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0 Money and Inflation CHAPTER FOUR
I’ve included a graph that unfolds over slides that tells the same story as Figure 4-1 on p. 86 of the text. If you prefer to show Figure 4-1, you can “hide” slides and “unhide” slide 26.

1 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.

2 U.S. inflation & its trend, 1960-2003

3 U.S. inflation & its trend, 1960-2003
In the short run, supply shocks and other factors can push inflation above or below its long-run trend. We study those factors in Chapter 13 (on Aggregate Supply and the Phillips Curve). In this chapter, we learn about the long-run trend behavior of prices and inflation.

4 The connection between money and prices
Inflation rate = the percentage increase in the average level of prices. price = amount of money required to buy a good. Because prices are defined in terms of money, we need to consider the nature of money, the supply of money, and how it is controlled.

5 Money: definition Money is the stock of assets that can be readily used to make transactions.

6 Money: functions medium of exchange we use it to buy stuff
store of value transfers purchasing power from the present to the future unit of account the common unit by which everyone measures prices and values If your students have taken principles of economics, they will probably be familiar with the material on this slide. It might be worthwhile, though, to take an extra moment to be sure students understand that the definition of store of value (an item that transfers purchasing power from the present to the future) simply means money retains its value over time, so you need not spend all your money as soon as you receive it. The idea should be familiar, even though Greg’s wording is a bit more sophisticated than that in most other texts.

7 Money: types fiat money commodity money has no intrinsic value
example: the paper currency we use commodity money has intrinsic value examples: gold coins, cigarettes in P.O.W. camps Again, this material should be review for most students. Note: Many students have seen the film The Shawshank Redemption starring Tim Robbins and Morgan Freeman. Most of this film takes place in a prison. The prisoners have an informal “underground economy” in which cigarettes are used as money, even by prisoners who don’t smoke. Students who have seen the film will better understand “commodity money” if you mention this example. Also, the textbook (p.78) has a case study on cigarettes being used as money in POW camps during WWII.

8 Discussion Question Which of these are money? a. Currency b. Checks
c. Deposits in checking accounts (called demand deposits) d. Credit cards e. Certificates of deposit (called time deposits) You might want to ask students to determine, for each item listed, which of the functions of money it serves. Answers: a - yes b - no, not the checks themselves, but the funds in checking accounts are money. c - yes (see b) d - no, credit cards are a means of deferring payment. e - CDs are a store of value, and they are measured in money units (“Hey, I just bought a $1000 CD, dude!”). They are not readily spendable, though.

9 The money supply & monetary policy
The money supply is the quantity of money available in the economy. Monetary policy is the control over the money supply. Again, this is mostly review. $$$

10 The Federal Reserve Building Washington, DC
The central bank Monetary policy is conducted by a country’s central bank. The Federal Reserve Building Washington, DC In the U.S., the central bank is called the Federal Reserve (“the Fed”). Again, this is mostly review.

11 Money supply measures, April 2002
_Symbol Assets included Amount (billions)_ C Currency $598.7 M1 C + demand deposits, travelers’ checks, other checkable deposits M2 M1 + small time deposits, savings deposits, money market mutual funds, money market deposit accounts M3 M2 + large time deposits, repurchase agreements, institutional money market mutual fund balances The most important thing that students should get from this slide is the following: Each successive measure of the money supply is BIGGER and LESS LIQUID than the one it follows. I.e., checking account deposits (in M1 but not C) are less liquid than currency. Money market deposit account balances (in M2 but not M1) are less liquid than demand deposits. Large time deposits (those over $100,000 and therefore not Federally insured) are less liquid than small time deposits. Whether you require your students to learn the definitions of every component of each monetary aggregate is up to you. Most professors agree that students should learn the definitions of M1, M2, demand deposits, and time deposits. Some professors feel that, since the quantity of information students can learn in a semester is finite, it is not worthwhile to require students to learn such terms as “repurchase agreements.” However, you might verbally define such terms to help students better understand the nature of the monetary aggregates.

12 The Quantity Theory of Money
A simple theory linking the inflation rate to the growth rate of the money supply. Begins with a concept called “velocity”…

13 Velocity basic concept: the rate at which money circulates
definition: the number of times the average dollar bill changes hands in a given time period example: In 2003, $500 billion in transactions money supply = $100 billion The average dollar is used in five transactions in 2003 So, velocity = 5 In order for $500 billion in transactions to occur when the money supply is only $100b, each dollar must be used, on average, in five transactions.

14 Velocity, cont. This suggests the following definition: where
V = velocity T = value of all transactions M = money supply

15 Velocity, cont. Use nominal GDP as a proxy for total transactions.
Then, where P = price of output (GDP deflator) Y = quantity of output (real GDP) P Y = value of output (nominal GDP) You might ask students if they know the difference between nominal GDP and the value of transactions. Answer: nominal GDP includes the value of purchases of final goods; total transactions also includes the value of intermediate goods. Even though they are different, they are highly correlated. Also, our models focus on GDP, and there’s lots of great data on GDP. So from here on out, we’ll use the income version of velocity.

16 The quantity equation 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.

17 Money demand and the quantity equation
M/P = real money balances, the purchasing power of the money supply. A simple money demand function: (M/P )d = k Y where k = how much money people wish to hold for each dollar of income (k is exogenous)

18 Money demand and the quantity equation
money demand: (M/P )d = k Y quantity equation: M V = P Y The connection between them: k = 1/V When people hold lots of money relative to their incomes (k is high), money changes hands infrequently (V is low).

19 back to the Quantity Theory of Money
starts with quantity equation assumes V is constant & exogenous: With this assumption, the quantity equation can be written as

20 The Quantity Theory of Money, cont.
How the price level is determined: With V constant, the money supply determines nominal GDP (P Y ) Real GDP is determined by the economy’s supplies of K and L and the production function (chap 3) The price level is P = (nominal GDP)/(real GDP) It’s worthwhile to underscore the order (logical, though not necessarily chronological, order) in which variables are determined in this model (as well as the other models students will learn in this course). First, real GDP is already determined outside this model. (Real GDP is determined by the model from Chapter 3, which was completely independent of the money supply or velocity or other nominal variables.) Second, the Quantity Theory of money determines nominal GDP. Third, the values of nominal GDP (PY) and real GDP (Y) together determine P (as a ratio of PY to Y). If, on an exam or homework problem, students forget the logical order in which endogenous variables are determined---or on a more fundamental level, forget which variables are endogenous and which are exogenous ---then they are much less likely to earn the high grades that most of them desire. [Note the similarity between the way P is determined and the definition of the GDP deflator from Chapter 2.]

21 The Quantity Theory of Money, cont.
Recall from Chapter 2: The growth rate of a product equals the sum of the growth rates. The quantity equation in growth rates:

22 The Quantity Theory of Money, cont.
Let  (Greek letter “pi”) denote the inflation rate: The result from the preceding slide was: Solve this result for  to get

23 The Quantity Theory of Money, cont.
Normal economic growth requires a certain amount of money supply growth to facilitate the growth in transactions. Money growth in excess of this amount leads to inflation. The text on this slide is an intuitive way to understand the equation. For students that are more comfortable with concrete numerical examples, you could offer the following: Suppose real GDP is growing by 3% per year over the long run. Thus, production, income, and spending are all growing by 3%. This means that the volume of transactions will be growing as well. The central bank can achieve zero inflation (on average over the long run) simply by setting the growth rate of the money supply at 3%, in which case exactly enough new money is being supplied to facilitate the growth in transactions.

24 The Quantity Theory of Money, cont.
Y/Y depends on growth in the factors of production and on technological progress (all of which we take as given, for now). Hence, the Quantity Theory of Money predicts a one-for-one relation between changes in the money growth rate and changes in the inflation rate. Note: the theory doesn’t predict that the inflation rate will equal the money growth rate. It does predict that a change in the money growth rate will cause an equal change in the inflation rate. Next: If the Quantity Theory of Money is correct, then we would expect that countries with high inflation have high money growth rates, and countries with low inflation have low money growth rates. Let’s look at the data to see whether this implication is consistent with real-world experience

25 International data on inflation and money growth
Figure 4-2 from p. 87 of the text.

26 U.S. data on inflation and money growth
Figure 4-1 from p. 86. We see here that the positive relationship between money growth and inflation implied by the Quantity Theory holds up over time as well as across countries.

27 U.S. Inflation & Money Growth, 1960-2003
This graph unfolds over this and the next three slides. Its purpose is to show that the long-run trends in inflation and money growth are highly correlated, even though the short-run movements aren’t.

28 U.S. Inflation & Money Growth, 1960-2003
This slide dims the inflation data so that students can focus on the behavior of the trend inflation rate.

29 U.S. Inflation & Money Growth, 1960-2003
Next, we add in the money growth rate (dark blue) and its trend (light blue). Advance to the next slide to more clearly see the relationship between the trend money growth rate and the trend inflation rate.

30 U.S. Inflation & Money Growth, 1960-2003
Finally, the money growth rate data is dimmed, to more clearly see that correlation between the trend of money growth (bright blue) and the trend of inflation (bright red).

31 Seigniorage To spend more without raising taxes or selling bonds, the govt can print money. The “revenue” raised from printing money is called seigniorage (pronounced SEEN-your-ige) The inflation tax: Printing money to raise revenue causes inflation. Inflation is like a tax on people who hold money. 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.88 “Paying for the American Revolution.”

32 Inflation and interest rates
Nominal interest rate, i not adjusted for inflation Real interest rate, r adjusted for inflation: r = i  

33 The Fisher Effect The Fisher equation: i = r + 
Chap 3: S = I determines r . Hence, an increase in  causes an equal increase in i. This one-for-one relationship is called the Fisher effect. Note that S and I are real variables. In Chapter 3, we learned about the factors that determine S and I. These factors did not include the money supply, velocity, inflation, or other nominal variables. Hence, in the classical (long-run) theory we are learning, changes in money growth or inflation do not affect the real interest rate. This is why there’s a one-for-one relationship between changes in the inflation rate and changes in the nominal interest rate. (Again, the Fisher effect does not imply that the nominal interest rate EQUALS the inflation rate. It implies that CHANGES in the nominal interest rate equal CHANGES in the inflation rate, given a constant value of the real interest rate.)

34 U.S. inflation and nominal interest rates, since 1954
Percent 16 14 12 10 8 Nominal interest rate 6 4 Figure 4-3 on p.90 of the text. Inflation rate 2 -2 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 Year

35 Inflation and nominal interest rates across countries
Figure 4-4 on p.91

36 Exercise: Suppose V is constant, M is growing 5% per year, Y is growing 2% per year, and r = 4. Solve for i (the nominal interest rate). If the Fed increases the money growth rate by 2 percentage points per year, find i . Suppose the growth rate of Y falls to 1% per year. What will happen to ? What must the Fed do if it wishes to keep  constant? This exercise gives students an immediate application of the Quantity Theory of Money and the Fisher effect. The math is not difficult.

37 Answers---the details:
Suppose V is constant, M is growing 5% per year, Y is growing 2% per year, and r = 4. First, find  = 5  2 = 3. Then, find i = r +  = = 7. i = 2, same as the increase in the money growth rate. If the Fed does nothing,  = 1. To prevent inflation from rising, Fed must reduce the money growth rate by 1 percentage point per year. Answers---the details: a. First, we need to find . Constant velocity implies  = (M/M) - (Y/Y) = = 3. Then, i = r +  = = 7. b. Changes in the money growth rate do not affect real GDP or its growth rate. So, a two-point increase in money growth causes a two-point increase in inflation. According to the Fisher effect, the nominal interest rate should rise by the increase in inflation: two points (from I = 7 to I = 9). c.  = (M/M) - (Y/Y). If (Y/Y) falls by 1 point, then  will increase by 1 point; the Fed can prevent this by reducing (M/M) by 1 point. Intuition: With slower growth in the economy, the volume of transactions will be growing more slowly, which means that the need for new money will grow more slowly.

38 Two real interest rates
 = actual inflation rate (not known until after it has occurred) e = expected inflation rate i – e = ex ante real interest rate: the real interest rate people expect at the time they buy a bond or take out a loan i –  = ex post real interest rate: the real interest rate people actually end up earning on their bond or paying on their loan

39 Money demand and the nominal interest rate
The Quantity Theory of Money assumes that the demand for real money balances depends only on real income Y. We now consider another determinant of money demand: the nominal interest rate. The nominal interest rate i is the opportunity cost of holding money (instead of bonds or other interest-earning assets). Hence, i   in money demand. The concept of “money demand” can be a bit awkward for students the first time they learn it. A good way to explain it is to imagine that a consumer has a certain amount of wealth, which is divided between money and other assets. The other assets typically generate some type of income (e.g., interest income in the case of bonds), but are much less liquid than money. There is therefore a trade-off: The more money the consumer holds in his portfolio, the more interest income he foregoes; the less money he holds, the more interest income he makes, but the less liquid is his portfolio. With this for background, a consumer’s “money demand” refers to the fraction of his wealth he would like to hold in the form of money (as opposed to less-liquid income-generating assets like bonds).

40 The money demand function
(M/P )d = real money demand, depends negatively on i i is the opp. cost of holding money positively on Y higher Y  more spending  so, need more money (L is used for the money demand function because money is the most liquid asset.) An increase in the nominal interest rate represents the increase in the opportunity cost of holding money rather than bonds, and would motivate the typical consumer to hold less of his wealth in the form of money, and more in the form of bonds (or other interest-earning assets). An increase in real income (other things equal) causes an increase in the consumer’s consumption and therefore spending. To facilitate this extra spending, the consumer will require more money. Thus, the consumer would like a larger fraction of his wealth to be in the form of money (rather than bonds, etc). This might involve redeeming some of his bonds. Or it might simply involve holding the additional income in the form of money rather than putting it into bonds.

41 The money demand function
When people are deciding whether to hold money or bonds, they don’t know what inflation will turn out to be. Hence, the nominal interest rate relevant for money demand is r + e.

42 The supply of real money balances
Equilibrium The supply of real money balances Real money demand

43 What determines what variable how determined (in the long run)
M exogenous (the Fed) r adjusts to make S = I Y Again, it is very important for students to learn the logical order in which variables are determined. I.e., you do NOT need to know P in order to determine Y. You DO need to know Y in order to determine L, and you need to know L and M in order to determine P. P adjusts to make

44 How P responds to M For given values of r, Y, and e,
a change in M causes P to change by the same percentage --- just like in the Quantity Theory of Money. This slide shows the connection between the money market equilibrium condition and the (simpler) Quantity Theory of Money, presented earlier in this chapter.

45 What about expected inflation?
Over the long run, people don’t consistently over- or under-forecast inflation, so e =  on average. In the short run, e may change when people get new information. EX: Suppose Fed announces it will increase M next year. People will expect next year’s P to be higher, so e rises. This will affect P now, even though M hasn’t changed yet (continued…) This slide and the next correspond to the subsection of Chapter 4 entitled “Future Money and Current Prices,” appearing on pp

46 How P responds to e For given values of r, Y, and M ,

47 Why is inflation bad? Discussion Question
What costs does inflation impose on society? List all the ones you can think of. Focus on the long run. Think like an economist. Many of the social costs of inflation are not hard to figure out, if students “think like an economist.” Suggestion: After you pose the question, don’t immediately ask for students to volunteer their answers. Instead, tell them to think about the question for a moment, jot down their answers, and THEN ask for volunteers. You will get more participation (quantity & quality) this way, especially from students who don’t consider themselves fast thinkers. After presenting the following slides (which describe the costs), see how many of the costs presented here were anticipated by the students’ responses to the question on this slide.

48 A common misperception
Common misperception: inflation reduces real wages This is true only in the short run, when nominal wages are fixed by contracts. (Chap 3) In the long run, the real wage is determined by labor supply and the marginal product of labor, not the price level or inflation rate. Consider the data…

49 Average hourly earnings & the CPI
First, point out the CPI (the dark blue line, right-hand scale): It’s risen tremendously over the past 40 years. If the common misperception were true, then the real wage should show exactly the opposite behavior. It doesn’t. Average hourly earnings (the red line) have increased roughly in tandem with the cost of living. As a result, inflation has not caused a downward trend in the real wage (hourly earnings in today’s dollars, green). The real wage isn’t constant--it varies within the $13 to $16 range--but there is no downward trend in the real wage over the long term. (The movements in the real wage are due to movements in the labor supply and MPL curves.) Original source: BLS: Form 790, obtained from -

50 The classical view of inflation
The classical view: A change in the price level is merely a change in the units of measurement. So why, then, is inflation a social problem?

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

52 The costs of expected inflation: 1. shoeleather cost
def: the costs and inconveniences of reducing money balances to avoid the inflation tax.   i   real money balances Remember: In long run, inflation doesn’t affect real income or real spending. So, same monthly spending but lower average money holdings means more frequent trips to the bank to withdraw smaller amounts of cash.

53 The costs of expected inflation: 2. menu costs
def: The costs of changing prices. Examples: print new menus print & mail new catalogs The higher is inflation, the more frequently firms must change their prices and incur these costs.

54 The costs of expected inflation: 3. relative price distortions
Firms facing menu costs change prices infrequently. Example: Suppose a firm issues new catalog each January. As the general price level rises throughout the year, the firm’s relative price will fall. Different firms change their prices at different times, leading to relative price distortions… …which cause microeconomic inefficiencies in the allocation of resources.

55 The costs of expected inflation: 4. unfair tax treatment
Some taxes are not adjusted to account for inflation, such as the capital gains tax. Example: Jan 1: you bought $10,000 worth of Starbucks stock Dec 31: you sold the stock for $11,000, so your nominal capital gain was $1000 (10%). Suppose  = 10% during the year. Your real capital gain is $0. But the govt requires you to pay taxes on your $1000 nominal gain!! In the 1970s, the income tax was not adjusted for inflation. A lot of people received nominal salary increases large enough to push them into a higher tax bracket, but not large enough to prevent their real salaries from falling in the face of high inflation. This led to political pressure to index the income tax brackets. If inflation had been higher during , when lots of people were earning high capital gains, then there might have been more political pressure to index the capital gains tax.

56 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 often has these conversations with me, concluding that the dollar just isn’t worth what it was when she was young. I ask her “well, how much is a dollar worth today?”. She considers the question, and then offers her estimate: “About 60 cents.” I then offer her 60 cents for every dollar she has. She doesn’t accept the offer. :)

57 Additional cost of unexpected inflation: arbitrary redistributions of purchasing power
Many long-term contracts not indexed, but based on e. If  turns out different from e, then some gain at others’ expense. Example: borrowers & lenders If  > e, then (i  ) < (i  e) and purchasing power is transferred from lenders to borrowers. If  < e, then purchasing power is transferred from borrowers to lenders. 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 differently 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 nice example on p. 9 (at the top of the page). (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.)

58 Additional cost of high inflation: increased uncertainty
When inflation is high, it’s more variable and unpredictable:  turns out different from e more often, and the differences tend to be larger (though not systematically positive or negative) Arbitrary redistributions of wealth become more likely. This creates higher uncertainty, which makes risk averse people worse off.

59 One benefit of inflation
Nominal wages are rarely reduced, even when the equilibrium real wage falls. Inflation allows the real wages to reach equilibrium levels without nominal wage cuts. Therefore, 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.

60 Hyperinflation def:   50% per month
All the costs of moderate inflation described above become HUGE under hyperinflation. Money ceases to function as a store of value, and may not serve its other functions (unit of account, medium of exchange). People may conduct transactions with barter or a stable foreign currency. The bottom half of p. 102 has two excellent examples of life during a hyperinflation, both involving beer, a commodity with which your students may be somewhat familiar. See also the excellent case study on pp Note: On p. 102, the text states “Hyperinflation is often defined as inflation that exceeds 50 percent per month.” I’ve included this definition at the top of this slide, to be consistent with the textbook. However, some professors are a bit uncomfortable assigning a specific number (such as 50% per month) to the definition of hyperinflation, because, for example, most would agree that 49% per month inflation is high enough to be considered hyperinflation. The definition I like to use in my own teaching is this: hyperinflation: a really, really, really high rate of inflation Feel free to edit the definition of “hyperinflation” on this slide if you wish.

61 What causes hyperinflation?
Hyperinflation is caused by excessive money supply growth: When the central bank prints money, the price level rises. If it prints money rapidly enough, the result is hyperinflation.

62 Recent episodes of hyperinflation
slide 62

63 Why governments create hyperinflation
When a government cannot raise taxes or sell bonds, it must finance spending increases by printing money. In theory, the solution to hyperinflation is simple: stop printing money. In the real world, this requires drastic and painful fiscal restraint. Before revealing the contents of this slide, you might consider asking students the following question: “Solving the problem of hyperinflation is easy. Why, then, do governments allow hyperinflation to occur?”

64 The Classical Dichotomy
Real variables are measured in physical units: quantities and relative prices, e.g. quantity of output produced real wage: output earned per hour of work real interest rate: output earned in the future by lending one unit of output today Nominal variables: measured in money units, e.g. nominal wage: dollars per hour of work nominal interest rate: dollars earned in future by lending one dollar today the price level: the amount of dollars needed to buy a representative basket of goods slide 64

65 The Classical Dichotomy
Note: Real variables were explained in Chap 3, nominal ones in Chap 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.

66 Chapter summary Money Quantity theory of money
the stock of assets used for transactions serves as a medium of exchange, store of value, and unit of account. Commodity money has intrinsic value, fiat money does not. Central bank controls money supply. Quantity theory of money assumption: velocity is stable conclusion: the money growth rate determines the inflation rate.

67 Chapter summary Nominal interest rate Money demand
equals real interest rate + inflation rate. Fisher effect: nominal interest rate moves one-for-one w/ expected inflation. is the opp. cost of holding money Money demand depends on income in the Quantity Theory more generally, it also depends on the nominal interest rate; if so, then changes in expected inflation affect the current price level.

68 Chapter summary Costs of inflation
Expected inflation shoeleather costs, menu costs, tax & relative price distortions, inconvenience of correcting figures for inflation Unexpected inflation all of the above plus arbitrary redistributions of wealth between debtors and creditors

69 Chapter summary Hyperinflation
caused by rapid money supply growth when money printed to finance govt budget deficits stopping it requires fiscal reforms to eliminate govt’s need for printing money

70 Chapter summary Classical dichotomy
In classical theory, money is neutral--does not affect real variables. So, we can study how real variables are determined w/o reference to nominal ones. Then, eq’m in money market determines price level and all nominal variables. Most economists believe the economy works this way in the long run.


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