7 Money Growth Inflation C17

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Copyright © 2004 South-Western

Introduction to Macroeconomics

Lecture 7. Money Growth and Inflation

25 (26) April 2013




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




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?




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.



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




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



• 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



M

B





• 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



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



Figure 1 Money Supply, Money Demand, and theEquilibrium Price Level


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



Figure 2 The Effects of Monetary Injection


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



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).



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



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.



The Quantity Theory: Money growth and inflation



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



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.



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



Figure 3 Nominal GDP, the Quantity of Money,and the Velocity of Money: Stable in the U.S.


Indexes

(1960 = 100)

2,000

1,000

500

0

1,500

1960 1965 1970 1975 1980 1985 1990 1995 2000

Nominal GDP

Velocity

M2



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.



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




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




Figure 4 Money and Prices During Four Hyperinflations


(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




Figure 4 Money and Prices During Four Hyperinflations


(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



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.




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.




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.




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.




Figure 5. The Nominal Interest Rate and theInflation Rate – the U.S.




Inflation and Interest Rates: Vietnam




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




THE COSTS OF INFLATION

• A Fall in Purchasing Power? • Inflation does not in itself reduce people’s real

purchasing power.




THE COSTS OF INFLATION • Shoeleather costs

• Menu costs

• Relative price variability

• Tax distortions

• Confusion and inconvenience

• Arbitrary redistribution of wealth




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.




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.




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.




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.




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.




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




How Inflation Raises the Tax Burden on Saving

Copyright©2004 South-Western




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.




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.




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.




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.




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



Homework

Textbook (6th edition): 1 and 7

Due on 9 (10) May

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7 Money Growth Inflation C17

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