Money Growth and

Inflation
 Inflation

Inflation is an increase in the

overall level of prices.

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 Inflation: Historical Aspects
 Over the past sixty 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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 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.

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 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.
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 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.

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 Money Supply, Money Demand, and
Monetary Equilibrium

Money demand has several

determinants, including interest
rates and the average level of
prices in the economy.

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 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.

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 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.

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 Money Supply, Money Demand, and
the Equilibrium Price Level
Value of Price
Money (1/P) Money supply
Level (P)
(High) 1 1 (Low)

3/4 1.33
value of money

price level
Equilibrium
1/2 2
Equilibrium

1/4 4
Money
demand
(Low) 0 (High)
Quantity fixed Quantity of
by the Fed Money
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 The Effects of Monetary Injection
Value of Price
Money (1/P) MS1 MS2
Level (P)
(High) 1 1. An 1 (Low)
increase in
the money
3/4 1.33
2. ...decreases the

supply...
value of money ...

3. …and
increases the
price level
A
1/2 2

B
1/4 4
Money
demand
(Low) 0 (High)
M1 M2 Quantity of
Money
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 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.

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 The Classical Dichotomy and
Monetary Neutrality

 Nominal variables are variables

measured in monetary units.
 Real variables are variables
measured in physical units.

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 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.

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 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.

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 Velocity and the Quantity Equation

V = (P x Y)/M
Where: V = velocity
P = the price level
Y = the quantity of output
M = the quantity of money

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 Velocity and the Quantity Equation

 Rewriting the equation gives the

quantity equation:

MxV=PxY

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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 x Y).

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 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.

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 Nominal GDP, the Quantity of Money,
Indexes and the Velocity of Money
(1960 = 100)

1,500
Nominal GDP

M2
1,000

500

Velocity

0
1960 1965 1970 1975 1980 1985 1990 1995 2000
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 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 x Y).
 Because money is neutral, money does
not affect output.

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 The Equilibrium Price Level, Inflation Rate,
and the Quantity Theory of Money

 When the Fed alters the money supply

and induces parallel changes in the
nominal value of output, these changes
are also reflected in changes in the price
level.
 When the Fed increases the money
supply rapidly, the result is a high rate of
inflation.

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 Hyperinflation

 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.

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 Money and Prices During Four
Hyperinflations
(a) Austria (b) Hungary
Index (Jan. Index (Jan.
1921 = 100) 1921 = 100)

100,000 100,000 Price level

Price level

10,000 Money 10,000

supply
Money
1,000 1,000 supply

100 100
1921 1922 1923 1924 1925 1921 1922 1923 1924 1925

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 Money and Prices During Four
Hyperinflations
c) Germany d) Poland

Index (Jan. Index (Jan.

1921 = 100) 1921 = 100)

100 trillion Price level 10 million

Price level
1 trillion
Money 1 million
10 billion supply Money
100 million 100,000
supply
1 million 10,000
10,000
1,000
100
1 100
1921 1922 1923 1924 1925 1921 1922 1923 1924 1925

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 Hyperinflation and
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.
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 The Fisher Effect

 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.

Nominal interest rate =

Real interest rate + Inflation rate

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 The Nominal Interest Rate
Percent
(per year) and the Inflation Rate
15

12

10 Nominal interest rate

3
Inflation
0
1960 1965 1970 1975 1980 1985 1990 1995
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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.
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 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

 Inflation distorts relative prices.

 Consumer decisions are distorted,
and markets are less able to allocate
resources to their best use.

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 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.

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 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.

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 How Inflation Raises the Tax
Burden On Saving
Economy 1 Economy 2
(price stability) (inflation)

Real interest rate 4% 4%

Inflation rate 0 8

Nominal interest rate 4 12

(Real interest rate + inflation rate)
Reduced interest due to 25 percent tax 1 3
(.25 x nominal interest rate)
After-tax nominal interest rate 3 9
(.75 x nominal interest rate)
After-tax interest rate 3 1
(after-tax nominal interest rate - inflation rate)

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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.
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 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.

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 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.

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 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.

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 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.
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 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

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 Graphical
Review

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 Money Supply, Money Demand, and
the Equilibrium Price Level
Value of Price
Money (1/P) Money supply
Level (P)
(High) 1 1 (Low)

3/4 1.33
value of money

price level
Equilibrium
1/2 2
Equilibrium

1/4 4
Money
demand
(Low) 0 (High)
Quantity fixed Quantity of
by the Fed Money
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 The Effects of Monetary Injection
Value of Price
Money (1/P) MS1 MS2
Level (P)
(High) 1 1. An 1 (Low)
increase in
the money
3/4 1.33
2. ...decreases the

supply...
value of money ...

3. …and
increases the
price level
A
1/2 2

B
1/4 4
Money
demand
(Low) 0 (High)
M1 M2 Quantity of
Money
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 Nominal GDP, the Quantity of Money,
Indexes and the Velocity of Money
(1960 = 100)

1,500
Nominal GDP

M2
1,000

500

Velocity

0
1960 1965 1970 1975 1980 1985 1990 1995 2000
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 Money and Prices During Four
Hyperinflations
(a) Austria (b) Hungary
Index (Jan. Index (Jan.
1921 = 100) 1921 = 100)

100,000 100,000 Price level

Price level

10,000 Money 10,000

supply
Money
1,000 1,000 supply

100 100
1921 1922 1923 1924 1925 1921 1922 1923 1924 1925

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 Money and Prices During Four
Hyperinflations
c) Germany d) Poland

Index (Jan. Index (Jan.

1921 = 100) 1921 = 100)

100 trillion Price level 10 million

Price level
1 trillion
Money 1 million
10 billion supply Money
100 million 100,000
supply
1 million 10,000
10,000
1,000
100
1 100
1921 1922 1923 1924 1925 1921 1922 1923 1924 1925

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 The Nominal Interest Rate
Percent
(per year) and the Inflation Rate
15

12

10 Nominal interest rate

3
Inflation
0
1960 1965 1970 1975 1980 1985 1990 1995
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