Inflation and the Quantity

Theory of Money
Introduction
• Zimbabwe President Robert Mugabe’s policy of seizing commercial
farms drove away entrepreneurs and investors.
• To bribe his enemies and pay the army, he simply printed more
money.
• The economy was flooded with money but could not produce more
goods.
• Prices went up: The inflation rate increased from 50% per year to 50%
per month to more than 50% per day.
Inflation
• An increase in the average level of prices.
• Inflation is measured by changes in a price index.
• The inflation rate is the percentage change in a price index from one
year to the next.
• , where P2 is the index value in year 2 and P1 is the index value in year
1.
Price Indexes
• Consumer price index (CPI): Measures the average price for a basket
of goods and services bought by a typical American consumer; covers
80,000 goods and services and is weighted so major items count
more.
• GDP deflator: The ratio of nominal to real GDP multiplied by 100;
covers finished goods and services.
• Producer price indexes (PPI): Measure the average price received by
producers; includes intermediate and finished goods and services.
Relevance of CPI as a Price Index
• For Americans, CPI is the measure of inflation that corresponds most
directly to their daily economic activity.
• The Bureau of Labor Statistics (BLS) computes the CPI.
• It tries to take both new goods and higher-quality goods into account
when computing the CPI.
Inflation in the United States
Real Price
• A price that has been corrected for
1982 2006
inflation. Real prices are used to
compare the prices of goods over time. Gallon of gasoline $1.25 $2.50

• The CPI is used to calculate real prices.

CPI 100 202

• The real price of gasoline (adjusted for

inflation) was slightly lower in 2006
than it was in 1982.
Quantity Theory of Money
• Sets out the general relationship between money, velocity, real
output, and prices
• Helps to explain the critical role of the money supply in determining
the inflation rate
• Mv = PYR
• M = Money supply
• P = Price level
• v = Velocity of money
• YR = Real GDP
Quantity Theory of Money Continued
• Since Mv is the total amount spent on finished goods and services, and PYR
is the price level times real GDP, both sides of this equation are also equal to
nominal GDP.
• Velocity of money (v): the average number of times a dollar is spent on finished
goods and services in a year. In short, it refers to how fast money passes from one
holder to the next.
• We assume that both real GDP (YR) and velocity (v) are stable compared to
the money supply (M).
• Real GDP is fixed by the real factors of production: capital, labor, and technology.
• The velocity of money is determined by factors that change only slowly, such as how
often workers are paid, or how long it takes to clear a check.
• In the United States, the velocity of money is about 7.
The Cause of Inflation
• The quantity theory of money in a nutshell
• When v and Y are fixed (indicated by the top bar), increases in M must cause increases in P.

• The quantity theory of money also says that the growth rate of the money supply
will be approximately equal to the inflation rate.
The Cause of Inflation: Application
• Nations with rapidly (slowly)
growing money supplies had
high (low) inflation rates.
• As indicated by the red line, on
average the relationship is
almost perfectly linear, with a
10% increase in the money
growth rate leading to a 10%
increase in the inflation rate.
The Cause of Inflation Continued
• An unexpected increase in the money supply can boost the economy
in the short run.
• As firms and workers come to expect and adjust to the new influx of
money, output will not grow any faster than normal.
• In the long run, money is neutral.
An Inflation Parable
• Butcher, brewer, and baker in a small economy in Zimbabwe
• Zimbabwe pays soldiers by printing more money
• The economy responded by producing more goods initially but later
realized the price has gone up.
• The economy then stopped producing more goods because of
expected inflation.
The Costs of Inflation
• Four problems associated with inflation:
• There is price confusion and money illusion.
• Inflation redistributes wealth.
• Inflation interacts with other taxes.
• Inflation is painful to stop.
Price Confusion and Money Illusion
• Money illusion: when people mistake changes in nominal prices for
changes in real prices.
• Inflation makes price signals more difficult to interpret.
• It is not always clear whether prices are rising because of increased
demand or because of an increase in the money supply.
• We sometimes mistake inflation for higher wages and prices in real
terms.
• Resources are wasted in activities that appear profitable but are not,
and resources flow more slowly to profitable uses.
Inflation Redistributes Wealth
• Inflation is a type of tax that transfers real resources from citizens to
the government.
• Inflation reduces the real return that lenders receive on loans,
transferring wealth from lenders to borrowers.
• When inflation and interest rates fall unexpectedly, wealth is
redistributed from borrowers (who are paying higher rates) to
lenders.
Inflation Redistributes Wealth: Rate of Return
• Real rate of return: the nominal rate of return minus the inflation rate.
• Nominal rate of return: the rate of return that does not account for inflation.
• The relationship between the lender’s real rate of return, the nominal rate of
return, and the inflation rate, is

• The real rate of return is equal to the nominal rate of return minus the
inflation rate.
Inflation Redistributes Wealth: Fisher Effect
• The tendency of nominal interest rates to rise with
expected inflation rates.
• When lenders expect inflation to increase, they will
demand a higher nominal interest rate.
• The Fisher effect says that the nominal interest
rate is equal to the expected inflation rate plus the
equilibrium real interest rate.
• It also says the nominal rate will rise with expected
inflation.
Inflation Redistributes Wealth: Monetizing
the Debt
• When the government pays off its debts by printing money.
• A government with massive debts has an incentive to increase the
money supply, since it benefits from unexpected inflation.
• The government doesn’t always inflate its debt away for two reasons:
• If lenders expect inflation, they will increase nominal rates.
• Buyers of bonds are often also voters, who would be upset if real returns
were shrunk.
Inflation Interacts with Other Taxes
• Most tax systems define incomes, profits, and capital gains in nominal
terms.
• Inflation will produce some tax burdens and liabilities that do not
make economic sense.
• If asset prices rise due to inflation, people pay capital gains taxes
when they should not.
• Inflation can push people into higher tax brackets.
• Corporations pay taxes on phantom profits.
Inflation Is Painful to Stop
• The government can reduce inflation by reducing the growth in the
money supply.
• When inflation is expected, lower inflation may be misinterpreted as a
reduction in demand.
• Firms reduce output and employment.
• Workers may become unemployed as the unexpected increase in
their real wage makes them unaffordable.
• Expectations will eventually adjust in the long run.
Takeaway
• Inflation is an increase in the average level of prices as measured by a price index.
• Sustained inflation is always and everywhere a monetary phenomenon.
• Although money is neutral in the long run, changes in the money supply can
influence real GDP in the short run.
• Inflation makes price signals more difficult to interpret.
• The tendency of the nominal interest rate to increase with expected inflation is
called the Fisher effect.
• Arbitrary redistributions of wealth make lending and borrowing riskier and thus
break down financial intermediation.
• Anything above a mild rate of inflation is generally bad for an economy.