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Introduction to Macroeconomics
Lecture 7. Money Growth and Inflation
25 (26) April 2013
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The Role of Money: Recall from last lecture
• Money is the set of assets in an economy that
people regularly use to buy goods and services
from other people.
• Broadly, these assets take the form of currency(paper money) or bank deposits (CC +DEP)
• Money is also used as a store of wealth, i.e. and
alternative to stocks, bonds and other assets
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Inflation: What is it? • Inflation is an increase in the overall level of prices.
• Hyperinflation is an extraordinarily high rate of
inflation.
• What causes inflation?
Many journalists blame inflation on rising prices…―inflation increased because of rising food prices.‖
• What is wrong with this explanation?
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Inflation: some facts
From the textbook:
• Over the past 60 years, prices have risen on average
about 5 percent per year.
• Deflation, meaning decreasing average prices,occurred in the U.S. in the nineteenth century.
• Hyperinflation refers to high rates of inflation such
as Germany experienced in the 1920s.
• In the 1970s prices rose by 7 percent per year.
• During the 1990s, prices rose at an average rate of 2
percent per year.
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Inflation: Some facts about Vietnam
At the outset of doi moi , Vietnam experienced hyperinflation (400% in 1989), but
achieved one of the most remarkable stabilizations in history, bringing inflation
down to the single digit range while raising the growth rate from 5 to 8% p.a. in just a few years. For a decade (1995-2006) VN enjoyed low inflation and high
growth. Since 2006 VN has experienced greater price and output instability.
Low inflation
& high growth
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The Classical Theory of Inflation: the Quantity Theory
• The quantity theory of money is used to explain the long-run determinants of the price level and the inflation rate.
• Asserting that the quantity of money available determines
the price level and that the growth rate in the quantity of
money available determines the inflation rate.
• Inflation is an economy-wide phenomenon that concerns
the value of the economy’s medium of exchange.
• When the overall price level rises, the value of money
falls.
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• The quantity theory is a simple theory of supply anddemand for money.
• Like every theory of supply and demand, there is aunique relationship between quantity and price in
equilibrium.• When we find equilibrium, we have
• The equilibrium quantity (amount of money supplied anddemanded)
• The equilibrium value of money (which is the overall pricelevel in the economy.)
• This theory provides a theory of inflation in terms of the determinants of supply and demand for money
The Quantity Theory
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• Money supply is determined by the central
bank.
• The central bank manages the money supply by managing the size of its balance sheet
(assets and liabilities) and by managing the
money multiplier (mm)
The Quantity Theory: Money supply
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M
B
The Quantity Theory: Money supply
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The Quantity Theory: Money supply
• Base money = Central bank liabilities = Central bank assets
NC D R BRCC B
• Money supply is monetary assets held by the public
M=CC+DEP
• Money supply is linked to base money by the money
multiplier (mm), which depends of the reserve requirement
ratio (r)
r c
cmm
Bmm M
1 where
Money supply is an exogenous, policy-determined variable,
controlled by the central bank
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The theory assumes that people demand money for two purposes:1. To facilitate transactions. A general measure of the volume of transactions is nominal GDP (PY), where P is the aggregate pricelevel and Y is real GDP.
2. To hold wealth (i.e. as a place to put their savings). But thereare alternative assets in which to save (e.g. bonds and stocks), sothe return on alternative assets (e.g. the interest rate on bonds)influences their demand for money as a store of wealth.
The Quantity Theory: Money Demand
What is your demand for money? How much do you
want? An infinite amount? Or, just lots!
Fi 1 M S l M D d d th
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Figure 1 Money Supply, Money Demand, and theEquilibrium Price Level
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Quantity of
Money
Value of
Money, 1 / P
Price
Level, P
Quantity fixed
by the central bank
Money supply
0
1
(Low)
(High)
(High)
(Low)
1 / 2
1 / 4
3 / 4
1
1.33
2
4
Equilibrium
value of money
Equilibrium
price level
Money
demand
A
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Figure 2 The Effects of Monetary Injection
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Quantity of
Money
Value of Money, 1 / P
PriceLevel, P
Money
demand
0
1
(Low)
(High)
(High)
(Low)
1 / 2
1
/ 4
3
/ 4
1
1.33
2
4
M 1
MS 1
M 2
MS 2
2. . . . decreases the value of
mone y . . . 3. . . . and
increases
the price
level.
1. An increase
in the money
supply . . .
A
B
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The Quantity Theory: Money and the Price Level
Y P V M
M
GDP
M
Y P V
The Quantity Theory Equation:
Where M is money supply, P is the price level, and Y is realGDP, V is the velocity of circulation,
V is the number of times the money supply turns over in a
given period of time (say one year).
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The Quantity Theory: Money and the price level
• So if GDP is $100 billion and M is $50 billion, V is 2.
• If we assume, as the Quantity Theory does, that V and Y areconstant.
There is an inverse relationship between the quantity of
money (M) and the value of money (1/P).
As M goes up, P goes up and if P goes up (1/P) goes down
a given amount of money buys less and less in the market
the value of money has declined
M
GDP
M
Y P V
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The Quantity Theory: Money growth and inflation
Y
Y
P
P
V
V
M
M Y P V M
)0
Y
Y
V
V
M
M
P
P
• The Quantity Theory Equation can be written in terms of rates
of change of the variables on both sides of the equation:
• Again assuming V
and Y are constant ( , then we have
The inflation rate in the long-run is determined
by the rate of growth of money.
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The Quantity Theory: Money growth and inflation
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The Quantity Theory: Money growth and inflationwith real GDP growth
•Assuming V is constant, but allowing for real GDP growth, we havethe following relationship between money growth and inflation
The inflation rate is the difference between the rate of growth of
money supply and money demand. As real GDP growth, the
transactions demand for money grows at the same rate.
• If money growth is 30% per year and real GDP growth is 5% per year, the
annual inflation rate will be 25%.
Y
Y
M
M
P
P
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The Quantity Theory: Money growth and inflationwith real GDP growth and changes in velocity
When we allow for change in the velocity of circulation, we
have
Y
Y
V
V
M
M
P
P
The velocity of circulation,
M
Y P V
But, in developing countries V normally falls over time?
Why?
normally stable in advanced countries.
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The Quantity Theory: Money growth and inflationwith real GDP growth and changes in velocity
In developing countries the velocity of circulation normally falls
over time. Why?
• The proportion of transactions conducted in the market rises –
so-called the monetization process → money demand rises
• Financial savings increase as a percent of GDP. As saving rates
rise → money demand (time deposits) typically rises
The velocity of circulation falls
The inflation effect of money growth is reduced.
Figure 3 Nominal GDP the Quantity of Money
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Figure 3 Nominal GDP, the Quantity of Money,and the Velocity of Money: Stable in the U.S.
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Indexes
(1960 = 100)
2,000
1,000
500
0
1,500
1960 1965 1970 1975 1980 1985 1990 1995 2000
Nominal GDP
Velocity
M2
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Money growth, GDP growth, Velocity and Inflation in Vietnam
In the period from 1995 to 2006, money growth rate was high, but GDP growth was
also high and the velocity of circulation was falling as the economy became more
monetized and as private saving in time deposits increase dramatically. As a result,high money growth did not lead to high inflation in the period.
Source: IMF, IFS online database.
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Since 2006, the link between money growth and inflation has tightened. Over this
period growth was slower and the demand for domestic currency deposits decline
(switching to gold and dollars) as a result the velocity probably increased.
Source: IMF, IFS online database.
Money growth, GDP growth, Velocity and Inflation in Vietnam
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CASE STUDY: Money and Prices during Four Hyperinflations
• Hyperinflation is inflation that exceeds 50 percent per month.
• Hyperinflation occurs in some countries
because the government prints too much moneyto pay for its spending.
Figure 4 Money and Prices During Four
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Figure 4 Money and Prices During Four Hyperinflations
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(a) Austria (b) Hungary
Money supply
Price level
Index
(Jan. 1921 = 100)
Index
(July 1921 = 100)
Price level
100,000
10,000
1,000
100
1925 1924 1923 1922 1921
Money supply
100,000
10,000
1,000
100
1925 1924 1923 1922 1921
Figure 4 Money and Prices During Four
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Figure 4 Money and Prices During Four Hyperinflations
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(c) Germany
1
Index
(Jan. 1921 = 100)
(d) Poland
100,000,000,000,000
1,000,000
10,000,000,000
1,000,000,000,000
100,000,000
10,000
100
Money
supply
Price level
1925 1924 1923 1922 1921
Price level
Money
supply
Index
(Jan. 1921 = 100)
100
10,000,000
100,000
1,000,000
10,000
1,000
1925 1924 1923 1922 1921
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Hyperinflation in Vietnam: 1988-92
Inflation was high because money growth was high. Money growth was high
because the central bank was financing government deficits due to large losses
by SOEs. The government stabilized the economy by closing down manySOEs and cutting its deficit. Money growth declined and so did inflation. Note
growth increased as the same time. This was one of the world’s most
successful stabilizations.
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The Inflation Tax
• When the government raises revenue by printing money, it is said to levy an inflation
tax.
• An inflation tax is like a tax on everyone whoholds money.
• The inflation ends when the government
institutes fiscal reforms such as cuts ingovernment spending.
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Monetary Neutrality in the Long-Run
• Changes in the money supply affect nominal variables but not real variables.
• Nominal variables are variables measured in
monetary units.• Real variables are variables measured in physical
units.
• The separation of real and nominal variables is now
called the classical dichotomy.
• Real economic variables do not change with changes
in the money supply.
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The Fisher Effect: Inflation and Interest Rates
• The Fisher effect refers to a one-to-oneadjustment of the nominal interest rate to the
inflation rate.
• According to the Fisher effect, when the rate of inflation rises, the nominal interest rate rises by
the same amount.
• The real interest rate stays the same.
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Figure 5. The Nominal Interest Rate and theInflation Rate – the U.S.
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Inflation and Interest Rates: Vietnam
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33
Inflation and Interest Rates: Nominal versus Real
Monthly Nominal and Real Deposit
and Lending Interest RatesMonthly Interest Rates on
VND, USD and Gold Deposits
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THE COSTS OF INFLATION
• A Fall in Purchasing Power? • Inflation does not in itself reduce people’s real
purchasing power.
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THE COSTS OF INFLATION • Shoeleather costs
• Menu costs
• Relative price variability
• Tax distortions
• Confusion and inconvenience
• Arbitrary redistribution of wealth
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Shoeleather Costs • Shoeleather costs are the resources wasted
when inflation encourages people to reduce
their money holdings.
• Inflation reduces the real value of money, so people have an incentive to minimize their cash
holdings.
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Shoeleather Costs • Less cash requires more frequent trips to the
bank to withdraw money from interest-bearing
accounts.
• The actual cost of reducing your moneyholdings is the time and convenience you must
sacrifice to keep less money on hand.
• Also, extra trips to the bank take time awayfrom productive activities.
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Menu Costs • Menu costs are the costs of adjusting prices.
• During inflationary times, it is necessary to
update price lists and other posted prices.
• This is a resource-consuming process that takesaway from other productive activities.
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Relative-Price Variability and the Misallocationof Resources • Inflation distorts relative prices.
• Consumer decisions are distorted, and markets
are less able to allocate resources to their best
use.
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Inflation-Induced Tax Distortion • Inflation exaggerates the size of capital gains
and increases the tax burden on this type of
income.
• With progressive taxation, capital gains aretaxed more heavily.
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Inflation-Induced Tax Distortion • The income tax treats the nominal interest
earned on savings as income, even though part
of the nominal interest rate merely compensates
for inflation.• The after-tax real interest rate falls, making
saving less attractive.
H I fl ti R i th T B d S i
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How Inflation Raises the Tax Burden on Saving
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Confusion and Inconvenience • When the Fed increases the money supply and
creates inflation, it erodes the real value of the
unit of account.
• Inflation causes dollars at different times tohave different real values.
• Therefore, with rising prices, it is more difficult
to compare real revenues, costs, and profitsover time.
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A Special Cost of Unexpected Inflation:Arbitrary Redistribution of Wealth • Unexpected inflation redistributes wealth
among the population in a way that has nothing
to do with either merit or need.
• These redistributions occur because many loansin the economy are specified in terms of the
unit of account — money.
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Summary
• The overall level of prices in an economy adjusts to bring money supply and money demand into balance.
• When the central bank increases the supply of money,
it causes the price level to rise.
• Persistent growth in the quantity of money supplied
leads to continuing inflation.
• A government can pay for its spending simply by
printing more money.
• This can result in an ―inflation tax‖ and hyperinflation.
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Summary
• The principle of money neutrality asserts that changesin the quantity of money influence nominal variables
but not real variables.
• According to the Fisher effect, when the inflation rate
rises, the nominal interest rate rises by the same
amount, and the real interest rate stays the same.
• Many people think that inflation makes them poorer
because it raises the cost of what they buy.• This view is a fallacy because inflation also raises
nominal incomes.
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Summary
• Economists have identified six costs of inflation:
• Shoeleather costs
• Menu costs• Increased variability of relative prices
• Unintended tax liability changes
• Confusion and inconvenience• Arbitrary redistributions of wealth
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Homework
Textbook (6th edition): 1 and 7
Due on 9 (10) May