Chapter
17
Money Growth and Inflation
Inflation
• Inflation
– Increase in the overall level of prices
• Deflation
– Decrease in the overall level of prices
• Hyperinflation
– Extraordinarily high rate of inflation
2
The Classical Theory of Inflation
• The level of prices and the value of money
• Inflation
– Economy-wide phenomenon
• Concerns the value of economy’s medium of
exchange
• Inflation - rise in the price level
– Lower value of money
– Each dollar - buys a smaller quantity of goods
and services
3
The Classical Theory of Inflation
• Classical Theory (Says, Hayek)
– Where Monetarists came from (Friedman and Univ. of
Chicago School)
• Money Supply
– Determined by the Fed and banking system
– Supply curve – vertical – fixed in the short-run
• Monetary equilibrium
– In the long-run overall level of prices adjusts
such that
• Demand for money equals the supply
4
Figure 1
How the supply and demand for money determine the
equilibrium price level
Value of
Money, 1/P
Price
Level, P
Money Supply
(high) 1
1 (low)
1.33
¾
A
Equilibrium
value of
money
2
½
¼
Money
Demand
(low)
4
Equilibrium
price level
(high)
0
Quantity fixed
by the Fed
Quantity of
Money
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
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quantity of money demanded into balance.
The Classical Theory of Inflation
• The effects of a monetary injection
• Economy – in equilibrium
– The Fed doubles the supply of money
• 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
6
Figure 2
An increase in the money supply
Value of
Money, 1/P
Price
Level, P
MS2
MS1
(high) 1
1. An increase
in the money
supply . . .
¾
1 (low)
1.33
A
2. . . .
decreases
the value of
money . . .
2
½
B
¼
Money
Demand
(low)
0
M1
M2
4
3. . . . and
increases the
price level.
(high)
Quantity of
Money
When the Fed increases the supply of money, the money supply curve shifts from MS1 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
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each dollar less valuable.
The Classical Theory of Inflation
• Quantity theory of money (J S Mills, I Fischer,
von Mises)
– Quantity of money available
• Ultimately determines the price level
• P = (M x V) / Y = M * constant
– Growth rate in quantity of money available
• Determines the inflation rate
• Δ M = Δ P * constant
8
The Classical Theory of Inflation
• Velocity and the quantity equation
• Velocity of money (V)
– Rate at which money changes hands
• V = (P × Y) / M
– P = price level (GDP deflator)
– Y = real GDP
– M = quantity of money
9
3
Nominal GDP, quantity of money, & 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
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money have grown dramatically over this period, while velocity has been relatively stable.
The Classical Theory of Inflation
• Velocity and the quantity equation
• Quantity equation: M × V = P × Y
• Quantity of money (M)
• Velocity of money (V)
• Dollar value of the economy’s output of goods and
services (P × Y )
– Shows: an increase in quantity of money
• Must be reflected in:
– Price level must rise
– Quantity of output must rise
– Velocity of money must fall
11
The Classical Theory of Inflation
• The classical dichotomy & monetary neutrality
• Nominal variables (e.g., P, nominal interest)
• Variables measured in monetary units
• Real variables (e.g., Real GNP, Unemployment)
• Variables measured in physical units
• Classical dichotomy
• Theoretical separation of nominal & real variables
• Monetary neutrality
• Changes in money supply don’t affect real variables
12
Figure 3
Nominal GDP, quantity of money, & 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
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money have grown dramatically over this period, while velocity has been relatively stable.
GDP Deflator and Real GDP Growth
GDP Deflator - Inflation
Real GDP (Economic) Growth
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The Classical Theory of Inflation
• Five steps - essence of quantity theory of
money
1. Velocity of money
•
Relatively stable over time
2. Changes in quantity of money (M)
•
Proportionate changes in nominal value of
output (P × Y)
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The Classical Theory of Inflation
• Five steps - quantity theory of money
3. Economy’s output of goods and services (Y)
•
Primarily determined by factor supplies
–
•
•
Kapital, Human K, Nat Resources (Ch. 12)
And available production technology (Tech)
Because money is neutral
–
Money does not affect output
»
»
Sargent – “Rational Expectations”
May be fooled in the short-run and therefore have shortrun effect
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The Classical Theory of Inflation
• Five steps - quantity theory of money
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.
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Money and prices during four
hyperinflations
• Hyperinflation
– Inflation that exceeds 50% per month
– Price level - increases more than a hundredfold over
the course of a year
• Data on hyperinflation
– Clear link between
• Quantity of money
• And the price level
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Money and prices during four
hyperinflations
• Four classic hyperinflation, 1920s
– Austria, Hungary, Germany, and Poland
– Slope of the money line
• Rate at which the quantity of money was growing
– Slope of the price line
• Inflation rate
– The steeper the lines
• The higher the rates of money growth or inflation
• Prices rise when the government prints too
much money
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Figure 4
Money and prices during four hyperinflations (a, b)
This figure shows the quantity of money and the price level during four
hyperinflations.
(Note that these variables are graphed on logarithmic scales. This means that equal
vertical distances on the graph represent equal percentage changes in the variable.)
In each case, the quantity of money and the price level move closely together. The
strong association between these two variables is consistent with the quantity theory
of money, which states that growth in the money supply is the primary cause of
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inflation
Figure 4
Money and prices during four hyperinflations (c, d)
This figure shows the quantity of money and the price level during four
hyperinflations.
(Note that these variables are graphed on logarithmic scales. This means that equal
vertical distances on the graph represent equal percentage changes in the variable.)
In each case, the quantity of money and the price level move closely together. The
strong association between these two variables is consistent with the quantity theory
of money, which states that growth in the money supply is the primary cause of
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inflation
German Hyperinflation (post WW I)
• Wholesale Price Index
• July 1914 1.0
http://www.usagold.com/germannightmare.html
• Jan 1919 2.6
• July 1919 3.4
• Jan 1920 12.6
• Jan 1921 14.4
• July 1921 14.3
• Jan 1922 36.7
• July 1922 100.6
• Jan 1923 2,785.0
• July 1923 194,000.0
• Nov 1923 726,000,000,000.0
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German Weimar Hyperinflation
• September 1922, a loaf of bread cost 163
marks. September of 1923 1,500,000 marks.
At the peak of hyperinflation, November
1923, 200,000,000,000 marks!
• People were paid by the hour and rushed to
buy whatever they could before the paper
notes lost their purchasing power.
• People had to shop with wheel barrows full
of money.
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It takes wheelbarrows full of money to buy …..things
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The Classical Theory of Inflation
• The Fisher effect
– Real interest rate = Nominal interest rate –
Inflation rate
– Nominal interest rate = Real interest rate +
Inflation rate
• Fisher effect: one-for-one adjustment of
nominal interest rate to inflation rate
• When the Fed increases the rate of money growth
• Long-run result
– Higher inflation rate
– Higher nominal interest rate
25
Expectations and Neutrality
• Keynesians
– Increase in Money Supply (Ms) -> lower real
interest rates (r) -> increase investment (I)
and expand production (Y) -> lower
unemployment (U)
• Except during a “liquidity trap”
• Monetarists
– Increase in Ms -> only leads to an increase in
inflation
– If Fed increases Ms -> ΔM -> ΔP
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Expectations and Neutrality
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Figure 5
The nominal interest rate and the inflation rate
This figure uses annual data since 1960 to show the nominal interest rate on 3month 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
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effect: When the inflation rate rises, so does the nominal interest rate
Figure
The Aggregate Supply Curve
• Long run
– Aggregate-supply curve is vertical
• Short run
– Aggregate-supply curve is upward sloping
• Why the aggregate-supply curve (LRAS) is
vertical in the long run
– Price level does not affect the long-run
determinants of GDP:
• Supplies of labor, capital, and natural resources
• Available technology
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Figure 4
The long-run aggregate-supply curve
Price
Level
Long-run
aggregate
supply
P1
1. A change
in the price
P2
level . . .
2. . . . does not affect
the quantity of goods
and services supplied
in the long run
Natural rate
of output
Quantity of Output
In the long run, the quantity of output supplied depends on the economy’s quantities of labor,
capital, and natural resources and on the technology for turning these inputs into output.
Because the quantity supplied does not depend on the overall price level, the long-run
aggregate-supply curve is vertical at the natural rate of output.
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Counter Cyclical Monetary Policy
Cooling the booms – reduce money supply (tight)
Heating up the recessions – increase money supply (loose)
Problem is getting the timing right – otherwise overheat/cool
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The Costs of Inflation
• A special cost of unexpected inflation:
arbitrary redistributions of wealth
• Unexpected inflation
– Redistributes wealth among the population
• Not by merit
• Not by need
– Redistribute wealth among debtors and
creditors
• Inflation - volatile & uncertain
– When the average rate of inflation is high
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