Chapter 17
Inflation: Its Causes and Costs
Outline
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What is inflation?
Causes of inflation
Arriving at the monetary equilibrium
Quantity theory of money
The classical dichotomy- Real versus nominal
Velocity of money
The Fisher effect
Costs of inflation
Inflation
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Inflation is the overall increase in price level.
Inflation rate can be measured as the percent
change in CPI, GDP deflator, or any overall price
index.
Recall that prices rise when the government
prints too much money (chap 1).
Causes of Inflation
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Level of prices and the value of money:
• P= Price level = # $ required to buy a basket of
goods and services
• 1/P= quantity of goods that can be bought with $1 =
value of money
• Therefore, price level and value of money are
inversely related
Monetary Equilibrium
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Determinants of money supply:
• The banking system along with the Bank of Canada
can influence the supply of money
• Money supply is determined by the Bank of Canada
and is treated as a policy variable
Determinants of money demand:
• Quantity of money held by public (demand) is
determined by interest rate on bonds
• Demand for money also depends on the average
price level in the economy
Monetary Equilibrium
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Determinants of money demand:
 Higher the price level (lower value of money), more
money people choose to hold, and demand for
money increases
Equilibrium
• In the LR, the overall level of prices adjusts to the
level where demand equals supply of money
• At the point of equilibrium, price level and value of
money have adjusted to balance supply and demand
for money
Quantity Theory of Money
The theory states 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.
The Classical dichotomy and Monetary
Neutrality
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Classical dichotomy is the theoretical separation
of nominal and real variables
Nominal variables are measured in monetary
units
Real variables are measured in physical units
Relative prices are real variables
Monetary neutrality states that changes in the
money supply affect nominal variables and do not
affect real variables
Velocity and the quantity equation
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Velocity of money is the rate at which money
changes hands or the speed at which the $
travels around the economy
MV=PY is the quantity equation and relates the
quantity of money and its velocity to the nominal
value of output
Velocity of money is relatively stable over time in
Canada
Therefore, when Bank of Canada increases
money supply rapidly, it results in inflation.
Velocity of
money
Inflation tax
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Hyperinflation is defined as inflation that exceeds
50% per month.
Inflation tax is the revenue the government raises
by creating money supply
When the government prints money in order to
fund its expenditure, it increases the price level
and thereby reduces the value of money.
Fisher Effect
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Money neutrality means that an increase in the
growth of money supply raises inflation rate but
does not affect any real variables.
However, increase in money supply does affect
(increase) nominal interest rate.
Recall real interest rate= nominal interest rateinflation rate.
The one-for-one adjustment between the nominal
interest rate to the inflation rate is the Fisher
effect.
The Costs of Inflation
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Inflation fallacy
Shoeleather costs
Menu costs
Relative price variability and misallocation of
resources
Inflation-induced tax distortions
Confusion and inconvenience
Arbitrary redistribution of wealth
Inflation fallacy
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Inflation leads to fall in purchasing power of
money and hurts consumers.
Suppliers on the other hand receive a higher price
for the same quantity sold.
Factors of production receive higher incomes
Inflation does not in itself reduce
real purchasing power
Neutrality of money
Shoeleather costs
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Inflation is like a tax and creates deadweight loss
for the society.
To reduce the burden of inflation tax, people hold
less money in hand and hold in interest bearing
savings instead.
The resources wasted (time and inconvenience)
in reducing money holdings is termed as
shoeleather costs.
During hyperinflation, local currency’s store of
value is vastly reduced.
Menu costs
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Menu costs are incurred when prices change
frequently and frequent changing of prices
increases the costs of firms.
Relative-price variability and the misallocation
of resources
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With no inflation, a firm’s relative prices would be
constant over a period of time ( a year).
With inflation, the relative prices of a firm will be
high in the early months of the year and low in
later months.
As market economies allocate resources based on
relative prices, inflation distorts prices resulting in
misallocation of resources by markets.
Inflation-induced tax distortions
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Inflation tends to raise the tax burden on income
from savings
 Tax
treatment of capital gains discourages savings
 All of the nominal interest earned on savings is
treated as income for purpose of taxation
Tax rate= 50%
Economy 1
Economy 2
Real interest rate
6%
6%
Inflation rate
0
10%
Nominal interest rate
6%
16%
After-tax nominal
interest rate
3%
4%
After-tax real interest
rate
3%
-6%
Save?
Confusion and Inconvenience
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Inflation erodes the real value of money as a unit
of account.
Cost of unexpected inflation: Arbitrary
redistribution of wealth
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Hyperinflation enriches the borrower by
diminishing the real value of the debt.
Deflation enriches the lender by increasing the
real value of the debt.
Unexpected inflation prevents the Fisher effect
from taking place imposing a risk on the borrower
and lender.
Inflation indexed bonds are a solution to protect
long term savings.