ECON 3330 Inflation

Inflation formula

π = (P year 2 − P year 1) / P year 1 × 100%

Inflation (definition)

An increase in the general price level

Price level vs. inflation

Price level is the level of prices at a point in time; inflation is the rate of change of that level over time

Quantity Theory of Money

MV = PY

M in MV = PY

Money supply (how much money is in the economy)

V in MV = PY

Velocity of money (how quickly money "rotates" in the economy; a measure of how many transactions take place)

P in MV = PY

Price level (price index / 100)

Y in MV = PY

Real output (real GDP)

Money neutrality (long run)

Money does not affect the real economy in the long run; it only affects prices (M↑ → P↑)

Is money neutral in the short run?

No. In the short run, M↑ → Y↑

Money illusion

When people think a nominal change is actually a real change and adjust their behavior accordingly

Money confusion

When people think a real change is actually a nominal change and don't adjust their behavior

Short run → intermediate → long run effect of M↑

Short run: Y↑ (boom). Then P↑ and Y↓ (bust, often below the starting level). Long run: only P↑

Example: V = 1.2, Y = 5 trillion, CPI = 183. Find M

M = PY/V = (1.83 × 5)/1.2 = 7.625 trillion

Example: Y = 200B, M = 140B, CPI = 98. Find V

V = PY/M = (0.98 × 200)/140 = 1.4

Who said inflation is "always and everywhere" a monetary phenomenon?

Milton Friedman

Why is inflation a monetary phenomenon?

Increases in money supply cause inflation

Can real factors cause inflation?

Temporary: yes. Persistent: no

What happens if AS shifts?

One-time change in the price level. For prices to change again, AS must shift again

What keeps prices rising again and again?

Only printing more money

Cost of inflation: uncertainty

Nobody knows the inflation rate while it's happening, which impedes decisions (buy/sell, expand/contract, open/close a business, lending)

Lender/borrower inflation example

Would you give a loan at 4% if you knew inflation would jump to 8%?

Which is worse: unpredictable or consistently high inflation?

Unpredictable inflation (people can adjust to consistently high inflation)

Cost of inflation: redistribution

Inflation redistributes wealth; whoever has the printing press wins

Why is inflation called a tax?

No tax collector needed, and it is much less visible than income taxes

Cost of inflation: growth

Higher inflation discourages savings → less capital → lower real GDP

Inflation and other taxes

You're taxed on nominal gains even if the real return is much smaller

Capital gains example: $100 → $110, 15% tax, 4% inflation

Nominal gain $10 (10%). Tax = $1.50. Net gain $8.50 (8.5%). After-tax real return = 8.5% − 4% = 4.5%

Real-return taxation comparison

If taxed on the real return (6%), tax would be $6 × 0.15 = $0.90

What is debt monetization?

The government printing enough money to pay off its debt

Why doesn't the government monetize its debt? (1)

Investors adjust expectations and stop lending or require a higher interest rate

Why doesn't the government monetize its debt? (2)

Voters will elect a new administration to reduce inflation