Chapter 31 Notes: Money Growth and Inflation

Chapter 31: Money Growth and Inflation

Why Inflation Occurs

Inflation: An increase in the overall level of prices.
Deflation: A decrease in the overall level of prices.
Hyperinflation: A monthly inflation rate exceeding 50%.
Short Run vs. Long Run:
- Short run: Inflation is influenced by many forces (discussed in later chapters).
- Long run: Inflation is primarily determined by the quantity theory of money (the focus of this chapter).

The Classical Theory of Inflation

Quantity Theory of Money: Explains the long-run determinants of the price level and the inflation rate.
- Asserts that the quantity of money determines the value of money.
- Main idea: Prices rise when the government prints too much money.

Approaches to Studying the Quantity Theory

Supply-Demand Diagram
Equation

Level of Prices and Value of Money

Price Level (P): The number of riyals needed to buy a basket of goods and services.
- When the price level rises, people have to pay more for goods and services.
Value of Money (1/P): The quantity of goods and services that can be bought with 1 riyal.
- A rise in the price level means a lower value of money because each riyal buys fewer goods and services.
- Inflation drives up prices and drives down the value of money.

Example

In 2021, the price of a cupcake is P = SR 4.
In 2022, the price increases to P = SR 5.
- Value of money in 2021: 1/4 = 0.25
- Value of money in 2022: 1/5 = 0.20
- Inflation explanation: The value of money decreased from 0.25 to 0.20, indicating inflation.

Money Supply (MS)

Money Supply in the Real World:
- Influenced by the central bank, the banking system, and consumers.
Money Supply in This Model:
- The central bank precisely controls MS and sets it at some fixed amount.

Money Demand (MD)

Money Demand:
- How much wealth people want to hold in liquid form.
- Depends on P: An increase in P reduces the value of money, so more money is required to buy goods and services.
Quantity of Money Demanded:
- Negatively related to the value of money.
- Positively related to P, other things equal.

The "Market" for Money

If SAMA increases the money supply:
- The value of money falls, and P rises.

Adjustment Process

Increasing money supply causes P to rise.
- At the initial P, an increase in MS causes an excess supply of money.
- People get rid of their excess money by spending it, increasing the demand for goods and services.
- Because the supply of goods does not increase, prices must rise, increasing the quantity of money demanded.
- "Too much money chasing too few goods."

The Classical Dichotomy

Classical Dichotomy: The theoretical separation of nominal variables and real variables.
Nominal Variables: Measured in monetary units.
- Nominal GDP, nominal interest rate (rate of return measured in SR), nominal wage (SR per hour worked).
Real Variables: Measured in physical units.
- Real GDP, real interest rate (measured in output), real wage (measured in output).

Relative Price Example

The relative price of a smartphone is:

$\frac{P \text{ of smartphone}}{P \text{ of pizza}} = \frac{\text{SR 450/smartphone}}{\text{SR 10/pizza}} = 45 \text{ pizzas per smartphone}$

Real Wage Example

Nominal wage, $W$ = SR 15/hour.
Price level, $P$ = SR 5/unit of output.
Real wage calculation:

$\text{Real wage} = \frac{W}{P} = \frac{\text{SR 15/hour}}{\text{SR 5/unit of output}} = 3 \text{ units of output per hour}$

Monetary Neutrality

Monetary developments affect nominal variables but not real variables.
- If the central bank doubles the money supply:
  - All nominal variables—including prices—will double.
  - But all real variables—including relative prices—will remain unchanged.
Monetary Neutrality: The proposition that changes in the money supply do not affect real variables.

Example

Initially, the relative price of smartphones in terms of pizza is:

$\frac{\text{SR 450}}{\text{SR 10}} = 45 \text{ pizzas per smartphone}$

If all prices double:

$\frac{\text{SR 900}}{\text{SR 20}} = 45 \text{ pizzas per smartphone}$

The relative price is unchanged!

Neutrality of Money Table

Item	Real or Nominal?	What happens to it?
Nominal wages	Nominal	Doubles
Price level	Nominal	Doubles
Real wage	Real	Does not change
Quantity of labor supplied	Real	Does not change
Quantity of labor demanded	Real	Does not change
Dividends paid out by a company	Nominal	Doubles

If the central bank doubles the money supply, the real wage and total employment do not change.

Long-Run vs. Short-Run Effects

Most economists believe the classical dichotomy and neutrality of money describe the economy in the long run.
Monetary changes can have important short-run effects on real variables.

The Velocity of Money

Velocity of Money: The rate at which money changes hands.
Notation:
- $P \times Y$ = nominal GDP = (price level) x (real GDP).
- $M$ = money supply.
- $V$ = velocity.
Velocity Formula:

$V = \frac{P \times Y}{M}$

Example

Money supply is SR 10,000, real GDP is 3,000 pizzas, and the price of pizza is SR 10.
$Y = \text{real GDP} = 3,000 \text{ pizzas}$
$P = \text{price level} = \text{price of pizza} = \text{SR 10}$
$P \times Y = \text{nominal GDP} = \text{value of pizzas} = \text{SR 30,000}$
Velocity calculation:

$V = \frac{P \times Y}{M} = \frac{\text{SR 30,000}}{\text{SR 10,000}} = 3$

The average riyal was used in 3 transactions.

The Quantity Equation

The Quantity Equation:

$M \times V = P \times Y$

Shows that an increase in the quantity of money in an economy must be reflected in one of the other three variables:
- The price level must rise.
- The quantity of output must rise.
- Or the velocity of money must fall.

The Quantity Theory of Money (cont.)

$V$ is relatively stable over time.
A change in $M$ causes nominal GDP ( $P \times Y$ ) to change by the same percentage.
A change in $M$ does not affect $Y$ : money is neutral (in the long run), $Y$ is determined by technology & resources.
So, $P$ changes by the same percentage as $P \times Y$ and $M$ .
Rapid money supply growth causes rapid inflation.

Milk Economy Example

The economy can produce 1,800 bottles of milk. $V$ is constant.
In 2023, money supply was 3,600 riyals and the price of milk was SR 8/bottle.
For 2024, SAMA increases money supply MS by 10%.

Calculations

Calculate the velocity $V$ .
Compute the 2024 values of nominal GDP and $P$ .
Compute the inflation rate for 2023–2024.
Suppose technological progress causes $Y$ to increase to 1,950 in 2024. Compute the 2023–2024 inflation rate.

Answers

Part A and B:
- $P \times Y = M \times V$ , so $8 \times 1,800 = 3,600 \times V$ , therefore $V = 4$ .
- Increase in the money supply = SR 3,600 + (10% to SR 3,600) = SR 3,960.
- Nominal GDP in 2024 = $P \times Y = M \times V = \text{SR 3,960} \times 4 = \text{SR 15,840}$
$P_{2024} = \frac{M \times V}{Y} = \frac{15,840}{1,800} = 8.8$
Inflation rate 2023-2024 = $\frac{(8.8 – 8)}{8} = 10\%$ (same as money supply)
Part C:
- $Y$ increased to 1,950 in 2024.
$P_{2024} = \frac{M \times V}{Y} = \frac{15,840}{1,950} = 8.12$
Inflation rate 2023-2024 = $\frac{(8.12 – 8)}{8} = 1.5\%$

The Inflation Tax

Inflation Tax: Revenue the government raises by creating (printing) money.
- Like a tax on everyone who holds money.
- When the government prints money:
  - The price level rises.
  - The riyals in your wallet are less valuable.

The Fisher Effect

Principle of Monetary Neutrality: An increase in the rate of money growth raises the rate of inflation but does not affect any real variable.
Because Real interest rate = Nominal interest rate – Inflation rate:
We get Nominal interest rate = Real interest rate + Inflation rate.
Fisher Effect: One-for-one adjustment of the nominal interest rate to the inflation rate.
- When SAMA increases the rate of money growth, the long-run result is:
  - Higher inflation rate.
  - Higher nominal interest rate.

The Inflation Fallacy

Inflation Fallacy:
- "Inflation robs people of the purchasing power of his hard-earned dollars."
- When prices rise:
  - Buyers pay more.
  - Sellers get more.
- Inflation does not in itself reduce people’s real purchasing power.

The Costs of Inflation

Shoeleather costs
Menu costs
Relative-price variability
Inflation-Induced Tax Distortions
Confusion and Inconvenience
Arbitrary Redistributions of Wealth

1. Shoeleather Costs

Inflation:
- Is like a tax on the holders of money.
- Avoid the inflation tax by holding less money (and going to the bank more often).
Shoeleather Costs: Resources wasted when inflation encourages people to reduce their money holdings.
- Can be substantial in countries with hyperinflation.
- Example: During Germany’s hyperinflation (1921-1923), merchants hired runners to take cash to the bank to convert it into a more stable currency.

2. Menu Costs

Menu Costs: Costs of changing prices.
- Inflation increases the menu costs firms must bear.
  - Deciding on new prices.
  - Printing new price lists and catalogs.
  - Sending the new price lists and catalogs to dealers and customers.
  - Advertising the new prices.
  - Dealing with customer annoyance over price changes.

3. Relative-Price Variability

Misallocation of Resources from Relative-Price Variability:
- Firms don’t all raise prices at the same time, so relative prices can vary.
- The higher the inflation rate, the greater this swing in relative prices will be.
- Consumer decisions are distorted, and markets are less able to allocate resources to their best use.

4. Inflation-Induced Tax Distortions

Inflation-Induced Tax Distortions:
- Inflation makes nominal income grow faster than real income.
- Taxes are based on nominal income and some are not adjusted for inflation.
- Inflation causes people to pay more taxes even when their real incomes don’t increase.

Example

Deposit SR 1,000 in the bank for one year. The tax rate is 25%.
CASE 1: inflation = 0%, nominal interest rate = 10%.
CASE 2: inflation = 10%, nominal interest rate = 20%.
- How much tax do you pay?
- What is the after-tax nominal interest rate?
- What is the after-tax real interest rate?

Answers

Amount of tax paid:
- CASE 1: interest income = SR 100, so you pay SR 25 in taxes.
- CASE 2: interest income = SR 200, so you pay SR 50 in taxes.
After-tax nominal interest rate:
- CASE 1: (1 – 0.25) x 10% = 7.5%.
- CASE 2: (1 – 0.25) x 20% = 15%.
After-tax real interest rate:
- CASE 1: 7.5% - 0% = 7.5%.
- CASE 2: 15% - 10% = 5%.
So, with inflation, a tax can reduce the real interest rate you receive. Without inflation, a tax has no such impact.

5. Confusion and Inconvenience

One of the functions of money is to be a “unit of account.”
- Inflation changes the yardstick we use to measure transactions.
- Complicates long-range planning and the comparison of riyal amounts over time.
- Difficult to judge the costs of the confusion and inconvenience that arise from inflation.

6. Arbitrary Redistributions of Wealth

Unexpected Inflation:
- Redistributes wealth among the population.
  - Not by merit.
  - Not by need.
- Redistributes wealth among debtors and creditors.
- Inflation: volatile and uncertain.
- When the average rate of inflation is high.

Deflation May Be Worse

Friedman Rule:
- Prescription for moderate inflation.
- A small and predictable amount of deflation may be desirable.
In practice, deflation is rarely steady and predictable.
- Redistribution of wealth away from debtors (who are often poorer).
In general, most of the costs of inflation are also costs of deflation (e.g., menu costs).