# In this chapter, you will learn:

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4 Money and Inflation (edited by L Lamb, 2011) U P D A T E

In this chapter, you will learn:
The classical theory of inflation causes effects social costs “Classical” – assumes prices are flexible & markets clear Applies to the long run 1

4.1 Money: Definition What are the functions of money?
Money is the stock of assets that can be readily used to make transactions. What are the functions of money? Medium of exchange: to buy g & s; more efficient than barter system Store of value: save for the future. Consider world without money i.e. barter system. You are a baker. How do you save for future? Unit of account: terms to set prices and record savings & debt.

The central bank Monetary policy is conducted by a country’s central bank. In the Canada, the central bank is called the Bank of Canada What do other countries call their central bank. Peoples Bank of China Federal Reserve European Central Bank: why doesn’t each European country have their own? Central Bank of the Russian Federation Central bank, among other jobs, controls the quantity of money circulating in an economy….called monetary policy. In Canada, ultimate control is in the hands of the federal cabinet, specifically the Minister of Finance. The Governor of the Bank of Canada is the head decision-maker (currently Mark Carney). Governor of B of C cannot be fired. The federal cabinet can issue a formal directive (statement of instructions of changes) and if Governor does not agree, he/she must resign. The Governor has power because such a statement of instructions would be made public along with the reasons why the Governor did not believe it was best for the economy. How does B of C control the supply of money? For instance, how do they reduce money supply? Most often with open-market operations.

4.2 Quantity Theory of Money
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.

International data on inflation and money growth
Belarus Indonesia Inflation rate (percent, logarithmic scale) Turkey Ecuador Argentina Singapore Figure 4-2, p.92 Each variable is measured as an annual average over the period The strong positive correlation is evidence for the Quantity Theory of Money. Source: International Financial Statistics. Money supply growth (percent, logarithmic scale)

U.S. inflation and money growth, 1960-2010
M2 growth rate The quantity theory of money is intended to explain the long-run relation of inflation and money growth, not the short-run relation. In the long run, inflation and money growth are positively related, as the theory predicts. (In the short run, however, inflation and money growth appear highly negatively correlated! One possible reason is that the causality is reversed in the short run: when inflation rises – or is expected to rise – the Fed cuts back on money growth. If the economy slumps and inflation falls, the Fed increases money growth. It might be appropriate to discuss this when covering the chapters on short-run fluctuations.) source: Federal Reserve Bank of St. Louis inflation rate

U.S. inflation and money growth, 1960-2010
Inflation and money growth have the same long-run trends, as the Quantity Theory predicts. The quantity theory of money is intended to explain the long-run relation of inflation and money growth, not the short-run relation. In the long run, inflation and money growth are positively related, as the theory predicts. (In the short run, however, inflation and money growth appear highly negatively correlated! One possible reason is that the causality is reversed in the short run: when inflation rises – or is expected to rise – the Fed cuts back on money growth. If the economy slumps and inflation falls, the Fed increases money growth. It might be appropriate to discuss this when covering the chapters on short-run fluctuations.) source: Federal Reserve Bank of St. Louis

4.3 Seigniorage To spend more without raising taxes or selling bonds, the govt can print money. The “revenue” raised from printing money is called seigniorage . Introduction of abbreviation “govt” for “government” It’s quicker and easier for students to write “govt” in their notes. In the U.S., seigniorage accounts for only about 3% of total government revenue. In Italy and Greece, seigniorage has often been more than 10% of total revenue. In countries experiencing hyperinflation, seigniorage is often the government’s main source of revenue, and the need to print money to finance government expenditure is a primary cause of hyperinflation. See Case Study on p.93 “Paying for the American Revolution.”

4.4 Inflation and interest rates
Nominal interest rate, i not adjusted for inflation Real interest rate, r adjusted for inflation: r = i   This is probably review, if your students have taken an introductory course in economics.

Figure 4.3 Inflation and Nominal Interest Rates Over Time Mankiw and Scarth: Macroeconomics, Canadian Fourth Edition Copyright © 2011 by Worth Publishers

Inflation and nominal interest rates across countries
Nominal interest rate (percent, logarithmic scale) Georgia Romania Zimbabwe Turkey Brazil Israel Kenya Source: same as textbook Each variable is measured as an annual average over The nominal interest rate is the rate on short-term government debt. U.S. Ethiopia Germany Inflation rate (percent, logarithmic scale)

4.5 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.

4.6 The social costs of inflation
…fall into two categories: 1. costs when inflation is expected 2. costs when inflation is different than people had expected

The costs of expected inflation: 1. Shoeleather cost
def: the costs and inconveniences of reducing money balances to avoid the inflation tax. Thanks to ATMs and internet banking, the shoeleather cost is likely to be very small.

The costs of expected inflation: 2. Menu costs
def: The costs of changing prices.

The costs of expected inflation: 3. Relative price distortions
Firms facing menu costs change prices infrequently.

The costs of expected inflation: 4. Unfair tax treatment
Some taxes are not adjusted to account for inflation, such as the capital gains tax.

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. Examples: Parents trying to decide how much to save for the future college expenses of their (now) young child. Thirty-somethings trying to decide how much to save for retirement. The CEO of a big corporation trying to decide whether to build a new factory, which will yield a revenue stream for 20 years or more. Your grandmother claiming that things were so much cheaper when she was your age. A silly digression: My grandmother used to have conversations like this with me, concluding that the dollar just isn’t worth what it was when she was young. I asked her “well, how much is a dollar worth today?”. She considered the question, and then offered her estimate: “About 60 cents.” I then offered her 60 cents for every dollar she has. She didn’t accept the offer. :)

Many long-term contracts not indexed, but based on E . Ask students this rhetorical question: Would it upset you if somebody arbitrarily took wealth away from some people and gave it to others? Well, this in effect is what’s happening when inflation turns out different than expected. Furthermore, it’s impossible to predict when inflation will turn out higher than expected, when it will be lower, and how big the difference will be. So, these redistributions of purchasing power are arbitrary and random. The text gives a simple numerical example on p.103. (In the short run, when many nominal wages are fixed by contracts, there are transfers of purchasing power between firms and their employees whenever inflation is different than expected when the contract was written and signed.)

Additional cost of high inflation: Increased uncertainty
When inflation is high, it’s more variable and unpredictable.

One benefit of inflation
Moderate inflation improves the functioning of labor markets. Students will better appreciate this point when they learn chapter 6 (the natural rate of unemployment). In this chapter, we will see how the failure of wages to adjust contributes to a long-term unemployment problem.

Hyperinflation Common definition:   50% per month
The bottom of p. 106 has an excellent example of life during a hyperinflation, which involves beer, a commodity with which your students may be somewhat familiar. See also the excellent case study on pp

A few examples of hyperinflation
country period CPI Inflation % per year M2 Growth % per year Israel 338% 305% Brazil 1256% 1451% Bolivia 1818% 1727% Ukraine 2089% 1029% Argentina 2671% 1583% Dem. Republic of Congo / Zaire 3039% 2373% Angola 4145% 4106% Peru 5050% 3517% Zimbabwe 5316% 9914% source: World Development Indicators, World Bank. The textbook discusses a few examples of hyperinflation, including: 1. interwar Germany (data and discussion) Bolivia in 1985 (case study) Zimbabwe in (case study) This table provides data on the hyperinflations in Bolivia and Zimbabwe, and some additional examples. Notes: The inflation and money growth figures are computed from the end of the first year to the end of the last year shown in each “period.” During 2008, Zimbabwe’s hyperinflation continued and became spectacular. The table on this slide excludes 2008 data because it is missing from the WDI database. It’s easy to find estimates of Zimbabwe’s 2008 inflation, for example here: However, I cannot verify their reliability or find good data on Zimbabwe’s money supply in 2008. If you taught with a previous edition of my PowerPoints for Mankiw’s Macroeconomics, the slide like this one gave inflation and money growth as cumulative figures (over the period shown) rather than annual averages. Thus, it was a bit harder to compare, say, the two-year hyperinflation of Argentina with the six-year hyperinflation of Zaire. This slide, however, shows all inflation and money growth figures as annual averages over the period shown, which makes comparisons easier and just seems to make more sense. Also, compared to the corresponding slide in the previous edition of my PowerPoint slides for Mankiw, the set of countries included here is slightly different.

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.