+

MACROECONOMICS
Lecturer: DANG HUYEN ANH
Email: Huyenanh098@gmail.com
+

Chapter 4
Money growth and Inflation
+
Reading materials

•  Gregory Mankiw, Cengage

learning, Principle of
macroeconomics, 9th edition,
chapter 17
IN THIS CHAPTER 4

!  How
does the money supply affect inflation and
nominal interest rates?

!  Does
the money supply affect real variables like real
GDP or the real interest rate?

!  How is inflation like a tax?

!  What are the costs of inflation? How serious are they?

+
Outline

!  Money in the economy

!  Money supply and the banking system

!  Inflation

!  Classical theory of inflation – the theory of money quantity

+ Money in the Economy

Money is the stock

of assets that can be readily used to
make transactions.

Fiat Money: something that serves as money but has no

The intrinsic value (has no other important uses).
two Examples: Coins, currency..
types
of
Commodity Money: something that performs the function
money
of money and has intrinsic value
Examples: Gold, silver…
+ Functions of Money

1. Medium of Exchange: money is acceptable as payment, we use it to

buy stuff
 Functions of Money
+
250.000 251.000
dollars dollars

2. Unit of Account: the common unit by which everyone measures

prices and values
+ Functions of Money

3. Store of Value: keeping money is a way to keep some of

our wealth in a readily spendable form for future needs. So You
can transfers purchasing power from the present to the future
+ Active learning

Which of these are money?

a. Currency
b. Checks
c. Deposits in checking accounts
(“demand deposits”)
d. Credit cards

10
+ Active learning: Answers

A. Currency - yes

B. Checks - no, not the checks themselves, but the funds in checking
accounts are money.

C. Deposits in checking accounts- yes (see b)

D. Credit cards - no, credit cards are a means of deferring payment.

+

Money Supply and the banking system

+ Where do banknotes in Currencies/bank
notes are issued
an economy come from? by the Central
Bank

The The
The The
Federal State
Bank of Bank of
Reserve - Bank of
England Canada
FED Vietnam
+ Two-tier Banking system

Issuing money
Central Bank

Commercial Banks Borrowing and

Lending money
 +
Primary Functions of the Central Bank

MONETARY
BASE
1. Issue currency/ banknotes.

2. Act as a banker’s bank, making loans to other commercial banks

3. Control the money supply with monetary policy.

Monetary Base is Currencies/bank notes issued by the Central Bank

+ Central bank and the Monetary base

Cash (C )

Monetary
Economy
base

Reserves
in the
banking
system
Commercial banks (R)
Monetary base is
the money issued
by the central
bank, including Monetary base, MB = C + R
Cash and Reserves MB is controlled by the central bank
Money creation and Money supply (MS)
+

Cash (C)

Economy

Money supply (MS)

base (MB)
Monetary

Reserves
(R)

Commercial banks

give Demand
deposits
loans
Receive in
Money Supply includes deposits banking
system
Cash and Demand Deposits (D)
in banking system
MS = C + D
or
MS = mm*MB Economy
+ Money creation mechanism

1.  Central Bank issue Money base

2.  Commercial Banks get deposit and lending

3.  Money supply (money stock) = Cash + Demand Deposit

MS= MB * mm

Question: Should Central bank Answer: No

allow Commercial banks lend Commercial banks have to keep a
out 100% their deposits? significant reserve ratio to keep their
deposit and lends in safe.
Reserves in banks are actual reserves,
including required reserve (imposed by the
Central bank) and excess reserve
+ Money creation
MS = MB * mm
From these below functions: Divide both
numerator
and
denominator
MS = C + D MS C+D to “D”
mm = =
MB C+R
MB = C + R
Replacing:
"  C/D = cr is Cash Ratio to demand deposits in payments
"  R/D = rr actual Reserve Ratio of commercial banks
(rr = required reserve + excess reserve)

Then:
MS
mm = = cr + 1
MB cr + rr
+
Example

Assume that the banking system has total reserves

of $100 billion. Assume also that required reserves
are 10 percent and banks hold no excess reserves
and households hold no currency.
What are the money multiplier and the money
supply?
+
Answer - example

!  Calculate money mutilplier: rr= 0,1 cr = 0 Therefore,

mm = (1+cr)/(rr+ cr) = 10

!  Calculate MS:

rr = R/D, so 0,1=100/D therefore, D = 1000

MS = C + D = 0 + 1000 = 1000
+ Monetary policy

Monetary
policy is the Contractionary
decrease MS
policy to monetary policy

control over the

money supply
by the Central
bank Expansionary
monetary induce MS
policy
+ Instruments of monetary policy

The central bank can control the Money supply using 3

instruments:

Open market Discount rate Reserve

operations charged on requirements
(OMO) loans to banks
Instruments of monetary policy
+ market operations
Open

Open market operations : Central bank buys/ sells bonds

in the open market
Open market is the
market for transactions of
bonds, stocks,
securities…
To increase Money supply:
the Central bank could buy Government bonds, paying with
new dollar (currency). So, the Monetary base (MB) increases,
and then, induce money supply (MS)

To decrease Money supply:

the Central bank could sell Government bonds. So, the Monetary
base (MB) decreases, and then, lower money supply (MS)
The instruments of monetary policy
+ discount rate
The
Banks borrow from the central bank when they feel they do not have
enough reserve on hand, either to satisfy bank regulators, meet
depositor withdrawals, make new loans or some other business reasons

The discount rate: the interest rate the Central

bank charges on loans to banks

To increase Money supply,

the Central bank could lower the discount rate,
encouraging banks to borrow more

To decrease Money supply, the Central bank could raise

the discount rate
The instruments of monetary policy
+
reserve requirements

Reserve requirements: the Central bank regulations

that impose a minimum Reserve on Deposit ratio

MS = mm * MB cr +1
m =
mm
cr + rr

To reduce Money supply: the Central bank could increase

reserve requirements, it causes the fall of the reserve ratio
(rr), so the MS decrease

To increase Money supply: the Central bank could

decrease reserve requirements, it causes the rise of the
reserve ratio (rr), so the MS increase
 Monetary policy tools - summary
+
1.  Open Market Operations: Central bank buy or sell bonds in Open market

!  If Central Bank sells bonds: Monetary base (MB) reduces # MS decrease

!  If Central Bank buys bonds: Monetary base increases # MS increases

2.  Reserve requirement: regulations on the minimum amount of reserves that banks must
hold against deposits

$  If the Central bank increases Reserve requirement ratio# actual reserve ratio increases #
money multiplier decreases# MS decreases

$  If the Central bank decreases Reserve requirement ratio# actual reserve ratio decreases #
money multiplier increases# MS increases

3.  Discount rate: the interest rate on the loans that Central bank makes to commercial banks

!  If Central Bank lowers discount rate# commercial banks will borrow less # Monetary base
(MB) reduces # MS decrease

!  If Central Bank raises discount rate# commercial banks will borrow more# Monetary base
(MB) increase# MS increase
+
Active learning
Controls of Money supply - Monetary policy
Fill in blanks

!  Expansionary monetary policy: MS increases

1.  OMO: …....................
2.  Required reserve rate:…..................
3.  Discount rate:…........................

!  Contractionary monetary policy: MS reduces

1.  OMO:…....................
2.  Required reserve rate:…...................
3.  Discount rate:…....................
+
Answer: Active learning
Controls of Money supply

! Expansionary monetary policy: MS increases

1.  OMO: increase B to purchase government bond
2.  rrr: reduce rrr to increase money multiplier
3.  Discount rate: reduces discount rate and increase
lending to commercial banks

! Contractionary monetary policy: MS reduces

1.  OMO: withdraw B by selling government bond
2.  rrr: increase rrr to lower money multiplier
3.  Discount rate: increase discount rate to reduce
lending from commercial banks
+

Inflation
 31

+ Inflation
!  Inflation is an Increase in the overall level of prices

!  Deflation is a Decrease in the overall level of prices

•  2018, inflation rates:

(?) Do you remember
•  2.4 percent in the United States the calculation of
•  1.2 percent in Japan inflation in chapter 1?
•  3.5 percent in Vietnam
•  12 percent in Nigeria
•  15 percent in Turkey
•  32 percent in Argentina

•  Hyperinflation is an extraordinarily high rate of inflation

•  inflation rate is 1.4 million percent per year in Venezuela
 +The Level of Prices and the Value of Money

In 1970, a cup of coffee cost 0.25USD, that means, 1 USD = 4 cup of coffee
...Due to inflation…,
that cup of coffee in 2019 cost 1,59 USD, that means, 1 USD = 0,6 cup of coffee
 33

+ The Level of Prices and the Value of Money

!  Price level, P: Number of currency needed to buy a basket of
goods and services. When the price level rises, people have to
spend more money for the goods and services they buy.

!  Value of money: The quantity of goods and services that can

be bought with 1 unit of currency.

Therefore, Value of money = 1/P

A rise in the price level %lower value of money

! Inflation drives up prices and drives down the value

of money.
 34

+ The Classical Theory of Inflation

The quantity theory of money
Most economists rely on the quantity theory of money to explain long-
run determinants of the price level and then the inflation rate and value
of money.

This theory asserts that the quantity of money determines the price
level, and then, the value of money
The quantity theory was
developed by some of the
The quantity theory of money: earliest economist: discussed
Prices rise when the government in 18th-century by David
Hume and was advocated
prints too much money. more recently by the famous
economist Milton Friedman

We study this theory using two approaches:

1.  A supply-demand diagram
2.  An equation
+

Money Supply- Demand Diagram

(the first approach to the quantity theory of money)
Money Supply (MS) 36

MS = mm * MB cr +1
m =
mm
cr + rr
Question: Who can determine Money supply?

!  Money supply in the real world: Determined by Central

bank, the banking system, and consumers.

!  Money supply in this model: We assume Central bank

precisely controls MS and sets it at some fixed amount.
Money Demand (MD) 37

!  Money demand : How much wealth people want to

hold in liquid form (money form)

An increase in P reduces the value of money, so

more money is required to buy the same amount of
goods and services.

Therefore:
Quantity of money demanded is positively related
to P and negatively related to the value of money
(1/P), other things equal.
P ' (or 1/P & ) % MD'

P & (or 1/P ') % MD&

 The diagram 38
(the value of money is negatively related to Price level)
Value of Price
Money, 1/P Level, P
(High) As the value of money (Low)
rises, the price level
1 1
falls.
¾ 1.33

½ 2

¼ 4
(Low) (High)
Quantity of Money
 The money supply-demand diagram 39
MS
Value of Price
Money
Money, 1/P Level, P
Supply
(High) (Low)
MS1
1 1

¾ 1.33

Central bank sets

½ 2
MS at some fixed
value, regardless
¼ 4
of P.
(Low) (High)
$1,000 Quantity
of Money
 The money supply-demand diagram 40

MD
Value of Price
Money, 1/P A fall in value of money (or Level, P
(High)
increase in P) increases the (Low)
quantity of money
1 demanded: 1

¾ 1.33

½ 2
Money
demand
¼ 4
MD1
(Low) (High)
Quantity
of Money
 The equilibrium price level 41

Value of Price
Money, 1/P Level, P
MS1
(High) (Low)

1 1

¾ 1.33
eq’m
value eq’m
of
A price
½ 2
money level

¼ 4
MD1
(Low) (High)
$1,000 Quantity
of Money
Eq’m = equilibrium
 The effects of a monetary injection 42

Value of If Central Price

Money, 1/P bank Level, P
MS1 MS2 increases the
(High) money (Low)
supply.
1 1
Then the value
of money falls,
¾ and P rises. 1.33
A
New ½ 2
eq’m New
value B eq’m
of ¼ 4 price
money MD1 level

$1,000 $2,000 Quantity of Money

 A brief look at the adjustment process43
What is the process that increasing money supply causes P to rise?

!  At the initial P, an increase in MS causes an excess supply of money.

!  People get rid of their excess money: spend it on goods and services or give
loans to others, who spend it.
(  Result: increased
demand for goods
and services.

(  But supply of goods

does not increase, so
prices must rise.

(  Therefore, the
quantity of money
demanded increases
because people are
using more money for
every transaction
The Quantity Theory of Money 44

!  The Money Supply – Money Demand Diagram shows that:

quantity of money available determines the price level and
that the growth rate in the quantity of money available
determines the inflation rate

The Diagram has

proved The Quantity
Theory of Money
+

The Quantity Equation

(the second approach to the quantity theory of money)
 The Classical Dichotomy 46

Classical dichotomy: Is the theoretical separation of nominal

variables and real variables.

Nominal variables: measured in monetary units. Including: Nominal

GDP, nominal interest rate (rate of return measured in $), nominal wage
($ per hour worked)

Real variables: measured in physical units. Including: Real GDP,

real interest rate (measured in output), real wage (measured in output)
EXAMPLE 1 of real vs. nominal variable: The relative price47
of a good
The relative price of a good is the price of one good in terms of
another.

!  The price of a smartphone is $450 and the price of a pizza is

$10.

!  What is the relative price of a smartphone? What are nominal

and real variables?

The relative price of a smartphone is:

= P smartphone / P pizza

= ($450/smartphone ) / ($10/pizza) (they are nominal variable)

= 45 pizzas per smartphone (this is real variable)

EXAMPLE 2: Real vs. nominal wage 48

The real wage is the price of labor relative to the price

of output.

!  The
nominal wage, W = $15/hour (the price of
labor), and the price level, P = 5 (the price of goods
and services, so it’s $5/unit of output).

!  Calculate the real wage.

!  Real wage = W / P

= ($15/hour) / ($5/unit of output)

= 3 units of output per hour

 49

The Classical Dichotomy: Monetary developments

affect nominal variables but not real variables.

If central bank doubles the money supply:

Then all nominal variables—including prices—will double

But all real variables—including relative prices—will remain

unchanged.
EXAMPLE 3: The neutrality of money 50

! 
The Neutrality of Money 51

!  Monetary neutrality: The proposition that changes in

the money supply do not affect real variables

Because, as mentioned before, doubling money supply:

Causes all nominal prices to double but relative prices
unchanged

!  Most economists believe that the classical dichotomy and

neutrality of money describe the economy in the long run.

!  In later chapters we will see that monetary changes can

have important short-run effects on real variables.
Active Learning 1: The neutrality of money
52

If the central bank doubles the money supply, what

happens with the inflation and real wage?

!  Doublingthe money supply:

->Nominal wages double
->Price level doubles -> inflation increase
-> Real wage is W/P remains unchanged
The Velocity of Money 53

!  Velocity of money:
!  The rate at which money changes hands (how many times
that a currency is used for)

!  Notation:
P x Y = nominal GDP = (price level) x
(real GDP)
M = money supply
V = velocity
PxY
!  Velocity formula:
V =
M
EXAMPLE 4: The velocity of money 54

Assume there is only one good in the economy, pizza. In

2019, money supply is $10,000, real GDP is 3,000 pizzas
and the price of pizza is $10. What was the velocity of
money?

!  Y = real GDP = 3,000 pizzas

!  P = price level = price of pizza = $10

-> P x Y= nominal GDP = value of pizzas = $30,000

-> Velocity, V = P × Y / M = nominal GDP / money

supply = $30,000/$10,000 = 3

The average dollar was used in 3 transactions.

Active Learning 2: Velocity of money 55

Assume there is only one good in the economy, corn.

The economy produce 1,800 bushels of corn.

V is constant. In 2019, money supply was $3,600 and

the price of corn was $8/bushel.

!  Compute nominal GDP and velocity in 2019.

!  Nominal GDP = P x Y = $8 x 1,800 = $14,400

!  Velocity V = P x Y / M = $14,400 / $3,600 = 4

+

The Quantity Equation

The Quantity Equation 57

(second approach to the Quantity theory of money)

!  The quantity equation: MxV=PxY

!  The equation relates the quantity of money (M) to the
nominal value of output (P × Y)
!  The equation shows that an increase in the quantity of
money in an economy causes b:
- The price level must rise
- The quantity of output must rise
- Or the velocity of money must fall
The Quantity Theory of Money - 58

Explaination
Assume that V is relatively stable over time.

Then, a change in M causes nominal GDP (P x

Y) to change by the same percentage.

But, change in M does not affect Y: money is

neutral, Y is determined by technology &
resources

So, P changes by same percentage as

P x Y and M.

-> Rapid money supply growth causes rapid

inflation.
Active Learning 3: Quantity theory of money
59

Assume there is only one good in the economy, corn. The

economy has enough labor, capital, and land to produce
1,800 bushels of corn.

V is constant. In 2019, money supply was $3,600 and the

price of corn was $8/bushel. For 2020, the Fed increases
MS by 10%.

A.  Compute the 2020 values of nominal GDP and P.

Compute the inflation rate for 2019–2020.

B.  Suppose tech. progress causes Y to increase to 1,950 in

2020. Compute the 2019–2020 inflation rate.
Active Learning 3: Answers, A 60

!  First,
calculate velocity because it is constant from
2019 to 2020. For 2019: P x Y = M x V, so 8 × 1,800 =
3,600 × V, therefore V= 4

!  Calculatenominal GDP for 2020, knowing the money

supply increased by 10% to $3,960.

!  Nominal GDP in 2020 = P x Y = M x V = 3,960 x 4 =

$15,840

!  Tocalculate inflation rate we need the price of corn in

2019 ($8) and in 2020: P = M x V / Y = 15,840/1,800 =
$8.80

!  Inflation
rate 2019-2020 = (8.80 – 8.00)/8.00 = 10%
(same as money supply)
Active Learning 3: Answers, B
61
2019: Y = 1,800 bushels; P = $8 per bushel, MS = $3,600.
In 2020, MS increases by 10%. V = 4 (constant)

B. Suppose tech. progress causes Y to increase to 1,950 in

2020. Compute the 2019–2020 inflation rate.
•  2020 prices: P = M x V / Y = 15,840/1,950 = $8.12

•  Inflation rate 2019-2020 = (8.12 – 8.00)/8.00 = 1.5%

Some conclusions from the exercise:

• If real GDP is constant, then inflation rate = money growth rate.
• If real GDP is growing, then inflation rate < money growth rate.
• Economic growth increases # of transactions.
• Some money growth is needed for these extra transactions.
• Excessive money growth causes inflation.
 63
The Inflation Tax
!  The inflation tax is Revenue the government raises by
creating (printing) money like a tax on everyone who
holds money

WHY? - When the government prints money

-> The price level rises
-> The currency in your wallet are less valuable

!  When tax revenue is inadequate and ability to borrow is

limited, government may print money to pay for its
spending. Almost all hyperinflations start this way.
!  In the U.S., the inflation tax today accounts for less than 3% of
total revenue
 64
The Fisher Effect – 1
!  Principle of monetary neutrality

! Anincrease in the rate of money

growth raises the rate of inflation
but does not affect any real variable
!  Because

Real interest rate = Nominal interest rate –

Inflation rate
!  We get

Nominal interest rate = Real interest rate +

Inflation rate
 65
The Fisher Effect – 2

!  Fisher effect
!  One-for-one adjustment of nominal interest rate to inflation
rate
!  When the Fed increases the rate of money growth, the long-
run result is:
!  Higher inflation rate
!  Higher nominal interest rate

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distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
 U.S. nominal interest & inflation rates, 1960–
2019

The close relation

between these
Nominal variables is
interest evidence for the
rate
Fisher effect.

Inflation rate

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distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 66
 67
The Inflation Fallacy

!  Inflation fallacy
!  “Inflation robs people of the purchasing power of his hard-
earned dollars”

!  When prices rise

!  Buyers pay more
!  Sellers get more

!  Inflation does not in itself reduce people’s real

purchasing power

© 2021 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license
distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
 U.S. average hourly earnings & the CPI 1965 -
2019

Inflation causes
the CPI and Nominal
nominal wages wage
to rise together CPI
over the long
run.

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 69
Shoeleather Costs

!  Inflation
!  Is like a tax on the holders of money

!  Avoid the inflation tax

!  By holding less money (and go to the bank more often)

!  Shoeleather costs

! Resources wasted when inflation

encourages people to reduce their
money holdings
! Can be substantial
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distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
 70
Menu Costs

! Menu costs
! Costs of changing prices
! Inflation increases menu costs firms
must bear
! Deciding on new prices
! Printing new price lists and catalogs
! Sending the new price lists and
catalogs to dealers and customers
! Advertising the new prices
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! Dealing with customer annoyance
distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Relative-Price Variability 71

!  Misallocation of resources from relative-price

variability:
!  Firms don’t all raise prices at the same time, so relative
prices can vary
!  Consumer decisions are distorted and markets are less able
to allocate resources to their best use

© 2021 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license
distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Inflation-Induced Tax Distortions 72

!  Inflation-induced tax distortions:

!  Inflation makes nominal income grow faster than real
income.
!  Taxes are based on nominal income,
and some are not adjusted for inflation.
!  So, inflation causes people to pay more taxes even when
their real incomes don’t increase.

© 2021 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license
distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Active Learning 4: Tax distortions 73

You deposit $1,000 in the bank for one

year.
CASE 1: inflation = 0%, nom. interest rate
= 10%
CASE 2: inflation = 10%, nom. interest
rate = 20%
A.  In which case does the real value of
your deposit grow the most?
© 2021 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license
Assume the tax rate is 25%.
distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
 Active Learning 4: Answers, A
Deposit $1,000.
CASE 1: inflation = 0%, nom. interest rate =
10%
CASE 2: inflation = 10%, nom. interest rate =
20%
A.  In which case does the real value of your
deposit grow the most?
! Real interest rate = Nominal interest rate –
Inflation rate
! In both cases, the real interest rate is 10%, so
© 2021 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license
the real value of the deposit grows 10%
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 Active Learning 4: Answers, B
Deposit $1,000. Tax rate =25%.
CASE 1: inflation = 0%, nom. interest rate = 10%
CASE 2: inflation = 10%, nom. interest rate =
20%

B.  In which case do you pay the most taxes?

! CASE 1: interest income = $100, so you pay

$25 in taxes.
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distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 75
 Active Learning 4: Answers, C
Deposit $1,000. Tax rate =25%.
CASE 1: inflation = 0%, nom. interest rate = 10%
CASE 2: inflation = 10%, nom. interest rate =
20%
C.  Compute the after-tax nominal interest rate,
then subtract inflation to get the after-tax real
interest rate for both cases.
CASE 1: nominal = 0.75 x 10% = 7.5%
real = 7.5% – 0% = 7.5%
CASE 2: nominal = 0.75 x 20% = 15%
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distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 76
 Active Learning 4: Summary and lessons
Deposit $1,000. Tax rate =25%.
CASE 1: inflation = 0%, nom. interest rate =
10%
CASE 2: inflation = 10%, nom. interest rate =
20%

Inflation…
! raises nominal interest rates (Fisher
effect) but not real interest rates
! increases savers’ tax burdens
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distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 77
Confusion and Inconvenience 78

!  Confusion and inconvenience:

!  Inflation changes the yardstick we use to measure
transactions
!  Complicates long-range planning and the comparison of
dollar amounts over time
!  Difficult to judge the costs of the confusion and
inconvenience that arise from inflation

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Arbitrary Redistributions of Wealth 79

!  Unexpected inflation
!  Redistributes wealth among the population
!  Not by merit

! Not by need
!  Redistribute wealth among debtors and creditors

!  Inflation: volatile and uncertain

!  When the average rate of inflation is high

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Deflation May Be Worse 80

! Friedman rule
! Prescriptionfor moderate inflation
! Small and predictable amount of
deflation may be desirable

! In practice, deflation is rarely

steady and predictable
! Redistribution of wealth away from
debtors (who are often poorer)

! Deflation often arises from broader

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THINK-PAIR-SHARE 81

Suppose you explain the concept

of an “inflation tax” to a friend. You
correctly tell them, “When a
government prints money to cover its
expenditures instead of taxing or
borrowing, it causes inflation. An
inflation tax is simply the erosion of
the value of money from this inflation.
Therefore, the burden of the tax lands
on those who hold money.” Your
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distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
THINK-PAIR-SHARE 82

A.  Is it true that rich people hold more

money than poor people do?
B.  Do rich people hold a higher percent of
their income as money than poor
people?
C.  Compared to an income tax, does an
inflation tax place a greater or lesser
burden on the poor? Explain.
D.  Are there any other reasons why
engaging in an inflation tax is not good
policy?
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distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
CHAPTER IN A NUTSHELL 83

! 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.
! The principle of monetary neutrality
asserts that changes in the quantity of
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distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
CHAPTER IN A NUTSHELL 84

! A government can pay for some of its spending

simply by printing money. When countries rely
heavily on this “inflation tax,” the result is
hyperinflation.
! One application of the principle of monetary
neutrality is the Fisher effect. According to the
Fisher effect, when the inflation rate rises, the
nominal interest rate rises by the same amount
so that the real interest rate remains the same.
! Many people think that inflation makes them
poorer because it raises the cost of what they
buy. This view is a fallacy, however, because
© 2021 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license
inflation also raises nominal incomes.
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CHAPTER IN A NUTSHELL 85

! Economists have identified six costs of

inflation: shoeleather costs associated with
reduced money holdings, menu costs
associated with more frequent adjustment of
prices, increased variability of relative prices,
unintended changes in tax liabilities due to
nonindexation of the tax code, confusion and
inconvenience resulting from a changing unit
of account, and arbitrary redistributions of
wealth between debtors and creditors.
! Many of these costs are large during
hyperinflation, but the size of these costs for
© 2021 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license
moderate inflation is less clear.
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