The Quantity Theory of Money Money x Velocity = Price x Transactions M x V = P x T V = PT/M Transactions Velocity Dollar value of transactions ~ Dollar value of output Money x Velocity = Price x Output M x V = P x Y V = PY/M Income Velocity
Money Demand and the Quantity Equation Money Demand: (M/P) d = kY Money Supply: M/P M/P = kY M(1/k) = PY MV = PY where V=(1/k) Constant Velocity implies that V is constant, so M determines PY
Money, Prices and Inflation Three Building Blocks for Model Determining Price Level 1. Production function and factor supplies determine Y. 2. Money Supply determines nominal value of output, PY, since velocity is fixed. 3. Price Level is then the ratio of PY to Y. MV = PY implies: %Change in M + %Change in V = %Change in P + % Change in Y.
Empirical Evidence on Money- Inflation Relationship Holds for the U.S. over long periods of time as seen when comparing inflation and money growth over a various decades Holds across countries when comparing inflation and money growth over a given decade of time Doesn’t hold over short periods of time
Money Growth and Inflation in the U.S. (Average Rates for Various Decades)
Money Growth and Inflation Across Countries (Average Rates for the 1990s)
Seignorage: Revenue from Printing Money Inflation is like a tax on real balances People hold less real balances than otherwise Value of revenue is approximately equal to inflation rate times the level of real balances: M/P)
Inflation and Interest Rates Real Interest Rate = Nominal Interest Rate - Inflation Rate r = i - The Fisher Effect: i = r + Ex Ante versus Ex Post Real Interest Rates: Expected versus Actual Inflation. Fisher Effect Becomes: i = r + e
Evidence Supports Fisher Effect Evidence for U.S. shows correlation between inflation and both short and long- term interest rates Evidence across countries shows relationship between inflation and interest rates over a given decade of time
Inflation and Interest Rates Across Countries (Average Rates for the 1990s)
The Nominal Interest Rate and the Demand for Money (M/P) d = L(i, Y) “i” is relevant interest rate since we are comparing real return on bonds (r) with real return on money (- : r - (- = i - - (- = i Future Money and Current Prices: M/P = L(r + e, Y) (See Appendix for details)
Social Costs of Inflation Costs of Expected Inflation: Shoeleather Costs Menu Costs Relative Price Variability Tax Code is not Fully Indexed Inconvenience for Measuring Economic Transactions
Costs of Unexpected Inflation: Arbitrary Redistribution of Wealth Examples: Creditors and Debtors Fixed Pensions Why specify contracts in nominal terms? Some indexing in U.S.: Social Security, Indexed Treasury Bonds, Part of Tax System High Inflation also Tends to be highly variable inflation So, further reason why high inflation may be a problem.