Ch.

8: Inflation
 𝑃!"# − 𝑃!
∗ 100%
𝑃!

GDP
CPI PCE
Deflator
CPI
PCE
GDP
Deflator
CPI vs. PCE:
Based on survey of what households
are buying
Basket stays ≈ constant

Only out-of-pocket spending

CPI vs. PCE:
Based on survey of what businesses
are selling

Basket changes to account for substitution

More spending is included (such as medical care

paid for by employers)
 Useful for:
Price conversions across time
Example: $1,000 annual salary in 1900; what is this
worth today?
𝑪𝑷𝑰 𝑻𝒐𝒅𝒂𝒚
𝑽𝒂𝒍𝒖𝒆 𝑻𝒐𝒅𝒂𝒚 = 𝑶𝒍𝒅 𝑽𝒂𝒍𝒖𝒆 ∗
𝑪𝑷𝑰 𝑶𝒍𝒅
 Useful for:
Price conversions across time
Example: $1,000 annual salary in 1900; what is this
worth today?
𝑪𝑷𝑰 𝑻𝒐𝒅𝒂𝒚
? = $𝟏, 𝟎𝟎𝟎 ∗
𝑪𝑷𝑰 𝑶𝒍𝒅
 Useful for:
Price conversions across time
Example: $1,000 annual salary in 1900; what is this
worth today?
𝟐𝟓𝟔. 𝟕𝟔
? = $𝟏, 𝟎𝟎𝟎 ∗
𝟑. 𝟓𝟔
 Useful for:
Price conversions across time
Example: $1,000 annual salary in 1900; what is this
worth today?
𝟐𝟓𝟔. 𝟕𝟔
$𝟕𝟐, 𝟏𝟐𝟑. 𝟔𝟎 = $𝟏, 𝟎𝟎𝟎 ∗
𝟑. 𝟓𝟔
Quantity Theory of Money

Fiat Commodity
 Monetary Base currency + reserves

currency + demand
M1
deposits

M2 M1 + savings accounts

Broader measures à less liquid

 Currency 1,762.0
Monetary Base 3,159.1
M1 3,900.8
M2 15,060.8
September 2019 billions of dollars
The Quantity Equation

𝑴𝒕 𝑽𝒕 =𝑷𝒕 𝒀𝒕 Real GDP

Money Velocity Price Level
Supply
We want to solve for the steady
state inflation rate…

…but right now we have 4

endogenous (unknown) vars.

𝑴𝒕 𝑽𝒕 =𝑷𝒕 𝒀𝒕
Classical Dichotomy
LR: real and nominal vars. are
separate
%
𝑴𝒕 𝑽𝒕 =𝑷𝒕 𝒀𝒕
 % %
𝑴𝒕 𝑽=𝑷𝒕 𝒀𝒕

Assumption: velocity is constant

over time
 M1

M2
 % % %
𝑴𝒕 𝑽=𝑷𝒕 𝒀𝒕

For now: assume this is exogenous

(determined by monetary policy)
 % % %
𝑴𝒕 𝑽=𝑷𝒕 𝒀𝒕
Solve for P:
%
𝑀 "
)
𝑉
∗
𝑃" =
)
𝑌"
 #! 𝑉%
𝑀
∗
𝑃! =
𝑌%!
Prices increase when:
a) Money supply increases
b) Real GDP decreases

LR: money supply determines price level

Quantity Theory of Inflation
#! 𝑉%
𝑀
∗
𝑃! =
𝑌%!
𝑔# = 𝑔̅$ + 𝑔̅% − 𝑔̅&
Quantity Theory of Inflation
#! 𝑉%
𝑀
∗
𝑃! =
𝑌%!
∗
𝜋 = 𝑔̅$ − 𝑔̅&
 ∗
𝜋 = 𝑔̅$ − 𝑔̅%
Quantity Theory says:
changes in money supply lead to 1-for-1
changes in inflation rate

Holds up empirically in US & elsewhere

 ∗
𝜋 = 𝑔̅$ − 𝑔̅%
Quantity Theory says:
changes in money supply lead to 1-for-1
changes in inflation rate

Implies: Monetary Neutrality

Monetary Neutrality
Changing money supply has no real effects on
economy; only affects prices

Empirically:
True in LR
False in SR (b/c of sticky prices)
Nominal Interest Rate
stated rate; paid in dollars

Real Interest Rate

equal to MPK; paid in “goods”
Fisher Equation

𝑖 =𝑅+𝜋
Nominal rates
increase when
inflation is high
Empirically:
real interest rates can be negative

Implies real int. rate does not have to equal

MPK in SR
Costs of Inflation
menu shoe leather
costs costs
Costs of Inflation
Distortions:
1) relative prices
2) taxes
Who’s hurt?
1) Someone who’s pension is not
indexed to inflation
2) Bank lending at fixed rate
3) Borrower paying variable rate
 Unions
negotiate
higher w

Higher firm
Inflation
costs

Unions Firms
demand increase
higher w prices

Aug. 1971: wage & price controls

Fiscal Causes of Inflation

G = 𝑇 + ∆𝐵 + ∆𝑀
Govt. Tax Borrowing Money
Spending Revenue Growth
Seignorage:
Revenue govt gets from ∆𝑀

Inflation Tax:
Paid by people holding money
As debt rises:
Lenders worry about being repaid

May stop lending

Hyperinflation
- >50% per month
- high inflation episodes tend to
recur
- can stop as quickly as it starts
 Zimbabwe
2009: 79.6% per month
billion

89,700,000,000,000,000,000,000 %

2019: 17.7% per month

175.7% annual
Govt. has stopped posting
inflation stats.
Hyperinflation
How to stop?

Money growth must fall; govt

must get its act together
Coordination Problem
Central Bank Independence
Monetary Fiscal Policy
Policy
Federal Congress &
Reserve President
Central Bank Independence
1. Members serve long terms
2. Financially independent
1. Dual mandate from Congress
2. President appoints Chair and BOG,
w/Senate approval