Economics: Theory Through Applications
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Chapter 26
Inflations Big and Small
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Learning Objectives
•
What is the quantity theory of money?
•
What is the classical dichotomy?
•
According to the quantity theory, what determines the rate of inflation in
the long-run?
•
What does it mean to say that “inflation is always and everywhere a
monetary phenomenon”?
•
What do we know about inflation and money growth in the United States?
•
What happened during past and recent hyperinflations?
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Learning Objectives
•
What is the inflation tax?
•
How is inflation caused by the central bank’s commitment problem?
•
What happens if there are multiple regions (states, countries)
independently choosing how much money to print?
•
What are the costs of an excessive inflation tax?
•
When does inflation cause a redistribution?
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Learning Objectives
•
What actions can government’s take to prevent excessive inflation?
•
How can hyperinflations be ended?
•
How do governments overcome the commitment problem?
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Figure 26.1- Button: Whip Inflation Now
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The Quantity Theory of Money
nominal spending  nominal GDP
nominal spending
money supply
nominal GDP

money supply
velocity of money 
velocity of money 
price level  real GDP
money supply
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Figure 26.2 - Labor Market Equilibrium
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Figure 26.3 - Credit Market Equilibrium
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The Classical Dichotomy
money supply  velocity of money  price level  real GDP
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Long Run Inflation
money supply  velocity of money  price level  real GDP
growth rate of money supply  growth rate of money velocity  inflation rate  growth rate of output
inflation rate  growth rate of money supply  growth rate of velocity 
growth rate of output  growth rate of money supply  growth rate of output
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Figure 26.4 - Inflation and Money Growth in
the Short Run
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Figure 26.5 - Inflation and Money Growth in
the Long Run
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Figure 26.6 - Inflation and Money Growth in
Different Countries
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Table 26.1 - Prices in Germany
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Figure 26.7 - Money Growth and Inflation in
Germany
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Figure 26.8 - The Use of Money in a
Hyperinflation
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Table 26.2 - The Start of the Hyperinflation
in Zimbabwe
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The Inflation Tax
deficit  change in government debt  change in money supply
government purchases  transfers  tax receipts  change in government debt
 change in money supply
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Figure 26.9 - The Gains to Inflation
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Closing the Output Gap
inflation on rate  autonomous inflation  inflation sensitivity  output gap
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Figure 26.10 - The Price Level in Argentina
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Uncertainty and Real Interest Rates
real interest rate  nominal interest rate  inflation rate
expected real interest rate  nominal interest rate  expected inflation rate
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Figure 26.11 - Central Bank Independence
and Inflation
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Key Terms
•
Quantity Theory of Money: The Quantity Theory of Money is a
relationship between money, output and prices that is used to study
inflation
•
Quantity equation: The quantity equation states that the supply of money
times the velocity of money equals nominal GDP
•
Circular flow of income: The circular flow of income measures the money
flows among the different sectors of the economy as individuals and firms
buy and sell goods and services
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Key Terms
•
Classical dichotomy: According to the classical dichotomy, real variables
are determined independently of nominal variables
•
Aggregate expenditure model: The aggregate expenditure framework
studies the relationship between planned spending and output
•
Long-run neutrality of money: The fact that changes in the money supply
have no long-run effect on real variables is called the long-run neutrality
of money
•
Nominal variable: A nominal variable is defined and measured in terms of
money
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Key Terms
•
Real variable: A real variable is defined and measured in terms other than
money, often in terms of real GDP
•
Monetary transmission mechanism: The monetary transmission
mechanism explains how the actions of the Federal Reserve Bank affect
aggregate economic variables, and in particular real GDP
•
Hyperinflation: A hyperinflation is a period of very large, often
escalating, inflation
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Key Terms
•
Inflation tax: An inflation tax occurs when the government prints money
to finance its deficit
•
Commitment problem: A government suffers from a commitment problem
when it is not able to make credible promises to pursue actions regardless
of how others respond to those actions
•
Taylor rule: A rule for monetary policy in which the target real interest
rate increases when inflation is too high and decreases when output is too
low
•
Risk premium: The risk premium is part of the interest rate needed to
compensate the lender for the risk of default
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Key Terms
•
Externality: An externality occurs when one person’s actions impose
uncompensated costs or benefits on others
•
Prisoner’s dilemma: In a prisoners’ dilemma game, there is a cooperative
outcome that both players would prefer to the Nash equilibrium of the
game
•
Fisher equation: According to the Fisher equation, the real interest rate
is approximately equal to the nominal interest rate minus the rate of
inflation
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Key Terms
•
Fixed exchange rate: In a fixed exchange rate regime, a central bank
uses it tools to target the value of the domestic currency in terms of a
foreign currency
•
Inflation targeting: Under a policy regime of inflation targeting, the
central bank uses its tools to set the rate of inflation as close as possible
to a target
•
Currency board: A fixed exchange rate regime in which each unit of
domestic currency is backed by holding the foreign currency, valued at the
fixed exchange rate
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Key Takeaways
•
The quantity theory of money states that the supply of money times the
velocity of money equals nominal GDP
•
According to the classical dichotomy, real variables, such as real GDP,
consumption, investment, the real wage, the real interest rate, etc., are
determined independently of nominal variables, such as the money supply
•
Using the quantity equation along with the classical dichotomy, in the long
run the inflation rate equals the rate of money growth minus the growth
rate of output
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Key Takeaways
•
The quote by Milton Friedman that “inflation is always and everywhere a
monetary phenomenon” points out the connection between money growth
and price growth (inflation)
– From this perspective, the source of inflation is money growth
•
Over long periods of time, inflation and money growth are closely linked
in the United States
•
The hyperinflations in many countries, such as Germany and Zimbabwe,
were times of rapid growth in prices coming from rapid expansions of the
money supply
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Key Takeaways
•
A government that prints money to finance its deficit is using an inflation
tax
– Individuals who hold nominal assets such as currency pay the tax
•
One source of inflation is a commitment problem of a central bank wishing
to use inflation to boost output
•
When there are multiple regions (states, countries) each with the power
to print money, then inflation will tend to be higher than it would be if
only a single central bank controlled the money supply
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Key Takeaways
•
Inflation can distort choices, such as the holding of money
– A small amount of inflation, so that it is one tax among many, makes economic
sense, but high inflation leads to significant distortion in the economy
•
Expected inflation is reflected in the terms of loan agreements
– Unexpected inflation, leads to a lower real interest rate and thus a
redistribution from the lender to the borrower
•
Governments can take a variety of actions to prevent excessive inflation
– These include the delegation of monetary policy to another central bank, the
creation of an independent monetary authority and constraining monetary
policy to focus solely on inflation
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Key Takeaways
•
Historically hyperinflations ended when the government restored fiscal
balance by eliminating deficit spending
•
A government can overcome a commitment problem by delegating the
conduct of monetary policy to a more conservative central bank
– This can be achieved through a currency board or through joining a monetary
union
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