Chapter 17
MONEY GROWTH AND INFLATION
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.
THE CLASSICAL THEORY OF
INFLATION
Inflation is an increase in the overall level of prices.
Hyperinflation is an extraordinarily high rate of
inflation.
THE CLASSICAL THEORY 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.
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.
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.
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.
Money Supply, Money Demand, and Monetary
Equilibrium
Money demand has several determinants,
including interest rates and the average level
of prices in the economy.
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.
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.
Figure 1 Money Supply, Money Demand, and the Equilibrium Price
Level
Value of Price
Money, 1/P Money supply Level, P
(High) 1 1 (Low)
3 1.33
/4
A
12
/ 2
Equilibrium Equilibrium
value of price level
14 4
money /
Money
demand
(Low) 0 (High)
Quantity fixed Quantity of
by the Fed Money
Copyright © 2004 South-Western
Figure 2 The Effects of Monetary Injection
Value of Price
Money, 1/P MS1 MS2 Level, P
(High) 1 1 (Low)
1. An increase
3
/4 in the money 1.33
2. . . . decreases supply . . .
the value of
3. . . . and
money . . . A
12
/ 2 increases
the price
level.
14
B
/ 4
Money
demand
(Low) (High)
0 M1 M2 Quantity of
Money
Copyright © 2004 South-Western
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.
The Classical Dichotomy and Monetary
Neutrality
Nominal variables are variables measured in
monetary units.
Real variables are variables measured in
physical units.
Problem from Chapter 16
If the reserve ratio is 15% and banks do
not hold any excess reserve, then, when
the central bank buys $40 million of
bonds from the public, what will happen
to bank reserves and money supply?
Next Lecture
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.
The Classical Dichotomy and Monetary
Neutrality
The irrelevance of monetary changes for real
variables is called monetary neutrality.
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.
Velocity and the Quantity Equation
V = (P Y)/M
◦ Where: V = velocity
P = the price level
Y = the quantity of output
M = the quantity of money
Velocity and the Quantity Equation
Rewriting the equation gives the quantity
equation:
MV=PY
Velocity and the Quantity Equation
The quantity equation relates the quantity of
money (M) to the nominal value of output
(P Y).
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.
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.
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
(a) Austria (b) Hungary
Index Index
(Jan. 1921 = 100) (July 1921 = 100)
100,000 100,000
Price level
Price level
10,000 10,000
Money supply
Money supply
1,000 1,000
100 100
1921 1922 1923 1924 1925 1921 1922 1923 1924 1925
Copyright © 2004 South-Western
Figure 4 Money and Prices During Four Hyperinflations
(c) Germany (d) Poland
Index Index
(Jan. 1921 = 100) (Jan. 1921 = 100)
100,000,000,000,000 10,000,000
Price level
1,000,000,000,000 Price level
Money 1,000,000
10,000,000,000
100,000,000 supply 100,000 Money
1,000,000 supply
10,000
10,000
100 1,000
1 100
1921 1922 1923 1924 1925 1921 1922 1923 1924 1925
Copyright © 2004 South-Western
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.
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.
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 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.
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.
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.
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.
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
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.
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.
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.
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.
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.
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
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.