chapter 17

Money Growth and Inflation

• Overview

  • The chapter discusses the relationship between money supply, inflation, and nominal interest rates.

  • Key concepts include:

    • How money supply affects inflation and real variables (e.g., real GDP, real interest rate).

    • Understanding inflation tax and other costs associated with inflation.

Value of Money

• Price Level (p)

  • The price level (p) denotes the average level of prices in the economy.

  • The value of $1 is calculated as ( \frac{1}{p} ).

• Examples of Value

  • If the price of a candy bar is $2, then ( \frac{1}{p} = \frac{1}{2} ), meaning $1 buys half a candy bar.

  • If the price rises to $3, then ( \frac{1}{p} = \frac{1}{3} ), meaning $1 buys a third of a candy bar.

  • Conclusion: As the price level increases, the value of the dollar decreases.

Money Supply

• Definition

  • Money supply is controlled by the Federal Reserve (Fed) and is relatively fixed in the short run.

• M1 and M2

  • M1: Includes cash, checking accounts, and cashable checks (most liquid form).

  • M2: Includes M1 plus savings accounts and time deposits (less liquid).

• Short-Run Assumption

  • In the short run, the money supply remains constant, while money demand adjusts with price level changes.

Money Demand

• Definition

  • Money demand is the amount of currency individuals wish to hold for spending purposes.

• Impact of Price Level

  • If the price level increases, the demand for money increases due to the need for more money to purchase goods.

Supply and Demand for Money

• Demand and Supply Graph

  • X-axis: Quantity of Money

  • Y-axis: Price Level

  • Money supply remains fixed, while demand can increase with higher price levels.

• Relationship

  • As the value of money decreases (price level increases), more money is required.

Equilibrium Value of Money

• Intersection of Curves

  • The intersection of money supply and demand curves determines the equilibrium value of money and the equilibrium price level.

• Effects of Increasing Money Supply

  • If money supply increases (e.g., from $1,000 million to $2,000 million), the equilibrium moves and the price level rises, resulting in a decrease in the value of money.

Nominal vs. Real Variables

• Definitions

  • Nominal Variables: Measured in monetary units (e.g., nominal GDP, nominal interest rate).

  • Real Variables: Measured in physical units (e.g., real GDP, real interest rate).

• Impact on GDP

  • Nominal GDP can increase with price level increase without a real increase in output, which is not beneficial for the economy.

• Example: A nominal interest rate increase does not necessarily translate to increased purchasing power if inflation is also high.

Classical Dichotomy and Money Neutrality

• Classical View

  • Classical economists argue that changes in money supply only affect nominal variables; real variables remain unchanged.

  • If money supply doubles, nominal variables (price level, nominal GDP) double, while real variables (real GDP, real wage) remain constant.

• Keynesian View

  • Keynesians believe real variables are affected by changes in money supply, at least in the short term.

• Monetary Neutrality

  • According to classical economists, money does not influence real economic variables; only nominal variables are affected.

Velocity of Money

• Definition

  • Velocity of money (v) measures how quickly money changes hands, defined as ( v = \frac{P \times Y}{M} ).

    • Where P = price level, Y = quantity of goods/services, M = money supply.

• Example Calculation

  • For given data (e.g., price per pizza, total pieces, money supply), calculate velocity and nominal GDP.

• Implications

  • Velocity tends to remain stable, unlike money supply and real GDP.

Inflation Rate and Money Supply

• Inflation Relationships

  • If velocity and real GDP remain constant, the growth rates of money supply (M) and price level (P) are equal (i.e., inflation results from increased money supply).

  • Historical examples highlight inflation rates sometimes exceeding money supply growth due to decreased real GDP.

Inflation Tax

• Concept

  • Inflation tax is an indirect tax on consumers due to inflation resulting from increased money supply (e.g., selling bonds).

• Mechanism

  • Government can raise money through bond sales to the central bank, leading to increased money supply and inflation.

  • Consumers bear the burden of increased prices, reflecting the effects of inflation tax.

Costs of Inflation

• Shoe Leather Costs

  • Higher inflation leads to more frequent trips to the bank to withdraw money.

• Menu Costs

  • Businesses incur expenses to update prices (e.g., reprinting menus).

• Misallocation of Resources

  • Some firms may not adjust prices immediately due to contracts, leading to inefficient resource distribution.

• Confusion and Inconvenience

  • Uncertainty regarding price levels makes it difficult for individuals and firms to make economic decisions.