MACROECONOMICS

Money Growth and Inflation

Arrange by:
Ni Wayan Lara Setiari/ 2307511108
Niarmi Jenifer Purba/ 2307511110
I Kadek Juli Adi Swara/ 2307511111

ECONOMY STUDY PROGRAM

FACULTY OF ECONOMIC AND BUSINESS
UDAYANA UNIVERSITY

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Table of Content
CHAPTER I ........................................................................................................................................... 3
Introduction ........................................................................................................................................... 3
1.1 Background .................................................................................................................................. 3
1.2 Formulation of the problem ....................................................................................................... 3
1.3 Purpose ......................................................................................................................................... 4
CHAPTER II ......................................................................................................................................... 5
Discussion ............................................................................................................................................... 5
2.1 The Classical Theory of Inflation............................................................................................... 5
2.1.1 The Level of Prices and the Value of Money ...................................................................... 5
2.1.2 Money Supply, Money Demand, and Monetary Equilibrium .......................................... 6
2.1.3 The Effects of a Monetary Injection ................................................................................... 8
2.1.4 The Classical Dichotomy and Monetary Neutrality ........................................................ 11
2.1.5 Velocity and the Quantity Equation.................................................................................. 12
2.1.6 The Inflation Tax ................................................................................................................ 13
2.1.7 The Fisher Effect ................................................................................................................ 13
2.2 The Costs of Inflation ................................................................................................................ 15
2.2.1 Demand-pull Inflation........................................................................................................ 15
2.2.3 Extreme Types of Inflation ................................................................................................ 18
2.2.4 Negative Effects of Inflation .............................................................................................. 19
2.2.5 Positive Effects of Inflation................................................................................................ 20
2.2.6 Economic Costs of Inflation .............................................................................................. 20
2.2.7 Main parties Involved and their Roles in Costs of Inflation........................................... 21
2.2.8 How We Deal with Costs of Inflation ................................................................................ 22
CHAPTER III...................................................................................................................................... 23
Conclusion............................................................................................................................................ 23
Refference ........................................................................................................................................ 25

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 CHAPTER I

Introduction

1.1 Background
In economic money has a lot of meaning, it’s can be everything that you can image in this
world, but in general money is instrument that we use for exchange goods and service. Money
can’t freely we printing because it has a value, if there any printing that doesn’t release from
any monetary institution that mean 100% that money not have any value for we use for
exchange instrument and any other function of money like store a value and make an account.
This situation will link to the growth of money. Money growth also will really impact our daily
live because money growth can change a price of good and services in our daily needs. If
suddenly our money growth so fast that can give some bad impact to our economic condition
such as Inflation. Inflation is the most daily problem for economist we all can’t avoid because
it always happens in every incident that relate to economic in this world. The inflation will
make us to thinking a lot for manage our need, because it will restrain us about our resource.
Our resource in this modern era is money, if we life in past with how much money we got now,
of course it can make we rich. For examples now if we got regional minimum wage in
Rp.2.600.000 that just will enough for us to buy some daily necessary, but if we got that much
in past, we literally can buy One motor cycle and still got some money changes from that. The
inflation too makes us live in uncertain life, its will very depend in how the monetary institution
will choose a path to make the economic growth, if there are false decision from the monetary
institution that will be the end of economic in a country.

1.2 Formulation of the problem

1. What is The Classical Theory of Inflation?
2. How the Level Price Effect the Value of Money?
3. How the Monetary Equilibrium relate to Money Demand and Money Supply?
4. What effect can monetary injection do to the economy within a country?
5. What the relationship of The Classical Dichotomy and Monetary Neutrality?
6. How the Equation of quantity work, and how do we can count the Velocity of money?
7. Why the Inflation has Tax?
8. What is Fisher Effect and why its very useful?
9. What is cause Inflation in general?

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10. What is types of Inflation base on how extreme?
11. Is inflation has more negative or good effect for economic?
12. How is Inflation cause from economist poin of viev?
13. Who has the Main parties Involved and their Roles in Costs of Inflation?
14. How we can deals with the causes of Inflation?

1.3 Purpose
1. To make more explanation about money growth and inflation
2. To understand what the relationship between money growth and inflation
3. To know some knowledge about inflation in general

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 CHAPTER II

Discussion

2.1 The Classical Theory of Inflation

The classical theory of inflation attributes sustained price inflation to excessive growth in
the quantity of money in circulation. For this reason, the classical theory is sometimes called
the “quantity theory of money,” even though it is a theory of inflation, not a theory of money.
More specifically, the classical theory of inflation explains how the aggregate price level is
determined through the interaction between money supply and money demand. Because traces
the behavior of an important economy-wide variable – inflation – back to the most basic forces
of supply and demand, the classical theory must qualify as one of the oldest “microfounded”
models in all of macroeconomics.

2.1.1 The Level of Prices and the Value of Money

The economy’s overall price level can be viewed in two ways. So far, we have viewed the
price level as the price of a basket of goods and services. When the price level rises, people
have to pay more for the goods and services they buy. Alternatively, we can view the price level
as a measure of the value of money. A rise in the price level means a lower value of money
because each rupiah in your wallet now buys a smaller quantity of goods and services.

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 Figure 1 presents the familiar diagram. The graph measures the quantity of money M along
the horizontal axis and the “price” of money 1/P along the vertical axis. This is the only tricky
part: remembering that because the aggregate price level P measures the number of money that
must be exchanged for each proverbial “basket of goods,” its inverse 1/P measures the number
of baskets of goods that must be traded for each money. Hence, 1/P is the price or value of
money in real terms.
In the graph, the money demand curve slopes down. Why? When the money price of a
basket of goods goes up, each person must carry more money to make the same purchases as
before. Thus, when 1/P falls, the quantity of money demand rises. This means that the demand
curve must move to the right along the horizontal axis in the graph as it way down the vertical
axis.
Suppose first that the central bank fixes the money supply at some level M0. An initial
equilibrium prevails where money supply equals money demand: the graph shows that this
requires the value of money to equal 1/P0 and hence the aggregate price level to be P0. Suppose
next that the central bank takes policy actions to increase the quantity of money in circulation
to M1. A new equilibrium is reached after the value of money falls to 1/P1 and the price level
rises to P1. This, again, is the key implication of the classical theory: money growth causes
inflation.
Thus, the classical theory allows us to think about inflation without any reference to interest
rates, unemployment, or any of the other variables that are more frequently referred to in
popular discussions of inflation and its causes today. This is a big part of what makes the
classical theory of inflation so useful. It recognizes that unemployment may be high or low and
interest rates may rise or fall– it does matter. If the money supply is growing too fast, inflation
results. The classical theory is also useful because it reveals inflation for what it truly is: a
debasement of the currency – an erosion in the purchasing power of money engineered through
deliberate policy actions taken by the central bank.

2.1.2 Money Supply, Money Demand, and Monetary Equilibrium

The supply and demand for money determines the value of Money. Thus, our next step in
developing the quantity theory of money is to consider the determinants of money supply and
money demand.
First, consider to money supply. In Indonesia, the Central Bank of Indonesia Reserve,
together with another Bank, can determine the supply of money. When the Central Bank of
Indonesia sells bonds in open market operations, it receives a rupiah in exchange for another

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currency and contracts the money supply. When the Central Bank of Indonesia buys
government bonds, it pays out the rupiah and expands the money supply. In addition, if these
rupiahs are deposited in banks that then hold them as reserves, the money multiplier swings
into action, and these open market operations can have an even greater effect on the money
supply. For our purpose, we ignore the complications introduced by the banking system and
simply take the quantity of money supplied as a policy variable that the Central Bank of
Indonesia controls.
Now consider money demand. Most fundamentally, the demand for money reflects how
much wealth people want to hold in liquid form. Many factors influence the quantity of money
demanded. The amount of currency that people hold in their wallets, for instance, depends on
how much they rely on credit cards and on whether an automatic teller machine is easy to find.
As we will emphasize, the quantity of money demanded depends on the interest rate that a
person could earn by using the money to buy an interest-bearing bond rather than leaving it in
a wallet or low-interest checking account.
Although many variables affect the demand for money. one variable stands out in
importance: the average level of prices in the economy. People hold money because it is the
medium of exchange. Unlike other assets, such as bonds or stocks, people can use the money
to the goods and services in their daily lives. How much money they choose to save for this
purpose, depends on the prices of those goods and services. More higher the prices are, the
more money the typical transaction requires, and the more money people will choose to save in
their wallets and checking accounts. That is, a higher price level (a lower value of money)
increases the quantity of money demanded.
What ensures that the quantity of money the Central Bank supplies balances the quantity
of money people demand? The answer, it turns out, depends on the time horizon being
considered. Later in this book, we will examine the short-run answer, and we will see that
interest rates play a key role: In the long run, however, the answer ‘is different and much
simpler. In the long run, the overall level of price adjusts to the level at which the demand for
money equals the supply. If the price level is above the equilibrium level, people will want to
hold more money than the Central Bank has created, so the price level must fall to balance
supply and demand. If the price level is below the equilibrium level. people will want to hold
less money than the Central Bank has created, and the practice lever must rise to balance supply
and demand. At the equilibrium price level, the quantity of money that ‘people want to hold
exactly balances the quantity of money supplied by the Central Bank

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 Figure 2 How the Supply and Demand for Money
Determine the Equilibrium Price Level

The two curves in this figure are the supply and demand curves for money. The supply
curve is vertical because the Fed has fixed the quantity of money available. The demand curve
for money is downward sloping, indicating that when the value of money is low (and the price
level is high), people demand a larger quantity of it to buy goods and services. At the
equilibrium, shown in the figure as point A, the quantity of money demanded balances the
quantity of money supplied. This equilibrium of money supply and money demand determines
the value of money and the price level.

2.1.3 The Effects of a Monetary Injection

Before we explain the Effect of the Mory Injection, first who holds the monetary policy in
Indonesia? In Indonesia, the Institution that holds the monetary policy is Bank Indonesia (BI).
BI divides the money based on how the interaction between the monetary institution, general,
banks the people make a supply and demand of money there are three kinds of money:

Cartal Money (Currency)

Currency or base money is money that is outside financial institutions plus financial
institution reserves. This money in the curve quantity of money is M0."The currency included
in the reserve component is money held in banks and money held by the central bank”. It has
characteristics: the form of the money is bank notes (money from paper) and coins, spread by
the government or an institution trusted by the government, can be used directly to carry out
transactions for goods and services.

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 Demand Deposit (Giral Money)

Demand deposits are money that is not held by the public directly, but is in the form of
accounts issued by commercial banks. Demand deposits and currency are included in near
money or have the symbol M1. The government does not give authority to commercial banks
to issue banknotes, so the money created by commercial banks is demand deposits. Some
examples of demand deposits are checks and giro bills which function as an order to pay a
certain amount of funds to the recipient of the check or giro. It has characteristics: Not in
physical form like paper and metal, Spread by a private bank in the form of an account or
checking account, and cannot be used for direct transactions.

Quasi money

Quasi money is a type of money that is relatively less liquid and its use is very time bound.
Meanwhile, Bank Indonesia defines quasi-money as assets that can be cashed quickly. Quasi-
money has a symbol M2. Some examples of quasi-money are savings accounts and time
deposits because they cannot be used directly to buy goods and services. Some examples of
quasi-money are as follows: Savings at the bank, Time deposits, and Domestic private foreign
currency savings accounts. Quasi-money has the same characteristics as a Demand Deposit but
it is just too liquid.

This Interaction of money can be seen in the diagram in Figure 3 below:

Figure 3. It is the relationship of money by the

interaction of the central bank, general, bank, and
people

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 Now we continue to the effects of a change in monetary policy. To do so, imagine that the
economy is in equilibrium and then, suddenly, the Bank of Indonesia doubles the supply of
money by printing some rupiah bills and dropping them around the country from helicopters.
(Or, less dramatically and more realistically, the Baof nk Indonesia could inject money into the
economy by buying some government bonds from the public in open-market operations.) What
happens to the value of money after such a monetary injection? How does the oes new equilibria
rum in the rupiah compare with the old one?

Figure 4. Is there any quantity of money in now a day,

It shows us how quantity and value of money after
some monetary policy

Figure 4 shows what happens. The monetary injection shifts the supply curve to the right
from MS1 to MS2, and the equilibrium moves from point A to point B. As a result, the value of
money (shown on the left axis) decreases from ½ to ¼, and the equilibrium price level (shown
on the right axis) increases from 2 to 4. In other words, when an increase in the money supply
makes the rupiah more plentiful, the result is an increase in the price level that makes each
rupiah less valuable. This explanation of how the price level is determined and why it might
change over time is called the quantity theory of money. Quantity theory of money is a theory
asserting that the quantity of money available determines the price level, the growth rate, and
also inflation rate. For that, we can reflect on some quotes from the economist name Milton
Friedman. He says “Inflation is always and everywhere a monetary phenomenon”. For the new
Equilibrium Because of the Increasing supply of money, that makes the demand for goods and
services increases too, causes of this the prices of goods and services also increase. The increase
in the price level, in turn, increases the quantity of money demanded because people are using

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more rupiah for every transaction. Eventually, the economy reaches a new equilibrium (point
B in Figure 4) at which the quantity of money demanded again equals the quantity of money
supplied. In this way, the overall price level for goods and services adjusts to bring money
supply and money demand into balance, that is how the equilibrium wishes to shift after
sommonetaryry policy.

2.1.4 The Classical Dichotomy and Monetary Neutrality

The classical dichotomy is the idea, attributed to classical and pre-Keynesian economics,
that real and nominal variables can be analyzed separately. The nominal variables are variables
we use to measure in monetary units and the second real variables are variables measured in
physical units. For example, the income fisherman is a nominal variable because it is measured
in rupiah, whereas the quantity of fproducedduce is a real variable. After all, it is measured in
bushels to be precise. An economy exhibited in the classical dichotomy uses real variables such
as output and real interest rates can be completely analyzed without considering what is
happening to their nominal counterparts, the monetary value of output, and the interest rate. In
particular, this means that real GDP and other real variables can be determined without knowing
the level of the nominal money supply or the rate of inflation. An economy exhibits the classical
dichotomy if money is neutral, affecting only the price level, not real variables. As such, if the
classical dichotomy holds, money only affects absolute rather than the relative prices between
goods. For the analysis in the Classical Dichotomy changes in the supply of money affect
nominal variables but not real ones. When the central bank doubles the money supply, the price
level doubles, the rupiah wage doubles, and all other currency values double. Real variables,
such as production, employment, real wages, and real interest rates, are unchanged. The
irrelevance of monetary changes to real variables is called monetary neutrality.

In new classical macroeconomics, there is a short-run Phillips curve that can shift vertically
according to the rational expectations being reviewed continuously. In the strict sense, money
is not neutral in the short-run, that is, classical dichotomy does not hold, since agents tend to
respond to changes in prices and the quantity of money by changing their supply decisions.
However, money should be neutral in the long run, and the classical dichotomy should be
restored in the long run since there was no relationship between prices and real macroeconomic
performance at the data level. This view has serious economic policy consequences. In the long
run, owing to the dichotomy, money is not assumed to be an effective instrument in controlling
macroeconomic performance, while in the short run, there is a trade-off between prices and

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output (or unemployment), but, owing to rational expectations, the government cannot exploit
it to build a systematic countercyclical economic policy.

2.1.5 Velocity and the Quantity Equation

The velocity of money is the speed of money transferring hand to hand to for pay produced
goods and services. In physics, the term velocity refers to the speed at which an object travels.
In economics, the velocity of money refers to the speed at which the typical currency bill travels
around the economy from wallet to wallet. To know how fast is velocity of money is, we divide
the nominal value of output (nominal GDP) by the quantity of money. If P is the price level (the
GDP deflator), Y is the quantity of output (real GDP), and M is the quantity of money, then
velocity is:

𝑽 = (𝑷 × 𝒀)/𝑴

To see why this makes sense, imagine a simple economy that produces only palm oil.
Suppose that the economy produces 100-ton palm oil in a year, that palmlam oil sells Rp.
2500kg, and that the quantity of money in the economy is Rp. 100,000. Then the velocity of
money is

100 × (2.500 × 1.000)/ 100.000

𝑉 = 2.500

In this economy, people spend a total of Rp. 250.000.000 per year on palm. For this Rp
2.500 of spending to take place with only Rp.100.00 of money, each dollar bill must change
hands on average 2.500 times per year.

When we rearrange the formula of Velocity and make rotation to money, that will give us
this equation:

𝑴 × 𝑽=𝑷 × 𝒀

This equation states that the quantity of money (M) times the velocity of money (V) equals
the price of output (P) times the amount of output (Y). It is called the quantity equation because
it relates the quantity of money (M) to the nominal value of output (P × Y). The quantity
equation shows that an increase in the quantity of money in an economy must be reflected in
one of the other three variables: The price level must rise, the quantity of output must rise, or
the velocity of money must fall.

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 From the equation, we now have all the elements necessary to explain the equilibrium price
level and inflation rate. They are as follows:

1. The velocity of money is relatively stable over time.

2. Because velocity is stable, when the central bank changes the quantity of money (M), it
causes proportionate changes in the nominal value of output (P × Y).

3. The economy’s output of goods and services (Y) is determined by factor supplies (labor,
physical capital, human capital, and natural resources) and the available production technology.
In particular, since money is neutral, money does not affect output.

4. Because output (Y) is fixed by factor supplies and technology, when the central bank
alters the money supply (M) and induces a proportional changein the nominal value of output
(P × Y), this change is reflected in a change in the price level (P).

5. Therefore, when the central bank increases the money supply rapidly, the the result is a
high rate of inflation.

These five points are the essence of the quantity theory of money

2.1.6 The Inflation Tax

Basically, Inflation Tax is the rise of revenue the monetary institutions like Bank Central
and the Government want to get after they create money. When the government wants to build
roads, pay salaries to its soldiers, or give transfer payments to the poor or elderly, it first has to
raise the necessary funds. Normally, the government does this by levying taxes, such as income
and sales taxes, and by borrowing from the public by selling government bonds. Yet the
government can also pay for spending simply by printing the money it needs. When the
government raises revenue by printing money, it is said to levy an inflation tax. The inflation
tax is not exactly like other taxes, however, because no one receives a bill from the government
for this tax. Instead, the inflation tax is subtler. When the government prints money, the price
level rises, and the currency in your wallet become less valuable. Thus, the inflation tax is like
a tax on everyone who holds money.

2.1.7 The Fisher Effect

If we look at the concept of monetary neutrality, an increase in the rate of money growth
raises the rate of inflation but does not affect any real variable. An important application of this
concept is the effect of money on interest rates. Interest rates are important variables for
macroeconomists to understand because they link the economy on today and economy of the

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future through their effects on saving and investment. To understand the relationship between
money, inflation, and interest rates, recall the distinction between the nominal interest rate and
the real interest rate. The nominal interest rate is the interest rate you hear about at your bank.
If you have a savings account, for instance, the nominal interest rate tells you how fast the
number of dollars in your account will rise over time. The real interest rate corrects the nominal
interest rate for the effect of inflation to tell you how fast the purchasing power of your savings
account will rise over time. The real interest rate is the nominal interest rate minus the inflation
rate:

𝑅𝑒𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 = 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 − 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒.

For example, if the bank posts a nominal interest rate of 6 percent per year and

the inflation rate is 2,5 percent per year, then the real value of the deposits grows by 3,5
percent per year. We can rewrite this equation to show that the nominal interest rate is the sum
of the real interest rate and the inflation rate:

𝑅𝑒𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 = 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 + 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒.

When we looking this way the nominal interest rate can be very useful because different
forces determine each of the two terms on the right side of this equation. As we know supply
and demand for loanable funds determine the real interest rate. According to the quantity theory
of money, growth in the money supply determines the inflation rate.

Let’s now consider how growth in the money supply affects interest rates. In the long run
if money still neutral, a change in money growth shouldn’t affect the real interest rate. The real
interest rate is a real variable. For the real interest rate to remain unchanged, a change in the
inflation rate must result in a one-for-one change in the nominal interest rate. Thus, when the
Central Bank increases the rate of money growth, the long-run result is both a higher inflation
rate and a higher nominal interest rate. This adjustment of the nominal interest rate to the
inflation rate is called the Fisher effect, after Irving Fisher (1867–1947), the economist who
first studied it.

Analysis on the Fisher effect has maintained a long-run perspective of how change inflation
rate affects the interest rate. The Fisher effect need not hold in the short run because inflation
may be unanticipated. A nominal interest rate is a payment on a loan, and it is typically set when
the loan is first made. If a jump in inflation catches the borrower and lender by surprise, the
nominal interest rate they agreed on will fail to reflect the higher inflation. But if inflation

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remains high, people will eventually come to expect it, and the nominal interest rates set in loan
agreements will reflect this expectation. To be precise, therefore, the Fisher effect states that the
nominal interest rate adjusts to expected inflation. Expected inflation moves with actual
inflation in the long run but not necessarily in the short run.

2.2 The Costs of Inflation

The cost of inflation is the negative consequences for the economy resulting directly or
indirectly from inflation. Inflation occurs when goods and services price getting more expensive
over time. With it will make purchasing power on people being weakens and that means in the
future your currency will be worth less and can buy less. Inflation can harm individuals by
reducing the value of their money (particularly savings) and shifting the distribution of income
to lenders and asset-holders. If inflation rises to levels that are too high, it can damage the
economy.

While there are multiple types of inflation, in general Inflation can we categorize into two
main ones. These are demand-pull inflation and cost-push inflation.

2.2.1 Demand-pull Inflation

This type of inflation is triggered when aggregate demand increases. Aggregate demand is
a measure of overall demand for goods/services throughout all sectors of the economy. This
increase in demand comes from businesses, governments, households, and even foreign buyers.
If that demand exceeds supply, all of the four sections compete for the limited supply. As they
keep bidding to get the goods/services they want, they, in turn, keep increasing the price of the
goods/services in the whole economy and this causes inflation. This is known as a lot of money
"chasing too few goods".

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 Figure 5. show how aggregate price level
and real GDP affect it other and it can shoe the
cause of inflation in demand – pull inflation.

Figure 5. above shows demand-pull inflation. The aggregate price level in the economy is
shown on the vertical axis, while real output as measured by real GDP is on the horizontal axis.
Long-run aggregate supply curve (LRAS) represents the full employment level of output that
the economy can produce labeled by YF. The initial equilibrium, labeled by E1 is at the
intersection of the aggregate demand curve AD1 and short-run aggregate supply curve SRAS.
The initial output level is Y1 with the price level in the economy at P1. A positive demand shock
causes the aggregate demand curve to shift to the right from AD1 to AD2. The equilibrium after
the shift is labeled by E2, which is located at the intersection of the aggregate demand curve
AD2 and short-run aggregate supply curve SRAS. The resulting output level is Y2 with the
price level in the economy at P2. The new equilibrium is characterized by higher inflation due
to an increase in aggregate demand.

2.2.2 Cost-push Inflation

Cost-push inflation occurs when there's a decrease in the aggregate supply of
goods/services due to rising costs of production. Aggregate supply is the economy's total
production of goods/services throughout all sectors of the economy. Basically, this means that
prices have gotten higher because the prices of production have also gotten higher. Included in
this is land, labor, and capital. Companies aren't able to keep producing the same amount of
goods/services at the same price because it has gotten more expensive to produce those
goods/services. To make a profit, they are going to increase prices which creates inflation.

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 Figure 6. show how aggregate price level and real
GDP affect it other and it can shoe the cause of
inflation in demand – pull inflation

Figure 6 above shows cost-push inflation. The aggregate price level in the economy is
shown on the vertical axis, whilst real output as measured by real GDP is on the horizontal axis.
Long-run aggregate supply curve (LRAS) represents the full employment level of output that
the economy can produce labelled by YF. The initial equilibrium, labelled by E1 is at the
intersection of the aggregate demand curve AD and short-run aggregate supply curve – SRAS1.
Initial output level is Y1 with the price level in the economy at P1. A negative supply shock
causes aggregate supply curve to shift to the left from SRAS1 to SRAS2. The equilibrium after
the shift is labelled by E2, which is located at the intersection of the aggregate demand curve
AD and short-run aggregate supply curve – SRAS2. The resulting output level is Y2 with the
price level in the economy at P2. The new equilibrium is characterized by higher inflation due
to a decrease in aggregate supply.

After we got the the model curve main cause of the Inflation in general from the curve we
can know it is explanation of the classical model of the price level. This we can look at the
curve below:

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 Figure 7. Classical model of price level

Figure 7. shows the short-run and long-run equilibrium in an economy using the AD-AS
model.

• AD is used to denote the aggregate demand curve.

• LRAS is used to denote the long-run aggregate supply curve
• SRAS is used to represent the short-run aggregate supply curve.

Let's consider what happens when there is an increase in the money supply. An increase in
money supply will cause the aggregate demand curve to shift to the right (from AD1 to AD2),
moving equilibrium (from E1 to E2). This results in higher prices (from P1 to P2) and higher
output produced(from Y1 to Y2). As prices increase in the economy, workers will demand
increased wages to retain their purchasing power. As wages increase, firms' production cost
increases, which shifts the SRAS to the left(from SRAS1 to SRAS2). This changes the
equilibrium (from E2 to E3), resulting in overall higher prices(P3). However, notice that as the
money supply has increased, only the price level has increased; the total output (Y1) has
remained unchanged in the long run. The classical price level model ignores the short-run
equilibrium (E2); rather, it assumes that the equilibrium moves directly to the long-run outcome
(from E1 to E3) when there's an increase in the money supply. A drawback of this model is that
when there's low inflation in the economy, it may take time for workers to increase their wages,
resulting in more sticky wages. This means that the money supply does affect the real GDP in
the short run. However, when there's high inflation, wages and prices tend to adjust much more
quickly.

2.2.3 Extreme Types of Inflation

Despite the fact that we as consumers will hate rising prices, in a nutshell if inflation stays
at a decent level it's actually beneficial to the health of the economy. The issue comes in when
we have inflation that exceeds a tolerable amount. Let's learn about the three types of inflation
that are of most concern to economists.

Hyperinflation

When prices begin to rise over the accepted level, this brings the fear of hyperinflation.
This type is a rapid and uncontrollable increase in inflation. Due to rising prices consumers, as
well as businesses, have to spend more money to buy the products they want/need. The money

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they do have is losing value every time the hyperinflation rate gets higher and puts people at
risk of bankruptcy.

Stagflation

Stagflation happen when the inflation rate and unemployment are high and rising, whilst
the economy's output is falling. Normally, it's expected that unemployment will go up when
the economy slows down. However, the fact that prices are rising at the same time as
unemployment is cause for concern. In a low-employment environment, consumers have less
spending power. If you add high inflation rates to that, then people's money becomes less
valuable with each passing day. Essentially, money has less value and there's less of it available
to spend.

Deflation

Deflation, or negative inflation, is characterized by dropping prices. It is different from

disinflation when the rate of inflation falls but still remains positive – the prices are rising but
at a slower rate. If the supply of money decreases, the value of it increases. Both of these
together mean that prices will also decrease. A drop in demand could also cause prices to fall.
At first, deflation sounds like a good thing! Prices of things are getting lower so why should we
be concerned? If prices drop that means that businesses had to lower their prices. Which means
that they're making less money. Since they're losing out on making a profit, they have to save
money some other way. They do this by laying off or firing the employees that work for them,
and by doing so, they increase the rate of unemployment.

2.2.4 Negative Effects of Inflation

Value of money decreases

Inflation causes the money we need to buy some goods and service to increase. For
example, before pandemic we can buy rice with price Rp. 8000/kg, but now we need Rp. 12.000
to buy 1 kg rice.

Inequality

Most of the burden of inflation falls on low-income households. Since they spend the
highest percentage of their income on necessities, inflation typically consumes a larger
proportion of their income. Asset prices (like housing and stocks) also tend to rise when
inflation is present. The increase in these prices overtakes the rising inflation rates. Since richer
households tend to have more assets, it increases the amount of inequality even more. It's due

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to the fact that the assets go up in value quicker than ordinary goods such as groceries. As a
result, they find themselves with more money than before while the low-income families are
forced to spend more money just to survive.

Cost of living goes up

As prices begin to rise, consumers will of course have to pay more for both necessary things
and luxuries. If incomes increase alongside inflation, then this might not be problematic. But in
the case that incomes do not change alongside inflation, then there will be more issues. The
percentage of income spent on the same amount of goods will rise. Additionally, inflation shifts
workers into higher tax brackets which means their taxes will go up. If inflation isn't taken into
account when calculating the tax brackets, workers will end up in a worse situation than before.

2.2.5 Positive Effects of Inflation

Rise in investments

The rise in inflation motivates people to spend now rather than wait until later when their
money might be worth less. For some, this might look like a lot of large purchases such as cars
and electronics. For others, this might make them want to seek the greatest return on investment.
Since money is worth less when inflation occurs, consumers want to stay above inflation as
much as possible so they can keep their purchasing power at the same level. The way they try
to do this is to seek high-yielding investments. This is a great move for the economy because
money is being moved to parts of the economy that are extremely productive.

Reduce debt

If a person has a large amount of debt, they might actually reap some reward from an
increase in the rate of inflation. Suppose you have a loan out with the bank. Your interest rate
is at 3%. If the inflation rate rises to 15% and your income rises alongside it, then the rate at
which you're paying the bank back actually declines.

2.2.6 Economic Costs of Inflation

The most common inflationary costs are shoe leather costs, menu costs, loss of purchasing
power, and wealth redistribution:

Shoe Leather

The shoe leather cost is the cost of time consumed and effort spent by people attempting to
offset the consequences of inflation, such as saving less cash, dealing in foreign currencies with

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lower rates of inflation, and making more visits to the bank. The name stems from the fact that
more walking is necessary to travel to the bank, collect money, and spend it, causing shoes to
wear out faster. A lot of time and relaxation is the price that has to be paid for lowering money
holdings.

Menu Costs

A menu cost is the expense incurred by a business as a result of altering its prices. The term
derives from the expense of restaurants printing new menus, but now it's used to refer to the
costs of altering pricing in general. With high inflation, businesses must alter their pricing often
frequently in order to keep up with broader economic developments, and this sometimes proves
to be an expensive activity: directly, such as printing new menus, and indirectly, such as the
extra time spent and effort required to change prices on a regular basis.

Loss of Purchasing Power

Inflation, by nature, reduces the purchasing power of a single dollar over time. With
inflation, each dollar has less purchasing power. As a result, those with the same pay next year
as they do this year will be able to buy less. Purchasing power could be sustained if salaries rise
at the same pace as inflation, although this is not always the case. People lose buying power
when salaries rise at a slower rate than inflation.

Wealth Redistribution

Inflation's influence is not dispersed equally across the economy, and as a result, there are
hidden costs for some and advantages for others from this fall in money's purchasing power.
For instance, when the price of hard assets (such as real estate or stocks) rises due to inflation,
those who own them gain, but those who want to buy them must pay a higher price.

2.2.7 Main parties Involved and their Roles in Costs of Inflation

Consumers
Consumers tend to have little benefit from inflation, especially if their pay does not increase
when the rate of inflation does. They suffer from the higher prices of goods/services while still
having the same amount of money.

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 Investors

Investors actually tend to benefit a bit if their stocks are in the sectors hit by inflation. For
example, if you're an investor and you have stocks in the gasoline sector, then you might notice
an increase in your stock prices due to the gas prices going up.

2.2.8 How We Deal with Costs of Inflation

From individual how we can deal with inflation, there are many strategy we can use for
deal with it such as making a long-term investment, make diversity to our portfolio (asset),
avoiding keeping too much cash, holding tangible Assets, etc. From government will usually
step in to help fight the negative consequences of inflation once it starts to become concerning.
A few of the ways are government take for deal the Inflation such asv controlling wages and
prices, reducing the supply of money, increasing interest rates to deter borrowing.

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 CHAPTER III

Conclusion

The classical theory of inflation is attributes sustained price inflation to excessive growth
in the quantity of money in circulation. And sometimes we called as the theory quantity of
money. Effect the level price to value of money happen when the price level rises, people have
to pay more for the goods and services they buy. Alternatively, we can view the price level as a
measure of the value of money. A rise in the price level means a lower value of money because
each rupiah in your wallet now buys a smaller quantity of goods and services. In the long run,
however different and much simpler. In the long run, the overall level of price adjusts to the
level at which the demand for money equals the supply. If the price level is above the
equilibrium level, people will want to hold more money than the Central Bank has created, so
the price level must fall to balance supply and demand. If the price level is below the
equilibrium level. people will want to hold less money than the Central Bank has created, and
the practice lever must rise to balance supply and demand. At the equilibrium price level, the
quantity of money that ‘people want to hold exactly balances the quantity of money supplied
by the Central Bank. Monetary institution can the Increasing supply of money, which makes
the demand for goods and services increases too, causes of this the prices of goods and services
also increase. The increase in the price level, in turn, increases the quantity of money demanded
because people are using more rupiah for every transaction. Eventually, the economy reaches
a new equilibrium. The quantity equation work to shows us that an increase in the quantity of
money in an economy must be reflected in one of the other three variables: The price level must
rise, the quantity of output must rise, or the velocity of money must fall and to count the velocity
of money we can divine the value output and the quantity of money. The relation on Classical
Dichotomy and Monetary Neutrality is when real variable is not relevant again on the monetary
change. When in the government want run their vision like build roads, pay salaries to its
soldiers, or give transfer payments to the poor or elderly, ctc. Its will cost a lot of money, but
there are to a lot of money the government hold surely will make interest rate more higher and
the end the condition of higher interest rate effected by inflation rate. Fisher effect is effect of
money on interest rates, and why it so useful because different forces determine each of the
two terms on the right side of this equation. As we know supply and demand for loanable funds
determine the real interest rate. According to the quantity theory of money, growth in the money
supply determines the inflation rate. The general cause of inflation in general are are demand-

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pull inflation and cost-push inflation. Base on the extreme type, inflation can we divide
become three, that is Hiperinflation, stagflation and deflation. Infaltion has more bad impact
Into our economic because it’s harm many aspect and sector because the change value of money,
inequality and Cost of living goes up make more difficult to people life. From an economist's
point of view there are four causes of inflation, namely Shoe Leather, Menu Costs, Loss of
Purchasing Power and Wealth Redistribution. The Main parties Involved and their Roles in
Costs of Inflation are Costumer and Investor. We can deals with the causes of Inflation by
making a long-term investment, make diversity to our portfolio (asset), avoiding keeping too
much cash, holding tangible Assets, etc.

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Refference

Alawiyah, T., Haryadi, H., & Amzar, Y. V. (2019). Pengaruh inflasi dan jumlah uang beredar
terhadap nilai tukar rupiah dengan pendekatan model struktural VAR. E-
Journal Perdagangan Industri Dan Moneter, 7(1), 51-60.

app.hellovaia.com (2022) .Costs of Inflation (Explanation). Acces in October 17, 2023

https://app.hellovaia.com/studyset/6649005/summary/40565103

Borio, C., Hofmann, B., & Zakrajšek, E. (2023). Does money growth help explain the recent
inflation surge? (No. 67). Bank for International Settlements.

Mankiw, N. G. (2019). Principles of microeconomics (9th ed.). CENGAGE Learning Custom

Publishing.

Olavia L. (2022). Yuk mengenal perbedaaan uang-giral uang kartal dan uang kuasi. Acces in
October 17, 2023. https://www.beritasatu.com/ekonomi/920039/yuk-
mengenal-perbedaaan-uang-giral-uang-kartal-dan-uang-kuasi

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