Money Growth and Inflation

Money Supply and Inflation

• This lecture discusses the relationship between money growth and inflation.

• Topics covered include:

  • How money supply affects inflation.

  • The Quantity Theory of Money (QTM).

  • Whether money supply affects real variables.

  • The costs of inflation.

Milton Friedman and the Quantity Theory of Money

• Milton Friedman argued that inflation is primarily a monetary phenomenon.

• He stated that inflation is always and everywhere a monetary phenomenon and can only be produced by a more rapid increase in the quantity of money.

• The quantity theory of money, developed by Friedman, explains the connection between money supply and inflation.

Value of Money

• Price level (P) is the price of a basket of goods (e.g., CPI or GDP deflator).

• The value of money is 1/P, representing the value of one peso in terms of goods.

• Example:

  • If a cup of coffee costs 2 pesos (P = 2), then 1 peso is worth 1/2 cup of coffee.

  • If a cup of coffee costs 3 pesos (P = 3), then 1 peso is worth 1/3 cup of coffee.

• As price levels rise due to inflation, the value of money decreases.

  • When price level increases, there is inflation which erodes purchasing power, making it necessary to spend more money to acquire the same amount of goods or services.

Quantity Theory of Money (QTM)

• The quantity theory of money states that the quantity of money (money supply) determines the value of money (1/P).

• The theory was developed by David Hume and later expounded by Milton Friedman.

• Two approaches to understanding QTM:

  • Supply and demand diagram.

  • An equation using the velocity of money.

Money Supply

• In this model, the money supply is fixed by the central bank (e.g., BSP).

• This is a simplification, as real-world money supply determination is more complex.

Money Demand

• Households demand money to maintain liquidity.

• Money is the most liquid asset, facilitating easy transactions.

• Demand for money depends on the price level (P).

• If P increases, the value of money (1/P) decreases, requiring more money to buy the same basket of goods.

• The quantity of money demanded is negatively related to the value of money.

Supply and Demand Diagram

• Y-axis: Value of money (1/P); price level decreases as you move up the axis.

• Money supply is fixed (e.g., at 1,000 pesos) by the BSP, regardless of the price level.

• Money demand is downward sloping: as the value of money decreases, more money is demanded.

• Equilibrium occurs at the intersection of money supply and money demand (e.g., point A).

  • At point A, the quantity of money is 1,000, P = 2, and the value of money is 1/2.

• The price level adjusts to equate the quantity of money demanded with money supply.

Effects of Increasing Money Supply

• If BSP increases the money supply, the money supply curve shifts to the right (e.g., from 1,000 to 2,000).

• A new equilibrium point (e.g., point B) is established.

• P rises (e.g., from 2 to 4), and the value of money decreases (e.g., from 1/2 to 1/4).

• This illustrates that increasing the money supply leads to increased prices (inflation).

Adjustment Process

• Increasing the money supply causes price levels to rise.

• At the initial price level, an increase in the money supply creates an excess supply of money.

• People spend the extra money on goods and services or loan it out, increasing demand.

• If the supply of goods does not increase proportionally, prices rise, leading to inflation.

Real vs. Nominal Variables

• Nominal prices are quoted in terms of money (e.g., 15 pesos per banana).

• Relative prices are in terms of physical units (e.g., bananas relative to coffee).

• Example: If bananas are 15 pesos each and coffee is 10 pesos per cup, the relative price is 1.5 bananas per cup.

• Relative prices are real variables since they are measured in physical units.

Neutrality of Money

• Neutrality of money (or monetary neutrality): Changes in money supply affect price levels but not real variables.

• Doubling the money supply doubles nominal prices but does not change relative prices.

• Example: If money supply doubles, the price of bananas becomes 30 pesos and coffee 20 pesos. The relative price is still 1.5 bananas per cup.

• Allocation of resources in the economy depends on relative prices, not nominal prices.

• In the long run, money is neutral; it affects nominal variables but not real variables.

• In the short run, changes in the money supply can affect real variables.

• Classical dichotomy: separation between real and nominal variables in the long run.

Quantity Theory of Money: Equation

Velocity of Money

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

• Formula: $V = (P * Y) / M$, where:

  • P = Price level

  • Y = Real GDP

  • M = Money supply

• Example:

  • If an economy produces 3,000 cups of coffee and the price is 10 pesos per cup, nominal GDP is 30,000 pesos.

  • If the money supply is 10,000 pesos, the velocity is 3.

  • This means the average peso is used in three transactions.

Quantity Equation

• Formula: $M * V = P * Y$

Expressing QTM with the Quantity Equation (5 Steps)

1. Start with the quantity equation: $M * V = P * Y$

2. Velocity (V) is stable and constant.

3. If M increases, nominal GDP (P * Y) increases.

4. Money is neutral, so real GDP (Y) is not affected by changes in M; Y depends on natural resources, technology, and population.

5. If M increases, and V and Y are constant, then P (price level) must increase proportionally.

• Conclusion: Money supply growth causes inflation.

Real Interest Rate vs. Nominal Interest Rate

• Real interest rate = Nominal interest rate - Inflation rate. Expressed as: $real \; interest \; rate = nominal \; interest \; rate - inflation \; rate$

• Rearranging gives: $nominal \; interest \; rate = real \; interest \; rate + inflation \; rate$

• The real interest rate is determined by the intersection of the demand for and supply of loanable funds.

• The inflation rate is determined by money supply growth.

Fisher Effect

• In the long run, money is neutral.

• Money growth rate only affects the inflation rate, not the real interest rate.

• Money growth affects inflation, which in turn affects the nominal interest rate one-for-one.

• The Fisher effect is the transmission between money supply growth and the nominal interest rate, mediated by the inflation rate.

• The Fisher Effect states that nominal interest rates and inflation rates should move together.

• When both rates do not move together, real interest rate changes.

Real-World Examples

• In 2020, during COVID, inflation increased while nominal interest rates decreased.

• Real interest rate = Nominal interest rate - Inflation.

• Because nominal interest rates decreased as inflation increased, the real interest rate decreased.

• Because of COVID, lockdowns and mobility restrictions decreased the appetite for investments; thus the demand for loanable funds (investments) decreased.

• A decreased demand for loanable funds causes the equilibrium real interest rate to fall.

Costs of Inflation

Shoe Leather Costs

• Increased inflation discourages keeping money in the bank because its value erodes.

• People make more frequent bank withdrawals to stay liquid.

• Shoe leather costs refer to the costs in terms of time and transaction costs because of making more frequent bank withdrawals.

• Less relevant today due to digital money and electronic transfers.

Menu Costs

• Menu costs are the costs of changing prices.

• Businesses must print new menus or update prices frequently due to inflation.

• Worse during hyperinflation.

Confusion and Inconvenience

• Inflation makes long-term contracts difficult to manage.

• Contracts need to be renegotiated due to changing purchasing power.

• Hampers long-term planning and comparison of values across time.

Tax Distortions

• Inflation can push wages higher, but these are nominal wages.

• Real wages (purchasing power) may not increase.

• People pay more taxes due to higher nominal wages, even if their real income is not increasing.

• Inflation creates distortions through taxation because people are taxed at a higher rate even without a real increase in income.

Redistribution of Wealth

• Inflation can cause a redistribution of wealth between debtors and creditors.

• Debtors repay their debt with pesos that aren't worth as much.

• Unexpectedly high inflation benefits debtors at the expense of creditors.

• Creditors (lenders) are worse off because the money they receive in the future has less purchasing power than expected.