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© 2007 Thomson South-Western
Money Growth and Inflation
• The Meaning of Money
– Money is the set of assets in an economy that
people regularly use to buy goods and services
from other people.
© 2007 Thomson South-Western
THE CLASSICAL THEORY OF
INFLATION
• Inflation is an increase in the overall level of
prices.
• Hyperinflation is an extraordinarily high rate
of inflation.
© 2007 Thomson South-Western
THE CLASSICAL THEORY OF
INFLATION
• Inflation: Historical Aspects
– Over the past 60 years, prices in the U.S. have
risen on average about 5 percent per year.
– Deflation, meaning decreasing average prices,
occurred in the U.S. in the nineteenth century.
– Hyperinflation refers to high rates of inflation such
as Germany experienced in the 1920s.
© 2007 Thomson South-Western
THE CLASSICAL THEORY OF
INFLATION
• Inflation: Historical Aspects
– In the 1970s prices rose by 7 percent per year.
– During the 1990s, prices rose at an average rate of
2 percent per year.
© 2007 Thomson South-Western
The Level of Prices and the Value of
Money
• The quantity theory of money is used to
explain the long-run determinants of the price
level and the inflation rate.
• Inflation is an economy-wide phenomenon that
concerns the value of the economy’s medium
of exchange.
• When the overall price level rises, the value of
money falls.
© 2007 Thomson South-Western
消費者物價指數
index
1981 =100
200
台灣 M1B、消費者物價指數
M1B
index
1981=100
1900
消費者物價指數
M1B
1700
180
1500
1300
160
1100
900
140
700
500
120
300
100
100
1981
1986
1991
1996
2001
2006
年
© 2007 Thomson South-Western
消費者物價指數
index
1981 =100
200
台灣 M2、消費者物價指數
M2
index
1981=100
2900
消費者物價指數
M2
2500
180
2100
160
1700
1300
140
900
120
500
100
100
1981
1986
1991
1996
2001
2006
年
© 2007 Thomson South-Western
Money Supply, Money Demand, and
Monetary Equilibrium
• The money supply is a policy variable that is
controlled by the Fed.
• Through instruments such as open-market
operations, the Fed directly controls the
quantity of money supplied.
• Money demand has several determinants,
including interest rates and the average level of
prices in the economy.
© 2007 Thomson South-Western
Money Supply, Money Demand, and
Monetary Equilibrium
• People hold money because it is the medium of
exchange.
– The amount of money people choose to hold
depends on the prices of goods and services.
• In the long run, the overall level of prices
adjusts to the level at which the demand for
money equals the supply.
© 2007 Thomson South-Western
Demand for Money
• Nominal interest rate (R) is the opportunity
cost of holding cash. Hence, higher nominal
interest rate means lower quantity demanded
for money.
• Since the purpose of holding money is to
facilitate planned transactions, more money
will be held the greater is the volume of
transactions planned.
© 2007 Thomson South-Western
Demand for Money
• Since it is the real quantities of goods and
services that people care about, not their
nominal values, the relevant quantity of money
demanded will be expressed in real terms. That
is, the behavioral relationship to be studied
relates real money balance (實質貨幣餘額) to
real transactions planned.
© 2007 Thomson South-Western
Demand for Money
• These three properties can be expressed formally as
follows:
M td
 L( yt , Rt )
Pt
+

In which M td / Pt is real money balance at t, yt is the
planned peal spending at t, and Rt is the nominal
interest rate at t.
© 2007 Thomson South-Western
Supply of Money
• Assume that central bank can directly control the
quantity of money supplied. Let M t be the quantity of
money supplied.
• In equilibrium, we have the following equilibrium
relationship between Money supply and price level:
M t  L( yt , rt   )  Pt
e
© 2007 Thomson South-Western
Supply of Money
• Suppose that changes in the quantity of money
supplied will not affect the real variables such as yt ,
and rt (that is, the neutrality of money holds). Then
given expected inflation rate (  e ) , an increase in
Money supply will cause an increase in price level:
M t
Pt 
L()
© 2007 Thomson South-Western
Supply of Money
• Suppose that the quantity of money
supplied evolves according to
M t  (1   ) M t 1
in which  is the money growth rate.
© 2007 Thomson South-Western
Supply of Money
• Taking natural logarithms on the above equilibrium
relationship yields
ln M t  ln L()  ln Pt
• Given the expected inflation rate (  e), we have
mt  pt ,
in which mt ( ln M t  ln M t 1 ) and pt ( ln pt  ln pt 1 )
are money growth rate and inflation rate at time t.
© 2007 Thomson South-Western
Supply of Money
• It is clear from the above equation that
inflation is always the monetary phenomenon.
• In equilibrium,
e
e
M t  Pt    t 
• Suppose that central bank announces that
money growth rate will increase starting from
T .There will be a jump in price level at T .
© 2007 Thomson South-Western
ln M t
ln Pt
a jump in
Pt
at
T
ln M t
ln Pt
T
© 2007 Thomson South-Western
How the Supply and Demand for Money
Determine the Equilibrium Price Level
Value of
1/P
Price
Level, P
Money supply
Money,
(High)
1
1
3
1.33
/4
12
/
Equilibrium
value of
money
(Low)
A
2
Mt 
14
/
(Low)
1
 L  
pt
Equilibrium
price level
4
Money
demand
0
Quantity fixed
by the Fed
Quantity of
Money
(High)
© 2007 Thomson South-Western
An Increase in the Money Supply
Value of
Money, 1/P
(High)
MS1
MS2
1
1
1. An increase
in the money
supply . . .
3
2. . . . decreases
the value of
money . . .
Price
Level, P
/4
12
/
1.33
A
2
B
14
/
(Low)
3. . . . and
increases
the price
level.
4
Money
demand
(High)
(Low)
0
M1
M2
Quantity of
Money
© 2007 Thomson South-Western
The Effects of a Monetary Injection
• The Quantity Theory of Money
– How the price level is determined and why it
might change over time is called the quantity
theory of money.
• The quantity of money available in the economy
determines the value of money.
• The primary cause of inflation is the growth in the
quantity of money.
© 2007 Thomson South-Western
The Classical Dichotomy and Monetary
Neutrality
• Nominal variables are variables measured in
monetary units.
• Real variables are variables measured in
physical units.
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The Classical Dichotomy and Monetary
Neutrality
• According to Hume and others, real economic
variables do not change with changes in the
money supply.
– According to the classical dichotomy, different
forces influence real and nominal variables.
• Changes in the money supply affect nominal
variables but not real variables.
• The irrelevance of monetary changes for real
variables is called monetary neutrality.
© 2007 Thomson South-Western
Velocity and the Quantity Equation
• The velocity of money refers to the speed at
which the typical dollar bill travels around the
economy from wallet to wallet.
V = (P  Y)/M
where V = velocity
P = the price level
Y = the quantity of output
M = the quantity of money
© 2007 Thomson South-Western
Velocity and the Quantity Equation
• Rewriting the equation gives the quantity
equation:
MV=PY
• The quantity equation relates the quantity of
money (M) to the nominal value of output
(P  Y).
© 2007 Thomson South-Western
Velocity and the Quantity Equation
• The quantity equation shows that an increase
in the quantity of money in an economy must
be reflected in one of three other variables:
– The price level must rise,
– the quantity of output must rise, or
– the velocity of money must fall.
© 2007 Thomson South-Western
Nominal GDP, the Quantity of Money,
and the Velocity of Money
Indexes
(1960 = 100)
2,000
Nominal GDP
1,500
M2
1,000
500
Velocity
0
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
© 2007 Thomson South-Western
台灣 M1B、貨幣流通速度
velocity
10
2200
velocity
2000
M1B
1800
名目GDP
8
M1B GDP
Index
1980 = 100
1600
1400
6
1200
1000
4
800
600
2
400
200
0
0
1961
1966
1971
1976
1981
1986
1991
1996
2001
2006
年
© 2007 Thomson South-Western
台灣 M2、貨幣流通速度
velocity
10
3000
8
velocity
2800
M2
2600
名目GDP
2400
M2 GDP
Index
1980 = 100
2200
2000
6
1800
1600
1400
4
1200
1000
800
2
600
400
200
0
0
1961
1966
1971
1976
1981
1986
1991
1996
2001
2006
年
© 2007 Thomson South-Western
Velocity and the Quantity Equation
• The Equilibrium Price Level, Inflation Rate,
and the Quantity Theory of Money
– The velocity of money is relatively stable over
time.
– When the Fed changes the quantity of money, it
causes proportionate changes in the nominal value
of output (P  Y).
– Because money is neutral, money does not affect
output.
© 2007 Thomson South-Western
CASE STUDY:
Money and Prices during Four Hyperinflations
• Hyperinflation is inflation that exceeds 50
percent per month.
• Hyperinflation occurs in some countries
because the government prints too much
money to pay for its spending.
© 2007 Thomson South-Western
Money and Prices During Four Hyperinflations
(a) Austria
(b) Hungary
Index
(Jan. 1921 = 100)
Index
(July 1921 = 100)
100,000
100,000
Price level
Price level
10,000
10,000
Money supply
1,000
100
Money supply
1,000
1921
1922
1923
1924
1925
100
1921
1922
1923
1924
© 2007 Thomson South-Western
1925
Money and Prices During Four Hyperinflations
(c) Germany
(d) Poland
Index
(Jan. 1921 = 100)
100,000,000,000,000
1,000,000,000,000
10,000,000,000
100,000,000
1,000,000
10,000
100
1
Index
(Jan. 1921 = 100)
10,000,000
Price level
Money
supply
Price level
1,000,000
Money
supply
100,000
10,000
1,000
1921
1922
1923
1924
1925
100
1921
1922
1923
1924
© 2007 Thomson South-Western
1925
The Inflation Tax
• When the government raises revenue by
printing money, it is said to levy an inflation
tax.
• An inflation tax is like a tax on everyone who
holds money.
• The inflation ends when the government
institutes fiscal reforms such as cuts in
government spending.
© 2007 Thomson South-Western
The Fisher Effect
• The Fisher effect refers to a one-to-one
adjustment of the nominal interest rate to the
inflation rate.
• According to the Fisher effect, when the rate
of inflation rises, the nominal interest rate rises
by the same amount.
• The real interest rate stays the same.
© 2007 Thomson South-Western
The Nominal Interest Rate and the Inflation Rate
Percent
(per year)
15
12
Nominal interest rate
9
6
Inflation
3
0
1960
1965
1970
1975
1980
1985
1990
1995
2000
© 2007 Thomson South-Western
THE COSTS OF INFLATION
• A Fall in Purchasing
Power?
• Inflation does not in
itself reduce people’s
real purchasing power.
© 2007 Thomson South-Western
THE COSTS OF INFLATION
•
•
•
•
•
•
Shoeleather costs
Menu costs
Relative price variability
Tax distortions
Confusion and inconvenience
Arbitrary redistribution of
wealth
© 2007 Thomson South-Western
Shoeleather Costs
• Shoeleather costs are the resources wasted
when inflation encourages people to reduce
their money holdings.
• Inflation reduces the real value of money, so
people have an incentive to minimize their
cash holdings.
• Less cash requires more frequent trips to the
bank to withdraw money from interest-bearing
accounts.
© 2007 Thomson South-Western
Shoeleather Costs
• The actual cost of reducing your money
holdings is the time and convenience you must
sacrifice to keep less money on hand.
• Also, extra trips to the bank take time away
from productive activities.
© 2007 Thomson South-Western
Menu Costs
• Menu costs are the costs of adjusting prices.
• During inflationary times, it is necessary to
update price lists and other posted prices.
• This is a resource-consuming process that
takes away from other productive activities.
© 2007 Thomson South-Western
Confusion and Inconvenience
• When the Fed increases the money supply and
creates inflation, it erodes the real value of the
unit of account.
• Inflation causes dollars at different times to
have different real values.
• Therefore, with rising prices, it is more
difficult to compare real revenues, costs, and
profits over time.
© 2007 Thomson South-Western
Relative-Price Variability and the
Misallocation of Resources
• Inflation distorts relative prices.
• Consumer decisions are distorted, and markets
are less able to allocate resources to their best
use.
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Inflation-Induced Tax Distortion
• Inflation exaggerates the size of capital gains
and increases the tax burden on this type of
income.
• With progressive taxation, capital gains are
taxed more heavily.
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Inflation-Induced Tax Distortion
• The income tax treats the nominal interest
earned on savings as income, even though part
of the nominal interest rate merely
compensates for inflation.
• The after-tax real interest rate falls, making
saving less attractive.
© 2007 Thomson South-Western
How Inflation Raises the Tax Burden on Saving
© 2007 Thomson South-Western
A Special Cost of Unexpected Inflation:
Arbitrary Redistribution of Wealth
• Unexpected inflation redistributes wealth
among the population in a way that has
nothing to do with either merit or need.
• These redistributions occur because many
loans in the economy are specified in terms of
the unit of account—money.
© 2007 Thomson South-Western
Summary
• The overall level of prices in an economy
adjusts to bring money supply and money
demand into balance.
• When the central bank increases the supply of
money, it causes the price level to rise.
• Persistent growth in the quantity of money
supplied leads to continuing inflation.
© 2007 Thomson South-Western
Summary
• The principle of money neutrality asserts that
changes in the quantity of money influence
nominal variables but not real variables.
• A government can pay for its spending simply
by printing more money.
• This can result in an “inflation tax” and
hyperinflation.
© 2007 Thomson South-Western
Summary
• According to the Fisher effect, when the
inflation rate rises, the nominal interest rate
rises by the same amount, and the real interest
rate stays the same.
• Many people think that inflation makes them
poorer because it raises the cost of what they
buy.
• This view is a fallacy because inflation also
raises nominal incomes.
© 2007 Thomson South-Western
Summary
• Economists have identified six costs of
inflation:
–
–
–
–
–
–
Shoeleather costs
Menu costs
Increased variability of relative prices
Unintended tax liability changes
Confusion and inconvenience
Arbitrary redistributions of wealth
© 2007 Thomson South-Western
Summary
• When banks loan out their deposits, they
increase the quantity of money in the
economy.
• Because the Fed cannot control the amount
bankers choose to lend or the amount
households choose to deposit in banks, the
Fed’s control of the money supply is
imperfect.
© 2007 Thomson South-Western