Money growth and inflation drives price increases

Money growth and inflation
ECO110 MACROECONOMICS, MONSOON 2021

Inflation and its trend USA 1960-2006
15% Percentage variation

in CPI over previous
12% 12 months
9% Long-term
trend
6%
3%
0%
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
This is an open access resource distributed under the terms and conditions of the Creative Commons Attribution license
The connection between money and prices
Inflation rate = the percentage increase in the average price level.

Price = amount of money required to buy a good.
Because prices are defined in terms of money, we need to consider the
nature of money, the money supply and how it is controlled.
Inflation
Inflation
 Increase in the overall level of prices
Deflation
 Decrease in the overall level of prices
Hyperinflation
 Extraordinarily high rate of inflation
Supply and demand for money and the monetary
equilibrium
• The central bank, along with the banking system, determines the money supply
• Sells bonds, receives rupees and reduced the money supply
• Buy bonds, pays rupees and increases the money supply
• If any of these rupees is deposited in banks, it produces a greater effect on
the money supply and generates more money into the system
• The demand money is determined by

• The average price level of the economy
• It is the medium of exchange
• How often credit cards are used
• It is easy or not to find an ATM
• Interest rate anyone can get using the money to buy an interest bearing bond
equilibrium
• Monetary balance short or long term
• In the long term, the general price level is adjusted to be at the level at
which demand equals money supply
• Classical Theory of Inflation
• The interest rate also affects the short term balance
How the Supply and Demand for Money Determine the
Equilibrium Price Level
Value of Price
Money, 1/P Money Supply Level, P
(high) 1 1 (low)
¾ 1.33
½ A 2
Equilibrium
Equilibrium
value of ¼ 4
Money price level
money
(low) Demand (high)
0 Quantity fixed Quantity of Money

by the Fed
The horizontal axis shows the quantity of money. The left vertical axis shows the value of money, and
the right vertical axis shows the price level. The supply curve for money is vertical because the
quantity of money supplied is fixed by the Fed. The demand curve for money is downward sloping
because people want to hold a larger quantity of money when each dollar buys less. At the
equilibrium, point A, the value of money (on the left axis) and the price level (on the right axis) have
adjusted to bring the quantity of money supplied and the quantity of money demanded into balance.
equilibrium
• The supply curve is vertical, because the central bank has fixed the amount of
money available
• The demand curve has a negative slope, because when the value of money is
low (high price), people want more money to buy goods and services
• If the price level is higher than equilibrium, the public wants to have more
money than is created the central bank, so the price level must be lowered to
balance supply and demand
• If the price level is lower than equilibrium, the public wants to have less
money than is created the central bank, so the price level should rise to balance
supply and demand
Effects of a Monetary Injection
Economy – in equilibrium
 The Fed doubles the supply of money (short term disturbance to the long run
equilibrium)
 Prints bills
 Drops them on market
 Or: The Fed – open-market purchase
 New equilibrium
 Supply curve shifts right
 Value of money decreases
 Price level increases
Effects of a monetary injection
• Remember that Monetary policy is the control over the money supply
• Quantity Theory of Money

• Theory that the available quantity of money determines the price
level and the growth rate of the amount of money available
determines the inflation rate
An Increase in the Money Supply
Value of Price
MS1 MS2
Money, 1/P Level, P
(high) 1 1 (low)
1. An increase
in the money
¾ supply . . . 1.33
A
2. . . . ½ 2
decreases 3. . . . and
B increases the
the value of
¼ 4 price level.
money . . . Money
Demand
(low) (high)
0 M1 M2 Quantity of
Money
When the Fed increases the supply of money, the money supply curve shifts from MS 1 to MS2.
The value of money (on the left axis) and the price level (on the right axis) adjust to bring supply
and demand back into balance. The equilibrium moves from point A to point B. Thus, when an
increase in the money supply makes dollars more plentiful, the price level increases, making
each dollar less valuable.
Classical dichotomy and monetary neutrality
• nominal variables: Variables expressed in monetary units
• GDP (Nominal), Price, Salary
• real variables: Variables expressed in units
• Production, money wage adjusted to account for inflation, the real interest rate
(nominal interest rate - inflation rate)
• classical dichotomy: Theoretical distinction between nominal and real variables
• relative price
• monetary neutrality: proposition that changes in money supply do not
affect real variables
• When the money supply doubles, the price level doubles, doubles the money wage
and all other monetary values are doubled. But the real variables such as
production, real wages and real interest rates do not vary
• Most economists think monetary changes significantly influence real variables in the
short term (1 or 2 years)
• Monetary neutrality can be valid in the long term (10 years or more)
The quantity theory of money
It is a simple theory of the relationship between the inflation rate to the
growth rate of money supply.
Velocity
 definition: the number of times an average bill changes hands in a given period of time
Example: In 2007,
 € 500 billion in transactions
 money supply = € 100 billion
 One euro medium is used in five transactions 2007
 Then, velocity = 5
This suggests the following definition:

T
V
M
where
V = velocity
T = Value of all transactions
M = Money supply
We use nominal GDP as an approximation of
total transactions.
So, P Y
V
M
where
P = Price of production (GDP deflator)
Y = Quantity produced (real GDP)
P Y = Value of production (Nominal GDP)
The quantity equation

M V = P Y
It is an identity:
It is true because the way the variables are defined
Usually, V is a constant
 (The Greek letter "pi") P

 
denotes the inflation rate: P
The result of the M P Y
 
previous slide: M P Y
We get M Y
  
M Y
M Y
  
M Y
Y/Y It depends on growth in the factors of production
and technical progress
(For now we take all this as given).
As is, the quantity theory predicts a

one to one relationship between
changes in the money growth rate and
changes in the inflation rate.
Quantity Theory of Money – A Summary
1. Velocity of money
 Relatively stable over time
2. Changes in quantity of money, M
 Proportionate changes in nominal value of
output (P × Y)
3. Economy’s output of goods & services, Y
 Primarily determined by factor supplies
 And available production technology
 Money does not affect output
Quantity Theory of Money – A Summary
4. Change in money supply, M

 Induces proportional changes in the nominal value of output
(P × Y)
 Reflected in changes in the price level (P)
5. Central bank - increases the money supply rapidly
 High rate of inflation
Nominal GDP, the Quantity of Money, and the Velocity of Money
This figure shows the nominal

value of output as measured by
nominal GDP, the quantity of
money as measured by M2, and
the velocity of money as
measured by their ratio. For
comparability, all three series
have been scaled to equal 100
in 1960. Notice that nominal
GDP and the quantity of money
have grown dramatically over
this period, while velocity has
been relatively stable.
Confronting theory with data
the quantity theory of money implies

1. Countries with higher money growth rates should have higher
inflation rates.
2. The long-term trend of inflation in a country should be similar
to the long-term trend rate of growth of money in that country.
Are the data consistent with these consequences?
Money growth and inflation rate percent
100 turkey
Inflation rate Ecuador Indonesia belarus
(percent,
logarithmic scale)
10
Argentina
1 US
switzerland
singapore
0,1
1 10 100
Money Supply Growth
(percent, logarithmic scale)
Inflation and the nominal interest rate
Nominal 100
Interest Rate romania
(percent, zimbabwe
logarithmic scale)
brazil Bulgaria
10 Israel
germany US
switzerland
1
0.1 1 10 100 1000
Inflation Rate
(percent, logarithmic scale)
Inflation and money growth rate in USA
In the long term, inflation and the rate
of money growth move together, as
predicted by quantity theory.
15%
12% M2 growth rate
9%
6%
3% Inflation
rate
0%
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
The Inflation Tax
The inflation tax

 Revenue the government raises by creating (printing) money
 When the government does not borrow by selling bonds or increasing the
tax rate
 Tax on everyone who holds money
 When the government prints money
 The price level rises
 And the dollars in your wallet are less valuable
The Nominal Interest Rate and the Inflation Rate
Fisher effect: the nominal interest rate and the inflation rate adjust perfectly
Real Interest Rate = Nominal Interest Rate – Inflation Rate
r = i 
This figure uses annual data since 1960 to show the nominal interest rate on three-month
Treasury bills and the inflation rate as measured by the consumer price index. The close
association between these two variables is evidence for the Fisher effect: When the inflation rate
rises, so does the nominal interest rate.
Exercise
Suppose V is constant, M is growing 5% per year,

Y grows at 2% per year, and r = 4.
to. Get the value of i.
b. If the Fed increases the money growth rate by 2 percentage points per
year, find i.
c. Suppose the growth rateY falls to 1% per year.
 What will happen to  ?
 What should the Fed do if it wants to keep  constant?
Answers
V constant, M growing 5% per year,

Y growing 2% per year, r = 4.
to. First, find  = 5  2 = 3.
afterwards find, i = r +  = 4 + 3 = 7.
b. i = 2, same as the increase in the rate of money growth.
c. If the Fed does nothing,  = 1.
To prevent inflation growth, the Fed must reduce the money growth
rate by one percentage point per year.
Real and Nominal Interest Rates in India
https://tradingeconomics.com/india/interest-rate
https://indianexpress.com/article/explained/how-high-real-interest-ra
tes-are-holding-back-investments-in-indian-economy-6513914
/
https://
economictimes.indiatimes.com/topic/nominal-and-real-interest-rates
https://data.worldbank.org/indicator/FR.INR.RINR?locations=IN
https://
www.livemint.com/Opinion/fc9fb0OnQOeCNTtCHrGiDK/How-real-is
-real-interest-rate.html
Why is inflation bad?
What costs does inflation impose to society?

Focus on short term and long term
The costs of inflation
Wrong perception:
inflation reduces real wages
This is true only in the short run, when nominal wages are fixed in
contracts
In the long run,
real wages are determined by labor supply and the marginal
productivity of labor, not the price level or inflation rate
 When prices rise, buyers pay more and sellers get more (inflation by itself does
not reduce people’s real purchasing power)
 Remember that the real wage is a real variable
1. Shoeleather cost

 definition:The costs and inconveniences of reducing money balances
to avoid the inflation tax.
 Remember: In the long term, inflation does not affect actual revenue
and actual expenditure.
 Then the same monthly spending but less money in hand involves
travel most frequent trips to the bank to withdraw smaller amounts of
cash.
 Menu Cost
 definition: The cost of changing prices.
Examples:
 Cost of printing new menus
 Cost of printing and sending new catalogos
The higher the inflation more frequently firms must change their
prices and incur these costs.
Inflation - distortion in relative prices

 Companies that face menu costs change prices less frequently.
 Example: A company releases its new catalogs every January. As the price level
increases throughout the year, the relative prices of the company will fall. Different
companies change their prices at different times, leading to a distortion of relative
prices.
 The economy allocates scarce resources based on relative prices.
 Consumers decide what they buy by comparing the quality and prices of the various
goods and services
 This determines how the factors of scarce production are assigned to industries and
companies when inflation distorts relative prices, consumer decisions are also
distorted
 Additional unforeseen cost of inflation:
abritrary redistribution in purchasing power
 Many long-term contracts are not indexed, but based on  e.
 If  is different from  e, so
some win at the expense of others.
Example: debtors and creditors
Yes  >  e, so (i  ) <(i   e)
and purchasing power is transferred from creditors to debtors.
Yes  <  e, then purchasing power is transferred from debtors to
creditors.
Hyperinflation
definition:   50% per month

All moderate costs of inflation described above become huge
under hyperinflation.
Money is no longer a store of value and also can not serve its other
functions (Unit of account, a medium of exchange).
Maybe people do transactions by barter or a stable foreign
currency.
What causes hyperinflation?
hyperinflation is caused by excessive growth of the money supply:

When the central bank prints money, the price level increases.
 If you print money too quick the result is hyperinflation.
Some examples of hyperinflation
money inflation
growth (%) (%)
Israel, 1983-1985 295 275

Poland, 1989-1990 344 400
Brazil, 1987-1994 1350 1323
Argentina, 1988-1990 1264 1912
Peru, 1988-1990 2974 3849
Nicaragua, 1987-1991 4991 5261
Bolivia, 1984-1985 4208 6515
Bolivian Hyperinflation 1984-1986
This graph plotting monthly inflation of Bolivia recorded from January 1984 to April 1986.
 Inflation, which was on average 2.5% per month in 1981 increased to 7% in 1982 to 11% in 1983.
Here we see how continues to grow in 1984 and 1985, reaching 182% in February 1985.
 Yellow vertical line shows the beginning of stabilization.
Money, Prices, and the Nominal Exchange Rate during the
German Hyperinflation
This figure shows the
money supply, the price
level, and the exchange
rate (measured as U.S.
cents per mark) for the
German hyperinflation
from January 1921 to
December 1924. Notice
how similarly these
three variables move.
When the quantity of
money started growing
quickly, the price level
followed, and the mark
depreciated relative to
the dollar. When the
German central bank
stabilized the money
supply, the price level
and exchange rate
stabilized as well.
Why governments create hyperinflation?
When a government can not raise taxes or sell bonds, they must finance
spending increases by printing money.
in theory, the solution to hyperinflation is simple: stop printing money.
In the real world, it requires fiscal control that is drastic and painful.

Money growth and inflation drives price increases

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Money growth and inflation drives price increases

Uploaded by

Copyright:

Available Formats

Money growth and inflation

ECO110 MACROECONOMICS, MONSOON 2021

15% Percentage variation

Inflation rate = the percentage increase in the average price level.

• The demand money is determined by

0 Quantity fixed Quantity of Money

• Quantity Theory of Money

This suggests the following definition:

The quantity equation

 (The Greek letter "pi") P

As is, the quantity theory predicts a

4. Change in money supply, M

This figure shows the nominal

the quantity theory of money implies

12% M2 growth rate

The inflation tax

Suppose V is constant, M is growing 5% per year,

V constant, M growing 5% per year,

What costs does inflation impose to society?

1. Shoeleather cost

Inflation - distortion in relative prices

definition:   50% per month

hyperinflation is caused by excessive growth of the money supply:

Israel, 1983-1985 295 275

You might also like