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Chapter 17 Money Growth and Inflation 23 October 2006 Eco 202
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Chapter 17
Money Growth and Inflation23 October 2006
Eco 202
2
End-of-Chapter Problems
1, 2, 6, 8, 11, 13
3
The Meaning of Money
Money is the set of assets in an economy that people regularly use to buy goods and services from other people.
Economists contend that money is productive because it lowers the transaction costs of exchange.
If money is a good thing, could it be possible to have too much money?
4
THE CLASSICAL THEORY OF INFLATION Inflation is an increase in the overall level of prices. Hyperinflation is an extraordinarily high rate of
inflation. Inflation: Historical Aspects
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.
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THE CLASSICAL THEORY OF INFLATION Inflation: Historical Aspects
In the 1970s prices rose by 7 percent per year. During the 1990s, prices rose at an average rate
of 2 percent per year.
7
This Decade
Year Inflation Rate (Dec-Dec)
2000 3.4
2001 1.6
2002 2.4
2003 1.9
2004 3.3
2005 3.4
8
THE CLASSICAL THEORY OF INFLATION The quantity theory of money is used to
explain the long-run determinants of the price level and 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.
9
Aside: Terminology
The Quantity Equation is not the same as the Quantity Theory of Money
Quantity Equation is true by definition—it is an identity.
Quantity Theory of Money is subject to testing.
10
Money Supply, Money Demand, and Monetary Equilibrium The money supply is a policy variable that is
controlled by the Fed. Through instruments such as open-market
operations, the Fed directly controls the quantity of money supplied.
11
Money Supply, Money Demand, and Monetary Equilibrium Money demand has several determinants,
including interest rates and the average level of prices in the economy.
12
Money Supply, Money Demand, and Monetary Equilibrium People hold money because it is the medium
of exchange. The amount of money people choose to hold
depends on the prices of goods and services. As prices rise, people will want to hold more of
their assets in the form of money (liquid asset), and less in the form of assets that are not liquid.
13
Money Supply, Money Demand, and Monetary Equilibrium In the long run, the overall level of prices
adjusts to the level at which the demand for money equals the supply. This suggests that changes in either the supply of
money or the demand for money will cause the price level to change.
Figure 1 Money Supply, Money Demand, and the Equilibrium Price Level
Copyright © 2004 South-Western
Quantity ofMoney
Value ofMoney, 1/P
Price Level, P
Quantity fixedby the Fed
Money supply
0
1
(Low)
(High)
(High)
(Low)
1/2
1/4
3/4
1
1.33
2
4
Equilibriumvalue ofmoney
Equilibriumprice level
Moneydemand
A
Figure 2 The Effects of Monetary Injection
Copyright © 2004 South-Western
Quantity ofMoney
Value ofMoney, 1/P
Price Level, P
Moneydemand
0
1
(Low)
(High)
(High)
(Low)
1/2
1/4
3/4
1
1.33
2
4
M1
MS1
M2
MS2
2. . . . decreasesthe value ofmoney . . .
3. . . . andincreasesthe pricelevel.
1. An increasein the moneysupply . . .
A
B
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THE CLASSICAL THEORY OF INFLATION The Quantity Theory of Money
How the price level is determined and why it might change over time is called the quantity theory of money. The quantity of money available in the economy
determines the value of money. The primary cause of inflation is the growth in the
quantity of money.
17
The Classical Dichotomy and Monetary Neutrality Nominal variables are variables measured in
monetary units. Real variables are variables measured in
physical units.
18
The Classical Dichotomy and Monetary Neutrality According to Hume and others, real
economic variables do not change with changes in the money supply. According to the classical dichotomy, different
forces influence real and nominal variables. Changes in the money supply affect nominal
variables but not real variables.
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The Classical Dichotomy and Monetary Neutrality The irrelevance of monetary changes for real
variables is called monetary neutrality.
20
Velocity and the Quantity Equation
The velocity of money refers to the speed at which the typical dollar bill travels around the economy from wallet to wallet.
21
Velocity and the Quantity Equation
V = (P Y)/M
Where: V = velocityP = the price level
Y = the quantity of output (real GDP)
M = the quantity of money Because Velocity is defined from the other three
variables, the Quantity Equation is an Identity
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Velocity and the Quantity Equation
Rewriting the equation gives the quantity equation:
M V = P Y
M = money supply
V = velocity
P = price level
Y = real GDP
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Velocity and the Quantity Equation
The quantity equation relates the quantity of money (M) to the nominal value of output (P Y).
24
Velocity and the Quantity Equation
The quantity equation shows that an increase in the quantity of money in an economy must be reflected in one of three other variables: the price level must rise, the quantity of output must rise, or the velocity of money must fall.
Figure 3 Nominal GDP, the Quantity of Money, and the Velocity of Money
Copyright © 2004 South-Western
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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Velocity and the Quantity Equation
The Equilibrium Price Level, Inflation Rate, and the Quantity Theory of Money The velocity of money is relatively stable over
time. When the Fed changes the quantity of money, it
causes proportionate changes in the nominal value of output (P Y).
Because money is neutral, money does not affect output (real GDP).
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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 money to pay for its spending.
Figure 4 Money and Prices During Four Hyperinflations
Copyright © 2004 South-Western
(a) Austria (b) Hungary
Money supply
Price level
Index(Jan. 1921 = 100)
Index(July 1921 = 100)
Price level
100,000
10,000
1,000
10019251924192319221921
Money supply
100,000
10,000
1,000
10019251924192319221921
Figure 4 Money and Prices During Four Hyperinflations
Copyright © 2004 South-Western
(c) Germany
1
Index(Jan. 1921 = 100)
(d) Poland
100,000,000,000,000
1,000,000
10,000,000,0001,000,000,000,000
100,000,000
10,000100
Moneysupply
Price level
19251924192319221921
Price levelMoneysupply
Index(Jan. 1921 = 100)
100
10,000,000
100,000
1,000,000
10,000
1,000
19251924192319221921
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Hyperinflation in Germany
At the end of World War I, Germany was required to pay reparations to the Allies
Germany began running large deficits Unable to tax or borrow enough to pay,
Germany began printing large quantities of money.
Prices started to rise.
33
Hyperinflation in Germany
Price of a newspaper in Germany, 1921-1923:
January 1921 0.30
May 1922 1
October 1922 8
February 1923 100
September 1923 1,000
October 1, 1923 2,000
October 15 20,000
October 29 1,000,000
November 9 15,000,000
November 17 70,000,000
Date Price in marks
Source: Mankiw, Macroeconomics, 5th ed., pp. 105-106
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Hyperinflation in Yugoslavia
From 1971-1991, Yugoslavia had an average annual inflation rate of 76% Only Zaire and Brazil had a higher inflation rate.
In December 1990, the Serbian parliament ordered the Serbian National Bank (a regional central bank) to issue large amounts of credits to friends of Slobodan Milosevic.
Source: Steve Hanke in April 28, 1999 Wall Street Journal
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Hyperinflation in Yugoslavia
This amounted to more than half the planned increase in the money supply for all of Yugoslavia in 1991
Croatia and Slovenia broke away In January 1992, hyperinflation began
Source: Steve Hanke in April 28, 1999 Wall Street Journal
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Hyperinflation in Yugoslavia
In January 1994, the official monthly inflation rate reached 313 million percent This was the second-highest monthly rate (after
Hungary in 1946) …and the second-longest (after the Soviet
hyperinflation of the early 1920s) People spent their time trying to exchange dinars
for marks or dollars on the black market
Source: Steve Hanke in April 28, 1999 Wall Street Journal
40
Hyperinflation in Yugoslavia
The Yugoslav mint was producing 900,000 bank notes a month, in denominations of up to 500 billion dinars
Source: Steve Hanke in April 28, 1999 Wall Street Journal; image from National Bank of Serbia
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Hyperinflation in Yugoslavia
On January 6, 1994, the government gave up and declared the German mark legal tender Tying a “superdinar” to the mark reduced inflation
Source: Steve Hanke in April 28, 1999 Wall Street Journal
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Money and Inflation in U.S.
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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 who holds money.
The inflation ends when the government institutes fiscal reforms such as cuts in government spending.
46
The Fisher Effect
The Fisher effect refers to a one-to-one adjustment 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 the Inflation Rate
Copyright © 2004 South-Western
Percent(per year)
1960 1965 1970 1975 1980 1985 1990 1995 20000
3
6
9
12
15
Inflation
Nominal interest rate
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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 money holdings is the time and convenience you must sacrifice to keep less money on hand.
Also, extra trips to the bank take time away from productive activities.
52
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
takes away from other productive activities.
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Relative-Price Variability and the Misallocation of Resources Inflation distorts relative prices. Consumer decisions are distorted, and
markets are less able to allocate resources to their best use.
54
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 are taxed more heavily.
55
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.
Table 1 How Inflation Raises the Tax Burden on Saving
Copyright©2004 South-Western
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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 to have different real values.
Therefore, with rising prices, it is more difficult to compare real revenues, costs, and profits over time.
58
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 loans in the economy are specified in terms of the unit of account—money.
59
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.
60
Summary
The principle of money neutrality asserts that changes in the quantity of money influence nominal variables but not real variables.
A government can pay for its spending simply by printing more money.
This can result in an “inflation tax” and hyperinflation.
61
Summary
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.
62
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
63
Summary
When banks loan out their deposits, they increase the quantity of money in the economy.
Because the Fed cannot control the amount bankers choose to lend or the amount households choose to deposit in banks, the Fed’s control of the money supply is imperfect.
