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CHAPTE

Money and Inflation

In this chapter, you will


learn

The classical theory of inflation


causes
effects
social costs
Classical assumes prices are flexible &
markets clear

Applies to the long run

CHAPTER 4

Money and Inflation

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CHAPTER 4

Money and Inflation

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U.S. inflation and its trend, 19602006


15%

% change in CPI from


12 months earlier

12%

long-run trend

9%
6%
3%
0%
1960 1965

1970 1975

1980 1985

1990 1995

2000 2005
slide 4

The connection between


money and prices

Inflation rate = the percentage increase


in the average level of prices.

Price = amount of money required to


buy a good.

Because prices are defined in terms of money,


we need to consider the nature of money,
the supply of money, and how it is controlled.

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Money and Inflation

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Money: Definition

Money is the stock


of assets that can be readily
used to make transactions.

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Money and Inflation

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Money: Functions

medium of exchange
we use it to buy stuff

store of value
transfers purchasing power from the present to
the future

unit of account
the common unit by which everyone measures
prices and values
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Money and Inflation

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Money: Types
1. fiat money

has no intrinsic value


example: the paper currency we use
2. commodity money

has intrinsic value


examples:
gold coins,
cigarettes in P.O.W. camps

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Money and Inflation

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Discussion Question
Which of these are money?
a. Currency
b. Checks
c. Deposits in checking accounts

(demand deposits)
d. Credit cards
e. Certificates of deposit

(time deposits)
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Money and Inflation

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The money supply and


monetary policy definitions

The money supply is the quantity of money


available in the economy.

Monetary policy is the control over the money


supply.

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Money and Inflation

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The central bank


Monetary policy
is conducted by
a countrys
central bank.

In India,
the central bank
is called the
Reserve Bank
of India.
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Money and Inflation

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Measures of Monetary and Liquidity Aggregates


(RBI, Aug 1, 2007)
M0 (Reserve Money): Currency in Circulation+ Bankers
Deposits with the RBI+ Other Deposits with the RBI.
M1: Currency with the Public+ Demand Deposits with the
Banking System+ Other deposits with the RBI.
M2: M1+ Savings Deposits of Post Office Savings Banks.
M3: M1+ Time Deposits with the Banking System.
M4: M3+ All Deposits with Post Office Savings Banks
(Excluding
National Savings Certificates).

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Data Source: Hand Book of Statistics, RBI

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(` Billion)
Components of Money Stock
Measures

Outstanding as on March 31

1 Currency with the Public (1.1 + 1.2


+ 1.3 1.4)
1.1 Notes in Circulation
1.2 Circulation of Rupee Coin
1.3 Circulation of Small Coins
1.4 Cash on Hand with Banks
2 Deposit Money of the Public
2.1 Demand Deposits with Banks
2.2 Other Deposits with Reserve
Bank
3 M1 (1 + 2)
4 Post Office Saving Bank Deposits
5 M2 (3 + 4)
6 Time Deposits with Banks
7 M3 (3 + 6)
8 Total Post Office Deposits
9 M4 (7 + 8)

2013-14
1
12,483.4
12,837.4
166.0
7.4
527.3
8,063.5
8,043.9
19.7
20,547.0
423.6
20,970.6
74,426.3
94,973.3
1,572.0
96,545.3

http://www.rbi.org.in/scripts/BS_ViewBulletin.aspx
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Components of Reserve Money in India (` Billion)


Outstanding as on
March 31
Item
2013-14
1
Reserve Money (1.1 + 1.2 + 1.3 =
2.1 + 2.2 + 2.3 + 2.4 + 2.5
17,327.4
2.6)
1 Components

1.1 Currency in Circulation


13,010.7
1.2 Bankers' Deposits with RBI
4,297.0
1.3 Other Deposits with RBI
19.7
2 Sources

2.1 Net Reserve Bank Credit to


6,987.1
Government
2.2 Reserve Bank Credit to Banks
486.5
2.3 Reserve Bank Credit to Commercial
88.4
Sector
2.4 Net Foreign Exchange Assets of RBI
18,025.3
2.5 Government's Currency Liabilities
173.4
to the Public
2.6 Net Non- Monetary Liabilities of RBI
8,433.2

Source: www.rbi.org.in

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Data Source: Hand Book of Statistics, RBI

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The Quantity Theory of Money


A simple theory linking the inflation rate
to the growth rate of the money supply.

Begins with the concept of velocity

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Velocity
basic concept: the rate at which money circulates
definition: the number of times the average rupee
changes hands in a given time period

example: In 2013-14, GDP nominal price =

Rs.11,35000 billion (GDP = 113.5 lakh crore)


money supply = Rs. 94973.3billion
The average rupee is used in twelve
transactions in 2013-14
So, velocity = 11,35000/94973.3= 12
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Money and quasi money (M2) as %


of GDP

198 199 200 201 201


Country Name
0
0
0
0
3
Australia
41 54 68 101 106
Austria

139 188 165


Brazil
12 30 47 69 80
Switzerland
91 103 116 146 182
China
37 79 137 181 195
European Union

109 156 148


France

98 146 151
United Kingdom
31 87 101 169 151
Hong Kong SAR, China

224 325 353


India
34 41 54 76 77
Iran, Islamic Rep.
62 58 36 20 13
Iraq

38 33
Korea, Rep.
30 34 65 131 134
Least developed countries: UN
classification
18 23 24 37 39
Sri Lanka
32 28 38 37 34
Middle East & North Africa (all
income levels)
35 56 58 62 58
Nigeria
29 20 22 21 22
High income: OECD
76 96 114 137 135
OECD members
74 93 111 133 131
Pakistan
41 39 39 41 41
South Asia
33 40 50 71 71
Thailand
42 76 115 116 135

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Velocity, cont.
This suggests the following definition:
T
V
M
where
V = velocity
T = value of all transactions
M = money supply

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Money and Inflation

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Velocity, cont.
Use nominal GDP as a proxy for total
transactions.
Then,

P Y
V
M

where
P

= price of output

= quantity of output

P Y = value of output

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Money and Inflation

(GDP deflator)
(real GDP)
(nominal GDP)

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The quantity equation


The quantity equation
M V = P Y
follows from the preceding definition of velocity.

It is an identity:
it holds by definition of the variables.

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Money demand and the


quantity equation

M/P = real money balances, the purchasing


power of the money supply.

A simple money demand function:


(M/P )d = k Y
where
k = how much money people wish to hold for
each rupee of income.
(k is exogenous)
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Money demand and the


quantity equation

money demand:
quantity equation:

(M/P )d = k Y
M V = P Y

The connection between them: k = 1/V


When people hold lots of money relative
to their incomes (k is high),
money changes hands infrequently (V is low).

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Back to the quantity theory of


money

starts with quantity equation


assumes V is constant & exogenous: V V
With this assumption, the quantity equation can
be written as

M V P Y

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The quantity theory of money,


cont.

M V P Y
How the price level is determined:

With V constant, the money supply determines


nominal GDP (P Y ).

Real GDP is determined by the economys


supplies of K and L and the production
function (Chap 3).

The price level is


P = (nominal GDP)/(real GDP).
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The quantity theory of money,


cont.

The quantity equation in growth rates:

M V
P Y

M
V
P
Y
The quantity theory of money assumes
V
V is constant, so
= 0.
V
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Money and Inflation

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The quantity theory of money,


cont.

(Greek letter pi)


denotes the inflation rate:
The result from the
preceding slide was:

P

P
M
P Y

M
P
Y

Solve this result


for to get

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Money and Inflation

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The quantity theory of money,


cont.

Normal economic growth requires a certain


amount of money supply growth to facilitate the
growth in transactions.

Money growth in excess of this amount leads


to inflation.

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The quantity theory of money,


cont.

Y/Y depends on growth in the factors of


production and on technological progress
(all of which we take as given, for now).
Hence,
Hence, the
the Quantity
Quantity Theory
Theory predicts
predicts
aa one-for-one
one-for-one relation
relation between
between
changes
changes in
in the
the money
money growth
growth rate
rate and
and
changes
changes in
in the
the inflation
inflation rate.
rate.
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Confronting the quantity


theory with data
The quantity theory of money implies
1. countries with higher money growth rates
should have higher inflation rates.
2. the long-run trend behavior of a countrys
inflation should be similar to the long-run trend
in the countrys money growth rate.

Are the data consistent with these implications?

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International data on inflation and


money growth
Turkey
Ecuador

Indonesia

Argentina

U.S.
Singapore

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Money and Inflation

Belarus

Switzerland

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Data Source: Hand Book of Statistics, RBI

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U.S. inflation and money growth,


1960-2006
15%
12%

Over
Over the
the long
long run,
run, the
the inflation
inflation and
and
money
money growth
growth rates
rates move
move together,
together,
M2 growth
as
theory
predicts.
as the
the quantity
quantity
theoryrate
predicts.

9%
6%
3%
0%
1960 1965

inflation
rate
1970 1975

1980 1985

1990 1995

2000 2005
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Seigniorage

To spend more without raising taxes or selling


bonds, the govt can print money.

The revenue raised from printing money


is called seigniorage
(pronounced SEEN-your-idge).

The inflation tax:


Printing money to raise revenue causes inflation.
Inflation is like a tax on people who hold
money.
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Inflation and interest rates

Nominal interest rate, i


not adjusted for inflation

Real interest rate, r


adjusted for inflation:
r = i

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The Fisher effect

The Fisher equation: i = r +


Chap 3: S = I determines r .
Hence, an increase in
causes an equal increase in i.

This one-for-one relationship


is called the Fisher effect.

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Money and Inflation

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percent
per year
15

Inflation and nominal interest


rates in the U.S., 1955-2006
nominal
interest rate

10

inflation rate

-5
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
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Money and Inflation

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Inflation and nominal interest rates


across countries
Romania
Zimbabwe
Brazil

Bulgaria

Israel
Germany

U.S.

Switzerland

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Money and Inflation

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Exercise:
Suppose V is constant, M is growing 5% per year,
Y is growing 2% per year, and r = 4.
a. Solve for i.
b. If the Fed increases the money growth rate by
2 percentage points per year, find i.
c. Suppose the growth rate of Y falls to 1% per year.
What will happen to ?
What must the Fed do if it wishes to

keep constant?
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Money and Inflation

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Answers:
V is constant, M grows 5% per year,
Y grows 2% per year, r = 4.
a. First, find = 5 2 = 3.
Then, find i = r + = 4 + 3 = 7.
b. i = 2, same as the increase in the money
growth rate.
c. If the Fed does nothing, = 1.
To prevent inflation from rising,
Fed must reduce the money growth rate by
1 percentage point per year.
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Two real interest rates

= actual inflation rate


(not known until after it has occurred)

e = expected inflation rate


i e = ex ante real interest rate:
the real interest rate people expect
at the time they buy a bond or take out a loan

i = ex post real interest rate:


the real interest rate actually realized
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Money demand and


the nominal interest rate

In the quantity theory of money,


the demand for real money balances
depends only on real income Y.

Another determinant of money demand:


the nominal interest rate, i.
the opportunity cost of holding money (instead
of bonds or other interest-earning assets).

Hence, i in money demand.


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The money demand function

(M P ) L(i , Y )
d

(M/P )d = real money demand, depends


negatively on i
i is the opp. cost of holding money
positively on Y
higher Y more spending
so, need more money
(L is used for the money demand function
because money is the most liquid asset.)
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The money demand function

(M P ) L(i , Y )
d

L(r , Y )
e

When people are deciding whether to hold


money or bonds, they dont know what inflation
will turn out to be.
Hence, the nominal interest rate relevant for
money demand is r + e.

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Money and Inflation

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Equilibrium
M
e
L(r , Y )
P
The supply of real
money balances

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Money and Inflation

Real money
demand

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What determines what


M
e
L(r , Y )
P
variable

how determined (in the long run)

exogenous (the Fed)

adjusts to make S = I

Y F (K , L )

M
L(i ,Y )
adjusts to make
P

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Money and Inflation

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How P responds to M
M
e
L(r , Y )
P

For given values of r, Y, and e,


a change in M causes P to change by the
same percentage just like in the quantity
theory of money.

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What about expected inflation?

Over the long run, people dont consistently


over- or under-forecast inflation,
so e = on average.

In the short run, e may change when people


get new information.

EX: Fed announces it will increase M next year.


People will expect next years P to be higher,
so e rises.

This affects P now, even though M hasnt changed


yet.
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Money and Inflation

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How P responds to e
M
L(r e , Y )
P

For given values of r, Y, and M ,


e i (the Fisher effect)
M P

P to make M P fall
to re-establish eq'm

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Money and Inflation

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Discussion question
Why is inflation bad?

What costs does inflation impose on society?


List all the ones you can think of.

Focus on the long run.


Think like an economist.

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A common misperception

Common misperception:
inflation reduces real wages

This is true only in the short run, when nominal


wages are fixed by contracts.

In the long run, the real wage is determined by


labor supply and the marginal product of labor,
not the price level or inflation rate.

Consider the data


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Money and Inflation

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Average hourly earnings and the


CPI, 1964-2006
$20

250

$18
200

hourly wage

$14
$12

150

$10
$8

100

$6
CPI (right scale)
wage in current dollars
wage in 2006 dollars

$4
$2
$0
1964
CHAPTER 4

1970
1976
1982
Money
and
Inflation

1988

1994

2000

CPI (1982-84 = 100)

$16

50

0
2006

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The classical view of inflation

The classical view:


A change in the price level is merely a change
in the units of measurement.

So why, then, is inflation a


social problem?

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The social costs of inflation


fall into two categories:
1. costs when inflation is expected
2. costs when inflation is different than

people had expected

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The costs of expected inflation:


1. Shoeleather cost

def: the costs and inconveniences of reducing


money balances to avoid the inflation tax.

i
real money balances

Remember: In long run, inflation does not


affect real income or real spending.

So, same monthly spending but lower average


money holdings means more frequent trips to
the bank to withdraw smaller amounts of cash.
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The costs of expected inflation:


2. Menu costs

def: The costs of changing prices.


Examples:
cost of printing new menus
cost of printing & mailing new catalogs
The higher is inflation, the more frequently
firms must change their prices and incur
these costs.

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The costs of expected inflation:


3. Relative price distortions

Firms facing menu costs change prices infrequently.


Example:
A firm issues new catalog each January.
As the general price level rises throughout the year,
the firms relative price will fall.

Different firms change their prices at different times,


leading to relative price distortions
causing microeconomic inefficiencies
in the allocation of resources.
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The costs of expected inflation:


4. Unfair tax treatment
Some taxes are not adjusted to account for
inflation, such as the capital gains tax.
Example:

Jan 1: you buy $10,000 worth of IBM stock


Dec 31: you sell the stock for $11,000,
so your nominal capital gain is $1000 (10%).

Suppose = 10% during the year.


Your real capital gain is $0.

But the govt requires you to pay taxes on your


$1000 nominal gain!!
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The costs of expected inflation:


5. General inconvenience

Inflation makes it harder to compare nominal


values from different time periods.

This complicates long-range financial


planning.

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Money and Inflation

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Additional cost of unexpected inflation:


Arbitrary
of purchasing
Many
long-termredistribution
contracts not indexed,
power
but based on e.

If turns out different from e,


then some gain at others expense.
Example: borrowers & lenders
If > e, then (i ) < (i e)
and purchasing power is transferred from
lenders to borrowers.
If < e, then purchasing power is transferred
from borrowers to lenders.
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Additional cost of high inflation:


Increased uncertainty
When inflation is high, its more variable and
unpredictable:
turns out different from e more often,
and the differences tend to be larger
(though not systematically positive or negative)

Arbitrary redistributions of wealth


become more likely.

This creates higher uncertainty,


making risk averse people worse off.
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Money and Inflation

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One benefit of inflation

Nominal wages are rarely reduced, even when


the equilibrium real wage falls.
This hinders labor market clearing.

Inflation allows the real wages to reach


equilibrium levels without nominal wage cuts.

Therefore, moderate inflation improves the


functioning of labor markets.

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Hyperinflation

def: 50% per month


All the costs of moderate inflation described
above become HUGE under hyperinflation.

Money ceases to function as a store of value,


and may not serve its other functions (unit of
account, medium of exchange).

People may conduct transactions with barter


or a stable foreign currency.
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What causes hyperinflation?

Hyperinflation is caused by excessive money


supply growth:

When the central bank prints money, the price


level rises.

If it prints money rapidly enough, the result is


hyperinflation.

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A few examples of
hyperinflation
money
growth (%)

inflation
(%)

Israel, 1983-85

295

275

Poland, 1989-90

344

400

Brazil, 1987-94

1350

1323

Argentina, 1988-90

1264

1912

Peru, 1988-90

2974

3849

Nicaragua, 1987-91

4991

5261

Bolivia, 1984-85

4208

6515

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Why governments create


hyperinflation

When a government cannot raise taxes or sell


bonds,

it must finance spending increases by printing


money.

In theory, the solution to hyperinflation is simple:


stop printing money.

In the real world, this requires drastic and painful


fiscal restraint.
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The Classical Dichotomy


Real variables: Measured in physical units
quantities and relative prices, for example:

quantity of output produced


real wage: output earned per hour of work
real interest rate: output earned in the future
by lending one unit of output today
Nominal variables: Measured in money units, e.g.,

nominal wage: rupees per hour of work.


nominal interest rate: Rupees earned in future
by lending one dollar today.

the4 price
level:
The amount
CHAPTER
Money
and Inflation

of : Rupees needed
slide 68

The Classical Dichotomy

Note: Real variables were explained in Chap 3,


nominal ones in Chapter 4.

Classical dichotomy:
the theoretical separation of real and nominal
variables in the classical model, which implies
nominal variables do not affect real variables.

Neutrality of money: Changes in the money


supply do not affect real variables.
In the real world, money is approximately neutral
in the long run.
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Chapter Summary
Money
the stock of assets used for transactions
serves as a medium of exchange, store of value, and
unit of account.
Commodity money has intrinsic value, fiat money
does not.
Central bank controls the money supply.
Quantity theory of money assumes velocity is stable,
concludes that the money growth rate determines the
inflation rate.
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Chapter Summary
Nominal interest rate
equals real interest rate + inflation rate
the opp. cost of holding money
Fisher effect: Nominal interest rate moves
one-for-one w/ expected inflation.
Money demand
depends only on income in the Quantity Theory
also depends on the nominal interest rate
if so, then changes in expected inflation affect the
current price level.
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Money and Inflation

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Chapter Summary
Costs of inflation
Expected inflation

shoeleather costs, menu costs,


tax & relative price distortions,
inconvenience of correcting figures for inflation
Unexpected inflation

all of the above plus arbitrary redistributions of


wealth between debtors and creditors

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Money and Inflation

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Chapter Summary
Hyperinflation
caused by rapid money supply growth when money

printed to finance govt budget deficits


stopping it requires fiscal reforms to eliminate

govts need for printing money

CHAPTER 4

Money and Inflation

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Chapter Summary
Classical dichotomy
In classical theory, money is neutral--does not affect

real variables.
So, we can study how real variables are determined

w/o reference to nominal ones.


Then, money market eqm determines price level

and all nominal variables.


Most economists believe the economy works this

way in the long run.


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Money and Inflation

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