Mankiw Chapter 5: Money and

Inflation

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CHAPTER 4

Money and Inflation

In this chapter you will learn
 What is money and who creates it.
 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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U.S. inflation & its trend, 1960-2003
14%
12%
10%
8%
6%
4%
2%
0%
1960

1965

1970

1975
Inflation rate

CHAPTER 4

1980

1985

1990

1995

2000

Inflation rate trend

Money and Inflation

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 Because prices are defined in terms of money. the supply of money. we need to consider the nature of money.  price = amount of money required to buy a good.The connection between money and prices  Inflation rate = the percentage increase in the overall level of prices. and how it is controlled. CHAPTER 4 Money and Inflation slide 4 .

CHAPTER 4 Money and Inflation slide 5 .Money: definition Money is the stock of assets that can be readily used to make transactions.

unit of account the common unit by which everyone measures prices and values CHAPTER 4 Money and Inflation slide 6 . store of value transfers purchasing power from the present to the future 3. medium of exchange we use it to buy stuf 2.Money: functions 1.

O.Money: types 1. commodity money • has intrinsic value • examples: gold coins.W. cigarettes in P. fiat money • has no intrinsic value • example: the paper currency we use 2. camps CHAPTER 4 Money and Inflation slide 7 .

S. the central bank is the Bank of England. CHAPTER 4 Money and Inflation slide 8 .  The central bank of the Euro Area is the European Central Bank (often referred to as the ECB). the central bank is called the Federal Reserve (“the Fed”)..The central bank  Monetary policy is conducted by a country’s central bank.  In the U.  In the U.K..

The money supply & monetary policy  The money supply is the quantity of money available in the economy.  Monetary policy is the control over the money supply. CHAPTER 4 Money and Inflation slide 9 .

The Quantity Theory of Money  One goal of this chapter is how the quantity of money affects the economy.  To do that we need a theory… CHAPTER 4 Money and Inflation slide 10 .

 M x V= P x T  where V = velocity PT = value of all transactions M = money supply CHAPTER 4 Money and Inflation slide 11 .The Quantity Theory of Money  A simple theory linking the inflation rate to the growth rate of the money supply.

The Transaction Velocity (V )  basic concept: the rate at which money circulates  definition: the number of times the average dollar bill changes hands in a given time period  example: In 2003. velocity V = 5 CHAPTER 4 Money and Inflation slide 12 . each dollar was used in five transactions in 2003 • So. • $500 billion in transactions (PT ) • money supply (M )= $100 billion • On average.

where P Y V  M P = price of output Y = quantity of output (GDP deflator) (real GDP) P Y = value of output (nominal GDP) CHAPTER 4 Money and Inflation slide 13 .The Income Velocity  Use nominal GDP as a proxy for total transactions. Then.

 It is an identity: it holds by definition of the variables. CHAPTER 4 Money and Inflation slide 14 .The quantity equation  The quantity equation M V = P Y follows from the preceding definition of velocity.

(k is exogenous) CHAPTER 4 Money and Inflation slide 15 .Money demand and the quantity equation  M/P = real money balances.  A simple money demand function: (M/P )d = k Y where k = how much money people wish to hold for each dollar of income. the purchasing power of the money supply.

CHAPTER 4 Money and Inflation slide 16 .Money demand and the quantity equation  money demand: (M/P )d = k Y  quantity equation: 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).

the quantity equation can be written as M V  P Y CHAPTER 4 Money and Inflation slide 17 .back to the Quantity Theory of Money  starts with quantity equation  assumes V is constant & exogenous: V V  With this assumption.

M V  P Y How the price level is determined:  With V constant. cont.The Quantity Theory of Money. the money supply determines nominal GDP (P Y )  Real GDP is determined by the economy’s supplies of K and L and the production function (chap 3)  The price level is P = (nominal GDP)/(real GDP) CHAPTER 4 Money and Inflation slide 18 .

so = 0.The Quantity Theory of Money.  The quantity equation in growth rates: M V P Y    M V P Y The quantity theory of money assumes V V is constant. cont. V CHAPTER 4 Money and Inflation slide 19 .  Recall from Chapter 2: The growth rate of a product equals the sum of the growth rates.

cont.The Quantity Theory of Money. Let  (Greek letter “pi”) denote the inflation rate: The result from the preceding slide was: P   P M P Y   M P Y Solve this result for  to get CHAPTER 4 Money and Inflation slide 20 .

 Normal economic growth requires a certain amount of money supply growth to facilitate the growth in transactions.The Quantity Theory of Money. cont. CHAPTER 4 Money and Inflation slide 21 .  Money growth in excess of this amount leads to inflation.

The Quantity Theory of Money. the Quantity Theory of Money predicts a one-for-one relation between changes in the money growth rate and changes in the inflation rate. Hence. for now). cont. CHAPTER 4 Money and Inflation slide 22 . Y/Y depends on growth in the factors of production and on technological progress (all of which we take as given.

U. Inflation & Money Growth.S. 1960-2003 14% 12% 10% 8% 6% 4% 2% 0% 1960 1965 1970 Inflation rate CHAPTER 4 1975 M2 growth rate 1980 1985 1990 Inflation rate trend Money and Inflation 1995 2000 M2 growth rate trend slide 24 .

International data on inflation and money growth Inflation rate 10.000 Democratic Repub Nicaragua of Congo Angola Brazil Georgia 100 Bulgaria 10 Germany Kuwait 1 USA Oman 0.1 0. logarithmic sc ale) 1. logarithmic Money and Inflation slide 25 .000 Money supply growth (perc ent.000 10.1 CHAPTER 4 1 Japan 10 Canada 100 1.000 (perc ent.

i not adjusted for inflation  Real interest rate.Inflation and interest rates  Nominal interest rate. r adjusted for inflation: r = i  CHAPTER 4 Money and Inflation slide 26 .

CHAPTER 4 Money and Inflation slide 27 .  This one-for-one relationship is called the Fisher effect.  Hence. an increase in  causes an equal increase in i.The Fisher Effect  The Fisher equation: i =r +  Chap 3: S = I determines r .

U. inflation and nominal interest rates. since 1954 Nominal interest rate Inflation rate CHAPTER 4 Money and Inflation slide 28 .S.

logarithmic s Money and Inflation slide 29 . logarithmic sc ale) Kazakhstan Kenya Uruguay Armenia Italy France 10 Nigeria United Kingdom United States Japan 1 Germany Singapore 1 CHAPTER 4 10 100 1000 Inflation rate (perc ent.Inflation and nominal interest rates across countries 100 Nominal interest rate (perc ent.

Old exam question CHAPTER 4 Money and Inflation slide 30 .

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 people actually end up earning on their bond or paying on their loan CHAPTER 4 Money and Inflation slide 31 .

 Hence. i   in money demand.  The nominal interest rate i is the opportunity cost of holding money (instead of bonds or other interest-earning assets). CHAPTER 4 Money and Inflation slide 32 .Money demand and the nominal interest rate  The Quantity Theory of Money assumes that the demand for real money balances depends only on real income Y.  We now consider another determinant of money demand: the nominal interest rate.

) CHAPTER 4 Money and Inflation slide 33 . cost of holding money  positively on Y higher Y  more spending  so.The money demand function (M P )  L(i . depends  negatively on i i is the opp. Y ) d (M/P )d = real money demand. need more money (L is used for the money demand function because money is the most liquid asset.

Y ) d  L(r   . they don’t know what inflation will turn out to be. Hence. CHAPTER 4 Money and Inflation slide 34 .The money demand function (M P )  L(i . the nominal interest rate relevant for money demand is r + e. Y ) e When people are deciding whether to hold money or bonds.

Y ) P The supply of real money balances CHAPTER 4 Money and Inflation Real money demand slide 35 .Equilibrium M e  L(r   .

What determines what M e  L(r   . L ) adjusts to make Money and Inflation M  L(i . Y ) P variable how determined (in the long run) M exogenous (the ECB) r adjusts to make S = I Y P CHAPTER 4 Y  F (K .Y ) P slide 36 .

How P responds to  M M e  L(r   .just like in the Quantity Theory of Money. CHAPTER 4 Money and Inflation slide 37 . Y ) P  For given values of r. Y. and e. a change in M causes P to change by the same percentage --.

even though M hasn’t changed yet.  EX: Suppose Fed announces it will increase M next year. so e =  on average. e may change when people get new information. people don’t consistently over.What about expected inflation?  Over the long run. (continued…) CHAPTER 4 Money and Inflation slide 38 .or under-forecast inflation.  This will affect P now. so e rises. People will expect next year’s P to be higher.  In the short run.

  e   i (the Fisher effect)   M P d   P to make  M P  fall to re-establish eq'm CHAPTER 4 Money and Inflation slide 39 . Y ) P  For given values of r. Y. and M .How P responds to  e M e  L(r   .

g. e.  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.The Classical Dichotomy Real variables are measured in physical units: quantities and relative prices.g. e.  nominal wage: dollars per hour of work  nominal interest rate: dollars earned in future by lending one dollar today  the price level: the amount of dollars needed to buy a representative basket of goods CHAPTER 4 Money and Inflation slide 40 .

CHAPTER 4 Money and Inflation slide 41 . which implies nominal variables do not affect real variables.The Classical Dichotomy  Note: Real variables were explained in Chap 3.  Neutrality of Money : Changes in the money supply do not affect real variables. money is approximately neutral in the long run.  Classical Dichotomy : the theoretical separation of real and nominal variables in the classical model. nominal ones in Chap 5. In the real world.

Old exam question CHAPTER 4 Money and Inflation slide 42 .

 Focus on the long run.  Think like an economist.Discussion Question Why is inflation bad?  What costs does inflation impose on society? List all the ones you can think of. CHAPTER 4 Money and Inflation slide 43 .

not the price level or inflation rate. when nominal wages are fixed by contracts. the real wage is determined by labor supply and the marginal product of labor.A common misperception  Common misperception: inflation reduces real wages  This is true only in the short run.  Consider the data… CHAPTER 4 Money and Inflation slide 44 .  (Chap 3) In the long run.

Average hourly earnings & the CPI Hourly earnings in 2004 dollars Average hourly earnings (nominal) Consumer Price Index CHAPTER 4 Money and Inflation slide 45 .

is inflation a social problem? CHAPTER 4 Money and Inflation slide 46 . So why.The classical view of inflation  The classical view: A change in the price level is merely a change in the units of measurement. then.

additional costs when inflation is different than people had expected. CHAPTER 4 Money and Inflation slide 47 .The social costs of inflation …fall into two categories: 1. costs when inflation is expected 2.

CHAPTER 4 Money and Inflation slide 48 .The costs of expected inflation: 1.    i   real money balances  Remember: In long run. inflation doesn’t affect real income or real spending. same monthly spending but lower average money holdings means more frequent trips to the bank to withdraw smaller amounts of cash. shoeleather cost  def: the costs and inconveniences of reducing money balances to avoid the inflation tax.  So.

 Examples: – print new menus – print & mail new catalogs  The higher is inflation. the more frequently firms must change their prices and incur these costs. CHAPTER 4 Money and Inflation slide 49 .The costs of expected inflation: 2. menu costs  def: The costs of changing prices.

CHAPTER 4 Money and Inflation slide 50 .  Different firms change their prices at different times. As the general price level rises throughout the year. relative price distortions  Firms facing menu costs change prices infrequently.The costs of expected inflation: 3. leading to relative price distortions…  …which cause microeconomic inefficiencies in the allocation of resources.  Example: Suppose a firm issues new catalog each January. the firm’s relative price will fall.

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 bought $10,000 worth of

Starbucks stock
 Dec 31: you sold the stock for $11,000,

so your nominal capital gain was $1000
(10%).
 = 10% during the year.
Your real capital gain is $0.

 Suppose

 But the govt requires you to pay taxes on

your $1000 nominal gain!!
CHAPTER 4

Money and Inflation

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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.

CHAPTER 4

Money and Inflation

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Additional cost of unexpected inflation:
arbitrary redistributions of purchasing
power
 Many long-term contracts not indexed,
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.
CHAPTER 4

Money and Inflation

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which makes risk averse people worse off.  This creates higher uncertainty. it’s more variable and unpredictable:  turns out different from e more often.Additional cost of high inflation: increased uncertainty  When inflation is high. CHAPTER 4 Money and Inflation slide 54 . and the differences tend to be larger (though not systematically positive or negative)  Arbitrary redistributions of wealth become more likely.

cuts.even even when whenthe theequilibrium equilibriumreal realwage wagefalls. markets. reduced. Therefore. Inflation Inflationallows allowsthe thereal realwages wagesto toreach reach equilibrium equilibriumlevels levelswithout withoutnominal nominalwage wage cuts. Therefore. CHAPTER 4 Money and Inflation slide 55 . falls.moderate moderateinflation inflationimproves improves the thefunctioning functioningof oflabor labormarkets.One benefit of inflation Nominal Nominalwages wagesare arerarely rarelyreduced.

the gov’t can print money.  The “revenue” raised from printing money is called seigniorage  The inflation tax: Printing money to raise revenue causes inflation.Seigniorage  To spend more without raising taxes or selling bonds. CHAPTER 4 Money and Inflation slide 56 . Inflation is like a tax on people who hold money.

 People may conduct transactions with barter or a stable foreign currency.  Money ceases to function as a store of value. and may not serve its other functions (unit of account.Hyperinflation  def:   50% per month  All the costs of moderate inflation described above become HUGE under hyperinflation. CHAPTER 4 Money and Inflation slide 57 . medium of exchange).

the result is hyperinflation. CHAPTER 4 Money and Inflation slide 58 .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.

Recent episodes of hyperinflation slide 59 .

889% Money and Inflation slide 60 .212% 2008 231.The most recent episode Zimbabwe Year Inflation rate CHAPTER 4 2000 55% 2001 112% 2002 199% 2003 599% 2004 133% 2005 586% 2006 1281% 2007 66.150.

 Alternatively.Why governments create hyperinflation  When a government cannot raise taxes or sell bonds. this requires drastic and painful fiscal restraint.  In the real world.  In theory. start using another currency.  it must finance spending increases by printing money. the solution to hyperinflation is simple: stop printing money. CHAPTER 4 Money and Inflation slide 61 .

 Central bank controls money supply. store of value. fiat money does not. and unit of account. 2.Chapter summary 1.  Commodity money has intrinsic value. Quantity theory of money  assumption: velocity is stable  conclusion: the money growth rate determines the inflation rate. CHAPTER 4 Money and Inflation slide 62 . Money  the stock of assets used for transactions  serves as a medium of exchange.

then changes in expected inflation affect the current price level. cost of holding money 4.  is the opp. Nominal interest rate  equals real interest rate + inflation rate.  Fisher effect: nominal interest rate moves one-for-one w/ expected inflation. CHAPTER 4 Money and Inflation slide 63 .Chapter summary 3. Money demand  depends on income in the Quantity Theory  more generally. it also depends on the nominal interest rate. if so.

tax & relative price distortions. Costs of inflation  Expected inflation shoeleather costs. menu costs. inconvenience of correcting figures for inflation  Unexpected inflation all of the above plus arbitrary redistributions of wealth between debtors and creditors CHAPTER 4 Money and Inflation slide 64 .Chapter summary 5.

Hyperinflation  caused by rapid money supply growth when money printed to finance govt budget deficits  stopping it requires fiscal reforms to eliminate govt’s need for printing money CHAPTER 4 Money and Inflation slide 65 .Chapter summary 6.

 Most economists believe the economy works this way in the long run.Chapter summary 7. CHAPTER 4 Money and Inflation slide 66 . eq’m in money market determines price level and all nominal variables.  So. money is neutral-does not affect real variables. Classical dichotomy  In classical theory. we can study how real variables are determined w/o reference to nominal ones.  Then.