1. Money and Inflation He realised well that the abundance of money makes everything dear, but he did not analyse how that takes place. The great difficulty of this analysis consists in discovering by what path and in what proportion the increase of money raises the price of things. RICHARD CANTILLON (died 1734), Essai sur la nature du commerce en général, II, 6.

2. Money and Inflation Price = amount of money required to buy a good. Inflation rate = ΔP/P = the percentage increase in the average level of prices (e.g. π = 5 % p.a.).  Deflation = decrease in the average level of prices. (e.g. π = - 1 % p.a.)  Disinflation = decrease in the inflation rate (e.g. π 1 = 5 % → π 2 = 3 %)  Price level stability: π = 0 % p.a.

3. Price of beer in the Czech Republic

4. CPI in the Czech Republic Price level has more than doubled since 1993

7. Food and rents in the CR

8. Average inflation rate 2000 - 2013

9. U.S. inflation rate (% per year)

10. The Quantity Theory of Money How does the quantity of money affect the economy? QTM - the quantity of money in the economy is related to the number of dollars exchanged in transactions.  Suppose that the supply of money in the economy is $10. In the first half of the year, 5 bottles of beer are sold each for $2. The owners of money then buy 1 lb. of ham for $10.  The total value of transactions over the year: o $2×5 + $10×1 = $20  M = $10, so each unit of M was transacted twice/year.  $10 × 2 = $2×5 + $10×1  M × V = ∑p i q i Stock Flow Velocity of circulation

11. The Quantity Theory of Money Fisher (1911): The Purchasing Power of Money: Let us begin with the money side. If the number of dollars in a country is 5,000,000, and their velocity of circulation is twenty times per year, then the total amount of money changing hands (for goods) per year is 5,000,000 times twenty, or $100,000,000. This is the money side of the equation of exchange… 200,000,000 loaves of bread at $.10 a loaf, 10,000,000 tons of coal at 5.00 a ton, and 30,000,000 yards of cloth at 1.00 a yard. The value of these transactions is evidently $100,000,000, i.e. $20,000,000 worth of bread plus $50,000,000 worth of coal plus $30,000,000 worth of cloth. The equation of exchange therefore (remember that the money side consisted of $5,000,000 exchanged 20 times) is as follows:— $5,000,000 × 20 times a year = 200,000,000 loaves × $.10 a loaf +10,000,000 tons × 5.00 a ton +30,000,000 yards × 1.00 a yard.

12. The Quantity Theory of Money If we aggregate over the entire economy (and over all transactions), we may write: M × V T = P × T  T … the total number of transactions during some period of time  P … price of a typical transaction  PT … number of dollars exchanged in a year  M … quantity of money  V T … transactions velocity of money  The rate at which money circulates in the economy IDENTITY

13. The Quantity Theory of Money Number of transactions T is difficult to measure so it is replaced by the total output in the economy Y. Assume that Y is proportional to T: T = aY  M × V T = P × T  M × V T = P × aY  M × V T /a = P × Y  M × V Y = P × Y  V Y …Income velocity of money  Number of times a dollar bill enters someone’s income in a given period of time.

14. The Quantity Theory of Money V can be viewed as a ratio of nominal GDP (PY), to the quantity of money (M): V = PY/M Assume that V is constant and exogenous M × V = P × Y If V is constant, a change in the quantity of money (M) must cause a proportionate change in nominal GDP (PY).

15. U.S. Nominal GDP, M2, and Velocity 1960–2011 Nominal GDP M2 Velocity Velocity is fairly stable over the long run. 1960=100

16. The Quantity Theory of Money Recall that in the classical model: Y*=F(K fixed,L fixed ) M × V = P × Y Fixed The quantity theory implies that the price level is proportional to the money supply. MONEY IS NEUTRAL -Does not affect Y -Does not affect relative prices Classical Dichotomy

17. ACTIVE LEARNING Exercise ACTIVE LEARNING 1 Exercise One good: corn. The economy has enough labor, 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. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

18. ACTIVE LEARNING Answers ACTIVE LEARNING 1 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Given: Y = 800, V is constant, MS = $2000 and P = $5 in 2005. Compute nominal GDP and velocity in 2008. Nominal GDP = P x Y = $5 x 800 = $4000 V = P x Y M = $4000 $2000 = 2

19. The Quantity Theory of Money M × V = P × Y See the BB: %ΔM + %ΔV = %ΔP + %ΔY %ΔV = 0 by assumption %ΔY depends on the growth of K,L and A. All constant by assumption => %ΔY = 0 Hence, the growth in the money supply (%ΔM) determines the rate of inflation (%ΔP = π).

20. ACTIVE LEARNING Exercise ACTIVE LEARNING 2 Exercise © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. One good: corn. The economy has enough labor, capital, and land to produce Y = 800 bushels of corn. V is constant. In 2008, MS = $2000, P = $5/bushel. For 2009, the Fed 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.

21. ACTIVE LEARNING Answers ACTIVE LEARNING 2 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Given: Y = 800, V is constant, MS = $2000 and P = $5 in 2008. For 2009, the Fed increases MS by 5%, to $2100. a.Compute the 2009 values of nominal GDP and P. Compute the inflation rate for 2008–2009. Nominal GDP = P x Y = M x V (Quantity Eq’n) P = P x Y Y = $4200 800 = $5.25 = $2100 x 2 = $4200 Inflation rate = $5.25 – 5.00 5.00 = 5% (same as MS!)

22. ACTIVE LEARNING Answers ACTIVE LEARNING 2 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Given: Y = 800, V is constant, MS = $2000 and P = $5 in 2005. For 2009, the Fed 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 Eq’n to compute P in 2009: P = M x V Y = $4200 824 = $5.10 Inflation rate = $5.10 – 5.00 5.00 = 2%

23. U.S. inflation and money growth, 1960-2006 slide 23 0% 3% 6% 9% 12% 15% 1960196519701975198019851990199520002005 M2 growth rate inflation rate Over the long run, the inflation and money growth rates move together, as the quantity theory predicts.

24. Money and prices in the CR

26. Money and prices (MA-12) Money growthInflation

27. International data on inflation and money growth Singapore U.S. Switzerland Argentina Indonesia Turkey Belarus Ecuador Milton Friedman: “Inflation is always and everywhere a monetary phenomenon.’’ HW (p.88) Seigniorage: The Revenue From Printing Money

28. The Consumer Price Index (CPI) measures the typical consumer’s cost of living the basis of cost of living adjustments (COLAs) in many contracts

29. How the CPI Is Calculated 1. Fix the “basket.” The Bureau of Labor Statistics (BLS) surveys consumers to determine what’s in the typical consumer’s “shopping basket.” 2. Find the prices. The BLS collects data on the prices of all the goods in the basket. 3. Compute the basket’s cost. Use the prices to compute the total cost of the basket.

30. How the CPI Is Calculated 4. Choose a base year and compute the index. The CPI in any year equals 5.Compute the inflation rate. The percentage change in the CPI from the preceding period. 100 x cost of basket in current year cost of basket in base year CPI this year – CPI last year CPI last year Inflation rate x 100% =

31.  2010 Price of Apples = $0.50  2010 Quantity of Apples = 4  2010 Price of Oranges = $1.00  2010 Quantity of Oranges = 3  2015 Price of Apples = $1.00 ( i.e. increase by 100% )  2015 Price of Oranges = $3.00 ( i.e. increase by 200% ) As if quantity (basket) was fixed

32.  2010 Price of Apples = $0.50  2010 Quantity of Apples = 4  2010 Price of Oranges = $1.00  2010 Quantity of Oranges = 3  … weight_apples in the base year = 2/6 = 40%  … weight_oranges in the base year = 3/6 = 60%

33. EXAMPLE basket: {4 pizzas, 10 lattes} $12 x 4 + $3 x 10 = $78 $11 x 4 + $2.5 x 10 = $69 $10 x 4 + $2 x 10 = $60 cost of basket $3.00 $2.50 $2.00 price of latte $122015 $112014 $102013 price of pizza year Compute CPI in each year 2013: 100 x ($60/$60) = 100 2014: 100 x ($69/$60) = 115 2015: 100 x ($78/$60) = 130 Inflation rate: 15% 115 – 100 100 x 100% = 13% 130 – 115 115 x 100% =

34. What’s in the CPI’s Basket in the U.S.?

36. CPI

37. Problems with the CPI: Substitution Bias Over time, some prices rise faster than others. Consumers substitute toward goods that become relatively cheaper, mitigating the effects of price increases. The CPI misses this substitution because it uses a fixed basket of goods. Thus, the CPI overstates increases in the cost of living.

38. Prices of food and rents in the CR

39. Problems with the CPI: Introduction of New Goods The introduction of new goods increases variety, allows consumers to find products that more closely meet their needs. In effect, dollars become more valuable. The CPI misses this effect because it uses a fixed basket of goods. Thus, the CPI overstates increases in the cost of living.

40. Problems with the CPI: Unmeasured Quality Change Improvements in the quality of goods in the basket increase the value of each dollar. The BLS tries to account for quality changes but probably misses some, as quality is hard to measure. Thus, the CPI overstates increases in the cost of living.

41. Problems with the CPI Each of these problems causes the CPI to overstate cost of living increases. The BLS has made technical adjustments, but the CPI probably still overstates inflation by about 0.5 percent per year. This is important because Social Security payments and many contracts have COLAs tied to the CPI.

42. The GDP Deflator The GDP deflator is a measure of the overall level of prices. Definition:  One way to measure the economy’s inflation rate is to compute the percentage increase in the GDP deflator from one year to the next. GDP deflator = 100 x nominal GDP real GDP

43. EXAMPLE: Compute nominal GDP in each year: 2013:$10 x 400 + $2 x 1000 = $6,000 2014:$11 x 500 + $2.50 x 1100 = $8,250 2015:$12 x 600 + $3 x 1200 = $10,800 PizzaLatte yearPQPQ 2013$10400$2.001000 2014$11500$2.501100 2015$12600$3.001200 37.5% Increase: 30.9%

44. EXAMPLE: Compute real GDP in each year, using 2013 as the base year: PizzaLatte yearPQPQ 2013$10400$2.001000 2014$11500$2.501100 2015$12600$3.001200 20.0% Increase: 16.7% $10 $2.00 2013:$10 x 400 + $2 x 1000 = $6,000 2014:$10 x 500 + $2 x 1100 = $7,200 2015:$10 x 600 + $2 x 1200 = $8,400

45. EXAMPLE: In each year, nominal GDP is measured using the (then) current prices. real GDP is measured using constant prices from the base year (2013 in this example). year Nominal GDP Real GDP 2013$6000 2014$8250$7200 2015$10,800$8400

46. EXAMPLE: The change in nominal GDP reflects both prices and quantities. year Nominal GDP Real GDP 2013$6000 2014$8250$7200 2015$10,800$8400 20.0% 16.7% 37.5% 30.9%  The change in real GDP is the amount that GDP would change if prices were constant (i.e., if zero inflation). Hence, real GDP is corrected for inflation.

47. EXAMPLE: Compute the GDP deflator in each year: year Nominal GDP Real GDP GDP Deflator 2013$6000 2014$8250$7200 2015$10,800$8400 2013:100 x (6000/6000) = 100.0 100.0 2014:100 x (8250/7200) = 114.6 114.6 2015:100 x (10,800/8400) = 128.6 128.6 14.6% 12.2%

48. Two Measures of Inflation, 1950–2010 Percent per year

49. Imported consumer goods:  included in CPI  excluded from GDP deflator Imported consumer goods:  included in CPI  excluded from GDP deflator The basket:  CPI uses fixed basket  GDP deflator uses basket of currently produced goods & services This matters if different prices are changing by different amounts. The basket:  CPI uses fixed basket  GDP deflator uses basket of currently produced goods & services This matters if different prices are changing by different amounts. Capital goods:  excluded from CPI  included in GDP deflator (if produced domestically) Capital goods:  excluded from CPI  included in GDP deflator (if produced domestically) Contrasting the CPI and GDP Deflator

50. Laspeyres index Paasche index In textbook: Index … × 100

51. Contrasting the CPI and GDP Deflator Weights in the current year may not be known (every month).

52. ACTIVE LEARNING CPI vs. GDP deflator ACTIVE LEARNING 3 CPI vs. GDP deflator In each scenario, determine the effects on the CPI and the GDP deflator. A. Starbucks raises the price of Frappuccinos. B. Caterpillar raises the price of the industrial tractors it manufactures at its Illinois factory. C. Armani raises the price of the Italian jeans it sells in the U.S. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

53. ACTIVE LEARNING Answers ACTIVE LEARNING 3 Answers A. Starbucks raises the price of Frappuccinos. The CPI and GDP deflator both rise. B.Caterpillar raises the price of the industrial tractors it manufactures at its Illinois factory. The GDP deflator rises, the CPI does not. C.Armani raises the price of the Italian jeans it sells in the U.S. The CPI rises, the GDP deflator does not. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

54. Correcting Variables for Inflation W nom 2000 = 13,219 CZK W nom 2013 = 25,078 CZK CPI 2000 = 100 (e.g. price of beer = 9 CZK) CPI 2013 = 137 (e.g. price of beer = 12 CZK) In 2000, one can buy 13,219 / 9 = 1,497 bottles In 2013, one can buy 25,078 / 12 = 2,090 bottles 2,090 / 1,497 = 1.4 One can buy 40% more bottles

55. Real wage in theory W real = W nominal / P P … price level measured by e.g. CPI

57. Correcting Variables for Inflation: Very important! Real vs. Nominal Interest Rates The nominal interest rate:  the interest rate not corrected for inflation The real interest rate:  corrected for inflation Real interest rate = (nominal interest rate) – (inflation rate)

58. Inflation and interest rates Suppose you deposit $100 in a bank account that pays i=8 % interest annually. Assume that the price of beer this year is P 1 =$2. Next year, you withdraw your savings and the accumulated interest: $100×(1+i)= $108  Assume that the price of beer next year is P 2 =$2.04 Are you 8 percent richer than you were when you made the deposit a year earlier?  In the first year, you could buy: $100/$2 = 50 bottles  In the second year, you can buy: $108/$2.04 = 53 bottles. o => You can buy 53/50-1 = 0.06 = 6% more What is the inflation rate in this economy?

59. Inflation and interest rates r … real interest rate

60. Inflation and interest rates Nominal interest rate, i … the interest rate that the bank pays:  is not adjusted for inflation Real interest rate, r … the interest rate that reflects the true increase in the purchasing power (6% in our example) :  is adjusted for inflation.

61. Inflation and interest rates If we neglect π ×r = 0.02 × 0.06 = 0.0012 Fisher equation

62. Correcting Variables for Inflation: Real vs. Nominal Interest Rates Example 1:  Deposit $1,000 for one year in 2015.  Nominal interest rate is 20%.  P 2015 = 2; P 2016 = 2.1  What is the real interest rate?

63. Correcting Variables for Inflation: Real vs. Nominal Interest Rates  Can the real interest rate be zero or even negative?  Can the nominal interest rate be zero or even negative?  Can the real interest rate exceed the nominal interest rate?

64. Real and Nominal Interest Rates in the U.S., 1950–2010

65. Fisher equation and the Fisher effect i = r+π  r is determined by S = I (Classical model)  π is determined by the money growth (QTM) The one-for-one relation between the inflation rate and the nominal interest rate is called the Fisher effect.

66. Inflation and nominal interest rates in the U.S., 1955-2006 percent per year -5 0 5 10 15 19551960196519701975198019851990199520002005 inflation rate nominal interest rate

67. Inflation and nominal interest rates across countries Switzerland Germany Brazil Romania Zimbabwe Bulgaria U.S. Israel

68. Two Real Interest Rates: Ex Ante and Ex Post When a borrower and lender agree on a nominal interest rate, they do not know what the inflation rate over the term of the loan will be. Suppose that they expect π e = 3 %. If the agreed r is 4 %, then: i = r + π e = 7 %  If the realised inflation differs, e.g. π = 5 %, t hen the ex post real interest rate will be: o r ex post = 7 % - 5 % = 2 % Hence, we must distinguish between two concepts of the real interest rate:  The real interest rate the borrower and lender expect when the loan is made: o … ex ante real interest rate = i – π e = 4 %  and the real interest rate actually realized: o … ex post real interest rate = i – π = 2 % Who lost and who gained when π > π e ?

69. Two Real Interest Rates: Ex Ante and Ex Post Because the nominal interest rate agreed by lender and borrower can adjust only to expected inflation (not to the realized inflation), the Fisher effect is more precisely written as: i = r + π e The ex ante real interest rate r is determined by equilibrium in the market for goods and services (or I=S). The nominal interest rate i moves one-for-one with changes in expected inflation π e.

70. The Costs of Inflation 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.

71. The Costs of Inflation Misallocation of resources from relative- price variability: Firms don’t 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.

72. The Costs of Inflation 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 don’t increase.

73. ACTIVE LEARNING Tax distortions ACTIVE LEARNING 3 Tax distortions © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 inflation to get the after-tax real interest rate for both cases.

74. ACTIVE LEARNING Answers ACTIVE LEARNING 3 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. a.In which case does the real value of your deposit grow the most? In both cases, the real interest rate is 10%, so the real value of the deposit grows 10% (before taxes). Deposit = $1000. CASE 1: inflation = 0%, nom. interest rate = 10% CASE 2: inflation = 10%, nom. interest rate = 20%

75. ACTIVE LEARNING Answers ACTIVE LEARNING 3 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. b.In which case do you pay the most taxes? CASE 1: interest income = $100, so you pay $25 in taxes. CASE 2: interest income = $200, so you pay $50 in taxes. Deposit = $1000. Tax rate = 25%. CASE 1: inflation = 0%, nom. interest rate = 10% CASE 2: inflation = 10%, nom. interest rate = 20%

76. ACTIVE LEARNING Answers ACTIVE LEARNING 3 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. c.Compute the after-tax nominal interest rate, then subtract inflation to get the after-tax real interest rate for both cases. CASE 1:nominal = 0.75 x 10% = 7.5% real = 7.5% – 0% = 7.5% CASE 2:nominal = 0.75 x 20% = 15% real = 15% – 10% = 5% Deposit = $1000. Tax rate = 25%. CASE 1: inflation = 0%, nom. interest rate = 10% CASE 2: inflation = 10%, nom. interest rate = 20%

77. ACTIVE LEARNING Summary and lessons ACTIVE LEARNING 3 Summary and lessons © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Inflation…  raises nominal interest rates (Fisher effect) but not real interest rates  increases savers’ tax burdens  lowers the after-tax real interest rate Inflation…  raises nominal interest rates (Fisher effect) but not real interest rates  increases savers’ tax burdens  lowers the after-tax real interest rate Deposit = $1000. Tax rate = 25%. CASE 1: inflation = 0%, nom. interest rate = 10% CASE 2: inflation = 10%, nom. interest rate = 20%

78. A Special Cost of Unexpected Inflation Arbitrary redistributions of wealth Higher-than-expected inflation transfers purchasing power from creditors to debtors: Debtors get to repay their debt with dollars that aren’t 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.

79. The Costs of Inflation 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.

80. Exercise: Suppose V is constant, M is growing 5% per year, Y is growing 2% per year, and r = 4. a.Solve for i. b.If the central bank increases the money growth rate by 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 central bank do if it wishes to keep  constant?