CHAPTER 8
Money, Prices, and Inflation
8-1
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Questions
• What do economists mean by
“money”?
• Why is money useful?
• What do economists mean when they
say that money is a unit of account?
• What determines the price level and
the inflation rate?
8-2
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Questions
• Why would a government ever
generate “hyperinflation”?
• What determines the level of money
demand?
• What determines the level of the
money supply?
• Why is inflation seen as something to
be avoided?
8-3
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Inflation
• In the 1970s, the United States
experienced an episode of relatively
mild inflation
– prices rose between five and ten percent
per year
– caused significant economic and political
trauma
• avoiding a repeat of the inflation of the 1970s
remains a major goal of economic policy
8-4
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 8.1 - Post-World War II Inflation in the
United States, 1951-2000
8-5
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Flexible-Price Model
• The Classical dichotomy implies
that real variables (real GDP, real
investment spending, or the real
exchange rate) can be analyzed and
calculated without considering
nominal variables (price level)
– money is “neutral”
• This is a special feature of the fullemployment flexible-price model
8-6
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Money
• is wealth that is held in a readilyspendable form
• is made up of
– coin and currency
– checking account balances
– other assets that can be turned into cash
or demand deposits nearly
instantaneously, without risk or cost
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The Usefulness of Money
• Without money, market transactions
would have to be performed through
barter
• In a barter economy, market
exchange would require the
coincidence of wants
– you would have to have some good or
service that someone wants and he or
she would have to have some good or
service that you want
8-8
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 8.2 - Coincidence of Wants
8-9
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The Usefulness of Money
• Money also serves as a unit of
account
– money is used as a yardstick to measure
value or quote prices
• Anything that alters the real value of
money in terms of its purchasing
power will also alter the real terms of
existing contracts that use the money
as a unit of account
8-10
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Demand for Money
• Businesses and households have a
demand for money
– they want to hold a certain amount of
wealth in the form of readily-spendable
purchasing power to carry out
transactions
• a higher level of spending means a larger
money demand
• There is a cost of holding money
8-11
– cash and checking deposits earn little or
no interest
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 8.3 - Reasons for and Opportunity
Cost of Holding Money
8-12
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The Quantity Theory of Money
• assumes that the only important
determinant of the demand for money
is the flow of spending
• can be summarized using
– the Cambridge money-demand function
1
M   (P  Y)
V
– the quantity equation
M V  P  Y
8-13
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The Quantity Theory of Money
M V  P  Y
• (P  Y) represents the total nominal
flow of spending
• M is the quantity of money
• V is a measure of how fast money
moves through the economy
– how many times the average unit of
money is used to buy a final good or
service
8-14
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 8.4 - The Velocity of Money
8-15
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Determining the Price Level
• In the flexible-price model of the
macroeconomy
– real GDP (Y) is equal to potential GDP
(Y*)
– the velocity of money is determined by
the sophistication of the banking system
– the money supply is determined by the
central bank
V
P  M
Y
8-16
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Determining the Price Level
V
P  M
Y
• If the price level is higher than the
quantity equation predicts
– households and businesses will have less
wealth in the form of money than they
wish
• they will cut back on purchases
– sellers will note demand is weak and
lower prices
8-17
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Determining the Price Level
V
P  M
Y
• If the price level is lower than the
quantity equation predicts
– households and businesses will have
more wealth in the form of money than
they wish
• they will increase purchases
– sellers will note demand is strong and
raise prices
8-18
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Determining the Price Level
• Example (third quarter of 1998)
– real GDP = $7,566 billion
– money stock = $1,072 billion
– velocity = 7.964
V
P  M 
Y
 7.964 

  $1,072  1.1284
 $7,556 
• In the third quarter of 1998, the price
level was equal to 112.84% of its
1992 level
8-19
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Money Stock
• The Federal Reserve determines the
money stock in the U.S.
– the determination of the money stock is
the basic task of monetary policy
• The Federal Reserve can directly
impact the monetary base
– the sum of currency in circulation and
deposits at the Federal Reserve’s twelve
branches
8-20
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The Money Stock
• To reduce the monetary base, the
Federal Reserve sells short-term
government securities
• To increase the monetary base, the
Federal Reserve buys short-term
government securities
• These transactions are called open
market operations
8-21
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Figure 8.5 - Open Market Operations
8-22
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The Money Stock
• The Federal Reserve directly controls
the monetary base
• The other measures of the money
stock are determined by the
interaction of the monetary base with
the banking sector
– regulatory requirements
– the incentive of financial institutions to
have enough funds on hand to satisfy
depositors’ demands
8-23
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The Money Stock
• Besides the monetary base (H), there
are other definitions of the money
stock such as
– M1 (currency, checking accounts,
travelers checks)
– M2 (M1 plus savings accounts, small term
deposits, money held in money market
accounts)
– M3 (M2 plus large term deposits and
institutional money market balances)
8-24
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Table 8.1 - Measures of the Money Stock
8-25
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Inflation
• The inflation rate is the proportional
rate of change in the price level
• Since
V
P
Y
M
• the inflation rate () will be
  v  m- y
– v=growth rate of velocity
– m=growth rate of the money stock
– y=growth rate of real GDP
8-26
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Inflation
• Example
– growth rate of real GDP=4% per year
– growth rate of velocity=2% per year
– growth rate of the money stock=5% per
year
  v  m - y  2%  5% - 4%  3%
8-27
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Inflation
• The bulk of changes in the rate of
inflation are due to changes in the
growth rate of the money stock
– the growth rate of the money stock (m)
can change quickly and substantially
– changes in the growth rates of real GDP
(y) and velocity (v) are generally smaller
8-28
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Inflation
• In the real world, inflation is not
always proportional to money growth
– in the 1980s, both inflation and velocity
fell sharply but the money stock grew
– in the first half of the 1990s, velocity fell
• meant that high growth of the money stock
did not lead to high inflation
– in the second half of the 1990s, velocity
grew
• money supply growth was negative to keep
inflation from rising
8-29
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 8.6 - Money Growth and Inflation Are
Not Always Parallel
8-30
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Money Demand
• Economic theory implies that money
demand should be inversely related to
the nominal interest rate
– cash and checking account balances earn
little or no interest
– the purchasing power of money erodes at
the rate of inflation
– the expected real return on money is -e
8-31
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Money Demand
• The opportunity cost of holding money
is the difference between the rate of
return on other assets (r) and the rate
of return on money (-e)
– the opportunity cost of holding money is
the nominal interest rate [i=r+e]
• As the opportunity cost of holding
money (i) rises, the quantity of
money balances demanded falls
8-32
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Figure 8.7 - Money Demand and the
Inflation Rate
8-33
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Money Demand
• The velocity of money can be
represented by
L
e
V  V  [V0  Vi(r   )]
– VL represents the financial technologydriven trend in velocity
– V0+Vi(r+e) represents the dependence
of the demand for money on the nominal
interest rate
8-34
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Money Demand
• The demand for nominal money
balances is
PY
M L
e
V  [V0  Vi(r   )]
8-35
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Money, Prices, and Inflation
• Suppose that the rate of growth of the
money stock permanently increases
– the inflation rate will rise
– if the real interest rate is stable, the
opportunity cost of holding money will
rise
– the velocity of money will increase
– if the money stock and real GDP remain
fixed, the price level will jump suddenly
and discontinuously
8-36
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 8.8 - Effects of a Rise in Money Growth
8-37
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Costs of Inflation
• The costs of expected inflation are
small
– requires you to make more trips to the
bank
– firms must spend resources changing
their prices
– households find it difficult to determine a
good deal from a bad one
– our tax laws are not designed to deal well
with inflation
8-38
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Costs of Inflation
• The costs of unexpected inflation are
more significant
– redistributes wealth from creditors to
debtors
• creditors receive less purchasing power than
they had anticipated
• debtors find the payments they must make
less burdensome than they had expected
8-39
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Hyperinflation
• occurs when inflation rises to more
than 20 percent per month
• arises when governments attempt to
obtain extra revenue by printing
money
– financing its spending by levying a tax on
holdings of cash
– known as an inflation tax
8-40
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 8.9 - The Inflation Tax
8-41
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Hyperinflation
• Eventually prices rise so rapidly that
the monetary system breaks down
– people would rather deal in barter terms
• Real GDP begins to fall
– the economy loses the benefits of the
division of labor
• In the end, the currency becomes
worthless
8-42
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• By “money” economists mean
something special: wealth in the form
of readily-spendable purchasing power
• Without money it is hard to imagine
how our economy could successfully
function
– the fact that everyone will accept money
as payment for goods and services is
necessary for the market economy to
function
8-43
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• Money is not only a medium of
exchange, it is also a unit of
account: a yardstick that we use to
measure values and to specify
contracts
8-44
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• Money demand is determined by
– businesses’ and households’ desire to
hold wealth in the form of readilyspendable purchasing power to carry out
transactions
– businesses’ and households’ recognition
that there is a cost to holding money
• wealth in the form of readily-spendable
purchasing power pays little or no interest
8-45
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• The velocity of money is how many
transactions a given piece of money
manages to facilitate in a year
– the principal determinant of velocity is
the economy’s “transactions technology”
• The stock of money is determined by
the central bank
– the Federal Reserve in the U.S.
8-46
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• The price level is equal to the money
stock times the velocity of money
divided by the level of real GDP
• The inflation rate is equal to the
proportional growth rate of the money
stock plus the proportional growth
rate of velocity minus the proportional
growth rate of real GDP
8-47
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• Governments cause hyperinflation
because printing money is a way of
taxing the public, and a government
that cannot tax any other way will be
strongly tempted to resort to it
8-48
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.