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INFLATION
OVERVIEW
The classical theory of inflation
causes
effects
social costs
Classical theory assumes prices are flexible and markets
clear.
Applies to the long run.
THE CONNECTION BETWEEN MONEY
AND PRICES
Inflation rate = percentage change in the overall price
level.
Price = amount of money required to buy a good.
Commodity money
hasintrinsic value
examples: gold, silver, precious metal …
MONEY SUPPLY AND MONETARY
POLICY
The money supply is the quantity of money available in
the economy.
Monetary policy is the control over the money supply.
Monetary policy is conducted by a country’s Central Bank.
In the U.S., the central bank is called the Federal Reserve
System (“the Fed”).
In Vietnam, the central bank is the Sate Bank of Vietnam.
THE QUANTITY THEORY OF MONEY
A simple theory linking the inflation rate to the growth
rate of the money supply.
Begins with a concept called “velocity”…
So, velocity = 5
THE QUANTITY THEORY OF MONEY
This suggests the following definition:
V=T/M
where
V = velocity
T = value of all transactions
M = money supply
THE QUANTITY THEORY OF MONEY
Use nominal GDP as a proxy for total transactions.
Then,
P Y
V
where
M
P = price of output (GDP deflator)
Y = quantity of output (real GDP)
P ×Y = value of output (nominal GDP)
M = quantity of money
The quantity equation is
M×V=Y×P
MONEY DEMAND AND THE QUANTITY
EQUATION
M/P = the real money balance, the purchasing power of
the money supply.
A simple money demand function:
(M/P )d = kY
where
k = how much money people wish to hold for
each dollar of income.
(k is exogenous) 0< k <1
Y = real income
MONEY DEMAND AND THE QUANTITY
EQUATION
M/P=Y/V (2)
The connection between them: k = 1 / V
M V P Y
From the equation we have
%∆M + %∆V = %∆P + %∆Y
Since V is constant then %∆V = 0 and
%∆P = %∆M – %∆Y
%∆P is the inflation rate which called π.
THE QUANTITY THEORY OF MONEY
The inflation rate equals
π = %∆M – %∆Y
Where
%∆M is the growth rate of money supply
%∆Y is the growth rate of real GDP which depends on
growth in the factors of production and on technological
progress (all of which we take as given), so %∆Y = 0. Y =
F(K,L) = Ybar
Thus, π = %∆M
Hence, the Quantity Theory predicts a one-for-one
relation between changes in the money growth rate and
changes in the inflation rate.
INFLATION AND INTEREST RATES
Nominal interest rate, i
not adjusted for inflation.
Real interest rate, r
adjusted for inflation.
r = i
THE FISHER EFFECT
The Fisher equation: i = r + π
In Topic 2 shows that the equilibrium in the loanable
funds market (S = I) determines r .
Hence, an increase in π causes an equal increase in i.
This one-for-one relationship is called the Fisher effect.
INFLATION AND NOMINAL INTEREST RATES
ACROSS COUNTRIES
100
Nominal
interest rate Kazakhstan
(percent, Kenya
logarithmic Armenia
scale) Uruguay
Italy
France
10
Nigeria
United Kingdom
United States
Japan
Germany
Singapore
1
1 10 100 1000
Inflation rate (percent, logarithmic scale)
EXERCISE:
Suppose V is constant, M is growing 5% per year, Y is
growing 2% per year, and r = 4.
a. Solve for i (the nominal interest rate).
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?
TWO REAL INTEREST RATES
Notation
π = actual inflation rate
(not known until after it has occurred)
e = expected inflation rate
Two real interest 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 – π = ex post real interest rate: the real interest rate
actually realized.
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.
The nominal interest rate i is the opportunity cost of
holding money (instead of bonds or other interest-earning
assets).
Hence, i↑ → money demand↓.
THE MONEY DEMAND FUNCTION
(M/P )d = L (i, Y)
(M/P )d = real money demand, depends
negatively on interest rate (i is the opportunity cost of
holding money).
positively on income (higher Y → more spending → need
more money).
Note: “L” is used for the money demand function
because money is the most liquid asset.
THE MONEY DEMAND FUNCTION
(M/P )d = L (i, Y)
= L (r + e, Y)
When people are deciding whether to hold money or
bonds, they don’t know what inflation will turn out to be.
M e
L (r , Y )
P
𝑴 𝒆
= 𝑳 (𝒓 + 𝝅 ,𝒀 )
𝑷
Variable How is determined (in the long run)
M exogenous (the Fed) →
r adjusts to ensure S = I →
Y
P adjusts to ensure M / P = L(i,Y)
¿
CAUSES OF INFLATION: INCREASE IN
MONEY SUPPLY
M
L (r e , Y )
P
For given values of r, Y, and e (the right-hand side of the
equation is constant), a change in M causes P to change by
the same percentage (as to keep the left-hand side of the
equation to be constant in order to hold the equation).
%∆M = %∆P = π
just like in the quantity theory of money.
Increase in money supply causes the price level to increase
→ inflation.
CAUSES OF INFLATION: CHANGE IN
EXPECTED INFLATION
Expected inflation e may change when people
get new information.
Example:
Suppose Fed announces it will increase M next year.
People will expect next year P to be higher, so e rises.
This will affect P now, even though M has not changed
yet.
CAUSES OF INFLATION: CHANGE IN
EXPECTED INFLATION
𝑴 𝒆
= 𝑳 (𝒓 + 𝝅 ,𝒀 )
𝑷
For given value of r, Y, and M :
↑e → ↑i (the Fisher effect : ↑)
→ ↓ (M/P )d : the right-hand side of equation decreases.
→ to hold the equation the left-hand side of
equation must decrease → ↑P
Increase in expected inflation causes the price level to
increase → inflation.
THE CLASSICAL VIEW ON COSTS OF
INFLATION
The social cost of inflation fall into two categories:
1. Costs when inflation is expected.
2. Additional costs when inflation is different than what
people had expected.
THE COSTS OF EXPECTED INFLATION:
1. SHOE LEATHER COSTS
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.
THE COSTS OF EXPECTED INFLATION:
2. MENU COSTS
The costs of changing prices.
Examples:
print new menus
print and mail new catalogs
The higher is inflation, the more frequently firms must
change their prices and incur these costs.
THE COSTS OF EXPECTED INFLATION:
3. RELATIVE PRICE DISTORTIONS
Firms facing menu costs change prices infrequently.
Example:
Suppose a firm issues new catalog each January. As the
general price level rises throughout the year, the firm’s
relative price will fall.
Different firms change their prices at different times,
leading to relative price distortions…
…which cause microeconomic inefficiencies
in the allocation of resources.
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:
1/1/2021: you bought $10,000 worth of Starbucks stock
12/31/2021: you sold the stock for $11,000,
so your nominal capital gain was $1000 (10%).
Suppose = 10% in 2021 → Your real capital gain is $0.
But the government requires you to pay taxes on your $1000
nominal gain.
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.
THE COSTS OF UNEXPECTED INFLATION: ARBITRARY
REDISTRIBUTION OF PURCHASING POWER