Money and Inflation
The Quantity Theory of Money
Economics Senior Seminar 2005
The “Equation of Exchange”
MV = PY
Money supply x velocity = price level x income
We can treat velocity as fairly constant
We know that income is affected by real
inputs like the availability of labor, capital,
and technology—not the money supply
2
Velocity
Source: Mankiw, Principles of Macroeconomics, 3rd ed. (2004), instructor ancillaries
3
Money Supply and Prices
MV = PY
If velocity is constant and income is not
determined by the money supply (in the long
run), then:
 All that’s left is M and P, and they have to move
together.
 When M↑, P↑.
4
Money Supply and the Price Level
Source: Mankiw, Principles of Macroeconomics, 3rd ed. (2004), instructor ancillaries
5
Money Supply and the Price Level
Source: Mankiw, Principles of Macroeconomics, 3rd ed. (2004), instructor ancillaries
6
Early Keynesians
Early Keynesians suggested that apparent
money supply increases were ineffective in
stopping the Great Depression
 During the Depression, rates on U.S.
Treasury securities dropped very low
 Investment also stayed low despite low
interest rates
 Fiscal policy was their prescription
7
Early Monetarists
In the 1960s, the monetarists showed that
Depression-era monetary policy was
contractionary, and that real interest rates
were actually considerably higher than the
Keynesians had indicated.
They concluded that in the short run, the Fed
should have increased the money supply to
counteract the contraction caused by bank
failures, etc.
8
Costs of Inflation
“Shoeleather costs”
With higher interest rates, the opportunity cost
of holding money is higher
So people make more frequent transactions
with a bank to hold lower average money
balances
9
Costs of Inflation
Menu costs
Inflation means that firms have to change
their nominal prices more often
 Print and mail new catalogs
 Communicate new prices to sales force
10
Costs of Inflation
Changing relative costs
Not all prices change at the same rate—some
are “stickier” than others
Therefore, relative prices change
Price level increase
People switch from
apples to pears—
decisions are distorted!
Apples
Pears
11
Costs of Inflation
Price “stickiness” is not the only reason for
relative price changes
Where the new money enters the economy is
important.
If the government spends the new money
first, then the things government buys will see
price increases first
 Who gains? People who sell to the government
 Who loses? People who are in competition with the
government, who buy what it buys
12
Costs of Inflation
Changing relative costs
Price of a good may fall out of step with
inflation over time, so that sales timing is
distorted
Relatively high
Price
increase
price—sales low
Relatively high
price—sales low
Price level
Price of
widgets
Relatively low
price—sales high
Time
13
Costs of Inflation
Loss of information
Inconveniences associated with a changing
standard
14
Costs of Inflation
Unexpectedly high inflation is redistributive
With fixed interest rates, lenders lose, as
purchasing power of repayment is lower than
was anticipated.
Borrowers gain
Unexpectedly low inflation redistributes as
well
Lenders gain, borrowers lose
15
Costs of Inflation
Inflation can create business cycles
Pushing interest rates down can create the
impression that long-term projects are more
profitable
People invest in those long-term projects by
buying capital for them
When the interest rate comes back up from its
artificially low levels, the capital investments
lose value
Stock prices drop, people are laid off.
16
Inflation and Business Cycles
Increase in willingness to save vs. Increase in money supply
Interest
rate
S
S’
Interest rate
i
i
i’
i’
S
Unsustainable
separation of
saving &
investment
D
S=I S’=I’ Loanable
funds
S+M
D
S’ S=I
I’
Loanable
funds
17
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.
18
Hyperinflation in Germany
Price of a
newspaper in
Germany,
1921-1923:
Source: Mankiw, Macroeconomics, 5th
ed., pp. 105-106
Date
January 1921
May 1922
October 1922
February 1923
Price in marks
0.30
1
8
100
September 1923
1,000
October 1, 1923
October 15
October 29
2,000
20,000
1,000,000
November 9
November 17
15,000,000
70,000,000
19
Hyperinflation in Germany
20
Hyperinflation in Germany
Source: Mankiw, Principles of Macroeconomics, 3rd ed. (2004), instructor ancillaries
21
Hyperinflation in Germany
Fiscal reform ended the inflation
At the end of 1923, the number of government
employees was cut by a third
A new central bank was created
 This demonstrated a commitment to not printing
money
Source: Mankiw, Macroeconomics, 5th ed., pp. 105-106
22
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
23
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
24
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
25
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
26
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
27
Three Other Hyperinflations
Austria (1921-1923)
Hungary (1921-1924)
Poland (1922-1924)
28
Hyperinflation in Austria
Source: Mankiw, Principles of Macroeconomics, 3rd ed. (2004), instructor ancillaries
29
Hyperinflation in Hungary
Source: Mankiw, Principles of Macroeconomics, 3rd ed. (2004), instructor ancillaries
30
Hyperinflation in Hungary
1946 hyperinflation was even worse
Resulted in largest denomination note ever
issued by any country:
100 Million Bil-Pengo (1946): 100,000,000,000,000,000 units
Image source: Tom Chao’s Paper Money Gallery: http://www.tomchao.com/eu/eu29a.html
31
Hyperinflation in Poland
Source: Mankiw, Principles of Macroeconomics, 3rd ed. (2004), instructor ancillaries
32
Inflation Today
Consumer Price Inflation Rates, 1984-2003
1984-1993
1994-1998
1999-2003
2003
US
3.8
2.4
1.8
1.7
Advanced
economies
4.2
2.2
1.8
1.7
Developing 48.5
countries
22.9
6.1
6.0
Transitional 72.8
economies
100.0
20.1
8.8
Source: http://business.baylor.edu/Steve_Gardner/LECOUT02c.html
33
Inflation Today
HIGHEST INFLATION3: 2003
1.
Zimbabwe
383.4%
2.
Angola
106.0
3.
Myanmar
52.8
4.
Haiti
37.3
5.
Venezuela
31.1
6.
Belarus
30.0
7.
Iraq
27.5
8.
Malawi
27.4
9.
Ghana
26.4
10.
Uzbekistan
21.9
Source: http://www.infoplease.com/ipa/A0762380.html
34
Stopping Inflation
Preserve alternative means of raising funds
Price controls
 Hidden inflation—monetary price increases but is not
measured
 Black market transactions
 Hidden quality deterioration
 Repressed inflation—shortages and queues develop
Central bank independence
 More independent central banks produce less inflation
Source: http://business.baylor.edu/Steve_Gardner/LECOUT02c.html
35
Stopping Inflation
Currency boards
 Link currency to a trusted foreign currency
 Can still fail (Argentina)
Commodity standard
 Historically—metals, tobacco, real estate…
36
Price Stability
To minimize uncertainty, Friedman and others
have suggested a fixed money growth rate
rule.
New classicals: active monetary and fiscal
policy is generally a bad idea.
However, even countries that have required
their central banks to follow such rules have
allowed them some discretion—because it is
understood that money growth will have a
short-run impact.
37
What About Gold?
What if the U.S. were to return to a gold
standard?
Central bank, and/or private banks, would
be required to exchange dollars for gold at
a fixed rate
Appeal: nature fixes supply of gold, not
subject to political whim
38
What About Gold?
David Ricardo (1817):
“Though it (paper money) has no intrinsic value, yet,
by limiting its quantity, its value in exchange is as
great as an equal denomination of coins….
Experience, however, shows that neither a state nor
bank ever has had the unrestricted power of issuing
paper money without abusing that power…
39
What About Gold?
David Ricardo (1817):
“…in all states, therefore, the issue of paper money
ought to be under some check and control; and none
seems so proper for that purpose as that of subjecting
the issuers…to the obligation of paying their notes
either in gold coin or bullion.”
40
What About Gold?
Problem 1: what about the official dollarto-gold ratio?
Inflation can occur even under a gold
standard
Altering the ratio has been done
 Jan. 31, 1934: FDR changed the dollar from
$20.67 per ounce to $35 per ounce
Devaluation may impose a credibility cost…
but some avoid announcement and allow
black markets
41
What About Gold?
Problem 2: what about emergencies when
the government leaves the gold standard?
This has been done
 1933: FDR prohibited withdrawals of gold or silver
 1971: Nixon ended the last vestiges of the gold
standard by preventing foreign central banks from
“cashing in” their dollars for gold
42
What About Gold?
Gold standard is not foolproof guard
against untrustworthy governments
--But inflation has been higher without it!
43
What About Gold?
Inflation can still occur under a gold
standard
When Spain imported gold and silver from the
New World, the money supply in Europe
tripled.
 Spanish prices were 340% higher in 1600 than
they had been in 1500
 England had a price increase of almost 260%
 France had a rise of about 220%
 This is still far less than even the relatively lowinflation US in the 20th century
44
Main Points
Increases in the money supply produce
increases in prices
Price increases cause misallocation of
resources
Inflation might be reduced by
preserving alternative means of raising funds
central bank independence
tying currency to a foreign currency, or
a commodity standard
45