Money Growth and Inflation Notes

Money Growth and Inflation

Inflation: An increase in the overall level of prices in the economy.
Economists measure the inflation rate as the percentage change in the Consumer Price Index (CPI), the GDP deflator, or another index of the overall price level.
In the United States, over the past 80 years, prices have risen on average 3.6% per year.
Deflation: A decrease in the overall level of prices.
- The average level of prices in the U.S. economy was 23% lower in 1896 than in 1880.
Inflation rates vary significantly across countries.
- In 2015, the inflation rate in the United States was 0.1%, while it was 1.5% in China, 4.9% in India, 15% in Russia, and 84% in Venezuela.
Hyperinflation: An extraordinarily high rate of inflation.
- In February 2008, Zimbabwe's central bank announced an inflation rate of 24,000%.
The quantity theory of money says that prices rise when the government prints too much money.

The Classical Theory of Inflation

The quantity theory of money is often called "classical" because it was developed by some of the earliest economic thinkers.

The Level of Prices and the Value of Money

Inflation is more about the value of money than about the value of goods.
The economy’s overall price level can be viewed in two ways:
- As the price of a basket of goods and services.
- As a measure of the value of money.
$P$ = the price level (e.g., CPI or GDP deflator).
$P$ measures the number of dollars needed to buy a basket of goods and services.
The quantity of goods and services that can be bought with $1 equals $1/P$ .
- When $P$ rises, the value of money falls.

Money Supply, Money Demand, and Monetary Equilibrium

The supply and demand for money determine the value of money.
Money Supply: Determined by the Federal Reserve (the Fed) and the banking system.
- The Fed sells bonds in open-market operations, which contracts the money supply.
- The Fed buys government bonds, which expands the money supply.
Money Demand: Reflects how much wealth people want to hold in liquid form.
- Influenced by:
  - Reliance on credit cards.
  - Availability of ATMs.
  - Interest rates.
  - The average level of prices in the economy.
A higher price level (a lower value of money) increases the quantity of money demanded.
In the long run, the overall level of prices brings money supply and money demand into equilibrium.
- If the price level is above the equilibrium level, the price level must fall to balance supply and demand.
- If the price level is below the equilibrium level, the price level must rise to balance supply and demand.
- At the equilibrium price level, the quantity of money that people want to hold exactly balances the quantity of money supplied by the Fed.

The Effects of a Monetary Injection

Monetary Injection: The Fed doubles the supply of money by printing more money.
The monetary injection shifts the supply curve to the right.
The value of money decreases.
The equilibrium price level increases.
Quantity Theory of Money: The quantity of money available in an economy determines the value of money, and growth in the quantity of money is the primary cause of inflation.
- Inflation is always and everywhere a monetary phenomenon.

A Brief Look at the Adjustment Process

The immediate effect of a monetary injection is to create an excess supply of money.
People try to get rid of this excess supply of money in various ways:
- Buy goods and services.
- Make loans to others by buying bonds or depositing the money in a bank savings account.
The injection of money increases the demand for goods and services.
The greater demand for goods and services causes the prices of goods and services to increase.
The increase in the price level, in turn, increases the quantity of money demanded.
The overall price level for goods and services adjusts to bring money supply and money demand into balance.

The Classical Dichotomy and Monetary Neutrality

Nominal Variables: Variables measured in monetary units (e.g., income of corn farmers).
Real Variables: Variables measured in physical units (e.g., quantity of corn produced).
Classical Dichotomy: The separation of real and nominal variables.
Relative Price: The price of one thing compared to another (e.g., the price of a bushel of corn is 2 bushels of wheat).
The real wage and the real interest rate are real variables.
Different forces influence real and nominal variables.
According to classical analysis, nominal variables are influenced by developments in the economy’s monetary system, whereas money is largely irrelevant for explaining real variables.
Monetary Neutrality: The irrelevance of monetary changes for real variables.
Changes in the supply of money affect nominal variables but not real ones.

Velocity and the Quantity Equation

Velocity of Money: The rate at which money changes hands.
If $P$ is the price level, $Y$ is the quantity of output, and $M$ is the quantity of money, then velocity is $V = (P <br /> umber Y)/M$ .
Quantity Equation: $M <br /> umber V = P <br /> umber Y$ , which relates the quantity of money to the nominal value of output.
An increase in the quantity of money in an economy must be reflected in one of the other three variables: the price level must rise, the quantity of output must rise, or the velocity of money must fall.
The velocity of money is relatively stable over time.
When the central bank changes the quantity of money ( $M$ ), it causes proportionate changes in the nominal value of output ( $P <br /> umber Y$ ).
The economy’s output of goods and services ( $Y$ ) is primarily determined by factor supplies and the available production technology; money does not affect output (monetary neutrality).
These changes are reflected in changes in the price level ( $P$ ).

Case Study: Money and Prices During Four Hyperinflations

Hyperinflation is generally defined as inflation that exceeds 50% per month.
The data on hyperinflation show a clear link between the quantity of money and the price level.

The Inflation Tax

When the government raises revenue by printing money, it is said to levy an inflation tax.
The inflation tax is like a tax on everyone who holds money.
Almost all hyperinflations follow the same pattern as the hyperinflation during the American Revolution.
The government has high spending, inadequate tax revenue, and limited ability to borrow.
The massive increases in the quantity of money lead to massive inflation.
The inflation ends when the government institutes fiscal reforms—such as cuts in government spending—that eliminate the need for the inflation tax.
Zimbabwe experienced one of history’s most extreme examples of hyperinflation in the 2000s.

The Fisher Effect

The Fisher Effect: The one-for-one adjustment of the nominal interest rate to the inflation rate.
Real interest rate = Nominal interest rate - Inflation rate
Nominal interest rate = Real interest rate + Inflation rate
In the long run over which money is neutral, a change in money growth should not affect the real interest rate.
When the Fed increases the rate of money growth, the long-run result is both a higher inflation rate and a higher nominal interest rate.
The Fisher effect states that the nominal interest rate adjusts to expected inflation.

The Costs of Inflation

A Fall in Purchasing Power? The Inflation Fallacy

Inflation does not in itself reduce people’s real purchasing power.
Real incomes are determined by real variables, such as physical capital, human capital, natural resources, and the available production technology.

Shoeleather Costs

Shoeleather Costs: The resources wasted when inflation encourages people to reduce their money holdings.
The shoeleather costs of inflation may seem trivial in the U.S. economy, which has had only moderate inflation in recent years, but this cost is magnified in countries experiencing hyperinflation.

Menu Costs

Menu Costs: The costs of changing prices.
Inflation increases the menu costs that firms must bear.

Relative-Price Variability and the Misallocation of Resources

Because prices change only once in a while, inflation causes relative prices to vary more than they otherwise would.
When inflation distorts relative prices, consumer decisions are distorted and markets are less able to allocate resources to their best use.

Inflation-Induced Tax Distortions

Lawmakers often fail to take inflation into account when writing the tax laws.
Inflation tends to raise the tax burden on income earned from savings.
Inflation exaggerates the size of capital gains and inadvertently increases the tax burden on this type of income.
Taxes on nominal capital gains and on nominal interest income discourage people from saving, which tends to depress the economy’s long-run growth rate.
One solution to this problem, other than eliminating inflation, is to index the tax system.

Confusion and Inconvenience

Money, as the economy’s unit of account, is what we use to quote prices and record debts.
When the Fed increases the money supply and creates inflation, it erodes the real value of the unit of account.
Inflation makes investors less able to sort successful from unsuccessful firms, which in turn impedes financial markets in their role of allocating the economy’s saving to alternative types of investment.

A Special Cost of Unexpected Inflation: Arbitrary Redistributions of Wealth

Unexpected inflation redistributes wealth among debtors and creditors.
If inflation were predictable, then Bigbank and Sam could take inflation into account when setting the nominal interest rate.
Inflation is especially volatile and uncertain when the average rate of inflation is high.

Inflation Is Bad, but Deflation May Be Worse

Some economists have suggested that a small and predictable amount of deflation may be desirable.
The Friedman rule suggests that deflation would lower the nominal interest rate and reduce the cost of holding money.
Deflation often arises because of broader macroeconomic difficulties.
Falling prices result when some event, such as a monetary contraction, reduces the overall demand for goods and services in the economy.
This fall in aggregate demand can lead to falling incomes and rising unemployment.

Case Study: The Wizard of Oz and the Free-Silver Debate

The Wizard of Oz is an allegory about U.S. monetary policy in the late 19th century.
From 1880 to 1896, the price level in the U.S. economy fell by 23%.
The free-silver advocates wanted silver, as well as gold, to be used as money to increase the money supply, push up the price level, and reduce the real burden of the farmers’ debts.
In 1898, prospectors discovered gold near the Klondike River in the Canadian Yukon. Increased supplies of gold also arrived from the mines of South Africa.
As a result, the money supply and the price level started to rise in the United States and in other countries operating on the gold standard.

Conclusion

The primary cause of inflation is growth in the quantity of money.
The costs of inflation include shoeleather costs, menu costs, increased variability of relative prices, unintended changes in tax liabilities, confusion and inconvenience, and arbitrary redistributions of wealth.
Monetary policy has profound effects on real variables in the short run.