National Income & Business Cycles

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Ohio Wesleyan UniversityGoran Skosples

4: Money and Inflation

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Objectives

The classical theory of inflation• causes• effects• social costs

“Classical” -- assumes prices are flexible & markets clear.

Applies in the long run.

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Inflation ( ) and its trend, 1960-2009

-3%

0%

3%

6%

9%

12%

15%

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

long-run trend

% change in CPI from 12 months earlier

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Money: functions & types

Functions:• medium of _________• store of _________• unit of ________

Types

1. _________ money

2. _________ money

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The money supply

Money Supply: controlled (imperfectly) by the government via (monetary policy):

1. _____________________: swap between bonds and money

2. ___________________: legal restrictions on the percent of bank assets that cannot be lent out.

3. _______________: the interest rate charged by the central bank on its loans to banks.

There are many measures of money (M1, M2, etc.). They are not important for this course.

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The Quantity Theory of Money

links the inflation rate to the growth rate of the money supply.

People hold money to conduct their _______ _____________.

Velocity• the number of times the average dollar bill

changes hands in a given time period• Ex: In 2001, $500 billion in transactions and

money supply was $100 billion. The average dollar is used in five transactions in 2001, so velocity = 5

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Velocity, cont. This suggests the following definition:

Use nominal GDP as a proxy for total transactions.

The Quantity Equation:

P YV

M

T

VM

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Inflation and Money Growth

Representing the quantity equation in percent-change form we have that

M V P YM V P Y

The quantity theory of money assumes

is constant, so = 0.V

VV

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Inflation and Money Growth

a) productive capability (K, L) determines % Y

b) V is constant

c)

then

prices rise (inflation ) only if:

% M % Y

PP

% M + % V = % P + % Y

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Implications of Quantity Theory

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. • Countries with ________ money growth rates

should have _________ inflation rates.• The long-run trend behavior of a country’s

inflation should be similar to the long-run trend in the country’s _________ growth rate.

YM %%

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International data on inflation and money growth

1 10 1000.1

1.0

10.0

100.0

ChinaSwitzerland

U.S.

Euro Area

Infla

tion

rate

(p

erce

nt, l

ogar

ithm

ic s

cale

)

Money supply growth(percent, logarithmic scale)

Singapore

EcuadorTurkey

Belarus

Argentina

Indonesia

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U.S. inflation and money growth, 1960-2009

-3%

0%

3%

6%

9%

12%

15%

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

inflation rate

M2 growth rate

Over the long run, the rates of inflation and money growth

move together, as the Quantity Theory predicts.

Over the long run, the rates of inflation and money growth

move together, as the Quantity Theory predicts.

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Inflation as a fiscal phenomenon: Seigniorage

To spend more without raising taxes or selling bonds, the gov’t can print money.

The “revenue” raised from printing money is called ______________.

The _____________:Printing money to raise revenue causes inflation. Inflation is like a tax on people who hold money.

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Inflation, interest rates, and the Fisher effect

Nominal interest rate, i ___________ for inflation

Real interest rate, r __________ for inflation:

Recall from Chap 3: S = I determines __

an increase in causes an equal increase in __.

This one-for-one relationship is called the _______ _________.

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U.S. inflation and nominal interest rates,

1960-2009

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010-2%

2%

6%

10%

14%

18%

inflation rate

nominal interest rate

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Inflation and nominal interest rates across countries

1 10 100 10001

10

100Nominal

interest rate(percent,

logarithmic scale)

Inflation rate(percent, logarithmic scale)

Zimbabwe

Romania

TurkeyBrazil

Israel

U.S.

GermanyEthiopia

Kenya

Georgia

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Exercise:Exercise:

Suppose V is constant, M is growing 5% per year, Y is growing 2% per year, and r = 4.

1. Solve for i (the nominal interest rate).

2. If the Fed increases the money growth rate by 2 percentage points per year, find i .

% V = % M = % Y = r =

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Exercise:Exercise:

3. Suppose the growth rate of Y falls to 1% per year.

• What will happen to ?

• What must the Fed do if it wishes to keep constant?

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Two real interest rates

= ______ inflation rate (not known until after it has occurred)

e = ________ inflation rate

i – e = ________ real interest rate: what people expect at the time they buy a bond or take out a loan

i – = ________ real interest rate:what people actually end up earning on their bond or paying on their loan

They differ because of the differences in expected and actual inflation.

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The money demand function

(M/P)d = real money demand, depends• negatively on __

- __ is the opportunity cost of holding money• positively on __

higher __ more spending so, need more money

(“L” is used for the money demand function because money is the most liquid asset.)

( ) ( , )dM P L i Y

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The money demand function

When people are deciding whether to hold money or bonds, they don’t know what ______ will turn out to be.

Hence, the nominal interest rate relevant for money demand is ________. Therefore, the price level depends on today’s money supply and expected future money supplies

( ) ( , )dM P L i Y

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What determines what

variable how determined (in the long run)

M

r

Y

( , )eML r Y

P

P

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How P responds to M

For given values of r, Y, and e,

a change in M causes P to change by

______________________

( , )eML r Y

P

– just like in the

quantity theory of money.

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What about expected inflation?

Over the long run, people don’t consistently over- or under-forecast inflation,

so e = __ on average.

In the short run, e may change when people get new information.

EX: Fed announces it will increase M next year. People will expect next year’s __ to be higher, so ___ rises.

This affects __ now, even though __ hasn’t changed yet….

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How P responds to e

For given values of r, Y, and M ,

( , )eML r Y

P

e

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A common misperception

Common misperception: inflation reduces real wages

This is true only in the ______ run, when nominal wages are fixed by contracts.

(Chap 3) In the _______ run, the real wage is determined by ___________ and _____________________________, not the price level or inflation rate.

Consider the data…

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The CPI and Average Hourly Earnings,

1965-2009

1965

= 1

00H

ourly wage in M

ay 2009 dollars

$0

$5

$10

$15

$20

0

100

200

300

400

500

600

700

800

900

1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

CPI (1965 = 100)

Nominal average hourly earnings,

(1965 = 100)

Real average hourly earnings in 2009 dollars,

right scale

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The classical view of inflation

The classical view: A change in the price level is merely a change in the units of measurement.

So why, then, is inflation a social problem?

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The Social Costs of Inflation1. ___________ __costs: waste productive effort

trying to protect oneself against 2. _____ costs: changing prices is costly (physical

or reputation cost)

3. Variability in _______ prices: leads to ________ inefficiency

4. _____ laws: measures capital gains by comparing nominal values instead of real values.

5. Inconvenience: currency is a less ______ measure when its value changes a lot.

Unexpected inflation redistributes wealth ___________.

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Benefit(s) of inflation?

________ wages are rarely reduced, even when the equilibrium real wage falls.

Inflation allows the real wages to reach equilibrium levels without nominal wage _____.

Therefore, moderate inflation improves the functioning of ______ markets.

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Hyperinflation

def: 50% per month

inflation costs HUGE under hyperinflation

Money ceases to function as a store of value, and may not serve its other functions

transactions with _____ or a stable ______ currency

Why it happens? excessive money supply growth:• central bank prints money the price level ____• if it prints money rapidly enough, the result is

_________________

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Why gov’ts create hyperinflation

When a government cannot raise ______ or sell _______,

it must finance spending increases by _______ ______.

In theory, the solution to hyperinflation is simple: stop _______________.

In the real world, this requires drastic and painful _________ restraint.

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A few examples of hyperinflation

country periodCPI Inflation % per year

M2 Growth % per year

Israel 1983-85 338% 305%

Brazil 1987-94 1256% 1451%

Bolivia 1983-86 1818% 1727%

Ukraine 1992-94 2089% 1029%

Argentina 1988-90 2671% 1583%

Dem. Republic of Congo / Zaire

1990-96 3039% 2373%

Angola 1995-96 4145% 4106%

Peru 1988-90 5050% 3517%

Zimbabwe 2005-07 5316% 9914%

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How does it work?

Gov’t prints money to cover the budget deficit:

then,

recall:

then

P

Meseigniorag

seigniorage

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The Printing Machine

If the government wants to keep running budget deficits, can it keep printing money ( ) to cover the deficit?

1.

2.

),( YrLM

Meseigniorag e

M

M

M

M

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Money Growth and Seigniorage

Seigniorage is first an _________ function, then a _________ function of nominal money growth.

M/P

M/M

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Some Hyperinflations of the 1920s and 40s

Country Time PT/P0

Average Monthly Inflation Rate (%)

Average Monthly Money

Growth (%)

Austria Oct. 1921 - Aug. 1922

Aug. 1922 - Nov. 1923

Nov. 1943 - Nov. 1944

Mar. 1923 - Feb. 1924

Aug. 1945 - Jul. 1946

Jan. 1923 - Jan. 1924

Dec. 1921 - Jan. 1924

70 47 31

Germany 1.0 x 1010 322 314

Greece 4.7 x 106 365 220

Hungary 1 44 46 33

Hungary 2 3.8 x 1027 19,800 12,200

Poland 699 82 72

Russia 1.2 x 105 57 49

PT/P0: Price level in the last month of hyperinflation divided by the price level in the first month.

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Nominal Money Growth and Seigniorage

Country

M/M which Maximizes

Seigniorage(%/ month)

Implied Seigniorage

(% of output)

Actual Rate ofMoney Growth(% per month)

Austria 12 13 31

Germany 20 14 314

Greece 28 11 220

Hungary 1 12 19 33

Hungary 2 32 6 12,200

Poland 54 4.6 72

Russia 39 0.5 49

The Classical Dichotomy

Nominal variables ______ influence real variables

Since money is a nominal measure, it cannot affect the real GDP of the economy

We call this _____________________

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Summary

1. Money• serves as a medium of exchange, store of value, and

unit of account. • Central bank controls money supply.

2. Quantity theory of money• conclusion: the money growth rate determines the

inflation rate.

3. Nominal interest rate• equals real interest rate + inflation rate. • Fisher effect: nominal interest rate moves one-for-one

w/ expected inflation. • is the opp. cost of holding money

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Summary

4. Money demand• depends on income in the Quantity Theory• it also depends on the nominal interest rate

5. Costs of inflation• Expected inflation• Unexpected inflation

6. Hyperinflation• caused by rapid money supply growth when money

printed to finance gov’t budget deficits

7. Classical dichotomy• In classical theory, money is neutral--does not affect real

variables