1. Chapter 17 Money Growth and Inflation 23 October 2006 Eco 202

2. 2 End-of-Chapter Problems 1, 2, 6, 8, 11, 13

3. 3 The Meaning of Money Money is the set of assets in an economy that people regularly use to buy goods and services from other people. Economists contend that money is productive because it lowers the transaction costs of exchange. If money is a good thing, could it be possible to have too much money?

4. 4 THE CLASSICAL THEORY OF INFLATION Inflation is an increase in the overall level of prices. Hyperinflation is an extraordinarily high rate of inflation. Inflation: Historical Aspects  Over the past 60 years, prices have risen on average about 5 percent per year.  Deflation, meaning decreasing average prices, occurred in the U.S. in the nineteenth century.  Hyperinflation refers to high rates of inflation such as Germany experienced in the 1920s.

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6. 6 THE CLASSICAL THEORY OF INFLATION Inflation: Historical Aspects  In the 1970s prices rose by 7 percent per year.  During the 1990s, prices rose at an average rate of 2 percent per year.

7. 7 This Decade YearInflation Rate (Dec-Dec) 20003.4 20011.6 20022.4 20031.9 20043.3 20053.4

8. 8 THE CLASSICAL THEORY OF INFLATION The quantity theory of money is used to explain the long-run determinants of the price level and the inflation rate. Inflation is an economy-wide phenomenon that concerns the value of the economy’s medium of exchange. When the overall price level rises, the value of money falls.

9. 9 Aside: Terminology The Quantity Equation is not the same as the Quantity Theory of Money Quantity Equation is true by definition—it is an identity. Quantity Theory of Money is subject to testing.

10. 10 Money Supply, Money Demand, and Monetary Equilibrium The money supply is a policy variable that is controlled by the Fed.  Through instruments such as open-market operations, the Fed directly controls the quantity of money supplied.

11. 11 Money Supply, Money Demand, and Monetary Equilibrium Money demand has several determinants, including interest rates and the average level of prices in the economy.

12. 12 Money Supply, Money Demand, and Monetary Equilibrium People hold money because it is the medium of exchange.  The amount of money people choose to hold depends on the prices of goods and services.  As prices rise, people will want to hold more of their assets in the form of money (liquid asset), and less in the form of assets that are not liquid.

13. 13 Money Supply, Money Demand, and Monetary Equilibrium In the long run, the overall level of prices adjusts to the level at which the demand for money equals the supply.  This suggests that changes in either the supply of money or the demand for money will cause the price level to change.

14. Figure 1 Money Supply, Money Demand, and the Equilibrium Price Level Copyright © 2004 South-Western Quantity of Money Value of Money, 1/ P Price Level, P Quantity fixed by the Fed Money supply 0 1 (Low) (High) (Low) 1 / 2 1 / 4 3 / 4 1 1.33 2 4 Equilibrium value of money Equilibrium price level Money demand A

15. Figure 2 The Effects of Monetary Injection Copyright © 2004 South-Western Quantity of Money Value of Money, 1/ P Price Level, P Money demand 0 1 (Low) (High) (Low) 1 / 2 1 / 4 3 / 4 1 1.33 2 4 M1M1 MS 1 M2M2 MS 2 2.... decreases the value of money... 3.... and increases the price level. 1. An increase in the money supply... A B

16. 16 THE CLASSICAL THEORY OF INFLATION The Quantity Theory of Money  How the price level is determined and why it might change over time is called the quantity theory of money. The quantity of money available in the economy determines the value of money. The primary cause of inflation is the growth in the quantity of money.

17. 17 The Classical Dichotomy and Monetary Neutrality Nominal variables are variables measured in monetary units. Real variables are variables measured in physical units.

18. 18 The Classical Dichotomy and Monetary Neutrality According to Hume and others, real economic variables do not change with changes in the money supply.  According to the classical dichotomy, different forces influence real and nominal variables. Changes in the money supply affect nominal variables but not real variables.

19. 19 The Classical Dichotomy and Monetary Neutrality The irrelevance of monetary changes for real variables is called monetary neutrality.

20. 20 Velocity and the Quantity Equation The velocity of money refers to the speed at which the typical dollar bill travels around the economy from wallet to wallet.

21. 21 Velocity and the Quantity Equation V = (P  Y)/M  Where: V = velocity P = the price level Y = the quantity of output (real GDP) M = the quantity of money  Because Velocity is defined from the other three variables, the Quantity Equation is an Identity

22. 22 Velocity and the Quantity Equation Rewriting the equation gives the quantity equation: M  V = P  Y M  V = P  Y M = money supply V = velocity P = price level Y = real GDP

23. 23 Velocity and the Quantity Equation The quantity equation relates the quantity of money (M) to the nominal value of output (P  Y).

24. 24 Velocity and the Quantity Equation The quantity equation shows that an increase in the quantity of money in an economy must be reflected in one of three other variables:  the price level must rise,  the quantity of output must rise, or  the velocity of money must fall.

25. Figure 3 Nominal GDP, the Quantity of Money, and the Velocity of Money Copyright © 2004 South-Western Indexes (1960 = 100) 2,000 1,000 500 0 1,500 196019651970197519801985199019952000 Nominal GDP Velocity M2

26. 26 Velocity and the Quantity Equation The Equilibrium Price Level, Inflation Rate, and the Quantity Theory of Money  The velocity of money is relatively stable over time.  When the Fed changes the quantity of money, it causes proportionate changes in the nominal value of output (P  Y).  Because money is neutral, money does not affect output (real GDP).

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29. 29 CASE STUDY: Money and Prices during Four Hyperinflations Hyperinflation is inflation that exceeds 50 percent per month. Hyperinflation occurs in some countries because the government prints too much money to pay for its spending.

30. Figure 4 Money and Prices During Four Hyperinflations Copyright © 2004 South-Western (a) Austria(b) Hungary Money supply Price level Index (Jan. 1921 = 100) Index (July 1921 = 100) Price level 100,000 10,000 1,000 100 19251924192319221921 Money supply 100,000 10,000 1,000 100 19251924192319221921

31. Figure 4 Money and Prices During Four Hyperinflations Copyright © 2004 South-Western (c) Germany 1 Index (Jan. 1921 = 100) (d) Poland 100,000,000,000,000 1,000,000 10,000,000,000 1,000,000,000,000 100,000,000 10,000 100 Money supply Price level 19251924192319221921 Price level Money supply Index (Jan. 1921 = 100) 100 10,000,000 100,000 1,000,000 10,000 1,000 19251924192319221921

32. 32 Hyperinflation in Germany At the end of World War I, Germany was required to pay reparations to the Allies Germany began running large deficits Unable to tax or borrow enough to pay, Germany began printing large quantities of money. Prices started to rise.

33. 33 Hyperinflation in Germany Price of a newspaper in Germany, 1921- 1923: January 19210.30 May 19221 October 19228 February 1923100 September 19231,000 October 1, 19232,000 October 1520,000 October 291,000,000 November 915,000,000 November 1770,000,000 DatePrice in marks Source: Mankiw, Macroeconomics, 5 th ed., pp. 105-106

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37. 37 Hyperinflation in Yugoslavia From 1971-1991, Yugoslavia had an average annual inflation rate of 76%  Only Zaire and Brazil had a higher inflation rate. In December 1990, the Serbian parliament ordered the Serbian National Bank (a regional central bank) to issue large amounts of credits to friends of Slobodan Milosevic. Source: Steve Hanke in April 28, 1999 Wall Street Journal

38. 38 Hyperinflation in Yugoslavia This amounted to more than half the planned increase in the money supply for all of Yugoslavia in 1991 Croatia and Slovenia broke away In January 1992, hyperinflation began Source: Steve Hanke in April 28, 1999 Wall Street Journal

39. 39 Hyperinflation in Yugoslavia In January 1994, the official monthly inflation rate reached 313 million percent  This was the second-highest monthly rate (after Hungary in 1946)  …and the second-longest (after the Soviet hyperinflation of the early 1920s)  People spent their time trying to exchange dinars for marks or dollars on the black market Source: Steve Hanke in April 28, 1999 Wall Street Journal

40. 40 Hyperinflation in Yugoslavia The Yugoslav mint was producing 900,000 bank notes a month, in denominations of up to 500 billion dinars Source: Steve Hanke in April 28, 1999 Wall Street Journal; image from National Bank of Serbia

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42. 42 Hyperinflation in Yugoslavia On January 6, 1994, the government gave up and declared the German mark legal tender  Tying a “superdinar” to the mark reduced inflation Source: Steve Hanke in April 28, 1999 Wall Street Journal

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45. 45 The Inflation Tax 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. The inflation ends when the government institutes fiscal reforms such as cuts in government spending.

46. 46 The Fisher Effect The Fisher effect refers to a one-to-one adjustment of the nominal interest rate to the inflation rate. According to the Fisher effect, when the rate of inflation rises, the nominal interest rate rises by the same amount. The real interest rate stays the same.

47. Figure 5 The Nominal Interest Rate and the Inflation Rate Copyright © 2004 South-Western Percent (per year) 196019651970197519801985199019952000 0 3 6 9 12 15 Inflation Nominal interest rate

48. 48 THE COSTS OF INFLATION A Fall in Purchasing Power?  Inflation does not in itself reduce people’s real purchasing power.

49. 49 THE COSTS OF INFLATION Shoeleather costs Menu costs Relative price variability Tax distortions Confusion and inconvenience Arbitrary redistribution of wealth

50. 50 Shoeleather Costs Shoeleather costs are the resources wasted when inflation encourages people to reduce their money holdings. Inflation reduces the real value of money, so people have an incentive to minimize their cash holdings.

51. 51 Shoeleather Costs Less cash requires more frequent trips to the bank to withdraw money from interest- bearing accounts. The actual cost of reducing your money holdings is the time and convenience you must sacrifice to keep less money on hand. Also, extra trips to the bank take time away from productive activities.

52. 52 Menu Costs Menu costs are the costs of adjusting prices. During inflationary times, it is necessary to update price lists and other posted prices. This is a resource-consuming process that takes away from other productive activities.

53. 53 Relative-Price Variability and the Misallocation of Resources Inflation distorts relative prices. Consumer decisions are distorted, and markets are less able to allocate resources to their best use.

54. 54 Inflation-Induced Tax Distortion Inflation exaggerates the size of capital gains and increases the tax burden on this type of income. With progressive taxation, capital gains are taxed more heavily.

55. 55 Inflation-Induced Tax Distortion The income tax treats the nominal interest earned on savings as income, even though part of the nominal interest rate merely compensates for inflation. The after-tax real interest rate falls, making saving less attractive.

56. Table 1 How Inflation Raises the Tax Burden on Saving Copyright©2004 South-Western

57. 57 Confusion and Inconvenience When the Fed increases the money supply and creates inflation, it erodes the real value of the unit of account. Inflation causes dollars at different times to have different real values. Therefore, with rising prices, it is more difficult to compare real revenues, costs, and profits over time.

58. 58 A Special Cost of Unexpected Inflation: Arbitrary Redistribution of Wealth Unexpected inflation redistributes wealth among the population in a way that has nothing to do with either merit or need. These redistributions occur because many loans in the economy are specified in terms of the unit of account—money.

59. 59 Summary The overall level of prices in an economy adjusts to bring money supply and money demand into balance. When the central bank increases the supply of money, it causes the price level to rise. Persistent growth in the quantity of money supplied leads to continuing inflation.

60. 60 Summary The principle of money neutrality asserts that changes in the quantity of money influence nominal variables but not real variables. A government can pay for its spending simply by printing more money. This can result in an “inflation tax” and hyperinflation.

61. 61 Summary According to the Fisher effect, when the inflation rate rises, the nominal interest rate rises by the same amount, and the real interest rate stays the same. Many people think that inflation makes them poorer because it raises the cost of what they buy. This view is a fallacy because inflation also raises nominal incomes.

62. 62 Summary Economists have identified six costs of inflation:  Shoeleather costs  Menu costs  Increased variability of relative prices  Unintended tax liability changes  Confusion and inconvenience  Arbitrary redistributions of wealth

63. 63 Summary When banks loan out their deposits, they increase the quantity of money in the economy. Because the Fed cannot control the amount bankers choose to lend or the amount households choose to deposit in banks, the Fed’s control of the money supply is imperfect.