Harcourt Brace & Company Inflation: Its Causes and Costs

Harcourt Brace & Company Inflation: Its Causes and Costs u Inflation is a sustained increase in the price level. It is a continuous increase versus a “once-and-for-all” increase in prices. u Inflation deals with the increase in the average of prices and not just significant increases in the price of a few goods.

Harcourt Brace & Company Inflation: Historical Aspects u Over the past sixty years, prices have risen on average about 5 percent per year. u Deflation, a situation of decreasing prices, occurred in the nineteenth century. u In the 1970’s prices rose by 7 percent per year. u From 1990 to 1996 prices rose about 3 percent per year.

Harcourt Brace & Company The Causes of Inflation u Inflation is an economy-wide monetary phenomenon that concerns, first and foremost, the value of an economy’s medium of exchange. u To understand the cause of inflation as a monetary phenomenon we must understand the concepts of Money Supply, Money Demand, and Monetary Equilibrium.

Harcourt Brace & Company Money Supply and Money Demand u Money Supply is a variable of the Federal Reserve Banks. Through instruments such as open market operations, the Fed directly controls the quantity of money supplied. u Money Demand has several determinants including: –interest rates –average level of prices in the economy

Harcourt Brace & Company u People hold money because it is the medium of exchange. The amount of money people choose to hold depends on the prices of the goods and services. u In the long run, the overall level of prices adjusts to the level at which the demand for money equals the supply. –Figure 16-1 Money Supply and Money Demand

Harcourt Brace & Company Money Supply, Money Demand and Equilibrium Price Level Value of Money Price Level Money Demand Q Fixed Money Supply Equilibrium Value of Money Equilibrium Price Level

Harcourt Brace & Company Monetary Equilibrium u The Fed could inject money (monetary injection) into the economy by buying government bonds. Results would be: –The supply curve shifting to the right –The equilibrium value of money decreasing –The equilibrium price level increasing u This process is referred to as the quantity theory of money.

Harcourt Brace & Company The Effects of Monetary Injection Value of Money Price Level Money Demand Q Fixed MS 1

Harcourt Brace & Company The Effects of Monetary Injection Value of Money Price Level Money Demand Q Fixed VM E PEPE MS 1

Harcourt Brace & Company The Effects of Monetary Injection Value of Money (High) Price Level (Low) Money Demand Q Fixed VM E PEPE LowHigh MS 1

Harcourt Brace & Company The Effects of Monetary Injection Value of Money (High) Price Level (Low) Money Demand Q Fixed VM E PEPE LowHigh MS 2 MS 1

Harcourt Brace & Company The Effects of Monetary Injection Value of Money (High) Price Level (Low) Money Demand Q Fixed VM E PEPE LowHigh MS 2 MS 1 VM E PEPE

Harcourt Brace & Company Cause of Inflation: The Quantity of Money Theory u The quantity of money available in the economy determines the value of money. Growth in the quantity of money is the primary cause of inflation. u Some macroeconomic variables are unchanged, given changes in the supply of money. (Hume)

Harcourt Brace & Company Monetary Neutrality An increase in the rate of money growth raises the inflation but does not affect any “real” variables (e.g. production, employment, real wages, and real interest rates.) Such irrelevance of monetary changes for “real” variables is called monetary neutrality.

Harcourt Brace & Company Velocity and The Quantity Equation u “How many times per year is the typical dollar bill used to pay for a newly produced good or service?” u The velocity of money refers to the speed at which the typical dollar bill travels around the economy from wallet to wallet.

Harcourt Brace & Company Velocity and The Quantity Equation V = (P x Y) ÷ M Where: V = Velocity P = The average price level Y = the quantity of output M = the quantity of money u Rewriting the equation gives the quantity equation. M x V = P x Y

Harcourt Brace & Company Five Step Foundation to The Quantity Theory of Money À The velocity of money is relatively stable over time. Á A proportionate change in the nominal value of output is related to changes in the quantity of money by the Fed. Â Because money is neutral, money does not affect output. (Chapter 12)

Harcourt Brace & Company Five Step Foundation to The Quantity Theory of Money à Changes in the money supply which induce parallel changes in the nominal value of output are also reflected in changes in the price level. Ä When the Fed increases the money supply rapidly, the result is a high rate of inflation.

Harcourt Brace & Company Hyperinflation & Inflation Tax u Hyperinflation is inflation that exceeds 50 percent per month. –Figure 16-4: Note the relationship between the growth rate of the quantity of money and the price level. u Hyperinflation in some countries is caused because the government prints too much money to pay for their spending.

Harcourt Brace & Company Hyperinflation & Inflation Tax u When the government raises revenue by printing money, it is said to levy an inflation tax. An inflation tax is like a tax on everyone who holds money. u The inflation ends when the government institutes fiscal reforms such as cuts in government spending.

Harcourt Brace & Company Relationship Between Money, Inflation and Interest Rates u Nominal Interest Rate = Real Interest Rate + Inflation Rate u Over the long run, a change in the money growth should not affect the Real Interest rate thus, the Nominal Interest Rate must adjust one-for-one to changes in the Inflation Rate.

Harcourt Brace & Company Relationship Between Money, Inflation and Interest Rates u When the Fed increases the rate of money growth, the result is both a high inflation rate and a higher nominal interest rate. This is called the, Fisher Effect

Harcourt Brace & Company Quick Quiz! u The government of a country increases the growth rate of the money supply from 5 percent per year to 50 percent per year. What happens to prices? u What happens to nominal interest rates? u Why would the government be doing this?

Harcourt Brace & Company The Costs of Inflation u At least six costs of inflation are identified as: 1. Shoeleather costs 2. Menu Costs 3. Increased variability of relative prices 4. Tax liabilities 5. Confusion and inconvenience 6. Arbitrary redistribution of wealth

Harcourt Brace & Company The Costs of Inflation: Shoeleather Costs u Inflation reduces the real value of money, so people have an incentive to minimize their cash holdings. Less cash requires people to make frequent trips to the bank because they keep their money in interest bearing accounts. u Extra trips to the bank takes time away from productive activities. (Mr. Miranda)

Harcourt Brace & Company The Costs of Inflation: Menu Costs u During inflationary times, it is necessary to update price lists and other posted prices. u This is a resource consuming process that takes away from other productive activities.

Harcourt Brace & Company The Costs of Inflation: Increased Variability of Relative Prices u During times of rising prices, there will be a delay between price increases. While these prices are constant, other prices will be rising. It then becomes difficult to know exact relative prices as prices change irregularly.

Harcourt Brace & Company The Costs of Inflation: Unintended Changes in Tax Liability u With inflation, unadjusted incomes are treated as real gains. Consequently, with progressive taxation, rising nominal incomes are taxed more heavily.

Harcourt Brace & Company The Costs of Inflation: Confusion and Inconvenience u With rising prices, it is necessary to constantly make corrections in order to compare real revenues, costs, and profits over time. The time spent making these adjustments could have been spent producing more goods and services.

Harcourt Brace & Company The Costs of Inflation: Arbitrary Redistribution of Wealth u With unanticipated or incorrectly anticipated inflation, wealth is redistributed between net monetary debtors and creditors. This may result in wealth transfers that would not otherwise be acceptable. –Recall the Fisher Effect.

Harcourt Brace & Company The Inflation Fallacy u Fallacy: “Inflation reduces individuals’ incomes and causes living standards to decline.” u Fact: “One person’s inflated price is another’s inflated income.” Unless incomes are fixed in nominal terms, the higher prices paid by consumers are exactly offset by the higher incomes received by sellers.