1. Lecture 19: Inflation in the Business Cycle Model L11200 Introduction to Macroeconomics 2009/10 Reading: Barro Ch.11 16 March 2010

2. Introduction Before the Mid-Term Exam: – Considered role of money demand and supply in determining the price level – Introduced concept and measurement of inflation Today – Incorporate inflation into decisions of agents in the Equilibrium Business Cycle Model

3. Real Effects of Inflation In previous version of the model, inflation rate was zero – Does positive inflation affect choices? – Channel through which it might is effect on real interest rate Real interest rate = nominal interest rate – inflation rate

4. Bonds rate and Interest Rates Rate of return on capital / bonds – Written in real terms, so no change if inflation is positive – Households make investment decisions based on real return, so changes in inflation rate push up nominal return and leave real return unchanged

5. Money Demand Does inflation impact on money demand? – Money demand was a trade-off between cash (lower transaction costs) or assets (which earn a return) – Interest rate on assets: – Return on holding money is -π – So net of these is i : money demand still driven by nominal interest rate

6. Labour and Capital Markets So positive inflation rate has no impact of asset holding / money demand decision What about capital and labour markets? – No effect on MPK (capital demand), or κK (labour supply) as R/P unchanged – No effect on MPL (labour demand) of W/P* as wage bargained in real terms – Overall: positive inflation doesnt impact output, capital/labour mix, consumption/saving or labour supply, money demand or asset holding

7. Money Growth and Inflation Understanding Dynamics of Inflation Growth of money supply = money at time t+1 – money at time t Rate money supply growth = growth of money supply between t and t+1 / money at time t Rate of inflation= growth of money prices between t and t+1 / price level at time t

8. Money Growth and Inflation Equilibrium in the money market given by So price level determined by: Hence (for fixed L(Y,i)) money growth determines price growth Inflation rate = money growth rate

9. Money Demand and Money Growth Demand for money also changes over time Increase in output (Y) raises money demand. With constant growth is Y is (constant) rate of growth of money demand

10. Inflation Dynamics Dynamics of inflation driven by: – Money growth: constant rate μ – Money demand growth: constant rate Price level = level of money supply / level of money demand Inflation rate = rate of money supply growth – rate of money demand growth

11. Changes in Money Growth What is the impact of a change in the growth of money? – Assume Y is constant (money demand constant) – Prices growing in line with money growth – Then government undertakes one-off increase in money supply – What is the impact on prices?

12. Changes in Money Growth Prices now grow at new (higher) rate of money growth – Nominal interest rate increases in line with one- off increase in prices – Real interest rate unchanged – Higher nominal interest rate induces effect on money demand: money demand falls as households offset higher opportunity cost of holding money by reducing money holding

13. Effect on Money Demand Household offload excess money holding – Now holding too much cash relative to assets at the new nominal interest rate – (Transactions costs are unchanged) – So off-load cash onto asset purchases – Increases demand investment (bought of out current output) – Raises price level in the economy

14. Jump in Price Level So increasing money supply growth has two effects – Increases steady-state inflation rate 1:1 – Induces one-off jump in price level via impact on money demand – So prices jump (high inflation) followed by fall in inflation down to new steady-state level

15. Printing Money Q: Can governments benefit from printing money (i.e. print new money and spend it) A: Maybe, if money demand is slow to adjust – Government prints money for itself – Nominal value of new money: – Real value of new money: – Real revenue from printing money:

16. Printing Money So return to government depends on how quickly M/P responds – If households lower money demand quickly, prices rise and M/P falls equivalent to increase in supply – So real revenue from printing money = 0 – If money demand is slow to adjust, government makes real return from printing money

17. Real Money Balance Adjustment Money Printing vs Money off-loading – So government is in a race against households – Government prints cash (and begins spending) – Causes price inflation, increases nominal interest rate – Households lower money demand and real money balances – Price rise (decreasing value of printed money) – Real return to government falls

18. Hyperinflation Evidence suggests that when governments try to print money, households respond quickly – E.g. German government 1920-23 tried to repay war debts by printing money – Households figured this, and lowered money demand – So inflation rate exceeded money growth rate (as households offloaded excess money holding) – Government printed more and more money, but couldnt outstrip growth in inflation rate (caused by household response)

19. Summary Inflation caused by growth in money supply – Has no effect on real variables, so leaves key economic outcomes unchanged – But can distort price dynamics and be mis-used by governments – Evidence suggests cannot be used on large-scale Next time: more orthodox spending policy! – Government taxation and spending