Money and Inflation

Chapter Four

Introduction

So far, our classical analysis has been in real terms and we

have largely ignored the dollar value of goods and services.
We have thus been unable to discuss important issues of
macroeconomics inflation and monetary policy.
Inflation percentage change in the overall level of prices
In this chapter we examine the classical theory of the
causes, effects, and social costs of inflation.
Causes: Why must we talk about money? Who controls
money?
Effects: seigniorage, gap between nominal and real interest
rates
Social Costs: Is it a major social problem?

U.S. inflation & its trend, 1960-2001

16
14

% p er year

12
10
8
6
4
2
0
1960

1965

1970

1975

1980

1985

inflation rate

1990

1995

2000

U.S. inflation & its trend, 1960-2001

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14

% p e r ye ar

12
10
8
6
4
2
0
1960

1965

1970

1975

1980

inflation rate

1985

1990

inflation rate trend

1995

2000

The Functions of Money

What is money? What does money include? Do money and

wealth refer to the same thing? Why are we willing to give
up valuable goods for intrinsically worthless pieces of paper?
Money stock of assets that can be readily used to make
transactions
3 functions of money:

Store of value: Money is a way to transfer purchasing power

from the present to the future. When is it an imperfect store of
value?
Unit of account: Money provides the terms in which prices are
quoted and debts are recorded.
Medium of exchange: Money is what we use to buy goods, it
makes exchange easier. Barter an economy without money,
double coincidence of wants

The Types of Money

The most common form of money in the U.S. is fiat money

money that has no intrinsic value but is established by
government decree
In the past, economies have used commodity money an
intrinsically valuable good that is also used for money
When an economy uses gold, or paper money that is
redeemable for gold, they are said to be on the gold
standard.
Why would gold be a useful type of commodity money?
Case Study: money in a POW camp

Why were cigarettes were used as currency? What did it

prevent?
Cigarettes were what type of money?

How the Quantity of Money is

Controlled

The quantity of money in circulation is called the money

supply.
With commodity money, the money supply is
determined by what?
With fiat money, who controls the supply of money?
Monetary policy is the control over the money supply.
Who sets monetary policy in the U.S.? An independent
institution called the central bank
How does the Fed dictate the supply of fiat money? An
open-market operation
What is an open-market operation and how does it
work?

How the Quantity of Money is

Measured

Recall what is money? Money is the stock of assets

used to facilitate transactions and the quantity of
money is the quantity of these assets.
What was the quantity of money in the POW camp?
Were there any other assets used for transactions?
Why is it difficult to measure the quantity of money in a
more complex economy like the U.S.?
No single asset is used for all transactions: cash, checks
This ambiguity leads to numerous measures of the
quantity of money.

What to Include in the Quantity of

Money

Currency the sum of

outstanding paper
money and coins
Demand deposits
funds people hold in
their checking accounts
Should we also include
other assets like
savings deposits and
money market mutual
funds?
What distinguishes the
different measures of
money is their degree
of liquidity.

The Quantity Theory of Money

Having discussed the supply and measurement of money, we

now examine how the quantity of money affects the economy.
The quantity theory theory of money demand based on the
observations that people hold money largely to facilitate
transactions
The link between transactions and money is expressed in the
quantity equation: M V = P T
T total # of transactions per year, the # of times that goods
are exchanged for money
P the price of a typical transaction, the # of dollars
exchanged
Thus, the # of dollars exchanged per year equals P T

 Transactions and the Quantity

Equation

M quantity of money
V transactions velocity of money; measures the # of
times that a typical dollar bill changes hands per year
Example: 60 loaves of bread, $.50 per loaf

What is total # of dollars exchanged?

Suppose quantity of money in economy is $10, what is the
transactions velocity of money?
What is the formula for velocity? V = (P T)/M

The quantity equation is an identity, what does that

mean?
What happens if the quantity of money increases to $20
while the velocity remains constant?

From Transactions to Income

For economists, what is the practical problem with the

first equation?
Remedy replace T with total output of the economy Y
Is this an imperfect remedy? Yes, but we assume T is
proportional to Y
Y amount of output; P price of one unit of output;
then the dollar value of output is P Y = nominal GDP
Quantity equation: M V = P Y
V in this version of the quantity equation is called the
income velocity of money

The Money Demand Function and

the Quantity Equation

To see how money affects the economy, express the

quantity of money in terms of the amount of goods it can
buy. This amount is called real money balances = M/P
Real money balances measures the purchasing power of
the stock of money; M = $10, P = $.50 per loaf, real
money balances M/P = 20 loaves (real balances are
measured in goods not dollars!)
Money demand function equation that states the
quantity of real balances people wish to hold

(M/P)d = k Y
k constant that tells how much money people want to hold
for every dollar of income
What does this equation tell us? What does higher income
lead to?

 The Money Demand Function and

the Quantity Equation

Does the money demand function resemble the quantity

equation in any way? When are they equivalent?
If the supply of money equals the demand for money:

(M/P)d = M/P
M/P = k Y M (1/k) = P Y
If V = (1/k), then our money demand function is
equivalent to the quantity equation

If we assume that V is constant, then the quantity

equation becomes a useful theory of the effects of
money; quantity theory of money: M V = P Y
What happens to nominal GDP if money supply increases?
If Y is fixed by f.o.p., how does nominal GDP change?

Money, Prices, and Inflation

We now have a theory that explains the economys
overall level of prices, 3 building blocks:

1.
2.

3.

What determines the level of real output, Y?

What determines the level of nominal output, P Y?
Why?
The price level is then the ratio of what to what?

Does this theory explain what happens when the Fed

changes the money supply?
The quantity theory implies that the price level is
proportional to the money supply
What about inflation? Is our theory of the price level
also a theory of the inflation rate?

 Money, Prices, and Inflation

The quantity equation in percentage-change form:

% M + % V = % P + % Y
= % P the variable we wish to explain
= % M under the control of the central bank
0 = % V we have assumed that velocity is constant
% Y depends on growth in f.o.p. and technological progress
= - % Y; it follows that the inflation rate depends on
the growth rate of the money supply

What should Fed do if it wants to keep = 0?

The quantity theory of money states that the central bank
has ultimate control of the rate of inflation. If it keeps the
money supply stable, prices will be stable. If it increases
the money supply rapidly, the price level will rise rapidly.

Case Study: Inflation and Money Growth

Inflation is always
and everywhere a
monetary
phenomenon
Milton Friedman
Empirical link
between inflation
and growth in the
quantity of money
Decades with high
money growth
tend to have high
inflation, and
decades with low
money growth
tend to have low
inflation.

 Inflation and Money Growth

International data
show the correlation
even more clearly.
Again, the link
between money
growth and inflation is
clear.
Countries with high
(low) money growth
tend to have high
(low) inflation.
This theory of inflation
works best in the long
run, notice we are
talking about 10 year
averages of money
growth and inflation.

U.S. Inflation & Money Growth, 19602001

16
14

% per year

12
10
8
6
4
2
0
1960

1965

1970

1975

1980

inflation rate

1985

1990

inflation rate trend

1995

2000

U.S. Inflation & Money Growth, 19602001

16
14

% per year

12
10
8
6
4
2
0
1960

1965

1970

inflation rate

1975
M2 growth rate

1980

1985

inflation rate trend

1990

1995

2000

M2 trend growth rate

Seigniorage: The Revenue From Printing

Money

If money growth leads to inflation, as the quantity theory

suggests, what would cause the government to increase
the money supply?
A govt. can finance spending in three ways: what are they?
The revenue raised through the printing of money is called
seigniorage.
When the govt. prints money to finance expenditure it
raises the money supply which causes inflation. Printing
money to raise revenue is like imposing an inflation tax.
How is the printing of money to raise revenue a tax?
U.S. 3% of govt. revenue; Italy 10% of govt. revenue

Which country do you think has higher inflation?

What about countries experiencing hyperinflation?

Inflation and Interest Rates

Is the rate of inflation related to interest rates? If so, how?

Nominal interest rate the rate that the bank pays on
deposits
Real interest rate the rate of increase of purchasing power
of your deposits
r = i - ; the real interest rate is the difference between the
nominal interest rate and the inflation rate
i = r + ; Fisher equation the nominal interest rate can
change because the real interest rate changes or the
inflation rate changes
Do we have a theory that explains the nominal interest rate?

How is the real interest rate determined?

How is the inflation rate determined?
The quantity theory and the Fisher equation explain how money
growth affects the nominal interest rate.

Case Study: Inflation and Nominal Interest

Rates

Fisher effect 1
for 1 relation
between the
inflation rate and
the nominal
interest rate
Empirical validity
of the Fisher effect
When inflation is
high (low),
nominal interest
rates are typically
high (low)
When were real
interest rates
highest?
When were real
interest rates
lowest?

 Inflation and Nominal Interest

Rates

International data
demonstrates the
Fisher effect.
Countries with
high (low) inflation
tend to have high
(low) nominal
interest rates.
Why would the
empirical links
between inflation
and nominal
interest rates be
important for bond
traders?

Exercise:
Suppose V is constant, M is growing 5% per
year, Y is growing 2% per year, and r = 4.
a. Solve for i (the nominal interest rate).
b. If the Fed increases the money growth rate

by
2 percentage points per year, find i .
c. Suppose the growth rate of Y falls to 1%

per year.
What will happen to ?
What must the Fed do if it wishes to
keep constant?

Two Real Interest Rates: Ex Ante and Ex

Post
When a borrower and a lender agree on a nominal interest
rate, they do not know what the inflation rate over the
term of the loan will be.
= actual inflation rate (not known until after it occurs)
e = expected inflation rate
Economists distinguish between 2 concepts of the real
interest rate:

1)

2)

i e = ex ante real interest rate the real interest rate

the borrower and lender expect when the loan is made
i = ex post real interest rate the real interest rate
actually realized

What would make the 2 real interest rates differ?

How does this distinction modify the Fisher effect?
i = r + e; how is the ex ante real interest rate
determined? So i moves 1 for 1 with changes in expected
inflation

The Nominal Interest Rate and the

Demand for Money

What does the quantity theory say determines money demand?

Money is an asset, so what does it cost? What is the cost of
holding money? Does it cost anything?
The nominal interest rate is the opportunity cost of holding
money: what you give up by holding money rather than bonds
What is the real return on holding money?
The quantity of money demanded depends on the price of
holding money, the nominal interest rate: (M/P)d = L(i,Y)
The demand for real money balances is a function of income
and the nominal interest rate

The higher the level of income (Y), the greater the demand for real
balances
The higher the nominal interest rate (i), the lower the demand for
real balances

Money and Current Prices

Quantity theory tells

us that money supply
and demand
determine the price
level and, by
definition, the rate of
inflation.
The Fisher effect
relates the inflation
rate to the nominal
interest rate.
But now, the nominal
interest rate feeds
back into the demand
for money.
A circularity issue
arises by having
money demand
depend on the
nominal interest rate.

Future Money and Current Prices

Consider how the introduction of the nominal interest

rate in the money demand function affects our theory of
the price level:
First, equate the supply of real money balances M/P to
the demand (M/P)d = L(i,Y) M/P = L(i,Y)
Next, use the Fisher equation to decompose the nominal
interest rate M/P = L(r + e,Y)
This equation tells us that the level of real money
balances depends on the expected rate of inflation
The quantity theory of money says that todays money
supply determines todays price level; Is this conclusion
still true? Explain?

What determines what

M
L(r e , Y )
P
variable

how determined (in the long run)

exogenous (the Fed)

adjusts to make S = I

Y F (K , L )

M
adjusts to make L(i ,Y )
P

How P responds to M
M
L(r e , Y )
P
For given values of r, Y, and e,
a change in M causes P to change by the
same
percentage --- just like in the
Quantity Theory of Money.

What about expected

inflation?

Over the long run, people dont consistently

over- or under-forecast inflation,
so e = on average.
In the short run, e may change when people
get new information.

EX: Suppose Fed announces it will increase

M next year. People will expect next years P to be
higher, so e rises.

This will affect P now, even though M hasnt

changed yet.
(continued)

How P responds to
M
L(r e , Y )
P
For given values of r, Y, and M ,
e i (the Fisher effect)
M P

P to make M P fall
to re-establish eq'm

Discussion Question
Why is inflation bad?
What costs does inflation impose on
society?
of.

List all the ones you can think

Focus on the long run.

Think like an economist.

A common misperception

Common misperception:
inflation reduces real wages

This is true only in the short run, when

nominal wages are fixed by contracts.

(Chap 3) In the long run,

the real wage is determined by labor
supply and the marginal product of labor,
not the price level or inflation rate.

Consider the data

Average hourly earnings & the

CPI
Hourly
Hourlyearnings
earnings
inin2001
2001dollars
dollars

16
16

perhour
hour
$$per

14
14
12
12

66
44
22

Average
Average
hourly
hourly
earnings
earnings

200
200
175
175
150
150
125
125

10
10
88

250
250
225
225

Consumer
Consumer
Price
PriceIndex
Index

100
100
75
75
50
50
25
25

00
00
1964
1964 1968
1968 1972
1972 1976
1976 1980
1980 1984
1984 1988
1988 1992
1992 1996
1996 2000
2000

CPI(1983=100)
(1983=100)
CPI

18
18

The classical view of inflation

The classical view:

A change in the price level is merely a
change in the units of measurement.

So why, then, is inflation

a social problem?

The social costs of inflation

fall into two categories:
1. costs when inflation is expected
2. additional costs when inflation is

different than people had

expected.

The costs of expected inflation:

1. shoeleather cost

def: the costs and inconveniences of reducing

money balances to avoid the inflation tax.
i
real money balances
Remember: In long run, inflation doesnt
affect real income or real spending.
So, same monthly spending but lower average
money holdings means more frequent trips to
the bank to withdraw smaller amounts of cash.

The costs of expected inflation:

2. menu costs

def: The costs of changing prices.

Examples:

print new menus

print & mail new catalogs

The higher is inflation, the more frequently

firms must change their prices and incur these
costs.

The costs of expected inflation:

3. relative price distortions

Firms facing menu costs change prices

infrequently.
Example:
Suppose a firm issues new catalog each January.
As the general price level rises throughout the
year, the firms relative price will fall.
Different firms change their prices at different
times, leading to relative price distortions
which cause microeconomic inefficiencies
in the allocation of resources.

The costs of expected inflation:

4. unfair tax treatment
Some taxes are not adjusted to account for
inflation, such as the capital gains tax.
Example:
1/1/2001: you bought $10,000 worth of
Starbucks stock
12/31/2001: you sold the stock for $11,000,
so your nominal capital gain was $1000 (10%).
Suppose
= 10% in 2001.
Your real capital gain is $0.
But the govt requires you to pay taxes on
your $1000 nominal gain!!

Additional cost of unexpected inflation:

arbitrary redistributions of purchasing
power

Many long-term contracts not indexed,

but based on e.
If turns out different from e,
then some gain at others expense.
Example: borrowers & lenders
If > e, then (r ) < (r e)
and purchasing power is transferred from
lenders to borrowers.
If < e, then purchasing power is transferred
from borrowers to lenders.

Additional cost of high inflation:

increased uncertainty

When inflation is high, its more variable and

unpredictable:
turns out different from e more often, and
the differences tend to be larger (though not
systematically positive or negative)

Arbitrary redistributions of wealth

become more likely.

This creates higher uncertainty, which makes

risk averse people worse off.

One Benefit of Inflation

The social costs of inflation indicate that it may be best for

monetary policy to aim for zero inflation, but can a small
stable inflation rate be a good thing?
Reductions in nominal wages rarely occur (almost never);
why are firms reluctant to cut wage rates?
Is a 2% wage cut with zero inflation equivalent to a 3%
raise in wages with 5% inflation? Which is the more
acceptable?
Moderate inflation makes labor markets function better.

What would happen if real wages remained fixed in the event

of a reduction in labor demand?

Moderate inflation allows real wages to remain flexible

without the negative affects of periodic nominal wage cuts.

Hyperinflation

def: 50% per month

All the costs of moderate inflation described

above become HUGE under hyperinflation.

Money ceases to function as a store of value,

and may not serve its other functions (unit of
account, medium of exchange).

People may conduct transactions with barter

or a stable foreign currency.

What causes hyperinflation?

Hyperinflation is caused by excessive money

supply growth.

When the central bank prints money, the price

level rises.

If it prints money rapidly enough, the result is

hyperinflation.

Recent episodes of
hyperinflation

Why governments create

hyperinflation

When a government cannot raise taxes or sell bonds,

it must finance spending increases by printing money.
In theory, the solution to hyperinflation is simple: stop
printing money.
In the real world, this requires drastic and painful fiscal
restraint.
Even if inflation is always and everywhere a monetary
phenomenon, the end of hyperinflation is often a fiscal
phenomenon.

Case Study: Interwar German

Hyperinflation

From Jan. 1922 to Dec.

1923 Germany began
printing massive
quantities of money, why?
What immediately
happened to the money
supply and prices?
In Dec. 1923, fiscal reform
ended the hyperinflation;
what do you think the
German govt. had to do?
What does our theoretical
analysis tell us should
happen to M/P at the end
of a hyperinflation?
Did real balances increase
immediately? Is there
any explanation for this?

The Classical Dichotomy

Real variables are measured in physical units:
quantities and relative prices, e.g.
quantity of output produced
real wage: output earned per hour of work
real interest rate: output earned in the future
by lending one unit of output today
Nominal variables: measured in money units, e.g.
nominal wage: dollars per hour of work
nominal interest rate: dollars earned in future
by lending one dollar today
the price level: the amount of dollars needed
to buy a representative basket of goods

The Classical Dichotomy

Note: Real variables were explained in Chap 3,

nominal ones in Chap 4.
Classical Dichotomy : the theoretical
separation of real and nominal variables in the
classical model, which implies nominal
variables do not affect real variables.
Neutrality of Money : Changes in the money
supply do not affect real variables.
In the real world, money is approximately
neutral in the long run.

Chapter summary
Money

1.

the stock of assets used for transactions

serves as a medium of exchange, store of value,

and unit of account.

Commodity money has intrinsic value, fiat money

does not.

Central bank controls money supply.

Quantity theory of money

2.

assumption: velocity is stable

conclusion: the money growth rate determines the

inflation rate.

Chapter summary
Nominal interest rate

3.

equals real interest rate + inflation rate.

Fisher effect: nominal interest rate moves one-forone w/ expected inflation.

is the opportunity cost of holding money

Money demand

4.

depends on income in the Quantity Theory

more generally, it also depends on the nominal

interest rate; if so, then changes in expected
inflation
affect the current price level.

Chapter summary
5.

Costs of inflation

Expected inflation
shoeleather costs, menu costs,
tax & relative price distortions,
inconvenience of correcting figures for inflation

Unexpected inflation
all of the above plus arbitrary redistributions of wealth
between debtors and creditors
Hyperinflation

6.

caused by rapid money supply growth when money printed to

finance
govt budget deficits

stopping it requires fiscal reforms to eliminate govts need for

printing money

Chapter summary
Classical dichotomy

7.

In classical theory, money is neutral--does

not affect real variables.

So, we can study how real variables are

determined w/o reference to nominal ones.

Then, equilibrium in money market

determines price level and all nominal
variables.

Most economists believe the economy

works this way in the long run.