Chapter 17
Money Growth and Inflation
23 October 2006
Eco 202
End-of-Chapter Problems

1, 2, 6, 8, 11, 13
2
The Meaning of Money



Money is the set of assets in an economy
that people regularly use to buy goods and
services from other people.
Economists contend that money is productive
because it lowers the transaction costs of
exchange.
If money is a good thing, could it be possible
to have too much money?
3
THE CLASSICAL THEORY OF
INFLATION



Inflation is an increase in the overall level of prices.
Hyperinflation is an extraordinarily high rate of
inflation.
Inflation: Historical Aspects



Over the past 60 years, prices have risen on average about
5 percent per year.
Deflation, meaning decreasing average prices, occurred in
the U.S. in the nineteenth century.
Hyperinflation refers to high rates of inflation such as
Germany experienced in the 1920s.
4
5
THE CLASSICAL THEORY OF
INFLATION

Inflation: Historical Aspects


In the 1970s prices rose by 7 percent per year.
During the 1990s, prices rose at an average rate
of 2 percent per year.
6
This Decade
Year
Inflation Rate (Dec-Dec)
2000
3.4
2001
1.6
2002
2.4
2003
1.9
2004
3.3
2005
3.4
7
THE CLASSICAL THEORY OF
INFLATION



The quantity theory of money is used to
explain the long-run determinants of the price
level and the inflation rate.
Inflation is an economy-wide phenomenon
that concerns the value of the economy’s
medium of exchange.
When the overall price level rises, the value
of money falls.
8
Aside: Terminology



The Quantity Equation is not the same as the
Quantity Theory of Money
Quantity Equation is true by definition—it is
an identity.
Quantity Theory of Money is subject to
testing.
9
Money Supply, Money Demand, and
Monetary Equilibrium

The money supply is a policy variable that is
controlled by the Fed.

Through instruments such as open-market
operations, the Fed directly controls the quantity
of money supplied.
10
Money Supply, Money Demand, and
Monetary Equilibrium

Money demand has several determinants,
including interest rates and the average level
of prices in the economy.
11
Money Supply, Money Demand, and
Monetary Equilibrium

People hold money because it is the medium
of exchange.


The amount of money people choose to hold
depends on the prices of goods and services.
As prices rise, people will want to hold more of
their assets in the form of money (liquid asset),
and less in the form of assets that are not liquid.
12
Money Supply, Money Demand, and
Monetary Equilibrium

In the long run, the overall level of prices
adjusts to the level at which the demand for
money equals the supply.

This suggests that changes in either the supply of
money or the demand for money will cause the
price level to change.
13
Figure 1 Money Supply, Money Demand, and the
Equilibrium Price Level
Value of
Money, 1/P
(High)
Price
Level, P
Money supply
1
1
3
1.33
/4
12
/
Equilibrium
value of
money
(Low)
A
(Low)
2
Equilibrium
price level
14
4
/
Money
demand
0
Quantity fixed
by the Fed
Quantity of
Money
(High)
Copyright © 2004 South-Western
Figure 2 The Effects of Monetary Injection
Value of
Money, 1/P
(High)
MS1
MS2
1
1
1. An increase
in the money
supply . . .
3
2. . . . decreases
the value of
money . . .
Price
Level, P
/4
12
/
1.33
A
2
B
14
/
(Low)
3. . . . and
increases
the price
level.
4
Money
demand
(High)
(Low)
0
M1
M2
Quantity of
Money
Copyright © 2004 South-Western
THE CLASSICAL THEORY OF
INFLATION

The Quantity Theory of Money

How the price level is determined and why it might
change over time is called the quantity theory of
money.


The quantity of money available in the economy
determines the value of money.
The primary cause of inflation is the growth in the
quantity of money.
16
The Classical Dichotomy and Monetary
Neutrality


Nominal variables are variables measured in
monetary units.
Real variables are variables measured in
physical units.
17
The Classical Dichotomy and Monetary
Neutrality

According to Hume and others, real
economic variables do not change with
changes in the money supply.


According to the classical dichotomy, different
forces influence real and nominal variables.
Changes in the money supply affect nominal
variables but not real variables.
18
The Classical Dichotomy and Monetary
Neutrality

The irrelevance of monetary changes for real
variables is called monetary neutrality.
19
Velocity and the Quantity Equation

The velocity of money refers to the speed at
which the typical dollar bill travels around the
economy from wallet to wallet.
20
Velocity and the Quantity Equation
V = (P  Y)/M

Where: V = velocity
P = the price level
Y = the quantity of output (real GDP)
M = the quantity of money

Because Velocity is defined from the other three
variables, the Quantity Equation is an Identity
21
Velocity and the Quantity Equation
Rewriting the equation gives the quantity
equation:
MV=PY
M = money supply
V = velocity
P = price level
Y = real GDP

22
Velocity and the Quantity Equation

The quantity equation relates the quantity of
money (M) to the nominal value of output
(P  Y).
23
Velocity and the Quantity Equation

The quantity equation shows that an increase
in the quantity of money in an economy must
be reflected in one of three other variables:



the price level must rise,
the quantity of output must rise, or
the velocity of money must fall.
24
Figure 3 Nominal GDP, the Quantity of Money, and
the Velocity of Money
Indexes
(1960 = 100)
2,000
Nominal GDP
1,500
M2
1,000
500
Velocity
0
1960
1965
1970
1975
1980
1985
1990
1995
2000
Copyright © 2004 South-Western
Velocity and the Quantity Equation

The Equilibrium Price Level, Inflation Rate,
and the Quantity Theory of Money



The velocity of money is relatively stable over
time.
When the Fed changes the quantity of money, it
causes proportionate changes in the nominal
value of output (P  Y).
Because money is neutral, money does not affect
output (real GDP).
26
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rrot.jpg
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CASE STUDY: Money and Prices during
Four Hyperinflations


Hyperinflation is inflation that exceeds 50
percent per month.
Hyperinflation occurs in some countries
because the government prints too much
money to pay for its spending.
29
Figure 4 Money and Prices During Four Hyperinflations
(a) Austria
(b) Hungary
Index
(Jan. 1921 = 100)
Index
(July 1921 = 100)
100,000
100,000
Price level
Price level
10,000
10,000
Money supply
1,000
100
Money supply
1,000
1921
1922
1923
1924
1925
100
1921
1922
1923
1924
Copyright © 2004 South-Western
1925
Figure 4 Money and Prices During Four Hyperinflations
(c) Germany
(d) Poland
Index
(Jan. 1921 = 100)
100,000,000,000,000
1,000,000,000,000
10,000,000,000
100,000,000
1,000,000
10,000
100
1
Index
(Jan. 1921 = 100)
10,000,000
Price level
Money
supply
Price level
1,000,000
Money
supply
100,000
10,000
1,000
1921
1922
1923
1924
1925
100
1921
1922
1923
1924
Copyright © 2004 South-Western
1925
Hyperinflation in Germany




At the end of World War I, Germany was
required to pay reparations to the Allies
Germany began running large deficits
Unable to tax or borrow enough to pay,
Germany began printing large quantities of
money.
Prices started to rise.
32
Hyperinflation in Germany

Price of a
newspaper in
Germany, 19211923:
Date
January 1921
0.30
May 1922
1
October 1922
8
February 1923
Source: Mankiw, Macroeconomics, 5th
ed., pp. 105-106
Price in marks
100
September 1923
1,000
October 1, 1923
2,000
October 15
20,000
October 29
1,000,000
November 9
15,000,000
November 17
70,000,000
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www.answers.com/topic/notgeld
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Hyperinflation in Yugoslavia

From 1971-1991, Yugoslavia had an average
annual inflation rate of 76%


Only Zaire and Brazil had a higher inflation rate.
In December 1990, the Serbian parliament
ordered the Serbian National Bank (a
regional central bank) to issue large amounts
of credits to friends of Slobodan Milosevic.
Source: Steve Hanke in April 28, 1999 Wall Street Journal
37
Hyperinflation in Yugoslavia



This amounted to more than half the planned
increase in the money supply for all of
Yugoslavia in 1991
Croatia and Slovenia broke away
In January 1992, hyperinflation began
Source: Steve Hanke in April 28, 1999 Wall Street Journal
38
Hyperinflation in Yugoslavia

In January 1994, the official monthly inflation
rate reached 313 million percent



This was the second-highest monthly rate (after
Hungary in 1946)
…and the second-longest (after the Soviet
hyperinflation of the early 1920s)
People spent their time trying to exchange dinars
for marks or dollars on the black market
Source: Steve Hanke in April 28, 1999 Wall Street Journal
39
Hyperinflation in Yugoslavia

The Yugoslav mint was producing 900,000
bank notes a month, in denominations of up
to 500 billion dinars
Source: Steve Hanke in April 28, 1999 Wall Street Journal;
image from National Bank of Serbia
40
41
Hyperinflation in Yugoslavia

On January 6, 1994, the government gave up
and declared the German mark legal tender

Tying a “superdinar” to the mark reduced inflation
Source: Steve Hanke in April 28, 1999 Wall Street Journal
42
Money and Inflation in U.S.
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The Inflation Tax



When the government raises revenue by
printing money, it is said to levy an inflation
tax.
An inflation tax is like a tax on everyone who
holds money.
The inflation ends when the government
institutes fiscal reforms such as cuts in
government spending.
45
The Fisher Effect



The Fisher effect refers to a one-to-one
adjustment of the nominal interest rate to the
inflation rate.
According to the Fisher effect, when the rate
of inflation rises, the nominal interest rate
rises by the same amount.
The real interest rate stays the same.
46
Figure 5 The Nominal Interest Rate and the Inflation
Rate
Percent
(per year)
15
12
Nominal interest rate
9
6
Inflation
3
0
1960
1965
1970
1975
1980
1985
1990
1995
2000
Copyright © 2004 South-Western
THE COSTS OF INFLATION

A Fall in Purchasing Power?

Inflation does not in itself reduce people’s real
purchasing power.
48
THE COSTS OF INFLATION






Shoeleather costs
Menu costs
Relative price variability
Tax distortions
Confusion and inconvenience
Arbitrary redistribution of wealth
49
Shoeleather Costs


Shoeleather costs are the resources wasted
when inflation encourages people to reduce
their money holdings.
Inflation reduces the real value of money, so
people have an incentive to minimize their
cash holdings.
50
Shoeleather Costs



Less cash requires more frequent trips to the
bank to withdraw money from interestbearing accounts.
The actual cost of reducing your money
holdings is the time and convenience you
must sacrifice to keep less money on hand.
Also, extra trips to the bank take time away
from productive activities.
51
Menu Costs



Menu costs are the costs of adjusting prices.
During inflationary times, it is necessary to
update price lists and other posted prices.
This is a resource-consuming process that
takes away from other productive activities.
52
Relative-Price Variability and the
Misallocation of Resources


Inflation distorts relative prices.
Consumer decisions are distorted, and
markets are less able to allocate resources to
their best use.
53
Inflation-Induced Tax Distortion


Inflation exaggerates the size of capital gains
and increases the tax burden on this type of
income.
With progressive taxation, capital gains are
taxed more heavily.
54
Inflation-Induced Tax Distortion


The income tax treats the nominal interest
earned on savings as income, even though
part of the nominal interest rate merely
compensates for inflation.
The after-tax real interest rate falls, making
saving less attractive.
55
Table 1 How Inflation Raises the Tax Burden on Saving
Copyright©2004 South-Western
Confusion and Inconvenience



When the Fed increases the money supply
and creates inflation, it erodes the real value
of the unit of account.
Inflation causes dollars at different times to
have different real values.
Therefore, with rising prices, it is more
difficult to compare real revenues, costs, and
profits over time.
57
A Special Cost of Unexpected Inflation:
Arbitrary Redistribution of Wealth


Unexpected inflation redistributes wealth
among the population in a way that has
nothing to do with either merit or need.
These redistributions occur because many
loans in the economy are specified in terms
of the unit of account—money.
58
Summary



The overall level of prices in an economy
adjusts to bring money supply and money
demand into balance.
When the central bank increases the supply
of money, it causes the price level to rise.
Persistent growth in the quantity of money
supplied leads to continuing inflation.
59
Summary



The principle of money neutrality asserts that
changes in the quantity of money influence
nominal variables but not real variables.
A government can pay for its spending simply
by printing more money.
This can result in an “inflation tax” and
hyperinflation.
60
Summary



According to the Fisher effect, when the
inflation rate rises, the nominal interest rate
rises by the same amount, and the real
interest rate stays the same.
Many people think that inflation makes them
poorer because it raises the cost of what they
buy.
This view is a fallacy because inflation also
raises nominal incomes.
61
Summary

Economists have identified six costs of
inflation:






Shoeleather costs
Menu costs
Increased variability of relative prices
Unintended tax liability changes
Confusion and inconvenience
Arbitrary redistributions of wealth
62
Summary


When banks loan out their deposits, they
increase the quantity of money in the
economy.
Because the Fed cannot control the amount
bankers choose to lend or the amount
households choose to deposit in banks, the
Fed’s control of the money supply is
imperfect.
63