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CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 0

Chapter 4Chapter 4

Money and InflationMoney and Inflation


In this chapter you will learnIn this chapter you will learn

The classical theory of inflation

– causes

– effects

– social costs

What is money? How is it related toinflation?


U.S. inflation & its trend,U.S. inflation & its trend, 19601960--20012001

0

2

4

6

8

10

12

14

16

1960 1965 1970 1975 1980 1985 1990 1995 2000

% p

e r y e a r

inflation rate


The connection betweenThe connection betweenmoney and pricesmoney and prices

Inflation rate = the percentageincrease in the average level of prices.

price = amount of money required tobuy a good.

Because prices are defined in terms of money, we need to consider thenature of money, the supply of money,and how it is controlled.


Money: definitionMoney: definition

MoneyMoney is the stock is the stock

of assets that can beof assets that can be

readily used to makereadily used to make

transactions.transactions.


Money: functionsMoney: functions

1. medium of exchangewe use it to buy stuff

2. store of valuetransfers purchasing power from the present to the future

3. unit of accountthe common unit by which everyone measures prices and values

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Money: typesMoney: 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


Money supply measures,Money supply measures, April 2002April 2002

_Symbol Assets included Amount (billions)_

C Currency $598.7

M1 C + demand deposits, 1174.0travelers’ checks,other checkable deposits

M2 M1 + small time deposits, 5480.1savings deposits,money market mutual funds,money market deposit accounts

M3 M2 + large time deposits, 8054.4repurchase agreements,institutional money marketmutual fund balances


The money supply and the central bankThe money supply and the central bank

Monetary policy, control over the money supply,is conducted by a country’s central bank .

In the U.S.,

the central

bank is called

the Federal

Reserve

(“the Fed”).

The Federal Reserve Building

Washington, DC


The Quantity Theory of MoneyThe Quantity Theory of Money

A simple theory linking the inflationrate to the growth rate of themoney supply.

Begins with a concept called “velocity”…


VelocityVelocity

basic concept: the rate at which moneycirculates

definition: the number of times the averagedollar bill changes hands in a given timeperiod

example: In 2001,

• $500 billion in transactions

• money supply = $100 billion

• The average dollar is used in fivetransactions in 2001

• So, velocity = 5CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 11

Velocity,Velocity, cont.cont.

Use nominal GDP as a proxy for totaltransactions.

Then, P Y V

M

×=

where

P = price of output (GDP deflator)

Y = quantity of output (real GDP)

P ×Y = value of output (nominal GDP)

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The quantity equationThe 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.


back to the Quantity Theory of Money back to the Quantity Theory of Money

starts with quantity equation

assumes V is constant & exogenous:

=V V

With this assumption, the quantityequation can be written as

× = ×M V P Y


The Quantity Theory of MoneyThe Quantity Theory of Money, cont., cont.

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 (chap 3)

The price level isP = (nominal GDP)/(real GDP)

× = ×M V P Y



Recall, 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

is constant, so = 0.V V V

∆



Let π (Greek letter “pi”)

denote the inflation rate:

M P Y

M P Y

∆ ∆ ∆= +

P

P

∆=π

π

∆ ∆= −

M Y

M Y

The result from the

preceding slide was:

Solve this result

for π to get



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.

π

∆ ∆= −

M Y

M Y

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π

∆ ∆= −

M Y

M Y

Hence, the Quantity Theory of Money predicts a one-for-one relation between changes in the money

growth rate and changes in the inflation rate .


International data onInternational data oninflation and money growthinflation and money growth

Inflation rate(percent,logarithmicscale)

1,000

10,000

100

10

1

0.1

Money supply growth (percent, logarithmic scale

0.1 1 10 100 1,000 10,000

Nicaragua

Angola

Brazil

Bulgaria

Georgia

Kuwait

USA

JapanCanada

Germany

Oman

Democratic Repubof Congo


U.S. data onU.S. data oninflation and money growthinflation and money growth

0 2 4 6

Growth in money supply (percent)

8 10 12

8

6

4

2

0

- 2

- 4

1970s

1910s

1940s

1980s

1960s1950s

1990s

1930s

1920s1870s

1890s

1880s

1900s

Inflationrate(percent)


SeigniorageSeigniorage

To spend more without raising taxes or

selling bonds, the govt can print money.

The “revenue” raised from printing money

is called seigniorage

(pronounced SEEN-your-ige)

The inflation tax:

Printing money to raise revenue causes

inflation. Inflation is like a tax on peoplewho hold money.


Inflation and interest ratesInflation and interest rates

Nominal interest rate, i not adjusted for inflation

Real interest rate, r adjusted for inflation:

r = i − π


The Fisher EffectThe Fisher Effect

The Fisher equation: i = r + π

Chap 3: S = I determines r .

Hence, an increase in π

causes an equal increase in i .

This one-for-one relationship

is called the Fisher effect.

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U.S. inflation and nominal interest rates,U.S. inflation and nominal interest rates,19521952--19981998

Percent

16

14

12

10

86

4

2

0

-2

Nominal interest rate

Inflationrate

1950 1955 1960 1965 1970

Year

1975 1980 1985 1990 20001995


Two real interest ratesTwo real interest rates

π = actual inflation rate

(not known until after it has occurred)

πe = expected inflation rate

i – πe = ex ante real interest rate:

what people expect at the time they buy abond or take out a loan

i – π = ex post real interest rate:what people actually end up earning on theirbond or paying on their loan


Money demand andMoney demand andthe nominal interest ratethe nominal interest rate

The Quantity Theory of Money assumes thatthe demand for real money balancesdepends only on real income Y .

We now consider another determinant of money demand: the nominal interest rate.

The nominal interest rate i is theopportunity cost of holding money (insteadof bonds or other interest-earning assets).

Hence, ↑i ⇒ ↓ in money demand.


The money demand functionThe money demand function

(M / P )d = real money demand, depends

negatively on i

i is the opp. cost of holding money

positively on Y

higher Y ⇒ more spending

⇒ so, need more money

(L is used for the money demand functionbecause money is the most liquid asset.)

( ) ( , )dM P L i Y =


The money demand functionThe money demand function

When people are deciding whether to hold

money or bonds, they don’t know what

inflation will turn out to be.

Hence, the nominal interest rate relevant

for money demand is r + πe.

( ) ( , )dM P L i Y =

( , )e L r Y += π


EquilibriumEquilibrium

( , )e M L r Y P

= + π

The supply of real

money balances Real money

demand

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What determines what What determines what

variable how determined (in the long run)

M exogenous (the Fed)

r adjusts to make S = I

Y

( , )e M

L r Y P

= + π

( , )Y F K L =

P adjusts to make ( , )M

L i Y P

=


HowHow P P responds toresponds to ∆M M

For given values of r , Y , and πe,

a change in M causes P to change bythe same percentage --- just like in the

Quantity Theory of Money.

( , )e M

L r Y P

= + π


What about What about expected inflationexpected inflation? ?

Over the long run, people don’t consistently

over- or under-forecast inflation,

so πe = π on average.

In the short run, πe may change when people

get new information.

EX: Suppose Fed announces it will increase

M next year. People will expect next year’s P

to be higher, so πe rises.

This will affect P now, even though M hasn’tchanged yet.

(continued…)


Why is inflation bad?Why is inflation bad?

Common misperception:inflation reduces real wages

This is true only in the short run, whennominal wages are fixed by contracts.

(Chap 3) In the long run,the real wage is determined by labor supplyand the marginal product of labor,not the price level or inflation rate .

Consider the data…


Average hourly earnings & the CPIAverage hourly earnings & the CPI

0

2

4

6

8

10

12

14

16

18

1964 1968 1972 1976 1980 1984 1988 1992 1996 2000

$ p e r h o u r

0

25

50

75

100

125

150

175

200

225

250

C P I ( 1 9 8 3 = 1 0 0 )

Average

hourly

earnings

Hourly earningsin 2001 dollars

Consumer

Price Index

0

2

4

6

8

10

12

14

16

18

1964 1968 1972 1976 1980 1984 1988 1992 1996 2000

$ p e r h o u r

0

25

50

75

100

125

150

175

200

225

250

C P I ( 1 9 8 3 = 1 0 0 )

Average

hourly

earnings

Hourly earningsin 2001 dollars

Consumer

Price Index


The social costs of inflationThe social costs of inflation

…fall into two categories:

1. costs when inflation is expected

2. additional costs when inflation isdifferent than people had expected.

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The costs of expected inflation:The costs of expected inflation:11.. shoeleathershoeleather costcost

def: the inconvenience of reducing moneybalances to avoid the inflation tax.

↑π ⇒ ↑i ⇒ ↓ real money balances

Remember: In long run, inflation doesn’t

affect real income or real spending.

So, same monthly spending but lower averagemoney holdings means more frequent trips tothe bank.


The costs of expected inflation:The costs of expected inflation:22.. menu costsmenu costs

def: The costs of changing prices.

Examples:

– print new menus

– print & mail new catalogs

The higher is inflation, the more frequentlyfirms must change their prices and incurthese costs.


The costs of expected inflation:The costs of expected inflation:33.. relative price distortionsrelative price distortions

Firms facing menu costs change pricesinfrequently.

Different firms change their prices atdifferent times, leading to relative pricedistortions…

…which cause microeconomicinefficiencies in the allocation of

resources.


The costs of expected inflation:The costs of expected inflation:44.. unfair tax treatmentunfair tax treatment

Some taxes are not adjusted to account forinflation, such as the capital gains tax.

Example: 1/2001: you bought $10,000 worth of

Starbucks stock 12/2001: you sold the stock for $11,000, so

your nominal capital gain was $1000 (10%). Suppose π = 10% in 2001. Real capital gain is $0. But the govt. requires you to pay taxes on your

$1000 nominal gain!!


The costs of expected inflation:The costs of expected inflation:55.. General inconvenienceGeneral inconvenience

Inflation makes it harder to comparenominal values from different time periods.

This complicates long-range financialplanning.


Additional cost of Additional cost of unexpected unexpected inflation:inflation:

arbitrary redistributions of purchasing power arbitrary redistributions of purchasing power

Many long-term contracts not indexed,but based on πe .

If π turns out different from πe ,

then some gain at others’ expense.

Example: borrowers & lenders

• If π > πe , then purchasing power is

transferred from lenders to borrowers.

• If π < πe , then purchasing power is

transferred from borrowers to lenders.

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Additional cost of high inflation:Additional cost of high inflation:increased uncertaintyincreased uncertainty

When inflation is high, it’s more variableand unpredictable:

π turns out different from πe more often,

and the differences tend to be larger(though not systematically positive or negative)

Arbitrary redistributions of wealthbecome more likely.

This creates higher uncertainty, whichmakes risk averse people worse off.


One benefit of inflationOne benefit of inflation

Inflation allows equilibrium real wages to

fall without nominal wage cuts.

Therefore, moderate inflation improves

the functioning of labor markets.

Inflation allows equilibrium real wages toInflation allows equilibrium real wages to

fall without nominal wage cuts.fall without nominal wage cuts.

Therefore, moderate inflation improvesTherefore, moderate inflation improves

the functioning of labor markets.the functioning of labor markets.


HyperinflationHyperinflation

def: π ≥ 50% per month

All the costs of moderate inflation described

above become HUGE under hyperinflation.

Money ceases to function as a store of value.

People may conduct transactions with barteror a stable foreign currency.


What causes hyperinflation?What causes hyperinflation?

Hyperinflation is caused by excessivemoney supply growth:

When the central bank prints money, theprice level rises.

If it prints money rapidly enough, theresult is hyperinflation.

1

10

100

1000

10000

p e r c e n t g r o w t h

Israel

1983-85

Poland

1989-90

Brazil

1987-94

Argentina

1988-90

Peru

1988-90

Nicaragua

1987-91

Bolivia

1984-85

inflation growth of money supply

Recent episodes of hyperinflationRecent episodes of hyperinflation

slide 46 CHAPTER 4CHAPTER 4 Money and InflationMoney and Inflation slide 47

Why governments create hyperinflationWhy governments create hyperinflation

When a government cannot raise taxes orsell bonds,

it must finance spending increases byprinting money.

In theory, the solution to hyperinflation issimple: stop printing money.

In the real world, this requires drastic andpainful fiscal restraint.

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The Classical DichotomyThe Classical Dichotomy

Classical Dichotomy : the theoreticalseparation of real and nominal variablesin the classical model, which impliesnominal variables do not affect real

variables. Neutrality of Money : Changes in the

money supply do not affect realvariables. In the real world, money isapproximately neutral in the long run.

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