30 Money Growth and Inflation
The Meaning of Money <ul><li>Money is the set of assets in an economy that people regularly use to buy goods and services ...
THE CLASSICAL THEORY OF INFLATION <ul><li>Inflation is an increase in the overall level of prices. </li></ul><ul><li>Hyper...
THE CLASSICAL THEORY OF INFLATION <ul><li>Inflation: Historical Aspects </li></ul><ul><ul><li>Over the past 60 years, pric...
THE CLASSICAL THEORY OF INFLATION <ul><li>Inflation: Historical Aspects </li></ul><ul><ul><li>In the 1970s prices rose by ...
THE CLASSICAL THEORY OF INFLATION <ul><li>The  quantity theory of money  is used to explain the long-run determinants of t...
Money Supply, Money Demand, and Monetary Equilibrium <ul><li>The money supply   is a policy variable that is controlled by...
Money Supply, Money Demand, and Monetary Equilibrium <ul><li>Money demand has several determinants, including interest rat...
Money Supply, Money Demand, and Monetary Equilibrium <ul><li>People hold money because it is the medium of exchange. </li>...
Money Supply, Money Demand, and Monetary Equilibrium <ul><li>In the long run, the overall level of prices adjusts to the l...
Figure 1 Money Supply, Money Demand, and the Equilibrium Price Level Copyright © 2004  South-Western Quantity of Money Val...
Figure 2 The Effects of Monetary Injection Copyright © 2004  South-Western Quantity of Money Value of Money,  1 / P Price ...
THE CLASSICAL THEORY OF INFLATION <ul><li>The Quantity Theory of Money </li></ul><ul><ul><li>How the price level is determ...
The Classical Dichotomy and Monetary Neutrality <ul><li>Nominal variables  are variables measured in monetary units. </li>...
The Classical Dichotomy and Monetary Neutrality <ul><li>According to Hume and others, real economic variables do not chang...
The Classical Dichotomy and Monetary Neutrality <ul><li>The irrelevance of monetary changes for real variables is called  ...
Velocity and the Quantity Equation <ul><li>The  velocity of money  refers to the speed at which the typical dollar bill tr...
Velocity and the Quantity Equation <ul><li>V = (P    Y)/M </li></ul><ul><ul><li>Where:  V   = velocity </li></ul></ul><ul...
Velocity and the Quantity Equation <ul><li>Rewriting the equation gives the quantity equation: </li></ul><ul><li>M      V...
Velocity and the Quantity Equation <ul><li>The  quantity equation  relates the quantity of money ( M ) to the nominal valu...
Velocity and the Quantity Equation <ul><li>The quantity equation shows that an increase in the quantity of money in an eco...
Figure 3 Nominal GDP, the Quantity of Money, and the Velocity of Money Copyright © 2004  South-Western Indexes (1960 = 100...
Velocity and the Quantity Equation <ul><li>The Equilibrium Price Level, Inflation Rate, and the Quantity Theory of Money  ...
CASE STUDY:  Money and Prices during Four Hyperinflations <ul><li>Hyperinflation is inflation that exceeds 50 percent per ...
Figure 4 Money and Prices During Four Hyperinflations Copyright © 2004  South-Western (a) Austria (b) Hungary Money supply...
Figure 4 Money and Prices During Four Hyperinflations Copyright © 2004  South-Western (c) Germany 1 Index (Jan. 1921 = 100...
The Inflation Tax <ul><li>When the government raises revenue by printing money, it is said to levy an  inflation tax. </li...
The Fisher Effect <ul><li>The  Fisher effect  refers to a one-to-one adjustment of the nominal interest rate to the inflat...
Figure 5 The Nominal Interest Rate and the Inflation Rate Copyright © 2004  South-Western Percent (per year) 1960 1965 197...
THE COSTS OF INFLATION <ul><li>A Fall in Purchasing Power? </li></ul><ul><ul><li>Inflation  does not  in itself reduce peo...
THE COSTS OF INFLATION <ul><li>Shoeleather costs </li></ul><ul><li>Menu costs </li></ul><ul><li>Relative price variability...
Shoeleather Costs <ul><li>Shoeleather costs  are the resources wasted when inflation encourages people to reduce their mon...
Shoeleather Costs <ul><li>Less cash requires more frequent trips to the bank to withdraw money from interest-bearing accou...
Menu Costs <ul><li>Menu costs  are the costs of adjusting prices. </li></ul><ul><li>During inflationary times, it is neces...
Relative-Price Variability and the Misallocation of Resources <ul><li>Inflation distorts relative prices.  </li></ul><ul><...
Inflation-Induced Tax Distortion <ul><li>Inflation exaggerates the size of capital gains and increases the tax burden on t...
Inflation-Induced Tax Distortion <ul><li>The income tax treats the nominal interest earned on savings as income, even thou...
Table 1 How Inflation Raises the Tax Burden on Saving Copyright©2004  South-Western
Confusion and Inconvenience <ul><li>When the Fed increases the money supply and creates inflation, it erodes the real valu...
A Special Cost of Unexpected Inflation: Arbitrary Redistribution of Wealth <ul><li>Unexpected inflation redistributes weal...
Summary <ul><li>The overall level of prices in an economy adjusts to bring money supply and money demand into balance. </l...
Summary <ul><li>The principle of money neutrality asserts that changes in the quantity of money influence nominal variable...
Summary <ul><li>According to the Fisher effect, when the inflation rate rises, the nominal interest rate rises by the same...
Summary <ul><li>Economists have identified six costs of inflation: </li></ul><ul><ul><li>Shoeleather costs </li></ul></ul>...
Summary <ul><li>When banks loan out their deposits, they increase the quantity of money in the economy. </li></ul><ul><li>...
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Principles of Macroeconomics :3

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  • Bullet 2: Mankiw has removed the word, “directly”
  • Velocity shouldn’t be in bold. Maybe move V down and align equal signs--it’s not..
  • Align text for second bullet.
  • The equation of the fisher effect must appear here or on a new next slide: “ Nominal interest rate = real interest rate + inflation rate”
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    1. 1. 30 Money Growth and Inflation
    2. 2. The Meaning of Money <ul><li>Money is the set of assets in an economy that people regularly use to buy goods and services from other people. </li></ul>
    3. 3. THE CLASSICAL THEORY OF INFLATION <ul><li>Inflation is an increase in the overall level of prices. </li></ul><ul><li>Hyperinflation is an extraordinarily high rate of inflation. </li></ul>
    4. 4. THE CLASSICAL THEORY OF INFLATION <ul><li>Inflation: Historical Aspects </li></ul><ul><ul><li>Over the past 60 years, prices have risen on average about 5 percent per year. </li></ul></ul><ul><ul><li>Deflation, meaning decreasing average prices, occurred in the U.S. in the nineteenth century. </li></ul></ul><ul><ul><li>Hyperinflation refers to high rates of inflation such as Germany experienced in the 1920s. </li></ul></ul>
    5. 5. THE CLASSICAL THEORY OF INFLATION <ul><li>Inflation: Historical Aspects </li></ul><ul><ul><li>In the 1970s prices rose by 7 percent per year. </li></ul></ul><ul><ul><li>During the 1990s, prices rose at an average rate of 2 percent per year. </li></ul></ul>
    6. 6. THE CLASSICAL THEORY OF INFLATION <ul><li>The quantity theory of money is used to explain the long-run determinants of the price level and the inflation rate. </li></ul><ul><li>Inflation is an economy-wide phenomenon that concerns the value of the economy’s medium of exchange. </li></ul><ul><li>When the overall price level rises, the value of money falls. </li></ul>
    7. 7. Money Supply, Money Demand, and Monetary Equilibrium <ul><li>The money supply is a policy variable that is controlled by the Fed. </li></ul><ul><ul><li>Through instruments such as open-market operations, the Fed directly controls the quantity of money supplied. </li></ul></ul>
    8. 8. Money Supply, Money Demand, and Monetary Equilibrium <ul><li>Money demand has several determinants, including interest rates and the average level of prices in the economy. </li></ul>
    9. 9. Money Supply, Money Demand, and Monetary Equilibrium <ul><li>People hold money because it is the medium of exchange. </li></ul><ul><ul><li>The amount of money people choose to hold depends on the prices of goods and services. </li></ul></ul>
    10. 10. Money Supply, Money Demand, and Monetary Equilibrium <ul><li>In the long run, the overall level of prices adjusts to the level at which the demand for money equals the supply. </li></ul>
    11. 11. Figure 1 Money Supply, Money Demand, and the Equilibrium Price Level Copyright © 2004 South-Western Quantity of Money Value of Money, 1 / P Price Level, P 0 1 (Low) (High) (High) (Low) 1 / 2 1 / 4 3 / 4 1 1.33 2 4 Quantity fixed by the Fed Money supply Equilibrium value of money Equilibrium price level Money demand A
    12. 12. Figure 2 The Effects of Monetary Injection Copyright © 2004 South-Western Quantity of Money Value of Money, 1 / P Price Level, P 0 1 (Low) (High) (High) (Low) 1 / 2 1 / 4 3 / 4 1 1.33 2 4 Money demand M 1 MS 1 M 2 MS 2 2. . . . decreases the value of mone y . . . 3. . . . and increases the price level. 1. An increase in the money supply . . . A B
    13. 13. THE CLASSICAL THEORY OF INFLATION <ul><li>The Quantity Theory of Money </li></ul><ul><ul><li>How the price level is determined and why it might change over time is called the quantity theory of money. </li></ul></ul><ul><ul><ul><li>The quantity of money available in the economy determines the value of money. </li></ul></ul></ul><ul><ul><ul><li>The primary cause of inflation is the growth in the quantity of money . </li></ul></ul></ul>
    14. 14. The Classical Dichotomy and Monetary Neutrality <ul><li>Nominal variables are variables measured in monetary units. </li></ul><ul><li>Real variables are variables measured in physical units. </li></ul>
    15. 15. The Classical Dichotomy and Monetary Neutrality <ul><li>According to Hume and others, real economic variables do not change with changes in the money supply. </li></ul><ul><ul><li>According to the classical dichotomy , different forces influence real and nominal variables. </li></ul></ul><ul><li>Changes in the money supply affect nominal variables but not real variables. </li></ul>
    16. 16. The Classical Dichotomy and Monetary Neutrality <ul><li>The irrelevance of monetary changes for real variables is called monetary neutrality . </li></ul>
    17. 17. Velocity and the Quantity Equation <ul><li>The velocity of money refers to the speed at which the typical dollar bill travels around the economy from wallet to wallet. </li></ul>
    18. 18. Velocity and the Quantity Equation <ul><li>V = (P  Y)/M </li></ul><ul><ul><li>Where: V = velocity </li></ul></ul><ul><ul><ul><li>P = the price level </li></ul></ul></ul><ul><ul><ul><li>Y = the quantity of output </li></ul></ul></ul><ul><ul><ul><li>M = the quantity of money </li></ul></ul></ul>
    19. 19. Velocity and the Quantity Equation <ul><li>Rewriting the equation gives the quantity equation: </li></ul><ul><li>M  V = P  Y </li></ul>
    20. 20. Velocity and the Quantity Equation <ul><li>The quantity equation relates the quantity of money ( M ) to the nominal value of output ( P  Y ). </li></ul>
    21. 21. Velocity and the Quantity Equation <ul><li>The quantity equation shows that an increase in the quantity of money in an economy must be reflected in one of three other variables: </li></ul><ul><ul><li>the price level must rise, </li></ul></ul><ul><ul><li>the quantity of output must rise, or </li></ul></ul><ul><ul><li>the velocity of money must fall. </li></ul></ul>
    22. 22. Figure 3 Nominal GDP, the Quantity of Money, and the Velocity of Money Copyright © 2004 South-Western Indexes (1960 = 100) 2,000 1,000 500 0 1,500 1960 1965 1970 1975 1980 1985 1990 1995 2000 Nominal GDP Velocity M2
    23. 23. Velocity and the Quantity Equation <ul><li>The Equilibrium Price Level, Inflation Rate, and the Quantity Theory of Money </li></ul><ul><ul><li>The velocity of money is relatively stable over time. </li></ul></ul><ul><ul><li>When the Fed changes the quantity of money, it causes proportionate changes in the nominal value of output (P  Y). </li></ul></ul><ul><ul><li>Because money is neutral, money does not affect output. </li></ul></ul>
    24. 24. CASE STUDY: Money and Prices during Four Hyperinflations <ul><li>Hyperinflation is inflation that exceeds 50 percent per month. </li></ul><ul><li>Hyperinflation occurs in some countries because the government prints too much money to pay for its spending. </li></ul>
    25. 25. Figure 4 Money and Prices During Four Hyperinflations Copyright © 2004 South-Western (a) Austria (b) Hungary Money supply Price level Index (Jan. 1921 = 100) Index (July 1921 = 100) Price level 100,000 10,000 1,000 100 1925 1924 1923 1922 1921 Money supply 100,000 10,000 1,000 100 1925 1924 1923 1922 1921
    26. 26. Figure 4 Money and Prices During Four Hyperinflations Copyright © 2004 South-Western (c) Germany 1 Index (Jan. 1921 = 100) (d) Poland 100,000,000,000,000 1,000,000 10,000,000,000 1,000,000,000,000 100,000,000 10,000 100 Price level 1925 1924 1923 1922 1921 Price level Index (Jan. 1921 = 100) 100 10,000,000 100,000 1,000,000 10,000 1,000 1925 1924 1923 1922 1921 Money supply Money supply
    27. 27. The Inflation Tax <ul><li>When the government raises revenue by printing money, it is said to levy an inflation tax. </li></ul><ul><li>An inflation tax is like a tax on everyone who holds money. </li></ul><ul><li>The inflation ends when the government institutes fiscal reforms such as cuts in government spending. </li></ul>
    28. 28. The Fisher Effect <ul><li>The Fisher effect refers to a one-to-one adjustment of the nominal interest rate to the inflation rate. </li></ul><ul><li>According to the Fisher effect, when the rate of inflation rises, the nominal interest rate rises by the same amount. </li></ul><ul><li>The real interest rate stays the same. </li></ul>
    29. 29. Figure 5 The Nominal Interest Rate and the Inflation Rate Copyright © 2004 South-Western Percent (per year) 1960 1965 1970 1975 1980 1985 1990 1995 2000 0 3 6 9 12 15 Inflation Nominal interest rate
    30. 30. THE COSTS OF INFLATION <ul><li>A Fall in Purchasing Power? </li></ul><ul><ul><li>Inflation does not in itself reduce people’s real purchasing power. </li></ul></ul>
    31. 31. THE COSTS OF INFLATION <ul><li>Shoeleather costs </li></ul><ul><li>Menu costs </li></ul><ul><li>Relative price variability </li></ul><ul><li>Tax distortions </li></ul><ul><li>Confusion and inconvenience </li></ul><ul><li>Arbitrary redistribution of wealth </li></ul>
    32. 32. Shoeleather Costs <ul><li>Shoeleather costs are the resources wasted when inflation encourages people to reduce their money holdings. </li></ul><ul><li>Inflation reduces the real value of money, so people have an incentive to minimize their cash holdings. </li></ul>
    33. 33. Shoeleather Costs <ul><li>Less cash requires more frequent trips to the bank to withdraw money from interest-bearing accounts. </li></ul><ul><li>The actual cost of reducing your money holdings is the time and convenience you must sacrifice to keep less money on hand. </li></ul><ul><li>Also, extra trips to the bank take time away from productive activities. </li></ul>
    34. 34. Menu Costs <ul><li>Menu costs are the costs of adjusting prices. </li></ul><ul><li>During inflationary times, it is necessary to update price lists and other posted prices. </li></ul><ul><li>This is a resource-consuming process that takes away from other productive activities. </li></ul>
    35. 35. Relative-Price Variability and the Misallocation of Resources <ul><li>Inflation distorts relative prices. </li></ul><ul><li>Consumer decisions are distorted, and markets are less able to allocate resources to their best use. </li></ul>
    36. 36. Inflation-Induced Tax Distortion <ul><li>Inflation exaggerates the size of capital gains and increases the tax burden on this type of income. </li></ul><ul><li>With progressive taxation, capital gains are taxed more heavily. </li></ul>
    37. 37. Inflation-Induced Tax Distortion <ul><li>The income tax treats the nominal interest earned on savings as income, even though part of the nominal interest rate merely compensates for inflation. </li></ul><ul><li>The after-tax real interest rate falls, making saving less attractive. </li></ul>
    38. 38. Table 1 How Inflation Raises the Tax Burden on Saving Copyright©2004 South-Western
    39. 39. Confusion and Inconvenience <ul><li>When the Fed increases the money supply and creates inflation, it erodes the real value of the unit of account. </li></ul><ul><li>Inflation causes dollars at different times to have different real values. </li></ul><ul><li>Therefore, with rising prices, it is more difficult to compare real revenues, costs, and profits over time. </li></ul>
    40. 40. A Special Cost of Unexpected Inflation: Arbitrary Redistribution of Wealth <ul><li>Unexpected inflation redistributes wealth among the population in a way that has nothing to do with either merit or need. </li></ul><ul><li>These redistributions occur because many loans in the economy are specified in terms of the unit of account—money. </li></ul>
    41. 41. Summary <ul><li>The overall level of prices in an economy adjusts to bring money supply and money demand into balance. </li></ul><ul><li>When the central bank increases the supply of money, it causes the price level to rise. </li></ul><ul><li>Persistent growth in the quantity of money supplied leads to continuing inflation. </li></ul>
    42. 42. Summary <ul><li>The principle of money neutrality asserts that changes in the quantity of money influence nominal variables but not real variables. </li></ul><ul><li>A government can pay for its spending simply by printing more money. </li></ul><ul><li>This can result in an “inflation tax” and hyperinflation. </li></ul>
    43. 43. Summary <ul><li>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. </li></ul><ul><li>Many people think that inflation makes them poorer because it raises the cost of what they buy. </li></ul><ul><li>This view is a fallacy because inflation also raises nominal incomes. </li></ul>
    44. 44. Summary <ul><li>Economists have identified six costs of inflation: </li></ul><ul><ul><li>Shoeleather costs </li></ul></ul><ul><ul><li>Menu costs </li></ul></ul><ul><ul><li>Increased variability of relative prices </li></ul></ul><ul><ul><li>Unintended tax liability changes </li></ul></ul><ul><ul><li>Confusion and inconvenience </li></ul></ul><ul><ul><li>Arbitrary redistributions of wealth </li></ul></ul>
    45. 45. Summary <ul><li>When banks loan out their deposits, they increase the quantity of money in the economy. </li></ul><ul><li>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. </li></ul>

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