money growth are closely linked in the United States

• The hyperinflations in many countries, such as Germany and Zimbabwe, were times of rapid growth in prices coming from rapid expansions of the money supply

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Key Takeaways

• A government that prints money to finance its deficit is using an inflation tax

– Individuals who hold nominal assets such as currency pay the tax

• One source of inflation is a commitment problem of a central bank wishing to use inflation to boost output

• When there are multiple regions (states, countries) each with the power to print money, then inflation will tend to be higher than it would be if only a single central bank controlled the money supply

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Key Takeaways

• Inflation can distort choices, such as the holding of money

– A small amount of inflation, so that it is one tax among many, makes economic sense, but high inflation leads to significant distortion in the economy

• Expected inflation is reflected in the terms of loan agreements

– Unexpected inflation, leads to a lower real interest rate and thus a redistribution from the lender to the borrower

• Governments can take a variety of actions to prevent excessive inflation

– These include the delegation of monetary policy to another central bank, the creation of an independent monetary authority and constraining monetary policy to focus solely on inflation

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Key Takeaways

• Historically hyperinflations ended when the government restored fiscal balance by eliminating deficit spending

• A government can overcome a commitment problem by delegating the conduct of monetary policy to a more conservative central bank

– This can be achieved through a currency board or through joining a monetary union

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