AO

Money Growth and Inflation

Money Growth and Inflation Notes

Introduction to Money Growth

  • Definition of Money Growth: Increase in the amount of money circulating in an economy over time.

    • Includes cash, coins, checking, and savings account balances.

    • Commonly measured using monetary aggregates: M1, M2, M3 (different levels of liquidity).

Inflation Overview

  • Inflation: General rise in the price level of goods and services in an economy.

    • Deflation: General decrease in price levels.

    • Hyperinflation: Extremely high inflation rate, often exceeding 50% monthly.

Historical Context of Inflation in the US

  • Inflation averaged 1.5% from 2008-2018.

  • Significantly higher rates were observed in the 1970s (approximately 7.8% annually).

Classical Theory of Inflation

  • Based on the Quantity Theory of Money.

    • Determines long-run price levels and inflation rates.

    • Higher money supply directly correlates with an increased price level and lower value of money.

Money Supply and Demand

  • Money Demand: Desire for liquidity, influenced by:

    • Credit card usage

    • ATM availability

    • Interest rates

    • General price level.

  • Money Supply: Set by central banks, represented as a vertical supply curve on a graph of money market equilibrium.

Quantity Theory of Money

  • Equation: M × V = P × Y

    • M = Quantity of money

    • V = Velocity of money

    • P = Price level

    • Y = Real GDP.

  • Implications:

    • Increase in money supply (M) leads to proportional changes in nominal output (P × Y).

    • Drives price level (P) up when supply outpaces economic output.

Risks of Excessive Money Growth

  • Hyperinflation: Inflation that exceeds 50% per month, resulting in prices soaring.

  • Inflation Tax: Revenue generated by governments printing more money, diminishing currency value for holders.

Example of Hyperinflation

  • Historical hyperinflation in 1920s Austria, Hungary, Germany, and Poland shows that rapid money printing leads to drastic price increases.

Monetary Policy Management

  • Central Bank Tools:

    • Interest Rate Adjustments: Raise rates to reduce spending, thus controlling money supply.

    • Open Market Operations: Selling government securities to absorb excess money.

    • Reserve Requirements: Changes to the reserves banks must hold can limit their capacity to lend, influencing money supply.

Long-Term Effects of Controlled Money Growth

  • Stable Prices: Helps maintain purchasing power.

  • Economic Growth: Predictable inflation fosters investment.

  • Consumer Confidence: Stability enhances economic confidence, encouraging spending and investment.

The Fisher Effect

  • Describes the relationship between nominal interest rates and inflation.

    • Real Interest Rate Formula: Real interest = Nominal interest - Inflation.

    • Fisher Effect explains that nominal rates adjust one-for-one with inflation changes, keeping real rates stable.

Costs of Inflation

  • Inflation Fallacy: Misconception that inflation inherently reduces purchasing power; it affects nominal values, not real values.

  • Shoeleather Cost: Resources wasted as people reduce their liquidity holdings to avoid losing purchasing power.

  • Menu Costs: Costs incurred by businesses due to frequent price changes in response to inflation.

  • Arbitrary Redistributions of Wealth: Unexpected inflation can unfairly benefit debtors or harm savers.

Conclusion

  • Understanding these concepts is essential for grasping the impact of money growth and inflation on the economy and for effective monetary policy management.