Money Growth and
Inflation
17
THE CLASSICAL THEORY OF
INFLATION
Inflation: Historical Aspects
Over the past 60 years, prices have risen on average
about 4 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.
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 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.
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
Money, 1/P
(High)
Price
Level, P
Money supply
1.33
/4
12
Equilibrium
value of
money
(Low)
(Low)
2
Equilibrium
price level
4
14
Money
demand
0
Quantity fixed
by the Fed
Quantity of
Money
(High)
Figure 2 The Effects of Monetary Injection
Value of
Money, 1/P
(High)
MS1
MS2
1
1. An increase
in the money
supply . . .
2. . . . decreases
the value of
money . . .
Price
Level, P
/4
12
1.33
2
B
14
(Low)
3. . . . and
increases
the price
level.
4
Money
demand
(High)
(Low)
0
M1
M2
Quantity of
Money
THE CLASSICAL THEORY OF
INFLATION
The Quantity Theory of Money
Implications:
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.
Changes in the money supply affect nominal
variables in long term but not real variables.
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 through the
economy.
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
The quantity equation relates the quantity of
money (M) to the nominal value of output
(P Y).
Figure 3 Nominal GDP, the Quantity of Money, and
the Velocity of Money
Indexes
(1960 = 100)
2,000
Nominal GDP
1,500
M2
1,000
500
Velocity
0
1960
1965
1970
1975
1980
1985
1990
1995
2000
Copyright 2004 South-Western
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).
Figure 4 Money and Prices During Four
Hyperinflations
(a) Austria
(b) Hungary
Index
(Jan. 1921 = 100)
Index
(July 1921 = 100)
100,000
100,000
Price level
Price level
10,000
10,000
Money supply
1,000
100
Money supply
1,000
1921
1922
1923
1924
1925
100
1921
1922
1923
1924
1925
Figure 4 Money and Prices During Four
Hyperinflations
(c) Germany
(d) Poland
Index
(Jan. 1921 = 100)
100,000,000,000,000
1,000,000,000,000
10,000,000,000
100,000,000
1,000,000
10,000
100
1
Index
(Jan. 1921 = 100)
10,000,000
Price level
Money
supply
Price level
1,000,000
Money
supply
100,000
10,000
1,000
1921
1922
1923
1924
1925
100
1921
1922
1923
1924
1925
THE COSTS OF INFLATION
A Fall in Purchasing Power?
Inflation does not in itself reduce peoples 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.
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.
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.
The after-tax real interest rate falls, making
saving less attractive.
Table 1 How Inflation Raises the Tax Burden on
Saving
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.