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Lecture 19: Inflation in the Business Cycle Model L11200 Introduction to Macroeconomics 2009/10 Reading: Barro Ch.11 16 March 2010.

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Presentation on theme: "Lecture 19: Inflation in the Business Cycle Model L11200 Introduction to Macroeconomics 2009/10 Reading: Barro Ch.11 16 March 2010."— Presentation transcript:

1 Lecture 19: Inflation in the Business Cycle Model L11200 Introduction to Macroeconomics 2009/10 Reading: Barro Ch March 2010

2 Introduction Before the Mid-Term Exam: – Considered role of money demand and supply in determining the price level – Introduced concept and measurement of inflation Today – Incorporate inflation into decisions of agents in the Equilibrium Business Cycle Model

3 Real Effects of Inflation In previous version of the model, inflation rate was zero – Does positive inflation affect choices? – Channel through which it might is effect on real interest rate Real interest rate = nominal interest rate – inflation rate

4 Bonds rate and Interest Rates Rate of return on capital / bonds – Written in real terms, so no change if inflation is positive – Households make investment decisions based on real return, so changes in inflation rate push up nominal return and leave real return unchanged

5 Money Demand Does inflation impact on money demand? – Money demand was a trade-off between cash (lower transaction costs) or assets (which earn a return) – Interest rate on assets: – Return on holding money is -π – So net of these is i : money demand still driven by nominal interest rate

6 Labour and Capital Markets So positive inflation rate has no impact of asset holding / money demand decision What about capital and labour markets? – No effect on MPK (capital demand), or κK (labour supply) as R/P unchanged – No effect on MPL (labour demand) of W/P* as wage bargained in real terms – Overall: positive inflation doesnt impact output, capital/labour mix, consumption/saving or labour supply, money demand or asset holding

7 Money Growth and Inflation Understanding Dynamics of Inflation Growth of money supply = money at time t+1 – money at time t Rate money supply growth = growth of money supply between t and t+1 / money at time t Rate of inflation= growth of money prices between t and t+1 / price level at time t

8 Money Growth and Inflation Equilibrium in the money market given by So price level determined by: Hence (for fixed L(Y,i)) money growth determines price growth Inflation rate = money growth rate

9 Money Demand and Money Growth Demand for money also changes over time Increase in output (Y) raises money demand. With constant growth is Y is (constant) rate of growth of money demand

10 Inflation Dynamics Dynamics of inflation driven by: – Money growth: constant rate μ – Money demand growth: constant rate Price level = level of money supply / level of money demand Inflation rate = rate of money supply growth – rate of money demand growth

11 Changes in Money Growth What is the impact of a change in the growth of money? – Assume Y is constant (money demand constant) – Prices growing in line with money growth – Then government undertakes one-off increase in money supply – What is the impact on prices?

12 Changes in Money Growth Prices now grow at new (higher) rate of money growth – Nominal interest rate increases in line with one- off increase in prices – Real interest rate unchanged – Higher nominal interest rate induces effect on money demand: money demand falls as households offset higher opportunity cost of holding money by reducing money holding

13 Effect on Money Demand Household offload excess money holding – Now holding too much cash relative to assets at the new nominal interest rate – (Transactions costs are unchanged) – So off-load cash onto asset purchases – Increases demand investment (bought of out current output) – Raises price level in the economy

14 Jump in Price Level So increasing money supply growth has two effects – Increases steady-state inflation rate 1:1 – Induces one-off jump in price level via impact on money demand – So prices jump (high inflation) followed by fall in inflation down to new steady-state level

15 Printing Money Q: Can governments benefit from printing money (i.e. print new money and spend it) A: Maybe, if money demand is slow to adjust – Government prints money for itself – Nominal value of new money: – Real value of new money: – Real revenue from printing money:

16 Printing Money So return to government depends on how quickly M/P responds – If households lower money demand quickly, prices rise and M/P falls equivalent to increase in supply – So real revenue from printing money = 0 – If money demand is slow to adjust, government makes real return from printing money

17 Real Money Balance Adjustment Money Printing vs Money off-loading – So government is in a race against households – Government prints cash (and begins spending) – Causes price inflation, increases nominal interest rate – Households lower money demand and real money balances – Price rise (decreasing value of printed money) – Real return to government falls

18 Hyperinflation Evidence suggests that when governments try to print money, households respond quickly – E.g. German government tried to repay war debts by printing money – Households figured this, and lowered money demand – So inflation rate exceeded money growth rate (as households offloaded excess money holding) – Government printed more and more money, but couldnt outstrip growth in inflation rate (caused by household response)

19 Summary Inflation caused by growth in money supply – Has no effect on real variables, so leaves key economic outcomes unchanged – But can distort price dynamics and be mis-used by governments – Evidence suggests cannot be used on large-scale Next time: more orthodox spending policy! – Government taxation and spending

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