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.