ECO 1102 Chapter 11: Money Growth and Inflation

Hyperinflation

Extraordinarily high rates of inflatio

Quantity theory of money

Prices rise when the government prints too much money

Classical theory of inflation

Inflation is an economy-wide phenomenon that concerns the value of the economy’s medium of exchange; only affects nominal variables

Price level can be viewed in two ways

1. As the price of a basket of goods and services
2. As a measure of the value of money

Money Supply

Bank of Canada with the banking system will determine the supply of money

Money Demand

Demand for money reflects how much wealth people want to hold in liquid form

What is demand for money dependent on

Interest Rates

Average level of prices in the economy

Higher price level increases the quantity of money demanded

What ensures money equilibrium

In the long run, the overall level of prices adjusts to the level at which the demand for money equals the supply

What does the equilibrium of money supply and money demand determine

The value of money and the price level

Effects of a monetary injection

Increases money supply → increases equilibrium price level → causes value of money to decrease

Quantity Theory of Money

The quantity of money available determines the price level and that the growth rate in the quantity of money available determines the inflation rate

The Adjustment Process

1. Monetary injection creates excess supply of money
2. Excess supply of money creates greater demand for goods and services
3. Greater demand for goods and services causes price level to increase
4. Increase in price level increases quantity of money demand so now there is a new equilibrium

Nominal Variables

Variables measured in monetaary units; heavily influenced by developments in the economy’s monetary system

Real Variables

Variables measured in physical units

Classical Dichotomy

Theoretical separation of nominal and real variables

Relative Prices

Price of one thing compared to another; these are real variables

Monetary Neutrality

Proposition that changes in the money supply do not affect real variables; does not apply to short-run

Velocity of money

Rate at which money changes hands

Velocity of Money Equation

(GDP Deflator x Real GDP)/Quantity of Money;

(P x Y)/M

Quantity Equation

Shows that an increase in the quantity of money will be reflected in one of three variables

Quantity Equation’s Equation

Quantity of Money x Velocity of Money = Price of Output x Amount of output;

M x V = P x Y

Does velocity of money change

No, velocity of money is relatively stable over time

Does amount of output change

No, output is affected by factor supplies; money is neutral so it doesn’t affect output

Does price level change

Yes, when the central bank increases money supply rapidly, result is a high rate of inflation

Why do government print more money

Governments use money creation as a way to pay for their spending

Inflation Tax

The government prints money → price level rises and dollar is less valuable;

Is a tax on everyone who holds money

Hyperinflation because of inflation tax pattern

Government has high spending, inadequate tax revenue and limited ability to borrow → prints money to pay for spending → leads to hyperinflation

Fisher Effect

One-for-one adjustment of the nominal interest rate to the inflation rate; only occurs in long run

Inflation fallacy

Inflation does not in itself reduce people’s real purchasing power;

inflation in income goes directly with inflation in prices

Shoeleather costs

resources wasted when inflation encourages people to reduce their money holdings; substantial in countries with hyperinflation

Menu Costs

Costs of changing prices

Relative Price Variability

Inflation causes relative prices to vary more than they otherwise would; consumer decisions become distorted and markets are less able to allocate resources to their best use

Inflation induced tax distortions

inflation raises the tax burden on income earned from savings

Treatment of capital gains

Profit made from selling an asset for more than purchase price; inflation exaggerates size of capital gains and increases tax burden

Treatment of interest income

Income tax treats the nominal interest rate earned on savings as income, even though part of the nominal interest rate is meant to compensate for inflation

Ways to change tax system

1. Tax laws can be rewritten to take into account inflation
2. Many aspects of the tax laws are not indexed, unlike income tax rate changes

Confusion of inflation

Inflation makes investors less able to sort out success from failing companies

Arbitrary redistributions of wealth

Unexpected inflation redistributes wealth among the population in a way that doesn’t have to do with merit or need

Friedman Rule

A want for moderate and predictable inflation; reduces nominal interest rate and shoe leather costs

Costs of deflation

1. Menu costs
2. Relative-price variability
3. Redistribution of wealth toward creditors and away from debtors

Causes of deflation

1. Decrease in demand for goods and services
2. Leads to falling incomes and rising unemployment