8 - Money Growth and Inflation Notes

The Quantity Theory of Money

  • The quantity theory of money (Classical Theory of Inflation) explains one of the 10 Principles of Economics:

    Prices rise when the government prints too much money

  • Most economists view this theory as a reliable explanation of inflation in the long run.

  • Suppose that the quantity of money determines the value of money

  • Study this theory using 2 approaches: A supply-demand diagram and an equation

The Money Supply-Demand diagram

The value of money

  • P = the price level (the CPI or GDP deflator)

  • P is the price of a basket of goods in terms of money.

  • 1/P1/P is the value of a unit of money, measured in goods.

    • Example: If a basket contains one candy bar

    • P = $2 , the value of $1 is 1/2 candy bar.

    • P = $3, the value of $1 is 1/3 candy bar.

  • Inflation increases prices and reduces the value of money.

  • The value of money is inversely related to the price level; as the value of money increases, the price level decreases.

  • The demand for money reflects how much wealth people want to hold in liquid form for transactions. People hold money because it is the medium of exchange

  • Higher price levels increase the demand for money (people need more cash to maintain their purchasing power)

Effects of a Monetary Injection

  • Increasing the money supply (MS shifts right) causes the price level (PP) to rise and value of money to fall (inflation)

  • Increasing the money demand (MD shifts right) causes the price level to fall and value of money to rise

Real vs. Nominal Variables

Definitions

  • Nominal variables are measured in monetary units (e.g., nominal GDP, nominal interest rate - rate of return in $, nominal wage - $ per hour worked) (measured in $)

  • Real variables are measured in physical units (e.g., real GDP, real interest rate - measured in output, real wage). (measured in output)

Relative Prices

  • Relative prices is the price of one good relative to (divided by) another.

    • Example: If a CD costs $15 and a pizza costs $10, the relative price of a CD is 1.5 pizzas (1.5 pizzas per CD)

  • Relative prices are expressed in physical units, making them real variables.

Real vs. Nominal Wage

  • The real wage is a crucial relative price, calculated as: WP\frac{W}{P}

    • WW is the nominal wage = price of labour ($15/hour)

    • PP is the price level = price of goods & services ($5/unit of output)

    • Eg: If the nominal wage is $15/hour and the price level is $5/unit of output, the real wage is 3 units of output per hour.

Classical Dichotomy and Neutrality of Money

Classical Dichotomy

  • Classical dichotomy is the theoretical separation of nominal and real variables.

  • Classical economists believed that changes in the money supply affect nominal variables but not real variables.

  • If the central bank doubles the money supply, classical thinkers contend:

    • nominal variables, including prices, will double

    • real variables, like relative prices, will remain unchanged.

Monetary Neutrality

  • Monetary neutrality suggests that changes in the money supply do not affect real variables.

  • Doubling the money supply doubles all nominal prices, but relative prices remain the same.

  • Real wage remains unchanged, so the quantity of labor supplied and demanded, and total employment, do not change.

  • Since employment of all resources is unchanged, total output is also unaffected by the money supply.

    In the long run…

  • Most economists believe that the classical dichotomy and monetary neutrality hold in the long run.

  • Monetary changes can have short-run effects on real variables.

The Quantity Equation

Velocity of Money

  • Velocity of money is the rate at which money changes hands.

  • Formula: V=P×YMV = \frac{P \times Y}{M}, where P×YP \times Y is nominal GDP = (price level) x (real GDP - quantity of g&s produced), and MM is the money supply.

Quantity Equation

M×V=P×YM \times V = P \times Y

  1. VV is stable (constant? in short tun)

  2. A change in MM causes nominal GDP (P×YP \times Y) to change by the same percentage.

  3. A change in MM does not affect YY (money is neutral; YY is determined by technology and resources).

    Reminder: Y=AF(K.L.H.N)Y=AF\left(K.L.H.N\right)

  4. PP changes by the same percentage as P×YP \times Y and MM.

  5. Rapid money supply growth causes rapid inflation.

Quantity Theory of Money: Example

Scenario

  • Economy produces corn: Y=800Y = 800 bushels.

  • Velocity (VV) is constant.

  • 2008: Money Supply (MS) = $2000, Price (PP) = $5/bushel.

  • 2009: Central Bank increases MS by 5% to $2100.

Calculations

a. Compute the 2009 values of nominal GDP and P. Compute the inflation rate for 2008-2009.
b. Suppose tech. progress causes Y to increase to 824 in 2009. Compute 2008-2009 inflation rate.

Summary and Lessons about the Quantity Theory of Money

  • If real GDP is constant, then the inflation rate equals the money growth rate.

  • If real GDP is growing, then inflation rate equals money growth rate minus economic growth rate.

  • Economic growth increases the number of transactions.

  • Some money growth is needed for these extra transactions.

  • Excessive money growth causes inflation.

Some Related Issues

Hyperinflation

  • Hyperinflation is defined as inflation exceeding 50% per month.

  • Excessive growth in the money supply always causes hyperinflation.

Inflation Tax

  • Governments may print money to cover spending, causing inflation, which acts as a tax on those holding money.

  • In the U.S., the inflation tax accounts for less than 3% of total revenue today.

The Fisher Effect

  • The Fisher effect states that an increase in inflation causes an equal increase in the nominal interest rate, leaving the real interest rate unchanged.

    • The real interest rate is determined by saving and investment in the loanable funds market.

    • Money supply growth determines the inflation rate.

    • The nominal interest rate adjusts one-for-one with changes in the inflation rate:

Real interest rate=Nominal interest rate+Inflation rate\text{Real interest rate} = \text{Nominal interest rate} + \text{Inflation rate}

The Costs of Inflation

The Inflation Fallacy

  • Most people believe inflation erodes real incomes; however, inflation is a general increase in prices of both what people buy and sell.

  • In the long run, real incomes are determined by real variables, not the inflation rate.

Costs of Expected Inflation

Shoeleather Costs

  • Resources wasted when inflation encourages people to reduce their money holdings.

    • Includes the time and transaction costs of frequent bank withdrawals.

Menu Costs

  • Costs of changing prices (printing new menus, mailing new catalogs, etc.).

Misallocation of Resources from Relative-Price Variability

  • Firms do not all raise prices at the same time, leading to variations in relative prices and distorting resource allocation.

Confusion & Inconvenience

  • Inflation changes the yardstick used to measure transactions, complicating long-range planning and comparisons of dollar amounts over time.

Tax Distortions

  • Inflation causes nominal income to grow faster than real income.

  • Taxes are based on nominal income and may not be adjusted for inflation, causing people to pay more taxes even without real income increases.

A Special Cost of Unexpected Inflation
Arbitrary Redistributions of Wealth

  • Higher-than-expected inflation transfers purchasing power from creditors to debtors.

  • Lower-than-expected inflation transfers purchasing power from debtors to creditors.

  • High inflation is more variable and less predictable, making these redistributions more frequent.