Lecture 7

MONEY GROWTH AND INFLATION

PRINCIPLES OF MACROECONOMICS

Lecturer: Minh Huynh, PhD.

 EASTERN INTERNATIONAL UNIVERSITY 1

 Contents

1 The Classical Theory of Inflation

2 The Costs of Inflation

2
 Objectives
● 7.1.
 Explain how the money supply affects inflation
rate and nominal interest rate.
 Explain how inflation is like a tax.
 Compute other variables from Velocity Formula
or The Quantity Equation.
● 7.2. List and describe six costs of inflation.

3
 Look for the answers to these questions:

● How does the money supply affect inflation and

● nominal
What areinterest
the main types of financial institutions in
rates?
the U.S.
● Does economy,
the money and affect
supply what isreal
their function?
variables like real
● GDP
Whatorare
thethe
realthree kinds
interest of saving?
rate?
● (In
What’s the difference
this chapter, we look between
at thesesaving and from a
questions
investment?
long-run perspective.)
●●How
Howisdoes the financial
inflation system coordinate saving
like a tax?
and investment?
● What are the costs of inflation? How serious are
● they?
How do govt. policies affect saving, investment,
and the interest rate?

4
 INTRODUCTION

● Inflation is an increase in the overall level of

prices (measured by the CPI or the GDP
deflator).
● Deflation, meaning decreasing average prices,
occurred in the U.S. in the nineteenth century.
● Hyperinflation refers to extremely high rates
of inflation such as Germany experienced in
the 1920s.
Hyperinflation is generally defined as inflation
exceeding 50% per month.
5
 INTRODUCTION

This lecture introduces the quantity theory of

money to explain one of the Ten Principles of
Economics:
Prices rise when the government prints
too much money.
Most economists believe the quantity theory
is a good explanation of the long run behavior
of inflation.

6
 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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  The Value of Money
● P = the price level
(e.g., the CPI or GDP deflator)
P is the price of a basket of goods, measured in
money.
● 1/P is the value of $1, measured in goods.
● Example: basket contains one ice-cream cone.
 If P = $2, value of $1 is 1/2 ice-cream cone
 If P = $3, value of $1 is 1/3 ice-cream cone
● Inflation drives up prices and drives down the value
of money.

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  Money Supply (MS)
● 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.

9
  Money Demand (MD)
● 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 (P) of goods and services.
An increase in P reduces the value of money,
so more money is required to buy g&s.
Thus, quantity of money demanded
is negatively related to the value of money
and positively related to P, other things equal.

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 The Money Supply-Demand Diagram
Value of Price
Money, 1/P Level, P
As the value of
money rises, the
1 1
price level falls.
¾ 1.33

½ 2

¼ 4

Quantity of
Money
11
 The Money Supply-Demand Diagram
Value of Price
Money, 1/P MS1 Level, P

1 1

¾ 1.33

The Fed sets MS

½ 2
at some fixed value,
regardless of P.
¼ 4

$1000 Quantity of
Money
12
 The Money Supply-Demand Diagram
Value of A fall in value of money Price
Money, 1/P (or increase in P) Level, P
increases the quantity of
1 money demanded: 1

¾ 1.33

½ 2

¼ 4
MD1

Quantity of
Money
13
 The Money Supply-Demand Diagram
Value of P adjusts to equate Price
Money, 1/P MS1 quantity of money Level, P
demanded with
1 money supply. 1

¾ 1.33
eq’m eq’m
value A
½ 2 price
of
level
money
¼ 4
MD1

$1000 Quantity of
Money
14
 The Effects of a Monetary Injection
Value of Price
Money, 1/P MS1 MS2 Level, P

Suppose the1 Fed 1

Then the value
increases the of money falls,
money supply.
¾ and P rises.1.33
A
½ 2
eq’m eq’m
value B
¼ 4 price
of MD1 level
money
$1000 $2000 Quantity of
Money
15
 The Effects of a Monetary Injection
● An increase in the money supply makes dollars more
plentiful, the price level increases, making each
dollar less valuable.
 Inflation happens.
● This theory is called the quantity theory of money:
the quantity of money available determines the price
level, and the growth rate of money determines the
inflation rate.

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 A Brief Look at the Adjustment Process
● Result from graph: Increasing MS causes P to rise.
● How does this work?
 At the initial P, an increase in MS causes
excess supply of money.
 People use the extra money to buy more g&s P
rises and 1/P falls.
 People deposit the extra money in the bank. But
the bank will lend the money to a borrower who
wants to buy more g&s  P rises and 1/P falls.
 This process will continue until monetary
equilibrium is restored at a higher price level.

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  Real vs. Nominal Variables
● Nominal variables are measured in monetary
units.
Examples:
 Nominal GDP,
 Nominal interest rate (rate of return measured in $)
 Nominal wage ($ per hour worked)
● Real variables are measured in physical units.
Examples:
 Real GDP,
 Real interest rate (measured in output)
 Real wage (measured in output)

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  Real vs. Nominal Variables
● Prices are normally measured in terms of money.
 Price of a compact disc: $15/cd
 Price of a pizza : $10/pizza
● A relative price is the price of one good relative to
(divided by) another:
 Relative price of CDs in terms of pizza:
price of cd $15/cd
= = 1.5 pizzas per cd
price of pizza $10/pizza
Relative prices are measured in physical units,
so they are real variables.
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  Real vs. Nominal Wage
● An important relative price is the real wage:
W = nominal wage = price of labor, e.g., $15/hour
P = price level = price of g&s, e.g., $5/unit of output
Real wage is the price of labor relative to the price
of output:
W $15/hour
= = 3 units of output per hour
P $5/unit of output

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 The Classical Dichotomy
● Classical dichotomy: the theoretical separation of
nominal and real variables.
● Hume and the classical economists suggested that in
the long run, monetary developments
affect nominal variables but not real variables.
● If central bank doubles the money supply,
Hume & classical thinkers contend
all nominal variables – including prices –
will double.
all real variables – including relative prices –
will remain unchanged.
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 The Neutrality of Money
● Monetary neutrality: changes in the money supply do
not affect real variables.
● Doubling money supply causes all nominal prices
to double; what happens to relative prices?
● Initially, relative price of cd in terms of pizza is
price of cd $15/cd
= = 1.5 pizzas per cd
price of pizza $10/pizza
The relative price
● After nominal prices double, is unchanged.
price of cd $30/cd
= = 1.5 pizzas per cd
price of pizza $20/pizza
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 The Neutrality of Money
● Similarly, the real wage W/P remains unchanged,
so
 quantity of labor supplied does not change
 quantity of labor demanded does not change
 total employment of labor does not change
● The same applies to employment of capital and
other resources.
● Since employment of all resources is unchanged,
total output is also unchanged by the money
supply.
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 The Velocity of Money
● Velocity of money: the rate at which money changes
hands.
● Velocity formula:
PxY
V =
M
Where:
P x Y = nominal GDP
= (price level) x (real GDP)
M = money supply
V = velocity

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 The Velocity of Money
● Velocity formula: PxY
V =
M
Example with one good: Pizza. In 2011,
Y = real GDP = 3000 pizzas
P = price level = price of pizza = $10
P x Y = nominal GDP = value of pizzas = $30,000
M = money supply = $10,000
V = velocity = $30,000/$10,000 = 3
The average dollar was used in 3 transactions.

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 ACTIVE LEARNING 1
Exercise
● One good: Corn.

 The economy has enough labor, capital, and land to

produce Y = 800 bushels of corn.
 V is constant.
 In 2011, MS = $2000, P = $5/bushel.
Compute nominal GDP and velocity in 2011.

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 The Quantity Equation
● Velocity formula:
PxY
V =
M

 Multiply both sides of formula by M:

MxV = PxY

 Called the quantity equation.

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 The Quantity Theory in 5 Steps
● Start with quantity equation: M x V = P x Y
1. V is stable.
2. So, a change in M causes nominal GDP (P x Y)
to change by the same percentage.
3. A change in M does not affect Y:
money is neutral, Y is real GDP (output)
Y is determined by technology & resources
4. So, P changes by same percentage as
P x Y and M.
5. Rapid money supply growth causes rapid inflation.

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 ACTIVE LEARNING 2
Exercise
One good: Corn. The economy has enough labor, capital,
and land to produce Y = 800 bushels of corn. V is constant.
In 2011, MS = $2000, P = $5/bushel.
For 2012, the CB increases MS by 5%, to $2100.
a. Compute the 2012 values of nominal GDP and P.
Compute the inflation rate & nominal GDP growth rate
for 2011-2012.
b. Suppose tech. progress causes Y to increase to 824 in
2012. Compute 2011-2012 inflation rate.

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 ACTIVE LEARNING 2

Summary and Lessons about the

Quantity Theory of Money

If real GDP is constant, then

inflation rate = money growth rate. (a)
If real GDP is growing, then
inflation rate < money growth rate. (b)
The bottom line:
 Economic growth increases # of transactions.
 Some money growth is needed for these extra
transactions.
 Excessive money growth causes inflation.
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 The Inflation Tax
● 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.
● The revenue from printing money is the
inflation tax: printing money causes inflation,
which is like a tax on everyone who holds money.
● In the U.S., the inflation tax today accounts for
less than 3% of total revenue.

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 Vietnam's Ratio of Tax to GDP in
Comparison With Neighboring Countries
%
30
26.3
25

20 17.3
15.5 15.5
15 13 12.1

10 7.8

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 The Fisher Effect
● Rearrange the definition of the real interest rate:
Nominal Inflation Real interest
= +
interest rate rate rate

● The real interest rate is determined by saving &

investment in the loanable funds market.
● Money supply growth determines inflation rate.
● So, this equation shows how the nominal interest
rate is determined.

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 The Fisher Effect
Nominal Inflation Real interest
= +
interest rate rate rate

● In the long run, money is neutral,

so a change in the money growth rate affects
the inflation rate but not the real interest rate.
● So, the nominal interest rate adjusts one-for-one
with changes in the inflation rate. (Long-run
perspective)
● This relationship is called the Fisher effect
after Irving Fisher, who studied it.
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 THE COSTS OF INFLATION

● The inflation fallacy: most people think

inflation erodes real incomes.
● But inflation is a general increase in prices
of the things people buy and the things they
sell (e.g., their labor).
● In the long run, real incomes are determined
by real variables, not the inflation rate.

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 U.S. Average Hourly Earnings & the CPI
Nominal
CPI Inflation causes wage
the CPI and
nominal wages
to rise together
over the long run.
Nominal wage

CPI
 THE COSTS OF INFLATION

● Shoeleather Costs.
● Menu Costs.
● Misallocation of resources from relative-price
variability.
● Confusion & inconvenience.
● Tax distortions.
● Arbitrary redistributions of wealth.

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  Shoeleather Costs
● The resources wasted when inflation encourages
people to reduce their money holdings
Includes the time and transactions costs of more
frequent bank withdrawals to keep less money in
hands.

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  Menu Costs
● The costs of adjusting prices, include:
printing new menus & catalogs,
sending these new price lists and catalogs to
dealers and customers.
advertising the new prices, and even dealing with
customer annoyance over price changes.

39
 Misallocation of resources from
relative-price variability
● Inflation distorts relative prices.
● Consumer decisions are distorted, and markets are
less able to allocate resources to their best use.

First, 1 = 1.5

Then, 1 =1

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  Confusion & 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.

41
  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.

42
 ACTIVE LEARNING 3
Tax distortions
You deposit $1000 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?
Assume the tax rate is 25%.
b. In which case do you pay the most taxes?
c. Compute the after-tax nominal interest rate,
then subtract off inflation to get the
after-tax real interest rate for both cases.
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 ACTIVE LEARNING 3
Summary and lessons
Deposit = $1000. 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
 lowers the after-tax real interest rate

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  Arbitrary redistributions of wealth
● Higher-than-expected inflation transfers purchasing
power from creditors to debtors: Debtors get to
repay their debt with dollars that aren’t worth as
much.
● Lower-than-expected inflation transfers purchasing
power from debtors to creditors.
● High inflation is more variable and less predictable
than low inflation.
● So, these arbitrary redistributions are frequent when
inflation is high.

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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.

46
 SUMMARY
● The principle of monetary neutrality
asserts that changes in the quantity of
money influence nominal variables but not
real variables.
● 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.

47
 SUMMARY
● 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
inflation also raises nominal incomes.

48
 SUMMARY
● Economists have identified six costs of inflation:
shoe-leather 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 non-
indexation 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 moderate inflation is less clear.
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 SUMMARY
● 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
inflation also raises nominal incomes.

50
 HOMEWORK
Question 1: The government of a country increases
the growth rate of the money supply from 5% per
year to 50% per year.
What happens to prices?
What happens to nominal interest rates?
Why might the government be doing this?

Question 2: List and describe six costs of inflation.

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