2011 LecturePowerPointSlides
LecturePowerPoint
toaccompany
1
Chapter11
Chapter11
MoneyGrowthandInflation
Copyright Nelson Education Limited
2
Inthischapter,
lookfortheanswerstothesequestions:
How does the money supply affect inflation and
nominal interest rates?
Does the money supply affect real variables like
real GDP or the real interest rate?
How is inflation like a tax?
What are the costs of inflation? How serious are
they?
Copyright 2011 Nelson Education Limited
3
Introduction
This chapter introduces the quantity theory of
money to explain one of the Ten Principles of
Economics from Chapter 1:
Prices rise when the government prints
too much money.
Most economists believe the quantity theory
is a good explanation of the long run behaviour
of inflation.
Copyright 2011 Nelson Education Limited
4
TheClassicalTheoryofInflation
Inflation is an increase in the overall level of
prices.
Hyperinflation is an extraordinarily high rate of
inflation.
TheClassicalTheoryofInflation
Inflation: Historical Aspects
Over the past 60 years, prices have risen on
average about 4 percent per year.
Deflation, meaning decreasing average
prices, occurred in Canada in the twentieth
century.
Hyperinflation refers to high rates of inflation
such as Germany experienced in the 1920s.
TheClassicalTheoryofInflation
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.
TheClassicalTheoryofInflation
The quantity theory of money is used to explain
quantity
the long-run determinants of the price level and
the inflation rate.
Inflation is an economy-wide phenomenon that
concerns the value of the economys medium of
exchange.
When the overall price level rises, the value of
money falls.
An inverse relationship between the price level
and the value of money
TheValueofMoney
P = the price level
(e.g., the CPI or GDP deflator)
P is the price of a basket of goods, measured in
money.
1/P is the value of $1, measured in goods.
Example: basket contains one candy bar.
If P = $2, value of $1 is 1/2 candy bar
If P = $3, value of $1 is 1/3 candy bar
Inflation drives up prices and drives down the
value of money.
Copyright 2011 Nelson Education Limited
9
TheQuantityTheoryofMoney
Developed by 18th century philosopher
David Hume and the classical economists
Advocated more recently by Nobel Prize Laureate
Milton Friedman
Asserts that the quantity of money determines the
value of money
We study this theory using two approaches:
1. A supply-demand diagram
2. An equation
Copyright 2011 Nelson Education Limited
10
MoneySupply(MS)
In real world, determined by the Bank of Canada
(BoC), the banking system, consumers.
In this model, we assume the BoC precisely
controls money supply (MS) and sets it at some
fixed amount.
Copyright 2011 Nelson Education Limited
11
MoneyDemand(MD)
Refers to how much wealth people want to hold in
liquid form.
Depends on P:
An increase in P reduces the value of money,
so more money is required to buy goods & services.
Thus, quantity of money demanded
is negatively related to the value of money
and positively related to P, other things equal.
(These other things include real income, interest
rates, availability of ATMs.)
Copyright 2011 Nelson Education Limited
12
TheMoneySupplyDemandDiagram
Value of
Money, 1/P
1
Price
Level, P
As the value of
money rises, the
price level falls.
1
1.33
2
4
Quantity
of Money
Copyright 2011 Nelson Education Limited
13
TheMoneySupplyDemandDiagram
Value of
Money, 1/P
Price
Level, P
MS1
1
1
1.33
The BoC sets MS
at some fixed value,
regardless of P.
$1000
2
4
Quantity
of Money
Copyright 2011 Nelson Education Limited
14
TheMoneySupplyDemandDiagram
Value of
Money, 1/P
1
A fall in value of money
(or increase in P)
increases the quantity
of money demanded:
Price
Level, P
1
1.33
2
4
MD1
Quantity
of Money
Copyright 2011 Nelson Education Limited
15
TheMoneySupplyDemandDiagram
Value of
Money, 1/P
MS 1
1
eqm
value
of
money
P adjusts to equate
quantity of money
demanded with
money supply.
1
1.33
Price
Level, P
A
2
MD1
$1000
eqm
price
level
4
Quantity
of Money
Copyright 2011 Nelson Education Limited
16
TheEffectsofaMonetaryInjection
Value of
Money, 1/P
MS 1
MS2
1
Suppose the BoC
increases the
money supply.
eqm
value
of
money
Price
Level, P
1
Then the value
of money falls,
and P rises.
1.33
A
2
B
MD1
$1000
$2000
4
eqm
price
level
Quantity
of Money
Copyright 2011 Nelson Education Limited
17
ABriefLookattheAdjustmentProcess
Result from graph: Increasing MS causes P to rise.
How does this work? Short version:
At the initial P, an increase in MS causes
excess supply of money.
People get rid of their excess money by spending
it on goods & services or by loaning it to others,
who spend it.
Result: increased demand for goods.
But supply of goods does not increase,
so prices must rise.
(Other things happen in the short run, which we will
18
study in later chapters.)
Realvs.NominalVariables
Nominal variables are measured in monetary
units.
Examples: nominal GDP,
nominal interest rate (rate of return measured in $)
nominal wage ($ per hour worked)
Real variables are measured in physical units.
Examples: real GDP,
real interest rate (measured in output)
real wage (measured in output)
Copyright 2011 Nelson Education Limited
19
Realvs.NominalVariables
Prices are normally measured in terms of money.
Price of a compact disc:
$15/cd
Price of a pepperoni pizza: $10/pizza
A relative price is the price of one good relative to
(divided by) another:
Relative price of CDs in terms of pizza:
$15/cd
price of cd
= 1.5 pizzas per cd
=
$10/pizza
price of pizza
Relative prices are measured in physical units,
so they are real variables.
Copyright 2011 Nelson Education Limited
20
Realvs.NominalWage
An important relative price is the real wage:
W = nominal wage = price of labour, e.g., $15/hour
P = price level = price of g&s, e.g., $5/unit of output
Real wage is the price of labour relative to the price
of output:
$15/hour
W
= 3 units output per hour
=
$5/unit of output
P
Copyright 2011 Nelson Education Limited
21
TheClassicalDichotomy
Classical dichotomy: the theoretical separation
of nominal and real variables
Hume and the classical economists
suggested that monetary developments
affect nominal variables but not real variables.
If the central bank doubles the money supply,
Hume & classical thinkers contend
all nominal variables (including prices)
will double.
all real variables (including relative prices)
will remain unchanged.
Copyright 2011 Nelson Education Limited
22
TheNeutralityofMoney
Monetary neutrality: the proposition that changes
in the money supply do not affect real variables
Doubling money supply causes all nominal prices
to double; what happens to relative prices?
Initially, relative price of cd in terms of pizza is
$15/cd
= 1.5 pizzas per cd
=
$10/pizza
The relative price
After nominal prices double,
is unchanged.
$30/cd
price of cd
= 1.5 pizzas per cd
=
$20/pizza
price of pizza
price of cd
price of pizza
Copyright 2011 Nelson Education Limited
23
TheNeutralityofMoney
Monetary neutrality: the proposition that changes
in the money supply do not affect real variables
Similarly, the real wage W/P remains unchanged, so
quantity of labour supplied does not change
quantity of labour demanded does not change
total employment of labour does not change
The same applies to employment of capital and
other resources.
Since employment of all resources is unchanged,
total output is also unchanged by the money supply.
Copyright 2011 Nelson Education Limited
24
TheNeutralityofMoney
Most economists believe the classical dichotomy
and neutrality of money describe the economy in
the long run.
In later chapters, we will see that monetary
changes can have important short-run effects
on real variables.
Copyright 2011 Nelson Education Limited
25
TheVelocityofMoney
Velocity of money: the rate at which money
changes hands
Notation:
P x Y = nominal GDP
= (price level) x (real GDP)
M
= money supply
V
= velocity
Velocity formula:
PxY
V=
M
Copyright 2011 Nelson Education Limited
26
TheVelocityofMoney
PxY
Velocity formula: V =
M
Example with one good: pizza.
In 2008,
Y
= real GDP = 3000 pizzas
P
= price level = price of pizza = $10
P x Y = nominal GDP = value of pizzas = $30,000
M
= money supply = $10,000
V
= velocity = $30,000/$10,000 = 3
The average dollar was used in 3 transactions.
Copyright 2011 Nelson Education Limited
27
ACTIVELEARNING1
Exercise
One good: corn.
The economy has enough labour, capital, and land
to produce Y = 800 bushels of corn.
V is constant.
In 2008, MS = $2000, P = $5/bushel.
Compute nominal GDP and velocity in 2008.
Copyright 2011 Nelson Education Limited
28
ACTIVELEARNING1
Answers
Given: Y = 800, V is constant,
MS = $2000 and P = $5 in 2008.
Compute nominal GDP and velocity in 2008.
Nominal GDP = P x Y =
$
PxY
=
V=
$
M
=
Copyright 2011 Nelson Education Limited
29
NominalGDP,theQuantityofMoney,and
theVelocityofMoney
Copyright 2011 Nelson Education Limited
30
TheQuantityEquation
PxY
Velocity formula: V =
M
Multiply both sides of formula by M:
MxV = PxY
Called the quantity equation
Copyright 2011 Nelson Education Limited
31
TheQuantityTheoryin5Steps
Start with quantity equation: M x V = P x Y
1. V is stable.
2. So, a change in M causes nominal GDP (P x Y)
to change by the same percentage.
3. change A in M does not affect Y:
money is neutral,
Y is determined by technology & resources
4. So, P changes by same percentage as
P x Y and M.
5. Rapid money supply growth causes rapid
inflation.
Copyright 2011 Nelson Education Limited
32
ACTIVELEARNING2
Exercise
One good: Corn. The economy has enough labour,
capital, and land to produce Y = 800 bushels of corn.
V is constant. In 2008, MS = $2000, P = $5/bushel.
For 2009, the BoC increases MS by 5%, to $2100.
a. Compute the 2009 values of nominal GDP and P.
Compute the inflation rate for 2008-2009.
b. Suppose tech. progress causes Y to increase to
824 in 2009. Compute 2008-2009 inflation rate.
Copyright 2011 Nelson Education Limited
33
ACTIVELEARNING2
Answers
Given: Y = 800, V is constant,
MS = $2000 and P = $5 in 2008.
For 2009, the BoC increases MS by 5%, to $2100.
a. Compute the 2009 values of nominal GDP and P.
Compute the inflation rate for 2008-2009.
= M x V (Quantity Eqn)
Nominal GDP = P x Y
P = PxY
Y
=
=
Inflation rate = $
$
=$
=
% (___________)
34
Copyright 2011 Nelson Education Limited
ACTIVELEARNING2
Answers
Given: Y = 800, V is constant,
MS = $2000 and P = $5 in 2005.
For 2009, the BoC increases MS by 5%, to $2100.
b. Suppose tech. progress causes Y to increase 3%
in 2009, to 824. Compute 2008-2009 inflation rate.
First, use Quantity Eqn to compute P:
$
MxV
P=
=
Y
$
Inflation rate =
=$
=
%
Copyright 2011 Nelson Education Limited
35
ACTIVELEARNING2
SummaryandLessonsaboutthe
QuantityTheoryofMoney
If real GDP is constant, then
inflation rate = money growth rate.
If real GDP is growing, then
inflation rate < money growth rate.
The bottom line:
Economic growth increases # of transactions.
Some money growth is needed for these extra
transactions.
Excessive money growth causes inflation.
Copyright 2011 Nelson Education Limited
36
Hyperinflation
Hyperinflation is generally defined as inflation
exceeding 50% per month.
Recall one of the Ten Principles from Chapter 1:
Prices rise when the government
prints too much money.
Excessive growth in the money supply always
causes hyperinflation.
Copyright 2011 Nelson Education Limited
37
TheInflationTax
When tax revenue is inadequate and ability to
borrow is limited, government may print money
to pay for its spending.
Almost all hyperinflations start this way.
The revenue from printing money is the
inflation tax: printing money causes inflation,
which is like a tax on everyone who holds
money.
Copyright 2011 Nelson Education Limited
38
TheFisherEffect
Rearrange the definition of the real interest rate:
Nominal
Real
Inflation
+
=
interest rate
interest rate
rate
The real interest rate is determined by saving &
investment in the loanable funds market.
Money supply growth determines inflation rate.
So, this equation shows how the nominal interest
rate is determined.
Copyright 2011 Nelson Education Limited
39
TheFisherEffect
Nominal
Real
Inflation
+
=
interest rate
interest rate
rate
In the long run, money is neutral,
so a change in the money growth rate affects
the inflation rate but not the real interest rate.
So, the nominal interest rate adjusts one-for-one
with changes in the inflation rate.
This relationship is called the Fisher effect
after Irving Fisher, who studied it.
Copyright 2011 Nelson Education Limited
40
NominalInterest&theInflationRates
Copyright 2011 Nelson Education Limited
41
TheFisherEffect&theInflationTax
Nominal
Real
Inflation
+
=
interest rate
interest rate
rate
The inflation tax applies to peoples holdings of
money, not their holdings of wealth.
The Fisher effect: an increase in inflation
causes an equal increase in the nominal interest
rate, so the real interest rate is unchanged.
Copyright 2011 Nelson Education Limited
42
TheCostsofInflation
The inflation fallacy: most people think inflation
erodes real incomes.
But inflation is a general increase in prices
of the things people buy and the things they sell
(e.g., their labour).
In the long run, real incomes are determined by
real variables, not the inflation rate.
Copyright 2011 Nelson Education Limited
43
TheCostsofInflation
Shoeleather costs: the resources wasted when
inflation encourages people to reduce their
money holdings
Includes the time and transactions costs of more
frequent bank withdrawals
Menu costs: the costs of changing prices
Printing new menus, mailing new catalogs, etc.
Copyright 2011 Nelson Education Limited
44
TheCostsofInflation
Misallocation of resources from relative-price
variability: Firms dont all raise prices at the
same time, so relative prices can vary
which distorts the allocation of resources.
Confusion & inconvenience: Inflation changes
the yardstick we use to measure transactions.
Complicates long-range planning and the
comparison of dollar amounts over time.
Copyright 2011 Nelson Education Limited
45
TheCostsofInflation
Tax distortions:
Inflation makes nominal income grow faster than
real income.
Taxes are based on nominal income,
and some are not adjusted for inflation.
So, inflation causes people to pay more taxes
even when their real incomes dont increase.
Copyright 2011 Nelson Education Limited
46
ACTIVELEARNING3
Taxdistortions
You deposit $1000 in the bank for one year.
CASE 1: inflation = 0%, nom. interest rate = 10%
CASE 2: inflation = 10%, nom. interest rate = 20%
a. In which case does the real value of your deposit
grow the most?
Assume the tax rate is 25%.
b. In which case do you pay the most taxes?
c. Compute the after-tax nominal interest rate,
then subtract off inflation to get the
after-tax real interest rate for both cases.
Copyright 2011 Nelson Education Limited
47
ACTIVELEARNING3
Answers
Deposit = $1000.
CASE 1: inflation = 0%, nom. interest rate = 10%
CASE 2: inflation = 10%, nom. interest rate = 20%
a. In which case does the real value of your
deposit grow the most?
In both cases, the real interest rate is _____,
so the real value of the deposit grows ______
(before taxes).
Copyright 2011 Nelson Education Limited
48
ACTIVELEARNING3
Answers
Deposit = $1000. Tax rate = 25%.
CASE 1: inflation = 0%, nom. interest rate = 10%
CASE 2: inflation = 10%, nom. interest rate = 20%
b. In which case do you pay the most taxes?
CASE 1: interest income = $_____,
so you pay $___ in taxes.
CASE 2: interest income = $_____,
so you pay $___ in taxes.
Copyright 2011 Nelson Education Limited
49
ACTIVELEARNING3
Answers
Deposit = $1000. Tax rate = 25%.
CASE 1: inflation = 0%, nom. interest rate = 10%
CASE 2: inflation = 10%, nom. interest rate = 20%
c. Compute the after-tax nominal interest rate,
then subtract off inflation to get the
after-tax real interest rate for both cases.
CASE 1:
nominal =
real
CASE 2:
=
nominal =
real
=
Copyright 2011 Nelson Education Limited
50
ACTIVELEARNING3
Summaryandlessons
Deposit = $1000. Tax rate = 25%.
CASE 1: inflation = 0%, nom. interest rate = 10%
CASE 2: inflation = 10%, nom. interest rate = 20%
Inflation
Inflation
raises nominal interest rates (Fisher effect)
raises nominal interest rates (Fisher effect)
but not real interest rates
but not real interest rates
increases savers tax burdens
increases savers tax burdens
lowers the after-tax real interest rate
lowers the after-tax real interest rate
Copyright 2011 Nelson Education Limited
51
ASpecialCostofUnexpectedInflation
Arbitrary redistributions of wealth
Higher-than-expected inflation transfers
purchasing power from creditors to debtors:
Debtors get to repay their debt with dollars that
arent worth as much.
Lower-than-expected inflation transfers
purchasing power from debtors to creditors.
High inflation is more variable and less predictable
than low inflation.
So, these arbitrary redistributions are frequent
when inflation is high.
Copyright 2011 Nelson Education Limited
52
TheCostsofInflation
All these costs are quite high for economies
experiencing hyperinflation.
For economies with low inflation (< 10% per
year), these costs are probably much smaller,
though their exact size is open to debate.
Copyright 2011 Nelson Education Limited
53
CONCLUSION
This chapter explains one of the Ten Principles of
economics:
Prices rise when the government prints
too much money.
We saw that money is neutral in the long run,
affecting only nominal variables.
In later chapters, we will see that money has
important effects in the short run on real
variables like output and employment.
Copyright 2011 Nelson Education Limited
54
CHAPTERSUMMARY
To explain inflation in the long run, economists use
the quantity theory of money. According to this
theory, the price level depends on the quantity of
money, and the inflation rate depends on the money
growth rate.
The classical dichotomy is the division of variables
into real & nominal. The neutrality of money is the
idea that changes in the money supply affect nominal
variables but not real ones. Most economists believe
these ideas describe the economy in the long run.
Copyright 2011 Nelson Education Limited
55
CHAPTERSUMMARY
The inflation tax is the loss in the real value of peoples
money holdings when the government causes inflation by
printing money.
The Fisher effect is the one-for-one relation between changes
in the inflation rate and changes in the nominal interest rate.
The costs of inflation include menu costs, shoeleather costs,
confusion and inconvenience, distortions in relative prices
and the allocation of resources, tax distortions, and arbitrary
redistributions of wealth.
Copyright 2011 Nelson Education Limited
56