1. INFLATION: ITS CAUSES AND COSTS
Chapter 28

2. Inflation: Its Causes and Costs
Inflation is a continuous increase in the overall price level.
Deflation
Hyperinflation

3. Inflation: Historical Aspects
Over the past sixty years, prices have risen on average about 5 percent per year.
In the 1970’s prices rose by 7 % per year.
From , prices rose an average of 3 % per year.

4. The Causes of Inflation
To understand the causes of inflation we must understand the concepts of money supply, money demand, and monetary equilibrium.

5. Money Supply and Money Demand
The money supply is a policy variable that is controlled by the Fed.

6. Money Supply and Money Demand
Money demand has several determinants, including interest rates and the average level of prices in the economy.
People hold money because it is the medium of exchange.

7. Money Supply and Money Demand
Value of
Money
Price
Level 1
(High) 1
(Low)
3/4
1.33
1/2 2
1/4 4
(Low)
(High)
Quantity of
Money

8. Money Supply and Money Demand
Value of
Money
Price
Level
Money supply 1
(High) 1
(Low)
3/4
1.33
1/2 2
1/4 4
Money
demand
(Low)
(High)
Quantity of
Money

9. Money Supply and Money Demand
Value of
Money
Price
Level
Money supply 1
(High) 1
(Low)
3/4
1.33
1/2 2
1/4 4
Money
demand
(Low)
(High)
Quantity fixed
by the Fed
Quantity of
Money

10. Money Supply and Money Demand
Value of
Money
Price
Level
Money supply 1
(High) 1
(Low)
3/4
1.33 A
1/2 2
1/4 4
Money
demand
(Low)
(High)
Quantity fixed
by the Fed
Quantity of
Money

11. Money Supply and Money Demand
Value of
Money
Price
Level
Money supply 1
(High) 1
(Low)
3/4
1.33 A
1/2 2
Equilibrium
value of money
1/4 4
Money
demand
(Low)
(High)
Quantity fixed
by the Fed
Quantity of
Money

12. Money Supply and Money Demand
Quantity fixed
by the Fed
Quantity of
Money
Value of
Price
Level A
Money supply 1
(Low)
(High)
1/2
1/4
3/4
1.33 2 4
Equilibrium
price level
value of money
demand

13. The Effects of Monetary Injection
Suppose the Fed injects money into the economy by buying government bonds.
ä The supply of money curve shifts to the right.
ä The equilibrium value of money decreases.
ä The equilibrium price level increases.

14. The Effects of Monetary Injection
Value of
Money
Price
Level
MS1 1
(High) 1
(Low)
3/4
1.33
1/2 2
1/4 4
Money
demand
(Low)
(High) M1
Quantity of
Money

15. The Effects of Monetary Injection
Value of
Money
Price
Level
MS1 1
(High) 1
(Low)
3/4
1.33
1/2 2
1/4 4
Money
demand
(Low)
(High) M1
Quantity of
Money

16. The Effects of Monetary Injection
Value of
Money
Price
Level
MS1
MS2 1
(High) 1
(Low)
1. An increase in the money supply...
3/4
1.33
1/2 2
1/4 4
Money
demand
(Low)
(High) M1 M1
Quantity of
Money

17. The Effects of Monetary Injection
Value of
Money
Price
Level
MS1
MS2 1
(High) 1
(Low)
1. An increase in the money supply...
3/4
1.33 A
1/2 2 B
1/4 4
Money
demand
(Low)
(High) M1 M1
Quantity of
Money

18. The Effects of Monetary Injection
Value of
Money
Price
Level
MS1
MS2 1
(High) 1
(Low)
1. An increase in the money supply...
3/4
1.33
2. ...decreases the value of money ... A
1/2 2 B
1/4 4
Money
demand
(Low)
(High) M1 M1
Quantity of
Money

19. The Effects of Monetary Injection
Value of
Money
Price
Level
MS1
MS2 1
(High) 1
(Low)
1. An increase in the money supply...
3/4
1.33
2. ...decreases the value of money ...
3. and
increases
the price
level. A
1/2 2 B
1/4 4
Money
demand
(Low)
(High) M1 M1
Quantity of
Money

20. 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.
ä The quantity of money available in the economy determines the value of money.
ä The primary cause of inflation is the growth in the quantity of money.

21. The Classical Dichotomy and Monetary Neutrality
Real economic variables do not change with changes in the money supply.

22. The Classical Dichotomy and Monetary Neutrality
Nominal variables are variables measured in monetary units.
Real variables are variables measured in physical units.
Changes in the money supply affect nominal variable but not real variables.

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

24. Velocity and the Quantity Equation
This is the equation of exchange or the quantity equation.
M x V = P x Y

25. 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.

26. Foundations of 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.
Because money is neutral, money does not affect output.

27. Foundations of the Quantity Theory of Money
When the Fed increases the money supply rapidly, the result is a high rate of inflation.

28. Hyperinflation and Inflation Tax
When the government raises revenue by printing money, it is said to levy an inflation tax.
ä An inflation tax is like a tax on everyone who holds money.

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

30. The Fisher Effect
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.

31. The Fisher Effect
When the Fed increases the rate of money growth, the result is both a higher inflation rate and a higher nominal interest rate.

32. The Costs of Inflation Shoeleather costs Menu costs
Relative price variability
Tax distortions
Confusion and inconvenience
Arbitrary redistribution of wealth

33. 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 reduce their cash holdings.

34. Shoeleather Costs
Less cash requires more frequent trips to the bank to withdraw money from interest-bearing accounts.
Extra trips to the bank take time away from productive activities.

35. Menu Costs Menu costs are the costs of changing prices.
During inflationary times, it is necessary to update price lists and other posted prices.

36. Menu Costs
This is a resource-consuming process that takes away from other productive activities.

37. 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.

38. Confusion and Inconvenience
With rising prices, it is more difficult to compare real revenues, costs, and profits over time.

39. The Inflation Fallacy
Inflation reduces individuals’ incomes and causes living standards to decline.