ECON 2120: Principles of Macroeconomics - Inflation and the Quantity Theory of Money

Chapter 12 - Inflation and the Quantity Theory of Money

Defining and Measuring Inflation

• Inflation is characterized by an increase in the average level of prices in the economy.

• Example of hyperinflation: Zimbabwe under President Robert Mugabe in 2001, where inflation rates reached more than 50% daily due to excess money supply without corresponding goods production.

Understanding Inflation

• Importance of defining and measuring inflation.

• Examines inflation's historical data and its causes and costs.

Measuring Inflation

• Inflation Rate (𝝅𝒕): Measures the percentage change in the average price level over time using the formula:
  𝝅𝒕 = (𝑷𝒕 - 𝑷𝒕−𝟏) / 𝑷𝒕−𝟏 × 100

• Example: A 15% inflation rate indicates a 15% increase in the average price of goods and services compared to last year.

Examples of Calculating Inflation

1. 2010 to 2011:

• Price Level: 100 to 110

• Inflation Rate: (110 - 100) / 100 × 100 = 10%

1. 2011: 250 to 300

• Inflation Rate: (300 - 250) / 250 × 100 = 20%

1. 4000 to 4040:

• Inflation Rate: (4040 - 4000) / 4000 × 100 = 1%

Price Indexes

• Price indexes measure the average price level of goods and services.

• Common price indexes:

1. Consumer Price Index (CPI)

2. GDP Deflator

3. Producer Price Index (PPI)

Consumer Price Index (CPI)

• Measures average price for a basket of goods/services for typical consumers, covering about 80,000 items.

• Major items have a higher weight in the CPI calculation than minor items.

GDP Deflator

• Defined as the ratio of nominal GDP to real GDP, multiplied by 100.

• Reflects prices of all final goods produced in a country, measuring inflation more broadly than CPI.

Producer Price Index (PPI)

• Measures the average price received by producers for goods and services, covering both intermediate and final goods.

• Helpful for calculating input cost changes and assessing inflation's effects before it reaches consumers.

Historical Inflation Trends in the U.S.

• Average inflation rate from 1950 to 2016: 3.6%, with higher inflation recorded in the 1970s.

• 2006-2016 average inflation rate: 2.1%.

Real Variables and Real Prices

• Real Prices: Adjusted for inflation, allows comparisons over time.

• To calculate real prices:
  Real Price in Year X Dollars = (CPI in Year Y / CPI in Year X) × Price in Year Y Dollars

• Example:** 2006 Gasoline Price in 1982 dollars**:

• CPI 1982 = 100, CPI 2006 = 202.

• Real Price ≈ $2.50 * (100/202) = $1.24.

What Causes Inflation?

• Causes of inflation are closely linked to the money supply, velocity of money, and real GDP.

Understanding Money

• Money is any widely accepted good for exchanging goods and services.

• Types of Money:

1. Commodity Money: Has intrinsic value (e.g., gold, silver).

2. Fiat Money: Has no intrinsic value, derives value from regulation (e.g., U.S. dollar).

Functions of Money

1. Medium of Exchange: Facilitates transactions.

2. Unit of Account: Prices are expressed in monetary terms.

3. Store of Value: Retains value over time.

Quantity Theory of Money

• Establishes a relationship between money supply, velocity, real output, and prices.

• Velocity of Money (𝒗): Indicates how often money is spent in a period.

• Equation: 𝑴𝒗 = 𝑷𝒀𝑹 (money supply * velocity = price level * real GDP).

Growth Rates in the Quantity Theory of Money

• Rewritten form: 𝑴 + 𝒗 ≈ 𝝅 + 𝒀𝑹 (growth rate of money supply + growth rate of velocity ≈ inflation rate + growth rate of real GDP).

• Implications for inflation:

• Increase in money supply (𝑴) or velocity (𝑣) can cause inflation.

• Decrease in real economic output (𝑌𝑅) can lead to higher inflation too but less likely.

Inflation Causation Insights

• Inflation tends to correlate with increases in the money supply rather than changes in real GDP or velocity.

• Milton Friedman’s assertion: “Inflation is always and everywhere a monetary phenomenon.”

Conclusion

• In summary, inflation results from an increase in the money supply, especially significant in times of rapid monetary growth.