Chapter 12
Inflation and the
Quantity Theory of
Money
MODERN PRINCIPLES OF ECONOMICS
Third Edition
Outline




Defining and Measuring Inflation
The Quantity Theory of Money
The Costs of Inflation
Why do governments sometimes
resort to inflation?
2
Inflation
• "Americans are getting stronger. Twenty
years ago, it took two people to carry ten
dollars worth of groceries. Today, a fiveyear-old can do it."
- Henny Youngman
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Introduction
 When Zimbabwean president Robert Mugabe
needed money in 2001, he printed more money
since his anti commercial policies had driven
productive farmers and entrepreneurs out of the
country.
 The government flooded the economy with
money.
 The economy, however, could not produce
more goods, and prices went up.
 The inflation rate increased from 50% a year to
more than 50% a day.
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Definition
Inflation:
An increase in the average level of prices.
Inflation is measured by changes in a price
index.
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Inflation
 Inflation is measured by changes in a price
index.
 The inflation rate is the percentage change in a
price index from one year to the next.
P2  P1
Inflation rate 
 100
P1
where P2 is the index value in year 2 and P1 is the
index value in year 1.
 Inflation is the average change of all prices.
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Inflation
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Self-Check
If the price index is 200 in Year 1 and 210 in
Year 2, the rate of inflation is:
a. 20%.
b. 5%.
c. 4.76%.
Answer: b – the rate of inflation is
(210-200)/200 x 100 = 5%.
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Price Indexes
1. Consumer price index (CPI): Measures the
average price for a basket of goods and
services bought by a typical American
consumer. Changes regularly to reflect new
and better-quality goods.
2. GDP deflator: The ratio of nominal to real GDP
multiplied by 100. Covers all final goods.
3. Producer price indexes (PPI): Measure the
average price received by producers. Includes
final and intermediate goods.
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Relevance of CPI as a Price Index
For Americans, CPI is the measure of inflation that
corresponds most directly to their daily economic
activity.
The BLS, which computes the CPI, tries to take
both new goods and better-quality goods—into
account when computing the CPI.
Survey covers 80,000 goods, weighted so that
major items (housing) count more.
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Inflation
The average inflation rate since
1950 was 3.3%, but in many
periods, especially in the 1970s,
inflation was significantly higher.
From 2003–2013, inflation in the
United States has averaged about
2.4%.
The Inflation Rate in the United States, 1950–2013
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Effect of Inflation on Price
The cumulative effect of inflation on a large basket of goods
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Definition
Real price:
A price that has been corrected for
inflation. Real prices are used to
compare the prices of goods over time.
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Real Prices
 The CPI is used to calculate real prices.
Gallon of gasoline
CPI
1982
$1.25
100
2006
$2.50
202
202
$1.25 
 $2.53
100
 The real price of gasoline (adjusted for inflation)
was slightly lower in 2006 than it was in 1982.
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Inflation
Average annual inflation rates
in selected countries (2002-2007)
• 2002 and 2007, Zimbabwe
had the highest inflation rate
in the world at 735% a year.
• Countries with the lowest
inflation rates had rates of
less than 1%.
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Hyperinflation
Hyperinflation is a situation where the price increases are so out of
control that the concept of inflation is meaningless.
The numbers in Table 31.2 are so high, they are hard to believe.
Hungary’s post-war hyperinflation is the largest on record.
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Hyperinflation
The worthless Hungarian
Pengo, 1946
 Hungary’s hyperinflation is the
highest on record.
• What cost 1 Hungarian pengo in
1945 cost 1.3 septillion pengos at
the end of 1946.
• Prices doubled every 15 hours
 Hyperinflation occurs when
people lose confidence in a
country’s currency holding value
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Self-Check
A real price is a price that has been corrected
for:
a. Population growth.
b. Foreign currency exchange rates.
c. Inflation.
Answer: c – real prices have been corrected for
inflation.
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Quantity Theory of Money
Quantity Theory of Money
is a theory of inflation
QTM does two things:
1. Sets out the general relationship between
inflation, money, real output, and prices.
2. Presents the critical role of the money
supply in regulating the level of prices.
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Quantity Theory of Money
Mv = PYR
Where: M = Money supply P = Price level
v = Velocity of money YR = Real GDP
 Since Mv is the total amount spent on final
goods and services and PYR is the price level
times real GDP, both sides of this equation are
also equal to nominal GDP.
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Definition
Velocity of money (v):
the average number of times a dollar is
spent on final goods and services in a
year.
In short, it refers to how fast money
passes from one holder to the next.
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Quantity Theory of Money
 We assume that both real GDP (YR) and
velocity (v) are stable compared to the money
supply (M).
• Real GDP is fixed by the real factors of
production— capital, labor, and technology.
• In the U.S. today, v is about 7.
• V is determined by factors that change only
slowly, such as whether workers are paid
monthly or biweekly, or how long it takes to
clear a check.
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Quantity Theory of Money
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Quantity Theory of Money
 If YR is fixed by the real factors of production
and v is stable, then the only thing that can
cause an increase in P is an increase in M.
 In other words, inflation is caused by an
increase in the supply of money.
 The quantity theory of money also says that the
growth rate of the money supply will be
approximately equal to the inflation rate.
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Self-Check
The number of times a dollar is spent on final
goods and services in a year is called:
a. The quantity theory of money.
b. The velocity of money.
c. The currency turnover rate.
Answer: b – the velocity of money.
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The Cause of Inflation
“Inflation is always and everywhere
a monetary phenomenon.”
Milton Friedman 1912 – 2008
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The Cause of Inflation
Nations with rapidly growing money supplies
had high inflation rates.
Nations with slowly growing money supplies had
low inflation rates.
In fact, as the red line indicates, on average, the
relationship is almost perfectly linear, with a 10
percentage point increase in the money growth
rate leading to a 10 percentage point increase in
the inflation rate.
Money Growth and Inflation
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The Quantity Theory of Money
How well does the theory hold up?
•In Peru, very well….
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Quantity Theory of Money
Some Important Implications of QTM:
1. If M and v grow more slowly than YR, prices will fall;
this is called deflation.
2. Changes in velocity will affect prices.
•
Hyperinflation: People will spend their money
faster (increase v) → even faster increase in
prices.
•
Great Depression: Fear → ↓spending (decreased
v) → deflation → worse depression.
3. In the long run, money is neutral.
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Definition
Deflation:
a decrease in the average level of prices
(a negative inflation rate).
Disinflation:
a reduction in the inflation rate.
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Inflation
 An unexpected increase in the money supply
can boost the economy in the short run.
 As firms and workers come to expect and adjust
to the new influx of money, output will not grow
any faster than normal.
 In the long run, money is neutral.
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Inflation
An Inflation Parable
Under some circumstances, changes in M can temporarily
change YR. Let’s see how…
Consider a mini-economy consisting of a baker, tailor, and
carpenter who buy and sell products among themselves.
Government prints
money to pay army
Soldiers buy from
baker, tailor, and
carpenter
When the baker, tailor, and carpenter
go to buy from each other, they find
they are no better off than before
because of higher prices
All three work harder to
increase output and raise their
prices.
Eventually they catch on and stop
working harder to produce more output.
Conclusion: Increase in M can boost the economy in the short run but as
firms and workers come to expect and adjust to the influx of new money,
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output (real GDP) will not grow any faster than normal.
The Costs of Inflation
 If all prices (including wages) are going up,
then why is inflation a problem?
 Four problems associated with inflation:
1.
2.
3.
4.
Price confusion and money illusion.
Inflation redistributes wealth.
Inflation interacts with other taxes.
Inflation is painful to stop.
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Price Confusion and Money Illusion
 Inflation makes price signals more difficult to
interpret.
 It is not always clear whether prices are rising
because of increased demand or just an
increase in the money supply.
 We sometimes mistake inflation for higher
wages and prices in real terms.
 Resources are wasted in activities that appear
profitable but are not, and resources flow more
slowly to profitable uses.
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Definition
Money illusion:
when people mistake changes in nominal
prices for changes in real prices.
Example: Mary receives a 10% increase in salary and
takes on a higher mortgage payment.
The rate of inflation is 10%: she is no better off in terms of
real salary.
She now has a higher house payment and is in danger of
losing her home.
Result: resources are wasted in unprofitable activities.
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Inflation Redistributes Wealth
 Inflation is a type of tax that transfers real
resources from citizens to the government.
 Inflation reduces the real return that lenders
receive on loans, transferring wealth from
lenders to borrowers.
 When inflation and interest rates fall
unexpectedly, wealth is redistributed from
borrowers (who are paying the higher rates) to
lenders.
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Definition
Real rate of return:
the nominal rate of return minus the
inflation rate.
Nominal rate of return:
the rate of return that does not account
for inflation.
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Self-Check
A decrease in the average level of prices is
called:
a. Deflation.
b. Disinflation.
c. Money illusion.
Answer: a – a decrease in the average level of
prices is called deflation.
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Inflation Redistributes Wealth
 The relationship between the lender’s real rate
of return, the nominal rate of return, and the
inflation rate, is:
rreal = i - p
Where: rreal = real rate of return
i = nominal rate of interest
p = rate of inflation
 The real rate of return is equal to the nominal
rate of return minus the inflation rate.
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Inflation Redistributes Wealth
Example:
Suppose a bank makes a 30-year home loan at
an interest rate of 7%. If inflation is 3% over that
period: bank’s actual rate of return = 7% - 3% = +
4%
If inflation rises unexpectedly to 13% (as it did in
late 1970s), the actual rate of return = 7% - 13%
= -6%!
The lender is now losing money on the loan.
The borrower gains.
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Definition
Fisher effect:
the tendency of nominal interest rates to
rise with expected inflation rates.
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Inflation Redistributes Wealth
 When lenders expect inflation to increase, they
will demand a higher nominal interest rate.
 The Fisher effect says that the nominal interest
rate is equal to the expected inflation rate plus
the equilibrium real interest rate.
i  Eπ  requilibrium
Where: requilibrium = equilibrium real rate of return
i = nominal rate of interest
Ep = expected rate of inflation
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The Fisher Effect
Nominal interest rates tend to increase with inflation rates.
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Inflation Redistributes Wealth
The actual rate of return: determined in large
part by the difference between expected
inflation and actual inflation.
From earlier equations we have:
Substituting i from equation (2) into equation (1) we get:
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Inflation Redistributes Wealth
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Definition
Monetizing the debt:
when the government pays off its debts
by printing money.
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Inflation Redistributes Wealth
 A government with massive debts has an
incentive to increase the money supply, as it
benefits from unexpected inflation.
 The government doesn’t always inflate its debt
away for two reasons:
• If lenders expect inflation, they will increase
nominal rates.
• Buyers of bonds are often also voters, and
would be upset if real returns were shrunk.
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Inflation Redistributes Wealth
Workers and firms are affected by inflation.
Wage agreements are often made several
years in advance.
Underestimating inflation → wages are too low
→ supply of labor: too low.
Overestimating inflation → wages are too high
→ demand for labor: too low.
Conclusion: errors in estimating the rate of
inflation → a misallocation of resources →
lower economic growth.
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Self-Check
A government monetizes its debt by:
a. Raising interest rates.
b. Lowering interest rates.
c. Printing money to pay off the debt.
Answer: c – a government monetizes its debt by
printing money to pay off the debt.
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Breakdown of Financial Intermediation
 If inflation is moderate and stable:
• Lenders and borrowers can forecast well
• Loans can be signed with rough certainty
regarding the value of future payment
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Breakdown of Financial Intermediation
 When nominal interest rates are not allowed to
rise and inflation rate is high, the real rate of
return will be negative.
 People take their money out of the banking
system.
 The supply of savings declines and financial
intermediation becomes less efficient.
 Negative real interest rates reduce financial
intermediation and economic growth.
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Breakdown of Financial Intermediation
 When inflation is volatile and unpredictable,
long-term loans become riskier.
 Few long-term contracts will be signed.
 Any contract involving future payments will be
affected by inflation.
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Breakdown of Financial Intermediation
Peru (1987-1992)
Private loans virtually disappeared.
Investment fell and the economy collapsed.
Mexico
1980s: Inflation rate at times exceeded 100%.
Long-term loans were hard to get.
As recently as 2002, 90% of debt matured within
one year.
Since the 1990s: inflation has been tamed.
Result: rapidly growing capital markets and increased
investment: Economic growth
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Inflation Interacts With Taxes
 Most tax systems define incomes, profits, and
capital gains in nominal terms.
 Inflation will produce some tax burdens and
liabilities that do not make economic sense.
 If asset prices rise due to inflation, people pay
capital gain taxes when they should not.
 Inflation can push people into higher tax
brackets.
 Corporations pay taxes on phantom profits.
 Ultimately, investment is discouraged
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Inflation is Painful to Stop
 The government can reduce inflation by
reducing the growth in the money supply.
 When inflation is expected, lower inflation may
be misinterpreted as a reduction in demand.
 Firms reduce output and employment.
 Workers may be thrown out of work as the
unexpected increase in their real wage makes
them unaffordable.
 Expectations will eventually adjust in the long
run.
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Inflation is Painful to Stop
A good lesson:
Inflation in 1980 was 13.5%.
Tough monetary policy reduced the rate of
inflation to 3%, but the consequence was…
The worst recession since the Great Depression.
Unemployment rate over 10%.
The unemployment rate didn’t return to near 5.5%
until 1988.
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Takeaway
 Inflation is an increase in the average level of
prices as measured by a price index.
 Sustained inflation is always and everywhere a
monetary phenomenon.
 Although money is neutral in the long run,
changes in the money supply can influence real
GDP in the short run.
 Inflation makes price signals more difficult to
interpret.
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Takeaway
 The tendency of the nominal interest rate to
increase with expected inflation is called the
Fisher effect.
 Arbitrary redistributions of wealth make lending
and borrowing more risky and thus break down
financial intermediation.
 Anything above a mild rate of inflation is
generally bad for an economy.
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