This preview shows page 1. Sign up to view the full content.
Unformatted text preview: Macroeconomic II 4
Money and Inflation In this chapter, you will learn… The classical theory of inflation Its causes Its effects Its macroeconomic costs It applies in the long run CHAPTER 4 Money and Inflation slide 1 The connection between
money and prices Inflation rate = the percentage increase
in the average level of prices. Price = amount of money required to
buy a good
good. Because prices are measured in units of money,
we need to consider the nature of money,
the supply of money, and how it is controlled. CHAPTER 4 Money and Inflation slide 3 1 Macroeconomic II The money supply and
monetary policy definitions The money supply is the quantity of money
available in the economy. Monetary policy is the control over the money
supply CHAPTER 4 Money and Inflation slide 8 Money supply measures, April 2006
symbol assets included amount
($ billions) Currency $739 M1 C + demand deposits,
other checkable deposits $1391 M2 M1 + small time deposits,
money market mutual funds,
money market deposit accounts $6799 C CHAPTER 4 Money and Inflation slide 10 The Quantity Theory of Money Its a simple theory linking the inflation rate to the
growth rate of the money supply. It begins with the concept of velocity… CHAPTER 4 Money and Inflation slide 11 2 Macroeconomic II Velocity basic concept: the rate at which money circulates definition: the number of times the average dollar
bill changes hands in a given time period example: In 2007, $500 billion in transactions money supply = $100 billion The average dollar is used in five transactions
in 2007 So, velocity = 5
CHAPTER 4 Money and Inflation slide 12 The quantity equation The quantity equation
M V = P Y
follows from the preceding definition of velocity. It is an identity:
it holds by definition of the variables. CHAPTER 4 Money and Inflation slide 15 Money demand and the quantity
equation M/P = real money balances, the purchasing
power of the money supply. A simple money demand function:
(M/P)d = kY
k = how much money people wish to hold for
each dollar of income.
(k is exogenous) CHAPTER 4 Money and Inflation slide 16 3 Macroeconomic II Money demand and the quantity
equation money demand: (M/P)d = kY quantity equation: M V = P Y The connection between them: k = 1/V When people hold lots of money relative
to their incomes (k is high),
money changes hands infrequently (V is low). CHAPTER 4 Money and Inflation slide 17 Back to the quantity theory of
money starts with quantity equation assumes V is constant & exogenous: V V With this assumption, the q
quantity equation can
be written as M V P Y CHAPTER 4 Money and Inflation slide 18 The quantity theory of money,
cont. M V P Y
How the price level is determined: With V constant, the money supply determines
nominal GDP (P Y ).
) Real GDP is determined by the economy’s
supplies of K and L and the production
function (Chap 3). The price level is
P = (nominal GDP)/(real GDP).
CHAPTER 4 Money and Inflation slide 19 4 Macroeconomic II The quantity theory of money,
cont. Recall from Chapter 2:
The growth rate of a product equals
the sum of the growth rates. The quantity equation in growth rates:
M M V V P P Y Y The quantity theory of money assumes
V V is constant, so
CHAPTER 4 = 0. V Money and Inflation slide 20 The quantity theory of money,
cont. (Greek letter “pi”)
denotes the inflation rate:
The result from the
preceding slide was: M M Solve this result
for to get CHAPTER 4 P P
P P M M Y Y Y Y Money and Inflation slide 21 The quantity theory of money,
cont. M M Y Y Normal economic growth requires a certain
amount of money supply growth to facilitate the
growth in transactions. Money growth in excess of this amount leads
to inflation. CHAPTER 4 Money and Inflation slide 22 5 Macroeconomic II The quantity theory of money,
cont. M M Y Y Y/Y depends on growth in the factors of
production and on technological progress
(all of which we take as given, for now).
Hence, the Quantity Theory predicts
a one-for-one relation between
changes in the money growth rate and
changes in the inflation rate.
CHAPTER 4 Money and Inflation slide 23 Confronting the quantity theory
The quantity theory of money implies
1. countries with higher money growth rates
should have higher inflation rates.
2 the long-run trend behavior of a country’s
inflation should be similar to the long-run trend
in the country’s money growth rate. Are the data consistent with these implications? CHAPTER 4 Money and Inflation slide 24 International data on inflation and
Ecuador Inflation rate Indonesia (percent,
logarithmic scale) Belarus 10 Argentina U.S. 1 Singapore Switzerland 0.1
1 10 100
Money Supply Growth
(percent, logarithmic scale) CHAPTER 4 Money and Inflation slide 25 6 Macroeconomic II U.S. inflation and money growth,
15% Over the long run, the inflation and
money growth rates move together,
M2 theory predicts.
as the quantitygrowth rate 12%
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
slide 26 Inflation and interest rates Nominal interest rate, i
not adjusted for inflation Real interest rate, r
adjusted f i fl ti
dj t d for inflation:
r = i CHAPTER 4 Money and Inflation slide 28 The Fisher effect The Fisher equation: i = r + Chap 3: S = I determines r. Hence, an increase in causes an equal increase in i. This one-for-one relationship
is called the Fisher effect. CHAPTER 4 Money and Inflation slide 29 7 Macroeconomic II Inflation and nominal interest rates
in the U.S., 1955-2006
interest rate 10 5 0 inflation rate -5
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
CHAPTER 4 Money and Inflation slide 30 Inflation and nominal interest rates
Interest Rate Romania (percent,
logarithmic scale) Zimbabwe
10 Bulgaria Israel
0.1 1 10 100 1000 Inflation Rate
(percent, logarithmic scale) CHAPTER 4 Money and Inflation slide 31 Exercise:
Suppose V is constant, M is growing 5% per year,
Y is growing 2% per year, and r = 4.
a. Solve for i.
y growth rate by
b. If the Fed increases the money g
2 percentage points per year, find i.
c. Suppose the growth rate of Y falls to 1% per year. What will happen to ? What must the Fed do if it wishes to keep constant? CHAPTER 4 Money and Inflation slide 32 8 Macroeconomic II Two real interest rates = actual inflation rate
(not known until after it has occurred) e = expected inflation rate i – e = ex ante real interest rate:
the real interest rate people expect
at the time they buy a bond or take out a loan i – = ex post real interest rate:
the real interest rate actually realized
CHAPTER 4 Money and Inflation slide 34 Money demand and
the nominal interest rate In the quantity theory of money,
the demand for real money balances
depends only on real income Y. Another determinant of money demand:
the nominal interest rate, i. the opportunity cost of holding money (instead
of bonds or other interest-earning assets). Hence, i in money demand.
CHAPTER 4 Money and Inflation slide 35 Money Demand Md L(i ) Y
P (M/P)d = real money demand, depends negatively on i. (Because i is the opportunity cost of
holding money) positively on Y
higher Y more spending so, need more money
CHAPTER 4 Money and Inflation slide 36 9 Macroeconomic II Money Equilibrium Money Demand (Md) = Money Supply (M) in
equilibrium. Therefore, M L(i ) Y
P CHAPTER 4 Money and Inflation slide 37 Money Equilibrium Recall that i = r + πe. In the long run, expectations are fulfilled on average:
πe = π. Therefore i = r + π
π. M L(i ) Y
CHAPTER 4 M L( r ) Y
P Money and Inflation slide 38 Money Equilibrium M L(r ) Y
P From page 25 of the textbook … Gro th rate of M – Gro th rate of P = Gro th rate of L
+ Growth rate of Y. Recall that r was determined in Ch. 3. Also, assume
that inflation, π, is constant in the long run. Then i = r +
π is constant. Therefore, L is constant. Therefore, π = Growth rate of M – Growth rate of Y, a constant.
CHAPTER 4 Money and Inflation slide 39 10 Macroeconomic II Price Level Therefore, the long run price level (P) is: P M
L( r Growth rate of M Growth rate of Y ) Y Note that if M increases—without any change in the
growth rate of M—then P increases by the same
proportion. Keep in mind that Y and its growth rate are determined by
non-monetary factors discussed in chapter 3.
CHAPTER 4 Money and Inflation slide 40 Price Level
L( r Growth rate of M Growth rate of Y ) Y If the growth rate of M increases, then so does P. If either Y or its growth rate increases, then P decreases
decreases. If the real interest rate, r, increases, then so does P. CHAPTER 4 Money and Inflation slide 41 Inflation Recall that
π = Growth rate of M – Growth rate of Y
in the long run. Therefore if either the growth rate of the money
supply (M) increases by, say, 2 percentage
points, or if the growth rate of total output (Y)
decreases by the same amount, then the rate of
inflation (π) will increase by the same 2
CHAPTER 4 Money and Inflation slide 42 11 Macroeconomic II Monetary Neutrality Note that unless there is a change in the real
parameters of chapter 3, the real endogenous
variables of that chapter will not change. In particular, changes in M or the growth rate of
M cannot affect the real variables that were
determined in chapter 3, for obvious reasons. CHAPTER 4 Money and Inflation slide 43 Monetary Neutrality However, although M/P is a real variable, it is
affected by changes in the growth rate of M. Also, changes in real variables such as Y and
the growth rate of Y do have an effect on P
although it is a nominal variable. CHAPTER 4 Money and Inflation slide 44 The money demand function (M P )d L (i , Y )
(M/P)d = real money demand, depends negatively on i
i is the opp. cost of holding money positively on Y
higher Y more spending so, need more money
(“L” is used for the money demand function
because money is the most liquid asset.)
CHAPTER 4 Money and Inflation slide 45 12 Macroeconomic II The money demand function (M P )d L (i , Y ) L (r e , Y )
When people are deciding whether to hold
money or bonds, they don’t know what inflation
will turn out to be.
Hence, the nominal interest rate relevant for
money demand is r + e. CHAPTER 4 Money and Inflation slide 46 Equilibrium
M L (r e , Y )
The supply of real
money balances CHAPTER 4 Real money
d Money and Inflation slide 47 What determines what
M L (r e , Y )
variable how determined (in the long run) M exogenous (the Fed) r adjusts to make S = I Y Y F (K , L ) P adjusts to make CHAPTER 4 Money and Inflation M L (i , Y )
slide 48 13 Macroeconomic II How P responds to M
M L (r e , Y )
P For given values of r, Y, and e,
a change in M causes P to change by the
same percentage – just like in the quantity
theory of money. CHAPTER 4 Money and Inflation slide 49 What about expected inflation? Over the long run, people don’t consistently
over- or under-forecast inflation,
so e = on average. In the short run, e may change when people
get new information. EX: Fed announces it will increase M next year.
People will expect next year’s P to be higher,
so e rises. This affects P now, even though M hasn’t
CHAPTER 4 Money and Inflation slide 50 How P responds to e
M L (r e , Y )
P For given values of r, Y, and M , e i (the Fisher effect) M P d P to make M P fall
to re-establish eq'm CHAPTER 4 Money and Inflation slide 51 14 Macroeconomic II Discussion question
Why is inflation bad? What costs does inflation impose on society?
List all the ones you can think of. F
Focus on the long run.
th l Think like an economist. CHAPTER 4 Money and Inflation slide 52 A common misperception Common misperception:
inflation reduces real wages This is true only in the short run, when nominal
wages are fixed by contracts.
y (Chap. 3) In the long run,
the real wage is determined by
labor supply and the marginal product of labor,
not the price level or inflation rate. Consider the data…
CHAPTER 4 Money and Inflation slide 53 Average hourly earnings and the CPI,
$18 200 hourly wa
$12 150 $10
$8 100 $6
CPI (right scale)
wage in current dollars
wage in 2006 dollars $4
CHAPTER 4 1970
Money and Inflation 1988 1994 2000 CPI (1982-84 = 100) $16 50 0
2006 slide 54 15 Macroeconomic II The classical view of inflation The classical view:
A change in the price level is merely a change
in the units of measurement. So why, then, is inflation a
social problem? CHAPTER 4 Money and Inflation slide 55 The social costs of inflation
…fall into two categories:
1. costs when inflation is expected
2. costs when inflation is different than people h d expected
t d CHAPTER 4 Money and Inflation slide 56 The costs of expected inflation:
1. Shoeleather cost def: the costs and inconveniences of reducing
money balances to avoid the inflation tax. i real money ba a ces
ea o ey balances Remember: In long run, inflation does not
affect real income or real spending. So, same monthly spending but lower average
money holdings means more frequent trips to
the bank to withdraw smaller amounts of cash.
CHAPTER 4 Money and Inflation slide 57 16 Macroeconomic II The costs of expected inflation:
2. Menu costs def: The costs of changing prices. Examples: cost of printing new menus cost of printing & mailing new catalogs The higher is inflation, the more frequently
firms must change their prices and incur
these costs. CHAPTER 4 Money and Inflation slide 58 The costs of expected inflation:
3. Relative price distortions Firms facing menu costs change prices infrequently. Example:
A firm issues new catalog each January.
As the general price level rises throughout the year,
the firm’s l ti
th fi ’ relative price will f ll
ill fall. Different firms change their prices at different times,
leading to relative price distortions…
…causing microeconomic inefficiencies
in the allocation of resources.
CHAPTER 4 Money and Inflation slide 59 The costs of expected inflation:
4. Unfair tax treatment
Some taxes are not adjusted to account for
inflation, such as the capital gains tax.
Example: Jan 1: you buy $10,000 worth of IBM stock Dec 31: you sell the stock for $11,000,
so your nominal capital gain is $1000 (10%). Suppose = 10% during the year.
Your real capital gain is $0. But the govt requires you to pay taxes on your
$1000 nominal gain!!
CHAPTER 4 Money and Inflation slide 60 17 Macroeconomic II The costs of expected inflation:
5. General inconvenience Inflation makes it harder to compare nominal
values from different time periods. This complicates long-range financial
planning. CHAPTER 4 Money and Inflation slide 61 Additional cost of unexpected inflation:
Arbitrary redistribution of purchasing power Many long-term contracts not indexed,
but based on e. If turns out different from e,
then some gain at others’ expense.
Example: borrowers & lenders If > e, then (i ) < (i e)
and purchasing power is transferred from
lenders to borrowers. If < e, then purchasing power is transferred
from borrowers to lenders.
CHAPTER 4 Money and Inflation slide 62 Additional cost of high inflation:
Increased uncertainty When inflation is high, it’s more variable and
unpredictable: turns out different from e more often,
and the differences tend to be larger
(though not systematically positive or negative) Arbitrary redistributions of wealth
become more likely. This creates higher uncertainty,
making risk averse people worse off.
CHAPTER 4 Money and Inflation slide 63 18 Macroeconomic II One benefit of inflation Nominal wages are rarely reduced, even when
the equilibrium real wage falls.
This hinders labor market clearing. Inflation allows the real wages to reach
equilibrium levels without nominal wage cuts. Therefore, moderate inflation improves the
functioning of labor markets. CHAPTER 4 Money and Inflation slide 64 Hyperinflation def: 50% per month All the costs of moderate inflation described above become HUGE under hyperinflation. Money ceases to function as a store of value,
and may not serve its other functions (unit of
account, medium of exchange). People may conduct transactions with barter
or a stable foreign currency.
CHAPTER 4 Money and Inflation slide 65 What causes hyperinflation? Hyperinflation is caused by excessive money
supply growth: When the central bank prints money, the price
rises. If it prints money rapidly enough, the result is
hyperinflation. CHAPTER 4 Money and Inflation slide 66 19 Macroeconomic II A few examples of hyperinflation
growth (%) Israel, 1983-85
Poland, 1989-90 inflation
(%) 295 275 344 400 Brazil, 1987-94 1350 1323 Argentina, 1988-90 1264 1912 Peru, 1988-90 2974 3849 Nicaragua, 1987-91 4991 5261 Bolivia, 1984-85 4208 6515 CHAPTER 4 Money and Inflation slide 67 Why governments create
hyperinflation When a government cannot raise taxes or sell
bonds, it must finance spending increases by printing
money In theory, the solution to hyperinflation is simple:
stop printing money. In the real world, this requires drastic and painful
CHAPTER 4 Money and Inflation slide 68 The Classical Dichotomy
Real variables: Measured in physical units –
quantities and relative prices, for example: quantity of output produced real wage: output earned per hour of work real i t
l interest rate: output earned in the future
d i th f t Nominal variables: Measured in money units, e.g.,
by lending one unit of output today nominal wage: Dollars per hour of work. nominal interest rate: Dollars earned in future
by lending one dollar today. the price level: The amount of dollars needed
to buy a representative basket of goods.
CHAPTER 4 Money and Inflation slide 69 20 Macroeconomic II The Classical Dichotomy Note: Real variables were explained in Chap 3,
nominal ones in Chapter 4. Classical dichotomy:
the theoretical separation of real and nominal
variables in the classical model, which implies
nominal variables do not affect real variables. Neutrality of money: Changes in the money
supply do not affect real variables.
In the real world, money is approximately neutral
in the long run.
CHAPTER 4 Money and Inflation slide 70 Chapter Summary
Money the stock of assets used for transactions serves as a medium of exchange, store of value, and
unit of account. Commodity money has intrinsic value fiat money
does not. Central bank controls the money supply.
Quantity theory of money assumes velocity is stable,
concludes that the money growth rate determines the
CHAPTER 4 Money and Inflation slide 71 Chapter Summary
Nominal interest rate equals real interest rate + inflation rate the opp. cost of holding money Fisher effect: Nominal interest rate moves
one-for-one w/ expected inflation.
t d i fl ti
Money demand depends only on income in the Quantity Theory also depends on the nominal interest rate if so, then changes in expected inflation affect the
current price level.
CHAPTER 4 Money and Inflation slide 72 21 Macroeconomic II Chapter Summary
Costs of inflation Expected inflation shoeleather costs, menu costs,
tax & relative price distortions,
inconvenience of correcting figures for inflation Unexpected inflation all of the above plus arbitrary redistributions of
wealth between debtors and creditors CHAPTER 4 Money and Inflation slide 73 Chapter Summary
Hyperinflation caused by rapid money supply growth when money printed to finance govt budget deficits stopping it requires fiscal reforms to eliminate govt’s need for printing money CHAPTER 4 Money and Inflation slide 74 Chapter Summary
Classical dichotomy In classical theory, money is neutral--does not affect
real variables. So, we can study how real variables are determined
w/o reference to nominal ones. Then, money market eq’m determines price level and all nominal variables. Most economists believe the economy works this way in the long run. CHAPTER 4 Money and Inflation slide 75 22 ...
View Full Document
This note was uploaded on 10/30/2010 for the course INTERNATIO 8989989 taught by Professor 90 during the Spring '10 term at Mt. Vernon Nazarene.
- Spring '10