Chapter 12: Money Growth and Inflation
By the end of this chapter, students should understand:
why inflation results from rapid growth in the money supply.
the meaning of the classical dichotomy and monetary neutrality.
why some countries print so much money that they experience hyperinflation.
how the nominal interest rate responds to the inflation rate.
the various costs that inflation imposes on society.
Word of caution: This chapter is highly theoretical.
You must understand the specialized terminology
of this chapter such as “real” variables, “nominal variables, the Classical Dichotomy and Money
are those measured in monetary units.
In other words in current dollars or market
These variables are observed.
For example, your salary is paid in current dollars and it is
When you buy soda or make a payment on your credit card balance, you are conducting these
activities in nominal terms. Other examples of nominal variables include the prices of goods, wages, the
current market value of GDP and nominal (observed, quoted) interest rate on loans.
is denoted in two ways: (1) in physical units e.g. a 2,500 sq. ft home, imports of 50,000
Honda Civics, purchase of 3 tons of tobacco; (2) in real terms using “real” or constant dollars or using
relative prices (the price of one good in terms of another).
Examples include real wages, real GDP and
the real interest rate.
What is the meaning of
Well, actually when we studied the trade model, this is what we
For example, the opportunity cost of 1 loaf of bread = 2 pounds of apples.
Suppose the price of
bread = $3.00 and the price of apples = $1.50 per pound.
Then the relative price of apples to bread = Price of apples / Price of bread = 1.50/3 = ½
For 1 pound
of apple give up ½ loaf of bread.
Similarly, the relative price of bread to apples = Price of bread/price of
apples = 3/1.50 = 2
for I loaf of bread give up 2 pounds of apples.
According to the principle of monetary neutrality, only nominal variables are affected by changes in the
quantity of money.
Think of it like so.
If the Fed doubles the money supply, does this mean the US
economy can produce twice as much goods and services?
No, the quantity of goods and services depends
on real variables such as the quantity and quality of resources, technology and institutional factors that
affect production and resource use.
So, what must happen?….Prices simply double.
This is the principle
of money neutrality.
This principle holds true in the long run but in the short run, it can affect production.
(This is studied in much greater detail in chapter 15.)
The term “Money Demand” refers to the amount of money that economic agents wish to hold at any
given price level.
Why do people want to hold money?
In this model, money’s most important function
is its function as a medium of exchange, that is, money is used to facilitate transactions. Economists