Chapter 12: Money Growth and Inflation
1. Quantity Theory of Money (QTM)
The Quantity Equation
The classical quantity theory of money is summarized by the equation:
MV=PY
Where:
M = Money Supply (the amount of money in circulation)
V = Velocity of Money
The average number of times a dollar is spent in a year.
P = Price Level
Y = Real Output
Real GDP; the total quantity of goods and services produced in the economy.
Interpretation
The quantity equation expresses the relationship between the money supply and nominal GDP:
Nominal GDP=PY
QTM assumes velocity (V) is stable (doesn’t change much in the short run) and that real GDP (Y) is determined by productive capacity, not by money.
Implication
If V and Y are constant in the long run:
Increase in M⇒Proportionate Increase in P
In plain language:
➡ Inflation is caused by too much money chasing too few goods.
Example
If money supply increases by 10% and real GDP increases by 3%, with constant V:
%ΔP≈10%−3%=7%
Inflation would be 7%.
2. Nominal Interest Rate, Real Interest Rate, and Inflation
Fisher Equation
i=r+π
Where:
i = nominal interest rate
r = real interest rate
π = expected inflation
Rearranged, real interest rate:
r=i−π
1. Who benefits if inflation is higher than expected?
Borrowers benefit
● They repay their loans with money that is worth less in purchasing power.
● Real interest rate becomes lower than intended, possibly negative.
Lenders lose
● They receive repayments that buy fewer goods/services than expected.
Rule of thumb:
➡ Unexpected inflation → Borrowers win, lenders lose
➡ Unexpected deflation → Lenders win, borrowers lose
2. Distributional Effects of Inflation
Inflation redistributes wealth between different groups:
Winners
Borrowers
Firms with flexible prices
Owners of real assets like real estate
Governments with high debt (inflation erodes real value of debt)
Losers
Lenders
Savers (unless interest rates rise enough)
Workers with fixed or slow-adjusting wages
People on fixed incomes
Example: Before 1975, Social Security and many pensions were fixed in nominal terms, so inflation sharply reduced retirees’ purchasing power.
Menu Costs
Costs firms face changing prices (printing new menus, updating software).
Shoe-Leather Costs
People reduce holdings of money, requiring frequent bank trips.
Uncertainty
High inflation makes long-term contracts more difficult, slowing investment.
3. What is the effect of productivity on inflation?
Productivity growth allows firms to pay higher wages without raising prices.
Key Relationship
Inflation=Nominal Wage Growth−Productivity Growth
Example:
Wages increase 6%
Productivity increases 4%
Inflation = 6 – 4 = 2%
If productivity rises fast → inflation pressure falls.
If productivity stagnates → inflation pressure rises.
3. If inflation is bad, is deflation better?
No. Deflation is usually WORSE.
Why deflation is dangerous
Consumers delay purchases
“Why buy today if it’s cheaper tomorrow?”
Leads to falling demand → recession.
Real debt burden rises
Borrowers suffer, defaults increase.
Wages are sticky downward
Firms lay off workers rather than cut wages.
Deflationary Spiral
Lower prices → lower profits
→ layoffs → lower spending → even lower prices.
Historical example
Great Depression in the 1930s had severe deflation, deepening the economic collapse.
4. Market for Money: Effect of Changing the Money Supply
Money Market Diagram
Vertical axis: Nominal Interest Rate
Horizontal axis: Quantity of Money
Money supply (MS) is vertical (set by the Fed)
Money demand (MD) is downward sloping
Increase in Money Supply
MS shifts right
Interest rate falls
Stimulates investment and spending
Decrease in Money Supply
MS shifts left
Interest rate rises
Slows investment and spending
This is the basis of monetary policy.
5. Institutional Theory of Inflation (Don’s addition)
This theory suggests:
A little inflation is acceptable and even helpful
Allows wages to rise without cutting real wages
Reduces unemployment (short-run Phillips Curve logic)
Inflation results from institutional factors, not just money supply:
Strong labor unions negotiating higher wages
Large firms with price-setting power
Government policies that influence cost structures
If the government is careful, inflation can be kept from becoming excessive.
This theory is less rigid than classical monetarist theory and emphasizes the role of:
bargaining power
wage–price dynamics
market structure
6. Different Views on the Relationship Between Inflation and Growth
Economists disagree strongly.
1. Classical/Monetarist View
High inflation → reduces long-term growth
Causes uncertainty, lowers investment
Money supply growth should be predictable and stable
2. Keynesian View
Moderate inflation can support growth by:
Lowering real wages when nominal wages are sticky
Preventing deflation
Stimulating demand during recessions
But:
High inflation → harmful
Low and stable inflation (2%) → good for growth
3. Structuralist View (commonly applied to developing nations)
Inflation may arise from structural problems:
bottlenecks (energy, transportation)
agricultural rigidities
Growth requires solving these issues, not just reducing money supply.
4. Empirical Evidence
Very high inflation (> 20–30%) → BAD for growth
Hyperinflation → economy collapses
Low inflation (1–3%) → best for long-term growth
Deflation → worst outcomes
Summary of Key Concepts
Quantity Theory of Money
MV = PY
Money supply drives inflation in the long run.
Interest Rates
Real interest rate = nominal rate – inflation
Borrowers win when inflation is unexpectedly high.
Inflation Effects
Hits lenders, savers, fixed-income groups
Helps borrowers, governments with debt
Deflation
Generally worse than inflation
Causes recessions and debt crises
Money Market
More money → lower interest rates
Less money → higher interest rates
Inflation Theories
Institutionalism: inflation OK if controlled
Monetarists: inflation = money growth
Keynesians: low inflation helps growth
High inflation ALWAYS harmful