Presentation on theme: "Money Growth and Inflation"— Presentation transcript:
1 Money Growth and Inflation 17Money Growth and Inflation
2 Inflation Inflation Deflation Hyperinflation Increase in the overall level of pricesDeflationDecrease in the overall level of pricesHyperinflationExtraordinarily high rate of inflation
3 The Classical Theory of Inflation The level of prices and the value of moneyInflationEconomy-wide phenomenonConcerns the value of economy’s medium of exchangeInflation - rise in the price levelLower value of moneyEach dollar - buys a smaller quantity of goods and services
4 The Classical Theory of Inflation Money demandReflects how much wealth people want to hold in liquid formDepends onCredit cards; ATM machines; Interest rateAverage level of prices in economyDemand curve – downward sloping
5 The Classical Theory of Inflation Money supplyDetermined by the Fed and banking systemSupply curve - verticalMonetary equilibriumIn the long runOverall level of prices adjusts to:Demand for money equals the supply
6 1How the supply and demand for money determine the equilibrium price level(high)(low)Value ofMoney, 1/P1PriceLevel, P1.3324Quantity fixedby the FedMoney SupplyMoneyDemandAEquilibriumvalue ofmoneyEquilibriumprice levelQuantity ofMoneyThe horizontal axis shows the quantity of money. The left vertical axis shows the value of money, and the right vertical axis shows the price level. The supply curve for money is vertical because the quantity of money supplied is fixed by the Fed. The demand curve for money is downward sloping because people want to hold a larger quantity of money when each dollar buys less. At the equilibrium, point A, the value of money (on the left axis) and the price level (on the right axis) have adjusted to bring the quantity of money supplied and the quantity of money demanded into balance.
7 The Classical Theory of Inflation The effects of a monetary injectionEconomy – in equilibriumThe Central Bank doubles the supply of moneyPrints bills; Drops them on marketOr: The Central Bank – open-market purchaseNew equilibriumSupply curve shifts rightValue of money decreasesPrice level increases
8 An increase in the money supply 2An increase in the money supply(high)(low)Value ofMoney, 1/P1PriceLevel, P1.3324M1MS1M2MS2MoneyDemand1. An increasein the moneysupply . . .Adecreasesthe value ofmoney . . .and increases the price level.BQuantity ofMoneyWhen the Fed increases the supply of money, the money supply curve shifts from MS1 to MS2. The value of money (on the left axis) and the price level (on the right axis) adjust to bring supply and demand back into balance. The equilibrium moves from point A to point B. Thus, when an increase in the money supply makes dollars more plentiful, the price level increases, making each dollar less valuable.
9 The Classical Theory of Inflation Quantity theory of moneyQuantity of money availableDetermines the price levelGrowth rate in quantity of money availableDetermines the inflation rate
10 The Classical Theory of Inflation A brief look at the adjustment processMonetary injectionExcess supply of moneyIncrease in demand of goods and servicesPrice of goods and services increasesIncrease in price levelIncrease in quantity of money demandedNew equilibrium
11 The Classical Theory of Inflation The classical dichotomy & monetary neutralityNominal variablesVariables measured in monetary unitsReal variablesVariables measured in physical unitsClassical dichotomyTheoretical separation of nominal & real variablesMonetary neutralityChanges in money supply don’t affect real variables
12 The Classical Theory of Inflation Velocity and the quantity equationVelocity of money (V)Rate at which money changes handsV = (P × Y) / MP = price level (GDP deflator)Y = real GDPM = quantity of money
13 The Classical Theory of Inflation Velocity and the quantity equationQuantity equation: M × V = P × YQuantity of money (M)Velocity of money (V)Dollar value of the economy’s output of goods and services (P × Y )Shows: an increase in quantity of moneyMust be reflected in:Price level must riseQuantity of output must riseVelocity of money must fall
14 Nominal GDP, quantity of money, & velocity of money 3Nominal GDP, quantity of money, & velocity of moneyThis figure shows the nominal value of output as measured by nominal GDP, the quantity of money as measured by M2, and the velocity of money as measured by their ratio. For comparability, all three series have been scaled to equal 100 in Notice that nominal GDP and the quantity of money have grown dramatically over this period, while velocity has been relatively stable.
15 The Classical Theory of Inflation Five steps - essence of quantity theory of moneyVelocity of moneyRelatively stable over timeChanges in quantity of money (M)Proportionate changes in nominal value of output (P × Y)
16 The Classical Theory of Inflation Five steps - quantity theory of moneyEconomy’s output of goods and services (Y)Primarily determined by factor suppliesAnd available production technologyBecause money is neutralMoney does not affect output
17 The Classical Theory of Inflation Five steps - quantity theory of moneyChange in money supply (M)Induces proportional changes in the nominal value of output (P × Y)Reflected in changes in the price level (P)Central bank - increases the money supply rapidlyHigh rate of inflation.
18 Money and prices during four hyperinflations Inflation that exceeds 50% per monthPrice level - increases more than a hundredfold over the course of a yearData on hyperinflationClear link betweenQuantity of moneyAnd the price level
19 Money and prices during four hyperinflations Four classic hyperinflation, 1920sAustria, Hungary, Germany, and PolandSlope of the money lineRate at which the quantity of money was growingSlope of the price lineInflation rateThe steeper the linesThe higher the rates of money growth or inflationPrices rise when the government prints too much money
20 Money and prices during four hyperinflations (a, b) 4Money and prices during four hyperinflations (a, b)This figure shows the quantity of money and the price level during four hyperinflations.(Note that these variables are graphed on logarithmic scales. This means that equal vertical distances on the graph represent equal percentage changes in the variable.)In each case, the quantity of money and the price level move closely together. The strong association between these two variables is consistent with the quantity theory of money, which states that growth in the money supply is the primary cause of inflation
21 Money and prices during four hyperinflations (c, d) 4Money and prices during four hyperinflations (c, d)This figure shows the quantity of money and the price level during four hyperinflations.(Note that these variables are graphed on logarithmic scales. This means that equal vertical distances on the graph represent equal percentage changes in the variable.)In each case, the quantity of money and the price level move closely together. The strong association between these two variables is consistent with the quantity theory of money, which states that growth in the money supply is the primary cause of inflation
22 The Classical Theory of Inflation The inflation taxRevenue the government raises by creating (printing) moneyTax on everyone who holds moneyThe Fisher effectPrinciple of monetary neutralityAn increase in the rate of money growthRaises the rate of inflationBut does not affect any real variable
23 The Classical Theory of Inflation The Fisher effectReal interest rate = Nominal interest rate – Inflation rateNominal interest rate = Real interest rate + Inflation rateFisher effect: one-for-one adjustment of nominal interest rate to inflation rateWhen the Fed increases the rate of money growthLong-run resultHigher inflation rateHigher nominal interest rate
24 The nominal interest rate and the inflation rate 5The nominal interest rate and the inflation rateThis figure uses annual data since 1960 to show the nominal interest rate on 3-month Treasury bills and the inflation rate as measured by the consumer price index. The close association between these two variables is evidence for the Fisher effect: When the inflation rate rises, so does the nominal interest rate
25 The Costs of Inflation A fall in purchasing power? Inflation fallacy “Inflation robs people of the purchasing power of his hard-earned dollars”When prices riseBuyers – pay moreSellers – get moreInflation in incomes - goes hand in hand with inflation in pricesInflation does not in itself reduce people’s real purchasing power
26 The Costs of Inflation Shoeleather costs Menu costs Resources wasted when inflation encourages people to reduce their money holdingsCan be substantialMenu costsCosts of changing pricesInflation – increases menu costs that firms must bear
27 The Costs of InflationRelative-price variability & misallocation of resourcesMarket economiesRely on relative prices to allocate scarce resourcesConsumers - compareQuality and prices of various goods and servicesDetermine allocation of scarce factors of productionInflation - distorts relative pricesConsumer decisions – distortedMarkets - less able to allocate resources to their best use
28 The Costs of Inflation Inflation-induced tax distortions Taxes – distort incentivesMany taxesMore problematic in the presence of inflationTax treatment of capital gainsCapital gains – Profits:Sell an asset for more than its purchase priceInflation discourages savingExaggerates the size of capital gainsIncreases the tax burden
29 The Costs of Inflation Inflation-induced tax distortions Tax treatment of interest incomeNominal interest earned on savingsTreated as incomeEven though part of the nominal interest rate compensates for inflationHigher inflationTends to discourage people from saving
30 How inflation raises the tax burden on saving 1How inflation raises the tax burden on savingEconomy A(price stability)Economy B(inflation)Real interest rateInflation rate 0 8Nominal interest rate(real interest rate + inflation rate)Reduced interest due to 25 percent tax(.25 × nominal interest rate)After-tax nominal interest rate(.75 × nominal interest rate)After-tax real interest rate(after-tax nominal interest rate – inflation rate)4%4138129In the presence of zero inflation, a 25 percent tax on interest income reduces the real interest rate from 4 percent to 3 percent.In the presence of 8 percent inflation, the same tax reduces the real interest rate from 4 percent to 1 percent.
31 The Costs of Inflation Confusion and inconvenience Money Yardstick with which we measure economic transactionsThe Central Bank’s jobEnsure the reliability of moneyWhen the Central Bank increases the money supplyCreates inflationErodes the real value of the unit of account
32 The Costs of InflationA special cost of unexpected inflation: arbitrary redistributions of wealthUnexpected inflationRedistributes wealth among the populationNot by meritNot by needRedistribute wealth among debtors and creditorsInflation - volatile & uncertainWhen the average rate of inflation is high