MODERN PRINCIPLES OF ECONOMICSThird Edition

Inflation and the Quantity Theory of Money

Chapter 12

Outline

Defining and Measuring Inflation The Quantity Theory of Money The Costs of Inflation Why do governments sometimes

resort to inflation?

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Inflation

•"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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Introduction

When Zimbabwean president Robert Mugabe needed money in 2001, he printed more money since his anti commercial policies had driven productive farmers and entrepreneurs out of the country.

The government flooded the economy with money.

The economy, however, could not produce more goods, and prices went up.

The inflation rate increased from 50% a year to more than 50% a day.

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Definition

Inflation:An increase in the average level of prices. Inflation is measured by changes in a price index.

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Inflation

Inflation is measured by changes in a price index.

The inflation rate is the percentage change in a price index from one year to the next.

where P2 is the index value in year 2 and P1 is the index value in year 1.

Inflation is the average change of all prices.

100P

PPrate Inflation1

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Inflation

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Self-Check

If the price index is 200 in Year 1 and 210 in Year 2, the rate of inflation is:

a. 20%. b. 5%. c. 4.76%.

Answer: b – the rate of inflation is (210-200)/200 x 100 = 5%.

Price Indexes

1. Consumer price index (CPI): Measures the average price for a basket of goods and services bought by a typical American consumer. Changes regularly to reflect new and better-quality goods.

2. GDP deflator: The ratio of nominal to real GDP multiplied by 100. Covers all final goods.

3. Producer price indexes (PPI): Measure the average price received by producers. Includes final and intermediate goods.

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Relevance of CPI as a Price Index

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For Americans, CPI is the measure of inflation that corresponds most directly to their daily economic activity.

The BLS, which computes the CPI, tries to take both new goods and better-quality goods—into account when computing the CPI.

Survey covers 80,000 goods, weighted so that major items (housing) count more.

Inflation

11The Inflation Rate in the United States, 1950–2013

The average inflation rate since 1950 was 3.3%, but in many periods, especially in the 1970s, inflation was significantly higher.From 2003–2013, inflation in the United States has averaged about 2.4%.

Effect of Inflation on Price

12The cumulative effect of inflation on a large basket of goods

Definition

Real price:A price that has been corrected for inflation. Real prices are used to compare the prices of goods over time.

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Real Prices

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53.2$100202 $1.25

1982 2006 Gallon of gasoline $1.25 $2.50CPI 100 202

The CPI is used to calculate real prices.

The real price of gasoline (adjusted for inflation) was slightly lower in 2006 than it was in 1982.

Inflation

Average annual inflation ratesin selected countries (2002-2007)

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• 2002 and 2007, Zimbabwe had the highest inflation rate in the world at 735% a year.

• Countries with the lowest inflation rates had rates of less than 1%.

Hyperinflation

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Hyperinflation is a situation where the price increases are so out of control that the concept of inflation is meaningless.The numbers in Table 31.2 are so high, they are hard to believe. Hungary’s post-war hyperinflation is the largest on record.

Hyperinflation

Hungary’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 Hyperinflation occurs when

people lose confidence in a country’s currency holding value

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The worthless Hungarian Pengo,

1946

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Self-Check

A real price is a price that has been corrected for:

a. Population growth. b. Foreign currency exchange rates. c. Inflation.

Answer: c – real prices have been corrected for inflation.

Quantity Theory of Money

Quantity Theory of Money is a theory of inflation

QTM 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.

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Quantity Theory of Money

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

Since Mv is the total amount spent on final goods and services and PYR is the price level times real GDP, both sides of this equation are also equal to nominal GDP.

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Mv = PYR

Definition

Velocity of money (v):the average number of times a dollar is spent on final goods and services in a year. In short, it refers to how fast money passes from one holder to the next.

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Quantity Theory of Money

We assume that both real GDP (YR) and velocity (v) are stable compared to the money supply (M). • Real GDP is fixed by the real factors of

production— capital, labor, and technology. • In the U.S. today, v is about 7. • V is determined by factors that change only

slowly, such as whether workers are paid monthly or biweekly, or how long it takes to clear a check.

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Quantity Theory of Money

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Quantity Theory of Money

If YR is fixed by the real factors of production and v is stable, then the only thing that can cause an increase in P is an increase in M.

In other words, inflation is caused by an increase in the supply of money.

The quantity theory of money also says that the growth rate of the money supply will be approximately equal to the inflation rate.

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Self-Check

The number of times a dollar is spent on final goods and services in a year is called:

a. The quantity theory of money. b. The velocity of money. c. The currency turnover rate.

Answer: b – the velocity of money.

The Cause of Inflation

“Inflation is always and everywhere a monetary phenomenon.”

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Milton Friedman 1912 – 2008

The Cause of Inflation

27Money Growth and Inflation

Nations with rapidly growing money supplies had high inflation rates.

Nations with slowly growing money supplies had low inflation rates.

In fact, as the red line indicates, on average, the relationship is almost perfectly linear, with a 10 percentage point increase in the money growth rate leading to a 10 percentage point increase in the inflation rate.

The Quantity Theory of Money

How well does the theory hold up?•In Peru, very well….

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Quantity Theory of Money

Some Important Implications of QTM: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.29

Definition

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

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Disinflation:a reduction in the inflation rate.

Inflation

An unexpected increase in the money supply can boost the economy in the short run.

As firms and workers come to expect and adjust to the new influx of money, output will not grow any faster than normal.

In the long run, money is neutral.

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InflationAn 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.

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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.

The Costs of Inflation

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

Four problems associated with inflation:

1. 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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Price Confusion and Money Illusion

Inflation makes price signals more difficult to interpret.

It is not always clear whether prices are rising because of increased demand or just an increase in the money supply.

We sometimes mistake inflation for higher wages and prices in real terms.

Resources are wasted in activities that appear profitable but are not, and resources flow more slowly to profitable uses.

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Definition

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

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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.

Inflation Redistributes Wealth

Inflation is a type of tax that transfers real resources from citizens to the government.

Inflation reduces the real return that lenders receive on loans, transferring wealth from lenders to borrowers.

When inflation and interest rates fall unexpectedly, wealth is redistributed from borrowers (who are paying the higher rates) to lenders.

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Definition

Real rate of return:the nominal rate of return minus the inflation rate.

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Nominal rate of return:the rate of return that does not account for inflation.

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Self-Check

A decrease in the average level of prices is called:

a. Deflation. b. Disinflation. c. Money illusion.

Answer: a – a decrease in the average level of prices is called deflation.

Inflation Redistributes Wealth

The relationship between the lender’s real rate of return, the nominal rate of return, and the inflation rate, is:

Where: rreal = real rate of return i = nominal rate of interest p = rate of inflation

The real rate of return is equal to the nominal rate of return minus the inflation rate.

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rreal = i - p

Inflation Redistributes Wealth

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.40

Definition

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

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Inflation Redistributes Wealth

When lenders expect inflation to increase, they will demand a higher nominal interest rate.

The Fisher effect says that the nominal interest rate is equal to the expected inflation rate plus the equilibrium real interest rate.

Where: requilibrium = equilibrium real rate of return i = nominal rate of interestEp = expected rate of inflation

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mequilibriurEπi

The Fisher Effect

43Nominal interest rates tend to increase with inflation rates.

Inflation Redistributes Wealth

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

From earlier equations we have:

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

Inflation Redistributes Wealth

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Definition

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

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Inflation Redistributes Wealth

A government with massive debts has an incentive to increase the money supply, as it benefits from unexpected inflation.

The government doesn’t always inflate its debt away for two reasons: • If lenders expect inflation, they will increase

nominal rates. • Buyers of bonds are often also voters, and

would be upset if real returns were shrunk.

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Inflation Redistributes Wealth

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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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Self-Check

A government monetizes its debt by:

a. Raising interest rates. b. Lowering interest rates. c. Printing money to pay off the debt.

Answer: c – a government monetizes its debt by printing money to pay off the debt.

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

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Breakdown of Financial Intermediation

When nominal interest rates are not allowed to rise and inflation rate is high, the real rate of return will be negative.

People take their money out of the banking system.

The supply of savings declines and financial intermediation becomes less efficient.

Negative real interest rates reduce financial intermediation and economic growth.

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Breakdown of Financial Intermediation

When inflation is volatile and unpredictable, long-term loans become riskier.

Few long-term contracts will be signed. Any contract involving future payments will be

affected by inflation.

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Breakdown of Financial Intermediation

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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Inflation Interacts With Taxes

Most tax systems define incomes, profits, and capital gains in nominal terms.

Inflation will produce some tax burdens and liabilities that do not make economic sense.

If asset prices rise due to inflation, people pay capital gain taxes when they should not.

Inflation can push people into higher tax brackets.

Corporations pay taxes on phantom profits. Ultimately, investment is discouraged

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Inflation is Painful to Stop

The government can reduce inflation by reducing the growth in the money supply.

When inflation is expected, lower inflation may be misinterpreted as a reduction in demand.

Firms reduce output and employment. Workers may be thrown out of work as the

unexpected increase in their real wage makes them unaffordable.

Expectations will eventually adjust in the long run.

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Inflation is Painful to Stop

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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Takeaway

Inflation is an increase in the average level of prices as measured by a price index.

Sustained inflation is always and everywhere a monetary phenomenon.

Although money is neutral in the long run, changes in the money supply can influence real GDP in the short run.

Inflation makes price signals more difficult to interpret.

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Takeaway

The tendency of the nominal interest rate to increase with expected inflation is called the Fisher effect.

Arbitrary redistributions of wealth make lending and borrowing more risky and thus break down financial intermediation.

Anything above a mild rate of inflation is generally bad for an economy.