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Money and Inflation
He realised well that the abundance of
money makes everything dear, but he did
not analyse how that takes place. The great
difficulty of this analysis consists in
discovering by what path and in what
proportion the increase of money raises the
price of things.
RICHARD CANTILLON (died 1734),
Essai sur la nature du commerce en
général, II, 6.
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0
In this chapter,
look for the answers to these questions:
• How does the money supply affect inflation and
nominal interest rates?
• Does the money supply affect real variables like
real GDP or the real interest rate?
• How is inflation like a tax?
• What are the costs of inflation? How serious are
they?
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1
Introduction
 This chapter introduces the quantity theory of
money to explain one of the Principles of
Economics :
Prices rise when the govt prints
too much money.
 Most economists believe the quantity theory
is a good explanation of the long run behavior
of inflation.
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2
Money and Inflation






Price = amount of money required to buy a good.
Inflation rate = ΔP/P = the percentage increase in
the average level of prices (e.g. π = 5 % p.a.).
Deflation = decrease in the average level of prices.
(e.g. π = - 1 % p.a.)
Disinflation = decrease in the inflation rate
(e.g. π1 = 5 % → π2 = 3 %)
Price level stability: π = 0 % p.a.
Because prices are defined in terms of money, we
need to consider the nature of money, the supply of
money, the demand for money, and what impact it
has on the economy.
The Value of Money
 P = the price level
(e.g., the CPI or GDP deflator)
P is the price of a basket of goods, measured in
money.
 1/P is the value of $1, measured in goods.
 Example: basket contains one candy bar.
 If P = $2, value of $1 is 1/2 candy bar
 If P = $3, value of $1 is 1/3 candy bar
 Inflation drives up prices and drives down the
value of money.
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4
The Quantity Theory of Money
 Developed by 18th century philosopher
David Hume and the classical economists
 Advocated more recently by Nobel Prize Laureate
Milton Friedman
 Asserts that the quantity of money determines the
value of money
 We study this theory using two approaches:
1. A supply-demand diagram
2. An equation
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5
Money Supply (MS)
 In real world, determined by Federal Reserve,
the banking system, consumers.
 In this model, we assume the Fed precisely
controls MS and sets it at some fixed amount.
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6
Money Demand (MD)
 Refers to how much wealth people want to hold
in liquid form.
 Depends on P:
An increase in P reduces the value of money,
so more money is required to buy g&s.
 Thus, quantity of money demanded
is negatively related to the value of money
and positively related to P, other things equal.
(These “other things” include real income,
interest rates, availability of ATMs.)
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7
The Money Supply-Demand Diagram
Value of
Money, 1/P
1
Price
Level, P
As the value of
money rises, the
price level falls.
1
¾
1.33
½
2
¼
4
Quantity
of Money
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8
The Money Supply-Demand Diagram
Value of
Money, 1/P
Price
Level, P
MS1
1
1
¾
1.33
½
¼
The Fed sets MS
at some fixed value,
regardless of P.
$1000
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2
4
Quantity
of Money
9
The Money Supply-Demand Diagram
Value of
Money, 1/P
1
A fall in value of money
(or increase in P)
increases the quantity
of money demanded:
Price
Level, P
1
¾
1.33
½
2
¼
4
MD1
Quantity
of Money
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10
The Money Supply-Demand Diagram
Value of
Money, 1/P
MS1
1
eq’m
value
of
money
P adjusts to equate
quantity of money
demanded with
money supply.
¾
½
Price
Level, P
1
1.33
A
¼
2
MD1
$1000
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eq’m
price
level
4
Quantity
of Money
11
The Effects of a Monetary Injection
Value of
Money, 1/P
MS1
MS2
1 Fed
Suppose the
increases the
money supply.
¾
eq’m
value
of
money
½
Price
Level, P
1
Then the value
of money falls,
and P rises.
1.33
A
2
B
¼
MD1
$1000
$2000
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4
eq’m
price
level
Quantity
of Money
12
Other Effects
 A) Increase in real GDP
 B) Increase in nominal IR
 C) Exo change in the demand for money
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13
A Brief Look at the Adjustment Process
Result from graph: Increasing MS causes P to rise.
How does this work? Short version:
 At the initial P, an increase in MS causes
excess supply of money.
 People get rid of their excess money by spending
it on g&s or by loaning it to others, who spend it.
Result: increased demand for goods.
 But supply of goods does not increase,
so prices must rise.
(Other things happen in the short run, which we will
study in later chapters.)
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14
Real vs. Nominal Variables
 Nominal variables are measured in monetary
units.
Examples: nominal GDP,
nominal interest rate (rate of return measured in $)
nominal wage ($ per hour worked)
 Real variables are measured in physical units.
Examples: real GDP,
real interest rate (measured in real goods)
real wage (measured in real goods)
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15
Real vs. Nominal Variables
Prices are normally measured in terms of money.
 Price of a compact disc:
$15/cd
 Price of a pepperoni pizza:
$10/pizza
A relative price is the price of one good relative to
(divided by) another:
 Relative price of CDs in terms of pizza:
$15/cd
price of cd
= 1.5 pizzas per cd
=
$10/pizza
price of pizza
Relative prices are measured in physical units,
so they are real variables.
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16
Real vs. Nominal Wage
An important relative price is the real wage:
W = nominal wage = price of labor, e.g., $15/hour
P = price level = price of g&s, e.g., $5/unit of output
Real wage is the price of labor relative to the price
of output:
$15/hour
W
=
= 3 units output per hour
P
$5/unit of output
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17
The Classical Dichotomy
 Classical dichotomy: the theoretical separation
of nominal and real variables
 Hume and the classical economists suggested
that monetary developments affect nominal
variables but not real variables.
 If central bank doubles the money supply,
Hume & classical thinkers contend
 all nominal variables—including prices—
will double.
 all real variables—including relative prices—
will remain unchanged.
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18
The Neutrality of Money
 Monetary neutrality: the proposition that changes
in the money supply do not affect real variables
 Doubling money supply causes all nominal prices
to double; what happens to relative prices?
 Initially, relative price of cd in terms of pizza is
$15/cd
= 1.5 pizzas per cd
=
$10/pizza
The relative price
 After nominal prices double,
is unchanged.
$30/cd
price of cd
= 1.5 pizzas per cd
=
$20/pizza
price of pizza
price of cd
price of pizza
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19
The Neutrality of Money
 Monetary neutrality: the proposition that changes
in the money supply do not affect real variables
 Similarly, the real wage W/P remains unchanged, so
 quantity of labor supplied does not change
 quantity of labor demanded does not change
 total employment of labor does not change
 The same applies to employment of capital and
other resources.
 Since employment of all resources is unchanged,
total output is also unchanged by the money supply.
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20
The Neutrality of Money
 Most economists believe the classical dichotomy
and neutrality of money describe the economy in
the long run.
 In later chapters, we will see that monetary
changes can have important short-run effects
on real variables.
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21
The Quantity Theory of Money




o

Stock


How does the quantity of money affect the economy?
QTM - the quantity of money in the economy is related
to the number of dollars exchanged in transactions.
Suppose that the supply of money in the economy is
$10. In the first half of the year, 5 bottles of beer are
sold for $2. The owners of money then buy 1 lb. of
ham for $10.
The total value of transactions over the year:
$2×5 + $10×1 = $20
M Velocity
= $10, of
socirculation
each unit of M was transacted twice/year.
$10 × 2 = $2×5 + $10×1
M × V = ∑piqi
Flow
The Quantity Theory of Money
Fisher (1911): The Purchasing Power of Money:
Let us begin with the money side. If the number of dollars in a country is
5,000,000, and their velocity of circulation is twenty times per year, then the
total amount of money changing hands (for goods) per year is 5,000,000
times twenty, or $100,000,000. This is the money side of the equation of
exchange…
200,000,000 loaves of bread at $ .10 a loaf,
10,000,000 tons of coal at 5.00 a ton, and
30,000,000 yards of cloth at 1.00 a yard.
The value of these transactions is evidently $100,000,000, i.e. $20,000,000
worth of bread plus $50,000,000 worth of coal plus $30,000,000 worth of
cloth. The equation of exchange therefore (remember that the money side
consisted of $5,000,000 exchanged 20 times) is as follows:—
$5,000,000 × 20 times a year
= 200,000,000 loaves × $ .10 a loaf
+10,000,000 tons × 5.00 a ton
+30,000,000 yards × 1.00 a yard.
The Quantity Theory of Money







Number of transactions T is difficult to measure so it
is replaced by the total output in the economy Y.
Assume that Y is proportional to T: T = aY
M × VT = P × T
M × VT = P × aY
M × VT/a = P × Y
M × VY = P × Y
VY …Income velocity of money
Number
of times a dollar bill enters someone’s
income in a given period of time.
The Velocity of Money
 Velocity of money: the rate at which money
changes hands
 Notation:
P x Y = nominal GDP
= (price level) x (real GDP)
M
= money supply
V
= velocity
 Velocity formula:
PxY
V =
M
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25
The Velocity of Money
PxY
Velocity formula: V =
M
Example with one good: pizza.
In 2012,
Y
= real GDP = 3000 pizzas
P
= price level = price of pizza = $10
P x Y = nominal GDP = value of pizzas = $30,000
M
= money supply = $10,000
V
= velocity = $30,000/$10,000 = 3
The average dollar was used in 3 transactions.
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26
ACTIVE LEARNING
Exercise
1
One good: corn.
The economy has enough labor, capital, and land
to produce Y = 800 bushels of corn.
V is constant.
In 2008, MS = $2000, P = $5/bushel.
Compute nominal GDP and velocity in 2008.
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ACTIVE LEARNING
Answers
1
Given: Y = 800, V is constant,
MS = $2000 and P = $5 in 2005.
Compute nominal GDP and velocity in 2008.
Nominal GDP = P x Y = $5 x 800 = $4000
$4000
PxY
= 2
=
V =
$2000
M
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U.S. Nominal GDP, M2, and Velocity
1960–2011
3,000
1960=100
2,500
Velocity is fairly
stable over the
long run.
Nominal GDP
2,000
M2
1,500
1,000
500
Velocity
0
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
29
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The Quantity Equation
Velocity formula:
PxY
V =
M
 Multiply both sides of formula by M:
MxV = PxY
 Called the quantity equation
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30
The Quantity Theory in 5 Steps
Start with quantity equation: M x V = P x Y
1. V is stable.
2. So, a change in M causes nominal GDP (P x Y)
to change by the same percentage.
3. A change in M does not affect Y: Money is
neutral,
Y is determined by technology & resources
4. 4. So, P changes by same percentage as
P x Y and M.
5. Rapid money supply growth causes rapid
inflation.
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31
The Quantity Theory in 5 Steps
Start with quantity equation: M x V = P x Y
The quantity theory of money says that the elasticity
of the price level with respect to the money supply
is ONE!.
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32
The Quantity Theory
 M×V=P×Y
 %ΔM + %ΔV = %ΔP + %ΔY
 %ΔV = 0 by assumption
 %ΔY depends on the growth of K,L and A. If all
constant => %ΔY = 0
 Hence, the growth in the money supply (%ΔM)
determines the rate of inflation (%ΔP = π).
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33
ACTIVE LEARNING
Exercise
2
One good: corn. The economy has enough labor,
capital, and land to produce Y = 800 bushels of corn.
V is constant. In 2008, MS = $2000, P = $5/bushel.
For 2009, the Fed increases MS by 5%, to $2100.
a. Compute the 2009 values of nominal GDP and P.
Compute the inflation rate for 2008–2009.
b. Suppose tech. progress causes Y to increase to
824 in 2009. Compute 2008–2009 inflation rate.
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34
ACTIVE LEARNING
Answers
2
Given: Y = 800, V is constant,
MS = $2000 and P = $5 in 2008.
For 2009, the Fed increases MS by 5%, to $2100.
a. Compute the 2009 values of nominal GDP and P.
Compute the inflation rate for 2008–2009.
Nominal GDP = P x Y = M x V (Quantity Eq’n)
= $2100 x 2 = $4200
P = P x Y = $4200 = $5.25
800
Y
$5.25 – 5.00
Inflation rate =
= 5% (same as MS!)
35
5.00
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ACTIVE LEARNING
Answers
2
Given: Y = 800, V is constant,
MS = $2000 and P = $5 in 2005.
For 2009, the Fed increases MS by 5%, to $2100.
b. Suppose tech. progress causes Y to increase 3%
in 2009, to 824. Compute 2008–2009 inflation rate.
First, use Quantity Eq’n to compute P in 2009:
$4200
MxV
P =
= $5.10
=
824
Y
$5.10 – 5.00
Inflation rate =
= 2%
5.00
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36
U.S. inflation and money growth,
1960-2006
15%
12%
Over the long run, the inflation and
money growth rates move together,
M2 growth
as the quantity
theory rate
predicts.
9%
6%
3%
0%
1960 1965
inflation
rate
1970 1975
1980 1985
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1990 1995
2000 2005
37 37
slide
Money and prices in the CR
240
220
200
180
CPI
160
M2
140
120
100
80
60
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I.13
I.12
I.11
I.10
I.09
I.08
I.07
I.06
I.05
I.04
I.03
I.02
I.01
I.00
I.99
I.98
I.97
I.96
I.95
I.94
I.93
40
38
Money and prices (MA-12)
25,0%
20,0%
15,0%
Inflation
Money growth
10,0%
5,0%
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
I.13
I.12
I.11
I.10
I.09
I.08
I.07
I.06
I.05
I.04
I.03
I.02
I.01
I.00
I.99
I.98
I.97
I.96
I.95
I.94
0,0%
39
International data on inflation and money
growth
Turkey
100
Ecuador
Inflation rate
Indonesia
Belarus
(percent,
logarithmic scale)
10
Argentina
U.S.
1
Singapore
Switzerland
0.1
1
10
100
Money Supply Growth
(percent, logarithmic scale)
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40
ACTIVE LEARNING
2
Summary and Lessons about the
Quantity Theory of Money
 If real GDP is constant, then
inflation rate = money growth rate.
 If real GDP is growing, then
inflation rate < money growth rate.
 The bottom line:
 Economic growth increases # of transactions.
 Some money growth is needed for these extra
transactions.
 Excessive money growth causes inflation.
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except
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41
Hyperinflation
 Hyperinflation is generally defined as inflation
exceeding 50% per month.
 Recall one of the Ten Principles from Chapter 1:
Prices rise when the government
prints too much money.
 Massively excessive growth in the money supply
always causes hyperinflation.
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42
Hyperinflation in Zimbabwe
Large govt budget deficits
led to the creation of
large quantities of money
and high inflation rates.
date
Zim$ per US$
Aug 2007
245
Apr 2008
29,401
May 2008
207,209,688
June 2008
4,470,828,401
July 2008
26,421,447,043
Feb 2009
37,410,030
Sept 2009
355
Sign posted in
public restroom
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43
The Inflation Tax
 When tax revenue is inadequate and ability to
borrow is limited, govt may print money to pay
for its spending.
 Almost all hyperinflations start this way.
 The revenue from printing money is the
inflation tax: printing money causes inflation,
which is like a tax on everyone who holds
money.
 In the U.S., the inflation tax today accounts for
less than 3% of total revenue.
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44
Correcting Variables for Inflation:
Very important! Real vs. Nominal Interest Rates
The nominal interest rate:
 the interest rate not corrected for inflation
The real interest rate:
 corrected for inflation
Real interest rate
= (nominal interest rate) – (inflation rate)
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45
The Fisher Effect
 Rearrange the definition of the real interest rate:
Nominal
Real
Inflation
+
=
interest rate
interest rate
rate
 The real interest rate is determined by saving &
investment in the loanable funds market.
 Money supply growth determines inflation rate.
 So, this equation shows how the nominal interest
rate is determined.
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46
The Fisher Effect
Nominal
Real
Inflation
+
=
interest rate
interest rate
rate
 In the long run, money is neutral,
so a change in the money growth rate affects
the inflation rate but not the real interest rate.
 So, the nominal interest rate adjusts one-for-one
with changes in the inflation rate.
 This relationship is called the Fisher effect
after Irving Fisher, who studied it.
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47
U.S. Nominal Interest & Inflation Rates, 1960–2011
18%
The close relation between
these variables is evidence
for the Fisher effect.
15%
12%
Nominal
interest rate
9%
6%
3%
Inflation rate
0%
-3%
1960
1965
1975
1980
1985
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1995
2000
2005
48
2010
The Fisher Effect & the Inflation Tax
Nominal
Real
Inflation
+
=
interest rate
interest rate
rate
 The inflation tax applies to people’s holdings of
money, not their holdings of wealth.
 The Fisher effect: an increase in inflation causes
an equal increase in the nominal interest rate,
so the real interest rate (on wealth) is unchanged.
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49
The Costs of Inflation
 The inflation fallacy: most people think inflation
erodes real incomes.
 But inflation is a general increase in prices
of the things people buy and the things they sell
(e.g., their labor).
 In the long run, real incomes are determined by
real variables, not the inflation rate.
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50
U.S. Average Hourly Earnings & the CPI
250
200
150
$20
Inflation causes
the CPI and
nominal wages
to rise together
over the long run.
$18
$16
$14
Nominal wage
(right scale)
100
$12
$10
$8
$6
50
CPI
(left scale)
0
1965 1970 1975 1980 1985 1990 1995 2000 2005
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$4
$2
$0
51 51
The Costs of Inflation
 Shoeleather costs: the resources wasted when
inflation encourages people to reduce their
money holdings
 Includes the time and transactions costs of
more frequent bank withdrawals
 Menu costs: the costs of changing prices
 Printing new menus, mailing new catalogs, etc.
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52
The Costs of Inflation
 Misallocation of resources from relative-price
variability: Firms don’t all raise prices at the
same time, so relative prices can vary…
which distorts the allocation of resources.
 Confusion & inconvenience: Inflation changes
the yardstick we use to measure transactions.
Complicates long-range planning and the
comparison of dollar amounts over time.
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53
The Costs of Inflation
 Tax distortions:
Inflation makes nominal income grow faster than
real income.
Taxes are based on nominal income,
and some are not adjusted for inflation.
So, inflation causes people to pay more taxes
even when their real incomes don’t increase.
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54
ACTIVE LEARNING
3
Tax distortions
You deposit $1000 in the bank for one year.
CASE 1: inflation = 0%, nom. interest rate = 10%
CASE 2: inflation = 10%, nom. interest rate = 20%
a. In which case does the real value of your deposit
grow the most?
Assume the tax rate is 25%.
b. In which case do you pay the most taxes?
c. Compute the after-tax nominal interest rate,
then subtract inflation to get the
after-tax real interest rate for both cases.
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ACTIVE LEARNING
Answers
3
Deposit = $1000.
CASE 1: inflation = 0%, nom. interest rate = 10%
CASE 2: inflation = 10%, nom. interest rate = 20%
a. In which case does the real value of your
deposit grow the most?
In both cases, the real interest rate is 10%,
so the real value of the deposit grows 10%
(before taxes).
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56
ACTIVE LEARNING
Answers
3
Deposit = $1000. Tax rate = 25%.
CASE 1: inflation = 0%, nom. interest rate = 10%
CASE 2: inflation = 10%, nom. interest rate = 20%
b. In which case do you pay the most taxes?
CASE 1: interest income = $100,
so you pay $25 in taxes.
CASE 2: interest income = $200,
so you pay $50 in taxes.
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57
ACTIVE LEARNING
Answers
3
Deposit = $1000. Tax rate = 25%.
CASE 1: inflation = 0%, nom. interest rate = 10%
CASE 2: inflation = 10%, nom. interest rate = 20%
c. Compute the after-tax nominal interest rate,
then subtract inflation to get the
after-tax real interest rate for both cases.
CASE 1:
nominal = 0.75 x 10% = 7.5%
real
= 7.5% – 0% = 7.5%
CASE 2:
nominal = 0.75 x 20% = 15%
real
= 15% – 10% = 5%
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58
ACTIVE LEARNING
3
Summary and lessons
Deposit = $1000. Tax rate = 25%.
CASE 1: inflation = 0%, nom. interest rate = 10%
CASE 2: inflation = 10%, nom. interest rate = 20%
Inflation…
 raises nominal interest rates (Fisher effect)
but not real interest rates
 increases savers’ tax burdens
 lowers the after-tax real interest rate
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59
A Special Cost of Unexpected Inflation
 Arbitrary redistributions of wealth
Higher-than-expected inflation transfers
purchasing power from creditors to debtors:
Debtors get to repay their debt with dollars that
aren’t worth as much.
Lower-than-expected inflation transfers purchasing
power from debtors to creditors.
High inflation is more variable and less predictable
than low inflation.
So, these arbitrary redistributions are frequent
when inflation is high.
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60
The Costs of Inflation
 All these costs are quite high for economies
experiencing hyperinflation.
 For economies with low inflation (< 10% per year),
these costs are probably much smaller,
though their exact size is open to debate.
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61
CONCLUSION
 This chapter explains one of the Ten Principles
of economics:
Prices rise when the govt prints
too much money.
 We saw that money is neutral in the long run,
affecting only nominal variables.
 In later chapters, we will see that money has
important effects in the short run on real
variables like output and employment.
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62
SUMMARY
• To explain inflation in the long run, economists use
the quantity theory of money. According to this
theory, the price level depends on the quantity of
money, and the inflation rate depends on the
money growth rate.
• The classical dichotomy is the division of variables
into real and nominal. The neutrality of money is
the idea that changes in the money supply affect
nominal variables but not real ones. Most
economists believe these ideas describe the
economy in the long run.
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63
SUMMARY
• The inflation tax is the loss in the real value of
people’s money holdings when the government
causes inflation by printing money.
• The Fisher effect is the one-for-one relation
between changes in the inflation rate and changes
in the nominal interest rate.
• The costs of inflation include menu costs,
shoeleather costs, confusion and inconvenience,
distortions in relative prices and the allocation of
resources, tax distortions, and arbitrary
redistributions of wealth.
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64