ELECTIVE L1: Money growth and inflation

money supply

• controlled by the central bank

• when central bank increases more money supply → price rises

• continous increase in money → persisten inflation

money demand

• how much people want to hold

monetary neutrality

• changes in money supply affect nominal variables not real variables

• nominal variables examples:

  • price, wages, money values

• real variables:

  • output, employment, real income

• in the long run, increasing money only raises prices, not real production

printing money & hyperinflation

• inflation tax: government can finance spending by printing money

• hyperinflation: too much money creation → money loses value quickly

the fisher effect

• i = nominal interest rate

• r = real interest rate

• 𝜋𝑒 = expected inflation

• when expected inflation increases, nominal interest rate also increase

• real interest rate stays roughly the same

does inflation make you poorer?

• not entirely true

• nominal income also increases but the real income (purchasing power) is what matters

costs of inflation

• shoe leather cost

• menu cost

• relative price variability

• tax distortions

• confusion and inconvenience

• redistribution of wealth

shoe-leather cost

• people reduce cash holdings

• more trips to the bank

menu cost

• business frequently change prices

relative price variability

• price change unevenly → confusion

tax distortions

• inflation affects taxes unfairly

confusion and inconvenience

• money becomes a less reliable measure

redistribution of wealth

• borrowers benefit

• lenders lose

severity of inflation

• hyperinflation

• moderate inflation

hyperinflation

• very harmful

• often defined as less 50% per month

• economically devastating as it destroys basic functions of money

moderate inflation

• cost exist but are smaller and debated

• 1-4% annually in many economies

• not automatically harmful sometimes can be useful

• pros:

  • encourages spending / investment: prices rise slowly → less likely to hoard cash

  • eases debt burdens: borrowers repay loans in “cheaper” future dollars

  • allows wage flexibility: real wages can adjust without nominal wage cuts which workers resist

• cons:

  • erodes purchasing power: especially fixed income

  • menu cost: frequent price change

  • uncertainty: inflation becomes volatile

  • redistribution effect: hurt saves and helps borrowers

central bank target low but positive inflation

• they aim for 2% inflation due to:

  • zero inflation risks deflation (worse, ppl delay spending)

  • slight inflation gives policymakers room to adjust interest rate

  • balances growth with stability