Chapter 4
Money and Inflation
Functions of Money
Types of Money
The Quantity
Theory of Money
The theory we will now develop,
called the quantity theory of money,
has its roots in the work of the early
monetary theorists, including the
philosopher and economist David
Hume (1711–1776). It remains the
leading explanation for how money
affects the economy in the long run.
Transactions and the Quantity Equation
The link between transactions and money is expressed in the following equation,
called the quantity equation:
where, T = the total number of transactions during some period of time, say, a year
P = the price of a typical transaction — the number of dollars exchanged
PT = equals the number of dollars exchanged in a year
M = the quantity of money
V = the transactions velocity of money
The right-hand side of the quantity equation tells us about transactions. The left-hand
side of the quantity equation tells us about the money used to make the transactions.
Transaction Velocity
of Money
It measures the rate at which money
circulates in the economy. In other
words, velocity tells us the number
of times a dollar bill changes hands
in a given period of time.
Let’s watch a video for better visual
representation of the equation.
[Link]
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From Transactions to Income
Transactions and output are related,
because the more the economy produces,
the more goods are bought and sold.
They are not the same, however.
When one person sells a used car to
another person, for example, they make a
transaction using money, even though
the used car is not part of current output.
Nonetheless, the dollar value of
transactions is roughly proportional to
the dollar value of output.
From Transactions to
Income
In the new version, Y is real GDP; P, the
GDP deflator; and PY, nominal GDP. The
quantity equation becomes
Because Y is also total income, V in this
version of the quantity equation is called
the income velocity of money. The
income velocity of money tells us the
number of times a dollar bill enters
someone’s income in a given period of
time.
The Money Demand
Function
and the Quantity
Equation
When we analyze how money
affects the economy, it is often
useful to express the quantity of
money in terms of the quantity
of goods and services it can buy.
This amount, M/P, is called real
money balances. Real money
balances measure the
purchasing power of the stock
of money.
The Money Demand Function
and the Quantity Equation
A money demand function is an equation that shows the determinants
of the quantity of real money balances people wish to hold. A simple
money demand function is
where k is a constant that tells us how much money people want to
hold for every dollar of income. This equation states that the quantity
of real money balances demanded is proportional to real income.
The Assumption of Constant Velocity
The quantity equation can be viewed as a definition: it defines velocity V as
the ratio of nominal GDP, PY, to the quantity of money M.
Yet if we make the additional assumption that the velocity of money is
constant, then the quantity equation becomes a useful theory about the
effects of money, called the quantity theory of money.
As with many of the assumptions in economics, the assumption of constant
velocity is only a simplification of reality. Velocity does change if the money
demand function changes.
The Assumption of Constant Velocity
With this assumption included, the quantity equation can be seen as a
theory of what determines nominal GDP. The quantity equation says
Therefore, a change in the quantity of money (M) must cause a
proportionate change in nominal GDP (PY ). That is, if velocity is fixed, the
quantity of money determines the dollar value of the economy’s output.
Money, Prices, and Inflation
The theory has three building blocks:
1. The factors of production and the production function
determine the level of output Y.
2. The money supply M determines the nominal value
of output PY. This conclusion follows from the
quantity equation and the assumption that the velocity
of money is fixed.
3. The price level P is then the ratio of the nominal value
of output PY to the level of output Y.
The productive capability of the economy determines real GDP, the quantity of money
determines nominal GDP, and the GDP deflator is the ratio of nominal GDP to real GDP.
Money, Prices, and Inflation
The quantity equation, written in percentage-change form, is
% Change in M + % Change in V = % Change in P + % Change in Y
Consider each of these four terms.
First, the percentage change in the quantity of money M is under the
control of the central bank.
Second, the percentage change in velocity V reflects shifts in money
demand; we have assumed that velocity is constant, so the percentage
change in velocity is zero.
Third, the percentage change in the price level P is the rate of inflation;
this is the variable in the equation that we would like to explain.
Money, Prices, and Inflation
Fourth, the percentage change in output Y depends on growth in the
factors of production and on technological progress, which for our present
purposes we are taking as given.
This analysis tells us that (except for a constant that depends on exogenous
growth in output) the growth in the money supply determines the rate of
inflation.
Thus, the quantity theory of money states that the central bank, which
controls the money supply, has ultimate control over the rate of inflation.
If the central bank keeps the money supply stable, the price level will be
stable. If the central bank increases the money supply rapidly, the price level
will rise rapidly.
Inflation and Money Growth
“Inflation is always and everywhere a monetary phenomenon.”
The quantity theory of money leads us to agree that the growth in the quantity
of money is the primary determinant of the inflation rate.
Friedman, together with fellow economist Anna Schwartz, wrote two treatises
on monetary history that documented the sources and effects of changes in the
quantity of money over the past century. Figure 4-1 uses some of their data and
plots the average rate of money growth and the average rate of inflation in the
United States over each decade since the 1870s.
The data verify the link between inflation and growth in the quantity of money.
Decades with high money growth (such as the 1970s) tend to have high
inflation, and decades with low money growth (such as the 1930s) tend to have
low inflation.
Inflation and Money Growth
Inflation
and
Money
Growth
Seigniorage: The Revenue
from Printing Money
A government can finance its spending in three ways.
• First, it can raise revenue through taxes, such as personal and
corporate income taxes.
• Second, it can borrow from the public by selling government bonds.
• Third, it can print money.
The revenue raised by the printing of money is called seigniorage.
The term comes from seigneur, the French word for “feudal lord.”
Printing money to raise revenue is like imposing an inflation tax.
Two Interest Rates: Real and Nominal
The interest rate that the bank pays is called the nominal
interest rate, and the increase in your purchasing power is
called the real interest rate.
If i denotes the nominal interest rate, r the real interest rate,
and the rate of inflation, then the relationship among these
three variables can be written as
The real interest rate is the difference between the nominal
interest rate and the rate of inflation.
The Fisher Effect
Rearranging terms in our equation for the real interest rate, we can show
that the nominal interest rate is the sum of the real interest rate and the
inflation rate:
The equation written in this way is called the Fisher equation, after
economist Irving Fisher (1867–1947). It shows that the nominal interest
rate can change for two reasons: because the real interest rate changes or
because the inflation rate changes.
This equation relating the real interest rate, nominal interest rate, and
inflation rate is only an approximation. The exact formula is . The
approximation in the text is reasonably accurate as long as r, i, and p are
relatively small (say, less than 20 percent per year).
The Fisher Effect
Once we separate the nominal interest rate into these two parts, we can use this
equation to develop a theory that explains the nominal interest rate. Chapter
3 showed that the real interest rate adjusts to equilibrate saving and investment.
The quantity theory of money shows that the rate of money growth
determines the rate of inflation. The Fisher equation then tells us to add the
real interest rate and the inflation rate together to determine the nominal
interest rate.
The quantity theory and the Fisher equation together tell us how money
growth affects the nominal interest rate. According to the quantity theory, an
increase in the rate of money growth of 1 percent causes a 1 percent increase in
the rate of inflation. According to the Fisher equation, a 1 percent increase in the
rate of inflation in turn causes a 1 percent increase in the nominal interest rate.
The one-for-one relation between the inflation rate and the nominal interest rate
is called the Fisher effect.
Two Real Interest Rates: Ex Ante and Ex Post
When a borrower and lender agree on a nominal interest rate, they do
not know what the inflation rate over the term of the loan will be.
The real interest rate that the borrower and lender expect when the
loan is made, called the ex ante real interest rate, and the real interest
rate that is actually realized, called the ex post real interest rate.
Although borrowers and lenders cannot predict future inflation with
certainty, they do have some expectation about what the inflation rate
will be. Let denote actual future inflation and the expectation of future
inflation. The ex ante real interest rate is , and the ex post real
interest rate is .
Two Real Interest Rates: Ex Ante and Ex Post
The two real interest rates differ when actual inflation differs from
expected inflation .
Clearly, the nominal interest rate cannot adjust to actual inflation,
because actual inflation is not known when the nominal interest rate is set.
The nominal interest rate can adjust only to expected inflation. The
Fisher effect is more precisely written as
The ex ante real interest rate r is determined by equilibrium in the market
for goods and services. The nominal interest rate i moves one-for-one with
changes in expected inflation .
The Nominal Interest Rate and the
Demand for Money
The quantity theory is based on a simple money demand function: it assumes
that the demand for real money balances is proportional to income.
Here we add another determinant of the quantity of money demanded—the
nominal interest rate.
If, instead of holding that money, you used it to buy government bonds or
deposited it in a savings account, you would earn the nominal interest rate.
Assets other than money, such as government bonds, earn the real return r.
Money earns an expected real return of , because its real value declines at the
rate of inflation. When you hold money, you give up the difference between
these two returns. Thus, the cost of holding money is , which the Fisher
equation tells us is the nominal interest rate i.
Cost of Holding Money
The demand for real money balances depends both on the level of income and
on the nominal interest rate. We write the general money demand function as
The letter L is used to denote money demand because money is the economy’s
most liquid asset (the asset most easily used to make transactions). This
equation states that the demand for the liquidity of real money balances is a
function of income and the nominal interest rate.
The higher the level of income Y, the greater the demand for real money
balances. The higher the nominal interest rate i, the lower the demand for real
money balances.
Future
Money
and
Current
Prices
Future Money and Current Prices
Consider how the introduction of this last link affects our theory of the price level.
First, equate the supply of real money balances to the demand L(i, Y):
Next, use the Fisher equation to write the nominal interest rate as the sum of
the real interest rate and expected inflation:
This equation states that the level of real money balances depends on the expected
rate of inflation.
Future Money and Current Prices
The last equation tells a more sophisticated story about the determination of
the price level than does the quantity theory.
The quantity theory of money says that today’s money supply
determines today’s price level. This conclusion remains partly true: if the
nominal interest rate and the level of output are held constant, the price level
moves proportionately with the money supply.
Yet the nominal interest rate is not constant; it depends on expected
inflation, which in turn depends on growth in the money supply. The
presence of the nominal interest rate in the money demand function yields an
additional channel through which money supply affects the price level.
Future Money and Current Prices
This general money demand equation implies that the price level depends
not only on today’s money supply but also on the money supply expected
in the future.
Suppose, the central bank announces that it will increase the money supply in
the future, but it does not change the money supply today. This announcement
causes people to expect higher money growth and higher inflation.
Through the Fisher effect, this increase in expected inflation raises the
nominal interest rate.
The higher nominal interest rate increases the cost of holding money and
therefore reduces the demand for real money balances.
Future Money and Current Prices
Because the central bank has not changed the quantity of money
available today, the reduced demand for real money balances leads to a
higher price level.
Hence, expectations of higher money growth in the future lead to a
higher price level today.
The effect of money on prices is complex. The Cagan model shows how
the price level is related to current and expected future monetary policy.
In particular, the analysis concludes that the price level depends on a
weighted average of the current money supply and the money
supply expected to prevail in the future.
The Cagan Model: How Current and Future Money
Affect the Price Level
If the quantity of real money balances demanded depends on the cost of holding money,
the price level depends on both the current money supply and the future money supply.
We posit a money demand function that is linear in the natural logarithms of all the
variables. The money demand function is
where, the log of the quantity of money at time t
the log of the price level at time t,
a parameter that governs the sensitivity of money demand
to the rate of inflation
This equation states that if inflation goes up by 1 percentage point, real money balances
fall by percent.
The Cagan Model: Assumptions
We have made a number of assumptions in writing the money demand function
in this way.
• First, by excluding the level of output as a determinant of money demand, we
are implicitly assuming that it is constant.
• Second, by including the rate of inflation rather than the nominal interest rate,
we are assuming that the real interest rate is constant.
• Third, by including actual inflation rather than expected inflation, we are
assuming perfect foresight.
The Cagan Model: Derivation
Equation 1 can be rewritten as
This equation states that the current price level is a weighted average of the
current money supply and the next period’s price level .
The next period’s price level will be determined the same way as this period’s
price level.
The Cagan Model: Derivation
Now substitute Equation 3 for in Equation 2 to obtain
This equation states that the current price level is a weighted average of the
current money supply and the next period’s price level . Equation 4 states that the
current price level is a weighted average of the current money supply , the next
period’s money supply , and the following period’s price level .
Once again, the price level in period is determined as in Equation 2.
The Cagan Model: Derivation
Now substitute Equation 5 for in Equation 2 to obtain
We can continue to use Equation 2 to substitute for the future price level. If we do
this an infinite number of times, we find
According to Equation 7, the current price level is a weighted average of the
current money supply and all future money supplies.
The Cagan Model: Derivation
Now substitute Equation 5 for in Equation 2 to obtain
We can continue to use Equation 2 to substitute for the future price level. If we do
this an infinite number of times, we find
According to Equation 7, the current price level is a weighted average of the
current money supply and all future money supplies.
The Cagan Model: Importance of
Note the importance of , the parameter governing the sensitivity of real money
balances to inflation.
The weights on the future money supplies decline geometrically at rate . If is
small, then is small, and the weights decline quickly. In this case, the current
money supply is the primary determinant of the price level.
Indeed, if equals zero, we obtain the quantity theory of money: the price level is
proportional to the current money supply, and the future money supplies do not
matter at all.
If is large, then is close to 1, and the weights decline slowly. In this case, the future
money supplies play a key role in determining today’s price level.
The Cagan Model: Importance of the model
Some economists use this model to argue that credibility is
important for ending hyperinflation. Because the price level
depends on both current and expected future money, inflation
depends on both current and expected future money growth.
Therefore, to end high inflation, both money growth and expected
money growth must fall. Expectations, in turn, depend on credibility
—the perception that the central bank is committed to a new, more
stable policy.
The Social Cost of Inflation
The Layman’s View and the Classical Response
The complaint about inflation is a common fallacy. The purchasing
power of labor—the real wage—depends on the marginal
productivity of labor, not on how much money the government
chooses to print.
If the central bank reduces inflation by slowing the rate of money
growth, workers will not see their real wage increasing more rapidly.
Instead, when inflation slows, firms will increase the prices of their
products less each year and, as a result, will give their workers
smaller raises.
What Economists and the Public Say
About Inflation
As we have been discussing, laymen and economists hold very
different views about the costs of inflation.
In 1996, economist Robert Shiller documented this difference
of opinion in a survey of the two groups.
The survey results are striking, for they show how the study of
economics changes a person’s attitudes.
What Economists and the Public Say
About Inflation
Question 1. The “biggest gripe about inflation” was that
“inflation hurts my real buying power, it makes me poorer.” Do
you completely agree with it?
77% 12%
General Public Economists
What Economists and the Public Say
About Inflation
Question 2. Do you agree with the following statement:
“When I see projections about how many times more a college education will
cost, or how many times more the cost of living will be in coming decades, I
feel a sense of uneasiness; these inflation projections really make me worry
that my own income will not rise as much as such costs will.”
66% 5%
General Public Economists
What Economists and the Public Say
About Inflation
Question 3. “Do you agree that preventing high inflation is an important
national priority, as important as preventing drug abuse or preventing
deterioration in the quality of our schools?”
52% 18%
General Public Economists
What Economists and the Public Say
About Inflation
Question 4. Do you completely agree with the following statement:
“I think that if my pay went up I would feel more satisfaction in my job, more
sense of fulfillment, even if prices went up just as much.”
49% 8%
General Public Economists
The Costs of Expected Inflation
One cost is the distortion of the inflation tax on the amount of money
people hold. The inconvenience of reducing money holding is
metaphorically called the shoeleather cost of inflation, because walking
to the bank more often causes one’s shoes to wear out more quickly.
A second cost of inflation arises because high inflation induces firms to
change their posted prices more often. Changing prices is sometimes
costly: for example, it may require printing and distributing a new
catalog. These costs are called menu costs, because the higher the rate
of inflation, the more often restaurants have to print new menus.
The Costs of Expected Inflation
Third cost of inflation arises because firms facing menu costs change
prices infrequently; therefore, the higher the rate of inflation, the greater
the variability in relative prices.
For example, suppose a firm issues a new catalog every January. If there is
no inflation, then the firm’s prices relative to the overall price level are
constant over the year.
Yet if inflation is 1 percent per month, then from the beginning to the end
of the year the firm’s relative prices fall by 12 percent. Sales from this
catalog will tend to be low early in the year (when its prices are relatively
high) and high later in the year (when its prices are relatively low).
Hence, when inflation induces variability in relative prices, it leads to
microeconomic inefficiencies in the allocation of resources.
The Costs of Expected Inflation
A fourth cost of inflation results from the tax laws. Many provisions of the tax
code do not take into account the effects of inflation.
One example of the failure of the tax code to deal with inflation is the tax
treatment of capital gains. Suppose you buy some stock today and sell it a year
from now at the same real price. It would seem reasonable for the government
not to levy a tax, because you have earned no real income from this investment.
Indeed, if there is no inflation, a zero tax liability would be the outcome.
But suppose the rate of inflation is 12 percent and you initially paid $100 per
share for the stock; for the real price to be the same a year later, you must sell
the stock for $112 per share. In this case the tax code, which ignores the effects
of inflation, says that you have earned $12 per share in income, and the
government taxes you on this capital gain. The problem is that the tax code
measures income as the nominal rather than the real capital gain. In this
example, and in many others, inflation distorts how taxes are levied.
The Costs of Expected Inflation
A fifth cost of inflation is the inconvenience of living in a world with a
changing price level. Money is the yardstick with which we measure
economic transactions. When there is inflation, that yardstick is
changing in length.
The dollar is a less useful measure when its value is always changing.
The changing value of the dollar requires that we correct for inflation
when comparing dollar figures from different times.