In this chapter, we learn: what inflation is, and how costly it can be.  Freshwater bias: didn’t bewail cost of unemployment--ch7 how the quantity theory of money and the classical dichotomy allow us to understand source of inflation –Nominal variables, e.g., money, have only nominal effects, e.g., on prices and nominal interest rates, no real effects. –Money cannot call forth goods. David Ricardo, Works, volume III.  Freshwater bias: classical dichotomy holds in long-run how the nominal interest rate, the real interest rate, and inflation are related through the Fisher equation.  Irving Fisher: Chained price indexes, Fisher equation … and debt deflation  debt burden  vicious circle the important link between fiscal policy and high inflation.  Freshwater bias: blame government

Inflation is the percentage change in an economy’s overall price level: π t = P t /P t-1 – 1 = (P t - P t-1 )/ P t-1 Hyperinflation is an episode of extremely high inflation, usually greater than 500 percent per year…a 6-fold increase From 1919 to 1923, prices in Germany rose by over a factor of a trillion and were rising 300-fold each month toward the end of Excess of claims on reduced German output capacity  Reparations claims  Labor claims…the 8-hour day  Bondholder claims  Passive resistance claims Printing money to meet claims  Money to meet bloated government payrolls –Assassination of minister who tried to raise taxes –Declining real value of tax collections  Money for the Reichbank’s friends

~1.4% The Consumer Price Index (CPI) is a price index for a bundle of consumer goods. Conceptually, the “market basket” is held constant In practice, the market basket is adjusted as consumption patterns change. Core CPI: exclude food and energy prices, which are volatile

Measures of the Money Supply Think of Money as Currency in your wallet and Deposits in your checking account  The balance on your RebelCard should also be thought of as “money,” but it’s not yet counted The monetary base (MB) includes currency (C) and reserves (R) held by private banks Banks a hold a fraction of the deposits (D) they owe you as reserves R = fD Reserves include Vault Cash and deposits banks themselves hold at their Central Banks  Our Central Bank is the Federal Reserve Bank

CHAPTER 8 Inflation

The Federal Reserve’s Balance Sheet Owns (Assets) Owes (Liabilities) Federal Reserve Notes Currency in circulation = C Vault cash Bank deposits at Fed = R Bank A fed Bank B fed Bank C fed Government Fed Gold Foreign Exchange Bank IOUs on Discount Loans Government Bonds Mortgage Backed Securities Fixed Assets Total Assets = Monetary Base = MB = H = High Powered Money = Total Liabilities

The Functions of a Modern Central Bank The Government's Bank: –Manages government transactions. –Controls availability of money and credit. The Banker’s Bank: Lender of last resort in crises Operates clearing system for interbank payments. Oversees financial intermediaries - ensure their soundness. - ensure public confidence

The Federal Reserve’s Balance Sheet Owns (Assets) Owes (Liabilities) Federal Reserve Notes Currency in circulation = C Vault cash Bank deposits at Fed = R Bank A fed Bank B fed Bank C fed Government Fed Gold Foreign Exchange Bank IOUs on Discount Loans Government Bonds Mortgage Backed Securities Fixed Assets Total Assets = Monetary Base = MB = H = High Powered Money = Total Liabilities

Functions of Federal Reserve District Banks Clear checks Issue new currency/withdraw damaged currency Make discount loans to banks in district Evaluate mergers/expansions of bank activities Liaison between business community and the Fed Examine bank holding companies and state-chartered member banks Collect data on local business conditions Research Money, Banking and the Financial System FRBNY’s special roles Bond and currency open market operations Supervise bank holding companies in NY district Member of Bank for International Settlements

Measures of the Money Supply Think of Money as Currency (C) in your wallet and Deposits (D) in your checking account  The balance on your RebelCard should also be thought of as “money,” but it’s not yet counted The monetary base (MB) includes currency (C) and reserves (R) held by private banks Banks a hold a fraction of the deposits (D) they owe you as reserves R = fD Reserves include Vault Cash and deposits banks themselves hold at their Central Banks  Our Central Bank is the Federal Reserve Bank  Banks receive no interest on Vault Cash (mostly held in ATM machines)  They now receive some interest on their deposits at the Fed Currency (Federal Reserve Notes in circulation) and bank Reserves are liabilities of the Central Bank. Think of them as High Powered Money (=Monetary Base) Central Bank Liabilities (the Monetary Base) are necessarily matched by its Assets  When the Fed buys something, say a government bond (T-bill or T-bond) or a mortgage backed security (MBS), its assets increase by the amount of the purchase.  The Fed pays for what it buys by “writing a check” to whoever sells it the asset. The check ends up deposited in a bank which then deposits it in its reserve account.  The Fed’s Assets (the T-bill) and its Liabilities (bank Reserves) increase by the same amount. An increase in the Monetary Base (high powered money) usually multiplies through a fractional reserve banking system to a greater increase in Money S upply.  The Fed buys something and pays with a check; the check is deposited in a bank; the bank holds a fraction of the deposit in reserve and loans out the rest; the borrower buys something; some of what he pays is held in Currency while the rest is Deposited in another bank which holds a fraction in Reserve and loans out the rest…

In general Money Supply = Money multiplier x Monetary Base M = m x MB Flavors of money: M1 = Currency + Demand Deposits + Travelers Checks  M1 is most liquid = means of payment M2 = M1 + Savings Accounts + Money Market Accounts + Small CDs  M2 = M1 + “Near monies” M3 = M2 + Large CDs + Short term repos + …

The Quantity Equation Let M t = money supply in year t; V t = velocity of money turnover in t; P t = price level in t; Y t = real GDP in t M t V t = P t Y t M t V t = Money held ($) x Turns/year = $ spent in year = $GDP ($/year) P t Y t = Stuff bought (units/year) x Price paid ($/unit) = $ purchases in year = $GDP ($/year) Thus, $ Purchases/year = $ Spent/year The Quantity Theory of Money: P = (V/Y) M

The Classical Dichotomy, Constant Velocity, and the Central Bank in the Long-Run The classical dichotomy: in the long run, the real and nominal sides of the economy are completely separate. Real GDP is determined solely by real considerations in the long-run– not by money. Money is said to be neutral In the quantity theory of money, real GDP is assumed as exogenously given and determined by real forces. In other words: The velocity of money is an exogenously given constant, assumed to be constant over time (i.e. no time subscript “t”). In other words: The money supply is determined by the central bank and we assume that monetary policy is exogenously given. In other words:

The Quantity Theory Solution for the Price Level To solve the model, we plug all the exogenous variables into the model and then solve for the endogenous price level: Increases in the money supply and decreases in real GDP cause prices to rise. We take real GDP and velocity as given in this model. Real GDP is determined by available resources and technology The velocity of money may depend on inflation and interest rates…but these must stabilize at some values In the long run, the key determinant of the price level is the money supply.

The Quantity Theory for Inflation We can express the quantity equation in terms of growth rates by applying growth rate formulas. Or, using g as growth rate: Velocity ( ) is constant. The rate of inflation is represented as. Therefore: The rate of inflation is equal to the growth rate in the money supply minus the growth rate in real GDP.

Real and Nominal Interest Rates The real interest rate is equal to the marginal product of capital and is paid in goods. The nominal interest rate is the interest rate on a money loan and is paid in dollars. The Fisher equation says that the nominal interest rate is equal to the real interest rate plus the rate of inflation: The nominal interest rate is generally high when inflation is high. The real interest is computed by subtracting inflation from the nominal interest rate: Empirically, the real interest rate has been negative – although the MPK is surely not negative. This implies that in the short run the real interest rate need not equal the MPK.

Costs of Inflation Examples of individuals who are hurt during inflation are as follows: An individual who has a pension that is not indexed to inflation. A bank that issues loans at fixed rates, but that pays interest rates that move with the market. An individual with a variable rate mortgage. Large surprise inflations can lead to large distributions in wealth. People with debts can pay back their loans with new cheaper dollars while creditors wind up losers. Taxes are based on nominal incomes but economic decisions are made based on real variables. Tax distortions are more severe when inflation is high. Inflation also distorts relative prices because some prices are faster at adjusting to inflation than other prices are. Shoe leather costs of inflation imply that people want to hold less money when inflation is high. Menu costs are the costs to firms of changing prices frequently. Costs are not generated by the rate of inflation, but rather by the unexpectedness and uncertainty generated from surprise changes in the rate of inflation.

The Fiscal Causes of High Inflation The government budget constraint says that the government’s uses of funds (G) must equal its sources of funds: tax revenue (T), borrowing (B), and changes in the stock of money (M): Seignorage and the inflation tax are names for the revenue that the government obtains from printing more money The inflation tax shows up as a rise in the price level and is thus paid by people holding money. Imagine an individual holding land as his asset. If prices double, the price of land doubles as well and the land is just as valuable as it was before the inflation tax hit. This individual does not pay the inflation tax. If a government runs large budget deficits, as debt rises, lenders may worry the government will have trouble paying back loans and they may stop lending to the government altogether. Raising taxes may not be politically feasible Thus, when taxes and borrowing are no longer an option, a desperate government resorts to “printing money” (borrowing from its central bank) to finance its budget. Countries experiencing hyperinflation typically raise about 5 percent of GDP based on the inflation tax.

Hyperinflations end when the rate of money growth falls rapidly. In other words, the government gets its finances in order through lower spending, higher taxes, and new loans. The coordination problem injects a certain amount of inertia into the inflation process because people build their expectations into the prices they set.

CHAPTER 8 Inflation 8.6 The Great Inflation of the 1970s During the Great Inflation, the rate peaked below 15 percent yet the inflation tax was a small fraction of government spending.

CHAPTER 8 Inflation Inflation rose in the 1970s for the following reasons: OPEC coordinated increases in oil prices that spurred inflation. The Federal Reserve made mistakes in running a monetary policy that grew the money supply too rapidly. Policymakers pursued such a policy because of the productivity slowdown.

CHAPTER 8 Inflation Summary Inflation is the annual percentage change in the overall price level in an economy. The fact that identical goods cost significantly more today than 100 years ago is a general reflection of inflation. A dollar today is worth much less than it was a decade or two ago.

CHAPTER 8 Inflation The quantity theory of money is our basic model for understanding the long-run determinants of the price level and therefore of inflation. There are two ways to express the solution. For the price level, the solution is. For the rate of inflation, the solution is, assuming a constant for velocity.

CHAPTER 8 Inflation The quantity theory says that the main determinant of inflation is the growth rate of money in an economy, or “too much money chasing too few goods.”

CHAPTER 8 Inflation The classical dichotomy, an important part of the quantity theory, states that the real and nominal sides of the economy are largely separate. Real economic variables, like real GDP, are determined only by real forces – like the investment rate and TFP. They are not influenced by nominal changes, such as a change in the money supply. The general consensus among economists is that the classical dichotomy holds in the long run but not necessarily in the short run.

CHAPTER 8 Inflation The nominal interest rate in an economy is paid in units of currency, while the real interest rate is paid in goods. These rates are related by the Fisher equation: i = r + π.

CHAPTER 8 Inflation Inflation – particularly when it is high and unexpected – can be very costly to an economy. Inflation generally transfers resources from lenders and savers to borrowers, because borrowers can repay their loans with dollars that are worth less. Other costs include high effective tax rates, distortions to relative prices, shoe-leather costs, and menu costs.

CHAPTER 8 Inflation The government budget constraint says that the government has three basic ways to finance its spending: through taxes, borrowing, and printing money. When the government finds it hard to reduce spending, raise taxes, or borrow, they will be forced to print money to satisfy the budget constraint. Hyperinflations are generally a reflection of such fiscal problems.