CHAPTER-5:

I N F L AT I O N : I T S C A U S E S , E F F E C T S , A N D
SOCIAL COSTS

C O U R S E T E AC H E R :
D R . TA M G I D A H M E D C H OW D H U RY
A S S O C I AT E P R O F E S S O R , S B E
OBJECTIVES OF THE CHAPTER
• After completing this chapter, students will be able to understand:
- Quantity theory of money and its use
- Concepts relevant to inflation and money growth
- Relation between interest rates and inflation
- Nominal interest rate and its relation to demand for money
- Social costs of inflation in the economy
THE QUANTITY THEORY OF MONEY
• A simple theory linking the inflation rate to the growth rate of the money supply.
MV=PT
Money x Velocity = Price x Transactions
Transaction (T): Number of times goods and services are transacted in a year.
Price (P) is the value (amount of Taka) of the transaction
Thus PT is the value of all transactions in a year.
M is the quantity of money
Velocity measures the rate at which money circulates in the economy.
An example: Assume 60 breads are sold in a year at 2 taka per bread.Thus,
The number of Taka exchanged is = 60 x 2 = 120/year.
Also assume that quantity of money in the economy is 40 Taka.
Velocity would be,V = PT/M = 120/40 = 3 times/year.
QUANTITY THEORY: FROM TRANSACTION TO
INCOME/GDP
• As GDP is the total amount of goods and services produced within a domestic
territory in a given year. This means, T or transaction is equal to GDP or
national income.
• Revised quantity equation:
MV=PY
Money x Velocity = Price x Output (Nominal GDP)
This equation is now called Income Velocity of money.
CONSTANT VELOCITY AND RELATION BETWEEN
MONEY BALANCE AND GDP
• In a short time period, assume in one year, the velocity of money is supposed to be fixed.
• Thus the quantity equation looks like:

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 economy’s supplies of K and L and the production function
(Chap 3).
QUANTITY THEORY AND ITS RELATION TO
INFLATION

M xV = P xY
In order to calculate the change in each variable, the equation can be modified
to:
M V P Y
  
M V P Y

The quantity theory of money assumes

V
V is constant, so = 0.
V
THE QUANTITY THEORY OF MONEY AND
INFLATION (CONT…)

 (Greek letter “pi”) P

 
denotes the inflation rate: P
The result from the M P Y
 
preceding slide was: M P Y

Solve this result

for  to get
THE QUANTITY THEORY OF MONEY AND INFLATION
(CONT…)

 Normal economic growth requires a certain amount of money

supply growth to facilitate the growth in transactions.

 If Money growth is higher than the growth in national income, too

much money will run after few goods and that will create inflation.

Hence, the Quantity Theory predicts

a one-for-one relation between
changes in the money growth rate and
changes in the inflation rate.
CASE BANGLADESH: CHANGE OF MONEY SUPPLY,
GDP AND INFLATION
 INTERNATIONAL DATA ON INFLATION AND MONEY GROWTH

100
Turkey
Ecuador Indonesia
Inflation rate Belarus
(percent,
logarithmic scale)
10

Argentina
U.S.
1
Switzerland
Singapore

0.1
1 10 100
Money Supply Grow th
(percent, logarithmic scale)
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.
 EFFECT OF INFLATION IN MONEY MARKET:
INFLATION & INTEREST RATE
 Nominal interest rate, i not adjusted for inflation Inflation and Nominal Interest Rate in BD
20
18
 Real interest rate, r adjusted for inflation: 16

r = i  14
12
Nom Interest
rate, 7.1

 The Fisher equation: i = r +  10

8

 Chap 3: S = I determines r . 6 Inflation, 6

4
 Hence, an increase in  2

causes an equal increase in i. 0

2011 2012 2013 2014 2015 2016

 This one-for-one relationship is called the Fisher effect.

IN-CLASS 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 Central Bank 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 Central Bank do if it wishes to
keep  constant?
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.

(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.)
EXTENDED MONEY DEMAND FUNCTION
The supply of real
money balances (M P )  L (i ,Y )  L (r   , Y )
d e Real money
demand

• When people are deciding whether to hold money or bonds, they don’t know what inflation
will turn out to be.

 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 year’s P to be
higher, so  e rises.

 This affects P now, even though M hasn’t changed yet….

THE SOCIAL COSTS OF INFLATION
1. Costs of expected inflation
1.A. Shoeleather cost: def: the costs and inconveniences of reducing money balances to avoid the
inflation tax. Higher monthly spending but lower average money holdings means more
frequent trips to the bank to withdraw smaller amounts of cash.
1.B. Menu costs: The costs of changing prices. Examples: cost of printing new menus, cost of
printing & mailing new catalogs
1.C. Unfair tax treatment: Some taxes are not adjusted to account for inflation, such as the capital
gains tax. Such as taxes on shares and bonds.
1.D. General inconvenience: Inflation makes it harder to compare nominal values from different
time periods. This complicates long-range financial planning.
THE SOCIAL COSTS OF INFLATION

2. Costs of unexpected inflation

2.A. Many long-term contracts not indexed, but based on  e.
2.B. Increased uncertainty: When inflation is high, it’s more variable and
unpredictable:
 turns out different from  e more often, and the differences tend to be
larger
(though not systematically positive or negative)
 HYPERINFLATION
 definition:   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.

Causes of 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.
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