Chapter 5
MONEY AND INFLATION
Dr. Mohammed Alwosabi
DEFINITION OF INFLATION
• Inflation is a process of continuous (persistent)
increase in the price level. Inflation results in a
decrease of the value of money.
• In the definition of inflation we have to observe
that:
– Inflation is an increase in the prices of all goods
and services not only of a particular good or
service. An increase in the price of one good is
not inflation.
– Inflation is an ongoing process, not a one-time
jump in the price level.
• Milton Friedman proposed that "inflation is always
and everywhere a monetary phenomenon".
• The source of inflation is the high growth rate of
money supply with “too much money chasing too
few goods”.
• A quick and simple solution to fighting inflation is
reducing the growth rate of the money supply.
• The proposition that inflation is the result of a high
rate of money growth is supported by evidence
from inflationary episodes throughout the world.
• The German hyperinflation of the 1921-23
supports the proposition that excessive monetary
growth causes inflation and not the other way
around since the increase in monetary growth
appears to have been exogenous, the government
expands the money supply to finance its
expenditures.
• Evidence for Latin American countries over the
ten-year period 1989-1999 indicates that in every
case in which a country's inflation rate is
extremely high for any sustained period of time,
its rate of money growth is extremely high
INFLATION RATE:
• To measure the inflation rate, we calculate the
annual percentage change in the price level.
Pthis year - Plast year
Inflation Rate 
 100
Plast year
• we measure the price level (P) of a country using
GDP Deflator or CPI.
GDP Deflator this year - GDP Deflator last year
Inflation Rate 
 100
GDP Deflator last year
CPI this year - CPI last year
Inflation Rate 
 100
CPI last year
• These two equations show the connection
between the inflation rate and the price level. If the
price level in the current year is higher than that of
the last year, the inflation rate will be positive
meaning higher inflation rate  the lower is the
value of money.
VIEWS OF INFLATION
• According to aggregate demand and supply
analysis, inflation is caused by expansionary
monetary policies.
• A continually increasing money supply causes a
continual increase in aggregate demand,
everything else held constant.
• Fiscal policy alone cannot produce inflation. There
is a limit on the total amount of possible
government expenditure. Decreasing taxes also
has a limit.
• Negative supply shocks increase the price level,
but cannot increase the inflation rate.
• Suppose that the economy is at the natural rate of
output. In the absence of accommodating policy
and everything else held constant, the net result of
a negative supply shock is that the economy
returns to full employment at the initial price level.
SOURCES OF INFLATION
• Inflation usually occurs as a result of
expansionary monetary policy.
(1) Cost-Push Inflation and High Employment
Targets
• Cost-push inflation arises due to a decrease in
supply as a result of the rise in the per-unit cost
of production.
• The negative supply shocks mainly occur
because of the push by workers to get higher
wages, the increase in the prices of other factors
of production, or the increase in the prices of
raw materials (e.g. oil price)
At a given price level, cost-push inflation starts as
the rise in the cost of production, because of an
increase in the money wage rate or an increase in
the prices of raw material  firms are willing to
produce less amount of the output  SAS
decreases  SAS shifts leftward  an increase in
prices and unemployment and a decrease in
RGDP  stagflation
LAS
P
SAS3
SAS2
P4
E
P3
SAS1
D
P2
C
P1
AD3
B
A
P0
AD2
AD1
Y1
Y
Y0
• Suppose that the last year price level was P0 and
PGDP is Y0, where AD0, SAS0 and LAS intersect at
point A, the LR FE equilibrium.
• If, in the current year, nominal wages or prices of
other factors of production increase  production
cost increases  firms reduce production  SAS
  SAS curve shifts leftward to SAS1 to point B.
• At point B, price level increases to P1 and RGDP
decreases to Y1 and therefore unemployment
increases above its natural rate (below FE)
• If government fiscal and monetary policies remain
unchanged, the economy would move back to
point A
• However, as a response to the increase in P and
unemployment, and a decrease in RGDP, the
government increases Qm, G or decreases T 
AD increases  AD curve starts to shift rightward
until it reaches AD1 at point C, where AD1
intersects with SAS1 and LAS.
• At point C, the economy is at higher price level
(P2) and RGDP goes back to PGDP (Y0) at full
employment
• With the new higher price, money wage rate and
prices of other productive resources start to
increase again which leads to increase in the cost
of production  SAS curve will shift leftward from
SAS1 to SAS2  stagflation  the process will be
repeated  higher price level (inflation)
• This is an ongoing process of rising price level.
• Note that a one-time increase in the price of one
resource without any following change in AD
produces stagflation but not inflation.
• The combination of a successful wage push by
workers and the government's commitment to
high employment leads to cost-push inflation.
• Cost-push inflation is a monetary phenomenon
because it cannot occur without the monetary
authorities pursuing an accommodating policy of
a higher rate of money growth.
• Accommodating policy (usually monetary policy)
occurs when government pursue active,
discretionary policy to eliminate high
unemployment that developed after a successful
wage push by workers.
• Monetary expansion increases AD repeatedly, and
wages continue to adjust upward. This recipe
leads to inflation
• In the absence of an accommodating monetary
policy and everything else held constant, a push
by workers to get higher wages will cause higher
unemployment and higher prices, and the net
result of a negative supply shock is that the
economy returns to full employment at the initial
price level.
(2) Demand-Pull Inflation
• Demand-pull inflation occurs when policy makers
pursue policies that raise AD and shift the
aggregate demand curve to the right
• Demand-pull inflation is a result of the increase in
spending faster than the increase in production of
output.
• An increase in aggregate demand is caused
mainly by the increase in Money supply (quantity
of money (Qm)), or the increase in any of C, I, G, or
X
• Suppose the economy is at LR full employment
equilibrium point A, where LAS, AD0 and SAS0
intersect with each other. At this point, RGDP =
PGDP = Y0 and P = P0.
• Then, because government goal is to achieve high
level of employment (high level of output),
government may increase Qm, or G, or decrease
T, which leads to an increase in AD  AD curve
shifts rightward from AD0 to AD1  the new SR
equilibrium is at point B,
• At B, RGDP is greater than PGDP, price level
increases from P0 to P1,  real wage rate has
decreased and unemployment falls below its
natural rate (above FE)  there is a shortage of
labor  money wage rate starts to increase to
attract more labor  SAS starts to decrease 
SAS curve starts to shift leftward  P starts to
increase and RGDP starts to decrease until SAS
curve shifted to SAS1 where it intersects AD1 and
LAS at point C
P
LAS
P4
SAS3
SAS2
E
D
P3
P2
SAS1
C
P1
AD3
B
P0
A
AD2
AD1
Y
Y0
Y1
• At point C, RGDP goes back to its potential LR and
FE level (Y0) and the price level increase further to
P2.
• This process is only a one-time rise in P. For
inflation to proceed, AD must persistently
increase.
• At this stage two actions may occur
simultaneously:
(1) Government wants to achieve a specific target
of high employment (and high production) so it
will increase G, Qm or decrease taxes, and
(2) Since now the money wage is higher which
means people can spend more and as a result P is
higher (P2), the result is the increase in Qm
• In either case  increase in AD  AD curve will
shift from AD1 to AD2  the process will continue
 higher price level (inflation)
• This is an ongoing process of rising price level.
• From the discussion above, according to
aggregate demand and supply analysis, it is
evidenced that high inflation cannot be driven by
fiscal policy alone. High money growth produces
high inflation. Inflation is caused by expansionary
monetary policies.
• Theoretically, one can distinguish a demand-pull
inflation from a cost-push inflation by comparing
the unemployment rate with its natural rate level.
(3) Budget Deficit and Inflation
•
High government budget deficit relative to GDP
can be a source of sustained inflation only if
1. it is persistent rather than temporary, and
2. if the government finances it by creating
money rather than by issuing bonds to the
public
ACTIVIST / NONACTIVIST POLICY DEBATE
• Activist is an economist who views the selfcorrecting mechanism through wage and price
adjustment to be very slow and hence sees the need
for the government to pursue active, discretionary
policy to eliminate high unemployment whenever it
develops.
• Activists argue that monetary and fiscal policies
should be deliberately used to smooth out the
business cycle.
• They are in favor of economic fine-tuning, which is
the frequent use of monetary and fiscal policies to
counteract even small undesirable movements in
economic activity.
• According to activists, the economy does not
always equilibrate quickly enough at natural real
GDP.
• They believe that activist monetary policy works; it
is effective at smoothing out the business cycle.
• Nonactivist is an economist who believes that the
performance of the economy would be improved if
the government avoided active policy to eliminate
unemployment
• Nonactivists argue against the use of deliberate
fiscal and monetary policies.
• They believe the discretionary policies should be
replaced by a stable and permanent monetary and
fiscal framework and the rules should be
established in place of activist policies.
• According to nonactivists, in modern economies,
wages and prices are sufficiently flexible to allow
the economy to equilibrate at reasonable speed at
natural real GDP.
• They believe activist monetary policies may not
work, and may be more destabilizing rather than
stabilizing, and are likely to make matters worse
rather than better.
• If aggregate output is below the natural rate level,
advocates of activist policy would recommend
that the government try to eliminate the high
unemployment by attempting to shift the
aggregate demand curve to the right while
advocates of nonactivist policy would recommend
that the government to do nothing.
• Activists usually view fiscal policy as having a
shorter effectiveness lag than monetary policy, but
there is substantial uncertainty about how long
this lag is.
• According to activist, the wage and price
adjustment process being extremely slow, and a
nonactivist policy results in a large loss of output
• Nonactivists usually view fiscal policy as having a
longer implementation lag than monetary policy,
but there is substantial uncertainty about how
long this lag is
• Nonactivists contend that an activist policy of
shifting the aggregate demand curve will be costly
because it produces more volatility in both the
price level and output
• There are five time lags that prevent an activist
policy from returning aggregate output to full
employment instantaneously
1. The data lag is the time it takes for policymakers
to obtain the data that tell them what is
happening to the economy,
2. The recognition lag is the time it takes for
policymakers to be sure of what the data are
signaling about the future course of the
economy.
3. The legislative lag represents the time it takes to
pass legislation to implement a particular (fiscal)
policy
4. The implementation lag is the time it takes for
policymakers to change policy instruments once
they have decided on a new policy.
5. The effectiveness lag is the time that it takes for
an activist policy to actually influence economic
activity.
• The existence of lags prevents the instantaneous
adjustment of the economy to policies changing
aggregate demand, thereby strengthening the
case for nonactivist policy.
• However, activist respond that even with time lags,
activist policy moves the economy to full
employment before the economy's self-correcting
mechanism would
EFFECTS OF INFLATION
• Inflation may be anticipated (expected) or
unanticipated (unexpected)
• A moderate anticipated (expected) has a small
cost, but a rapid anticipated inflation is costly
because it decreases potential GDP and slow
growth.
• Unanticipated (unexpected) inflation has two main
consequences in the labor market. It redistributes
income and results in the departure from full
employment
1. Higher than anticipated inflation (unexpectedly
high)  lowers the real wage rate  employers
gain at the expense of workers  increases the
quantity of labor demanded, makes jobs easier
to find, and lowers the unemployment rate.
2. Lower than anticipated inflation (unexpectedly
low)  raises the real wage rate  workers gain
at the expense of employers  decreases the
quantity of labor demanded, and increases the
unemployment rate.
3. If workers and employers base their wages on an
inflation forecast that turns out to be correct,
neither workers nor employers gain or lose from
the inflation.
•
Unanticipated inflation has two main
consequences in the market for financial capital:
it redistributes income and results in too much or
too little lending and borrowing.
1. When the inflation rate is higher than anticipated
(unexpectedly high)  the real interest rate is
lower than anticipated  borrowers gain but
lenders lose  borrowers want to have borrowed
more and lenders want to have loaned less.
2. When the inflation rate is lower than anticipated
(unexpectedly low)  the real interest rate is
higher than anticipated  lenders gain but
borrowers lose  borrowers want to have
borrowed less and lenders want to have loaned
more
• We can conclude from the above that Inflation that
is higher than expected, transfers resources from
workers to employers and from lenders to
borrowers.
• The opposite is true
• High levels of unanticipated inflation have other
negative impacts on economies for a number of
reasons.
1. They lead to distortions in the economy and give
confusing price signals to producers.
2. For individuals on fixed incomes, the rise in
prices increases the cost of living, eroding
purchasing power.
3. For investors it erodes the value of saving, while
effectively reducing the real rate of borrowing for
debtors.
4. It makes goods produced in the country more
expensive relative to goods produced abroad
resulting in a decrease in exports and an increase
in imports.
5. People who hold a lot of money loose from
inflation because money value becomes less
overtime.
6. Those who own “real” assets such as land,
stocks, etc. gain from inflation because the value
of these assets goes up with inflation.
SNAPSHOT ON THE CURRENT INFLATION IN
GCC COUNTRIES (2007- 08)
• The growth rate of money supply in Gulf
countries has in some cases exceeded 20
percent. Check the latest rates of inflation in
GCC countries.
• With this double digit inflation nominal interest
rates are way below the inflation rate which has
resulted in negative real rates of interests.
Factors Causing Inflation in GCC Stats
1. As a result of pegging GCC currencies - except
the Kuwaiti dinar- to a weakening dollar there
has been an increase in the cost of goods that
are imported from countries whose currencies
had appreciated against the dollar, like the EU,
Japan and China.
2. Rising food prices internationally due to the high
demand for some types of grains such as corn to
use them as bio fuels in addition to the increase
in the price of oil, this added to the increase in
the food prices.
3. Huge money supply and abundant liquidity,
triggered by sharply higher oil revenues, that is
accompanied by a fixed supply of goods and
services.
4. The rise in demand for real estate, which
increases real estate prices in addition to sharp
increase in the cost of housing due to shortage
in property supplies such as steel and cement.
5. The dollar peg forces GCC central banks to
follow the US Federal Reserve in setting interest
rates. But while the US central bank continues
cutting rates to stimulate a sluggish economy,
GCC central banks are faced with expanding
economies that were already overheating at the
higher rates. Cutting interest rate just fuel the
inflation more.
6. The increase in wages without controlling goods
markets that just increase prices to take
advantage of the wage rise
Solutions adopted by GCC
• It is not necessary to adopt all solutions by all
countries. Different countries adopted different
solutions
1. De-peg GCC Currencies from the tumbling dollar
and track a currency basket of their main trade
partners, including the US dollar, euro, sterling
and yen. The European Union is now the main
trading partner of the GCC accounting for 35 per
cent of their foreign trade, followed by Asian
countries 30 per cent and the US 10 per cent.
2. As a recommended basket, GCC states may link
their currencies with the International Monetary
Fund's Special Drawing Rights (SDRs), a mixed
basket of currencies.
3. Revaluation: the link to the dollar should be
revisited without necessarily de-pegging the Gulf
currencies,
4. Price should be controlled by governments,
especially of the necessary products.
5. Increase in interest rates should be implemented
to reduce money supply and liquidity in the
hands of public.
6. Increase the reserve requirement for banks
forcing lenders to keep more customer deposits
in their vaults.
7. Central banks should engage in open market
operations to decrease the abundant liquidity.
8. Create a suitable environment to invest the
liquidity surplus in import substitution products.
The Current Global Financial Crises
• The current financial crisis hits the world in many
ways and has its impact on most countries around
the world.
• There have been many debates, discussions,
articles, meetings, interviews, lectures, legislations,
and summits that create a huge amount of literature
on this crisis.
• It is the assignment of every one of you to write an
at least a 5-page (with 12 Times New Roman and 1.5
space) essay about this crisis stating the following:
1. The causes of the crisis
2. The different impacts of the crisis on countries,
consumers’ welfare, and business strength
3. The impact of the crisis on Bahrain and other
GCC countries
4. The actions that have been taken to reduce the
impact of the crisis
5. The solutions to go out of this crisis