Chapter 9: Money Growth and

Inflation

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Introduction
People regularly use money to buy goods and
services from other people. It is also a store of value,
which is why we are interested in inflation.
Inflation is an increase in the overall level of prices.
◦ Inflation in the UK exceeded 20% per year in the mid-1970s.
◦ In the late 1990s and early 2000s UK inflation has been low
and stable at around 2% per year.

Hyperinflation is an extraordinarily high rate of

inflation.
◦ In Zimbabwe in June 2008 inflation reached 231,000,000 per
cent .

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 What Is Inflation?
 Many countries use the consumer prices index (CPI) as their
measure of inflation.
• The price level is a snapshot of the weighted average of a basket
of goods at a point in time.
o Prices in the base year are given an index of 100.
o So if the index was 103 the next year then inflation was
3 per cent.
• We are also interested in the rate of change of price increases.
• If inflation rate changes from 4 per cent to 3 per cent then the
rate of change is slowing, but prices still rose.
 When price level falls, there is Deflation i.e. negative rate of inflation
is called deflation.

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The Classical Theory Of Inflation
 Prices rise when the government prints too
much money. This is the classical theory of
inflation.
◦ Inflation is an economy-wide phenomenon that
concerns the value of the economy’s medium of
exchange.
When the overall price level rises, the value of
money falls and people pay more for goods
and services.

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Money Supply, Money Demand, and
Monetary Equilibrium
The value of money is determined by the supply and demand for
money.
◦ The money supply is a policy variable that is controlled by the central
bank.
o The money supply is fixed until the central bank
decides to change it through instruments such as
open-market operations, the central bank directly
controls the quantity of money supplied.
o Therefore the supply of money is vertical (perfectly
inelastic) until the central bank decides to change it.

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 Money Supply, Money Demand, and
Monetary Equilibrium
Money demand has several determinants, including interest rates and the
average level of prices in the economy.
◦ People hold money because it is the medium of exchange.
◦ The amount of money people choose to hold depends on the prices of goods
and services.
◦ Therefore the lower the value of money the higher the demand.

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 Figure 1 Money Supply, Money Demand, and the Equilibrium Price
Level

Value of Price
Money, 1/P Money supply In the long run, the overall Level, P
level of prices adjusts to
(High) 1 the level at which the 1 (Low)
demand for money equals
the supply.
3
/4 1.33

A
/
12 2

Equilibrium Equilibrium
value of price level
money /
14 4
Money
demand
(Low) 0 (High)
Quantity fixed Quantity of
by the Fed Money
The Effects of a Monetary Injection
The quantity theory of money explains the long-
run determinants of the price level and the
inflation rate.
◦ The quantity of money available in the economy
determines the value of money.
◦ The primary cause of inflation is the growth in the
quantity of money (see figure 2).
◦ Assume that the economy is in equilibrium and the central
Bank suddenly increases the supply of money.
◦ The supply of money shifts to the right.
◦ The equilibrium value of money falls and the price level rises.

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 Figure 2 The Effects of Monetary Injection

Value of Price
Money, 1/P MS1 MS2 Level, P

(High) 1 1 (Low)

1. An increase
3
/4 in the money 1.33
2. . . . decreases supply . . .
the value of
3. . . . and
money . . . A
/
12
2 increases
the price
level.
B
/
14
4
Money
demand
(Low) (High)
0 M1 M2 Quantity of
Money
The Effects of Monetary Injection
The quantity theory of money asserts that the
quantity of money available determines the
price level and that the growth rate in the
quantity of money available determines the
inflation rate.

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A Brief Look at the Adjustment
Process
An increase in the money supply creates an
excess supply of money.
◦ People may:
◦ Buy goods and services with the funds.
◦ Use these excess funds to make loans to others. These
loans are then likely used to buy goods and services.
◦ Therefore the increase in the money supply leads to
an increase in the demand for goods and services.
◦ The increase in the demand for goods and services will
result in higher prices because their supply remains
unchanged.

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The Classical Dichotomy and
Monetary Neutrality
Hume and others suggested in the 18C that economic variables
could be divided into:
◦ Nominal variables measured in monetary units.
◦ Real variables measured in physical units.
This was termed the classical dichotomy.

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The Classical Dichotomy and Monetary
Neutrality
 Relative prices.
◦ Prices in the economy are nominal, but relative prices are
real.
◦ The relative price is defined in terms of the nominal price
of one good divided by the nominal price of another.
◦ The real value of a good is what other goods have been
sacrificed in purchasing the good. This is the opportunity
cost.
◦ Relative prices are not expressed in terms of money and
so relative prices are real variables.
◦ The relative price is expressed in terms of how much of
one good has to be given up in purchasing another.

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The Classical Dichotomy and Monetary
Neutrality
 Real Wages.
• The concept of relative prices has an important application for
wages.
o Imagine that a consumer only ever buys bananas and that the price
of a banana is $2.
o If the consumer’s wage is $10 per hour, then the consumer can buy
five bananas with their wage. To buy five bananas means one hour
of work.
o If bananas now cost $3 and wages rise to $12, then one hour of
work only buys four bananas.
• Real wages is a more accurate reflection of how the
consumer is affected.
 The real wage is the money wage adjusted for inflation measured by
the ratio of the wage rate to price.

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The Classical Dichotomy and Monetary
Neutrality
 Monetary Neutrality.
◦ The irrelevance of monetary changes for real
variables is called monetary neutrality.
◦ Different forces influence real and nominal variables.
◦ Real economic variables do not change with
changes in the money supply.
◦ When studying the long-run changes in the economy,
the neutrality of money offers a good description of
how the world works.

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Velocity and the Quantity Equation
The velocity of money refers to the speed at which the money
changes hands, travelling around the economy from wallet to
wallet.

V = (P  Y)/M
◦ Where: V = velocity
P = the price level
Y = the quantity of output
M = the quantity of money

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Velocity and the Quantity Equation
Rewriting the equation gives the quantity equation:

MV=PY

The quantity equation relates the quantity of money (M) to the

nominal value of output
(P  Y).

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Velocity and the Quantity Equation
The quantity equation shows that an increase in the
quantity of money in an economy must be reflected in
one of three other variables:
◦ The price level must rise.
◦ The quantity of output must rise, or….
◦ The velocity of money must fall.

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Velocity and the Quantity Equation
The Equilibrium Price Level, Inflation Rate, and the Quantity
Theory of Money
◦ The velocity of money is relatively stable over time.
◦ When the central bank changes the quantity of
money, it causes proportionate changes in the
nominal value of output (P  Y).
◦ Because money is neutral, money does not affect
output.

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The Costs Of Inflation
A Fall in Purchasing Power?
◦ Inflation does not in itself reduce people’s real
purchasing power.
◦ As prices rise, so do incomes. Thus, inflation does
not in itself reduce the purchasing power of incomes.
◦ However some people’s incomes may not rise
exactly with inflation.

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The Costs Of Inflation
① Shoeleather costs
② Menu costs
③ Relative price variability
④ Tax distortions
⑤ Confusion and inconvenience
⑥ Arbitrary redistribution of wealth

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① Shoeleather Costs
Shoeleather costs are the resources wasted when inflation
encourages people to reduce their money holdings.
◦ Inflation reduces the real value of money, so people
have an incentive to minimize their cash holdings.
◦ Less cash requires more frequent trips to the bank to
withdraw money from interest-bearing accounts.
These extra trips means time away from productive
activities.
◦ The actual cost of reducing your money holdings is
the time and convenience you must sacrifice to keep
less money on hand.

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② Menu Costs
Menu costs are the costs of adjusting prices.
◦ During inflationary times, it is necessary to update
price lists and other posted prices.
◦ This is a resource-consuming process that takes
away from other productive activities.

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③ Relative-Price Variability and the
Misallocation of Resources
Inflation distorts relative prices.
Consumer decisions are distorted, and markets are
less able to allocate resources to their best use.

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④ Inflation-Induced Tax Distortion
Inflation exaggerates the size of capital gains and
increases the tax burden on this type of income.
◦ With progressive taxation, capital gains are taxed
more heavily.
◦ The nominal interest earned on savings is treated as
income for income tax purposes, even though part of
the nominal interest rate merely compensates for
inflation.
◦ The after-tax real interest rate falls when inflation
rises, making saving less attractive.

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Table 1 How Inflation Raises the Tax Burden on Saving
⑤ Confusion and Inconvenience
When the central bank increases the money supply
and creates inflation, it erodes the real value of the unit
of account.
◦ Inflation causes money at different times to have
different real values.
◦ Therefore, with rising prices, it is more difficult to
compare real revenues, costs, and profits over time.

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⑥ A Special Cost of Unexpected Inflation:
Arbitrary Redistribution of Wealth
Unexpected inflation redistributes wealth among the population in
a way that has nothing to do with either merit or need.
These redistributions occur because many loans in the economy
are specified in terms of the unit of account—money.

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Deflation
Deflation where the price level actually falls
Deflation can be as damaging as inflation because:
◦ There is little incentive to spend today if the
expectation is for cheaper prices tomorrow.
◦ It might result in consumers not spending at levels
that provide incentives for firms to invest in new
capacity.
◦ Leading to little or no growth and with that….
◦ An increased likelihood of unemployment.

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