Chapter 14: Inflation and Deflation
•
Inflation is measured as the percentage change in prices over a period of time, typically
one year.
•
A
hyperinflation
is inflation of more than 50 percent per
month
(or roughly 13,000
percent per year).
•
A
deflation
is a sustained period of negative inflation.
•
In the long run, inflation is determined by the growth rate of the money supply.
•
Sustained inflation means the central bank is expanding the money supply rapidly.
•
Why would a central bank would pursue an inflationary policy?
•
What level of inflation harms the economy?
•
How does deflation occur and what are its effects?
14.1 Money and Inflation in the Long Run
•
Monetary policy affects real output in the short run, but is neutral in the long run.
•
Monetary policy has its strongest effects on the inflation rate in the long run.
•
Expenditure and supply shocks cause year-to-year changes in the inflation rate.
•
Average
inflation over long periods is closely tied to the growth of the money supply.
Velocity and the Quantity Equation
-the reason why money supply affects inflation is it affects the level of spending in the economy
•
The
velocity of money
is the ratio of total spending to the money supply; it measures
how quickly money circulates through the economy:
V
= total spending/
M
•
If spending is $500 and the money supply is $100, velocity is 5 = (500/100).
•
Total spending is nominal GDP; the price level (
P
) times real output (
Y
):
•
V = PY/M
•
Velocity is how quickly money circulates, or how many times $1 is spent over a year.
•
The
quantity equation of money
is the relationship among the money supply, velocity
and nominal GDP:
•
MV = PY
Quantity equation of money: says that total spending in the economy (PY) equals the
money supply (M) times the number of times each dollar is spent (V)
Velocity and Money Demand
•
The concept of velocity is related to the concept of money demand, the amount of money.
•
In equilibrium money demand,
M
d
, and money supply,
M
, are equal, so we can rewrite the
definition of velocity as:
V = PY
/
M
d
•
The relationship says that given the level of nominal GDP, there is an inverse relationship
between money demand and velocity; increases in money demand reduce velocity.
Deriving the Inflation Rate
•
The inflation rate is the growth rate of the price level.

•
Since the quantity equation always holds, the percentage changes of each side are equal:
% change in (
MV
) = % change in (
PY
)
•
The percentage change in
MV
is equal to the percentage changes in
M
and
V
and similarly
for
PY
:
(% change in
M
) + (% change in
V
) = (% change in
P
) + (% change in
Y
)
•
The % change in
P
is the inflation rate,
π,
so
substituting and rearranging:
π =
(% change in
M
) + (% change in
V
) - (% change in
Y
)
•
Inflation is determined by the percentage changes or growth rates of the money supply,
velocity and real output:
2 growth rates that are outside the control of the central bank
–
Since money is neutral, output growth is determined only by technology and
resources.