Session 7

Inflation
Prof Subramania Raju Rajasulochana
Associate Professor
SBM, NMIMS Mumbai
Topics
• Money Growth and Inflation: What is inflation?
• The costs of inflation (Deflation)
• Cost push inflation & Demand-pull inflation
Facts#
Steady economic growth and mild inflation
• In the UK, a loaf of bread, a pint of milk, and a dozen eggs in 1971 cost 9p, 5p, and 23p
respectively (about €0.10, €0.06, and €0.26). By January 2019, these prices had risen sharply:
bread to £1.40 (€1.56), milk to £0.50 (€0.56), and eggs to £1.50 (€1.67). This reflects price
increases of 1,455% for bread, 900% for milk, and 552.2% for eggs—a typical outcome in
advanced economies where price levels predictably increase over decades.
Episodes of hyperinflation
• In Yugoslavia, prices rose by 5 quadrillion percent (a figure with 15 zeros) in just over a year
(October 1993 to January 1995). Zimbabwe’s CPI (Consumer Price Index) skyrocketed by
231,000,000% in June 2008.
• The Zimbabwean central bank reported that black market prices for some goods rose by
70,000,000%, with items like laundry soap, cooking oil, and sugar experiencing enormous
price hikes of tens of millions of percent. Unskilled Zimbabwean workers earned
Z$200,000,000,000 a month, worth about US$10—barely enough to buy a loaf of bread,
even when the government issued Z$100 billion notes.
What is Inflation?
• General rise in the price level.
• Inflation reduces the “purchasing power” of money.
• Coulborn defined inflation is a state of “too much money chasing
too few goods.”
• The economist Milton Friedman said, “Inflation is always and
everywhere a monetary phenomenon.”
• David Hume proposed that “money is neutral.”
The Classical Theory Of Inflation
o Prices rise when the government prints too much money. This is the
classical theory of inflation.
o Inflation is an economy-wide phenomenon that concerns the value of the
economy’s medium of exchange.
o When the overall price level rises, the value of money falls and people
pay more for goods and services.
The Level of Prices and the Value of Money
o When the price level rises, people have to pay more for the goods and
services that they purchase.
o A rise in the price level also means that the value of money is now lower
because each pound or euro now buys a smaller quantity of goods and
services.
o If P is the price level, then the quantity of goods and services that can be
purchased with €1 is equal to 1/P.
Money Supply, Money Demand, and
Monetary Equilibrium
•The value of money is determined by the supply and demand for money.
o The money supply is a policy variable that is controlled by the central bank.
o The money supply is fixed until the central bank decides to change it through
instruments such as open-market operations, the central bank directly controls the
quantity of money supplied.
o Therefore, the supply of money is vertical (perfectly inelastic) until the central bank
decides to change it.
Money Supply, Money Demand, and
Monetary Equilibrium
•Money demand has several determinants, including interest
rates and the average level of prices in the economy.
o People hold money because it is the medium of exchange.
o The amount of money people choose to hold depends on the prices
of goods and services.
o Therefore, the lower the value of money the higher the demand.
 Figure 2. Money Supply, Money Demand, and the Equilibrium Price Level

Value of Price
Money, 1/P Money supply In the long run, the overall Level, P
level of prices adjusts to the
(High) 1 level at which the demand for 1 (Low)
money equals the supply.

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 Money
by the Central Bank
The Effects of a Monetary Injection
•The quantity theory of money explains the long-run determinants of the
price level and the inflation rate.
o The quantity of money available in the economy determines the value of money.
o The primary cause of inflation is the growth in the quantity of money (see Figure 3).
o Assume that the economy is in equilibrium and the central Bank suddenly increases the supply
of money.
o The supply of money shifts to the right.
o The equilibrium value of money falls and the price level rises.
Figure 3. 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
The Classical Dichotomy and Monetary
Neutrality
•Hume and others suggested in the 18C that economic variables could be
divided into:
o Nominal variables measured in monetary units.
o Real variables measured in physical units.
•This was termed the classical dichotomy.
The Classical Dichotomy and Monetary
Neutrality
Relative prices.
o Prices in the economy are nominal, but relative prices are real.
o The relative price is defined in terms of the nominal price of one good
divided by the nominal price of another.
o The real value of a good is what other goods have been sacrificed in
purchasing the good. This is the opportunity cost.
o Relative prices are not expressed in terms of money and so relative prices
are real variables.
o The relative price is expressed in terms of how much of one good has to be
given up in purchasing another.
The Classical Dichotomy and Monetary
Neutrality
• Real Wages.
o The concept of relative prices has an important application for wages.
o Imagine that a consumer only ever buys bananas and that the price of a banana is €2.
o If the consumer’s wage is €10 per hour, then the consumer can buy five bananas with their wage. To buy
five bananas means one hour of work.
o If bananas now cost €3 and wages rise to €12, then one hour of work only buys four bananas.
o Real wages is a more accurate reflection of how the consumer is affected.
o The real wage is the money wage adjusted for inflation measured by
the ratio of the wage rate to price.
The Classical Dichotomy and Monetary
Neutrality
Monetary Neutrality.
o The irrelevance of monetary changes for real variables is called monetary neutrality.
o Different forces influence real and nominal variables.
o Real economic variables do not change with changes in the money supply.
o When studying the long-run changes in the economy, the neutrality of money offers a good
description of how the world works.
Velocity and the Quantity Equation
•The velocity of money refers to the speed at which the money
changes hands, travelling around the economy from wallet to
wallet.
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:
MV=PY
The quantity equation relates the quantity of money (M) to the
nominal value of output
(P  Y).
Velocity and the Quantity Equation
• The Equilibrium Price Level, Inflation Rate, and the Quantity Theory of Money.
o The velocity of money is relatively stable over time.
o When the central bank changes the quantity of money, it causes proportionate
changes in the nominal value of output (P  Y).
o Because money is neutral, money does not affect output.