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Inflation: Its Causes and Costs
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Inflation: Its Causes and Costs
Inflation
is a sustained increase in the
price level. It is a continuous increase
versus a “once-and-for-all” increase in
prices.
Inflation deals with the increase in the
average of prices and not just
significant increases in the price of a
few goods.
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Inflation: Historical Aspects
 Over
the past sixty years, prices have risen
on average about 5 percent per year.
 Deflation, a situation of decreasing prices,
occurred in the nineteenth century.
 In the 1970’s prices rose by 7 percent per
year.
 From 1990 to 1996 prices rose about 3
percent per year.
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The Causes of Inflation
Inflation
is an economy-wide monetary
phenomenon that concerns, first and
foremost, the value of an economy’s
medium of exchange.
To understand the cause of inflation as
a monetary phenomenon we must
understand the concepts of Money
Supply, Money Demand, and Monetary
Equilibrium.
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Money Supply and Money Demand
Money
Supply is a variable of the
Federal Reserve Banks. Through
instruments such as open market
operations, the Fed directly controls
the quantity of money supplied.
Money Demand has several
determinants including:
– interest rates
– average level of prices in the economy
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Money Supply and Money Demand
People
hold money because it is the
medium of exchange. The amount of
money people choose to hold depends
on the prices of the 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.
– Figure 16-1
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Money Supply, Money Demand and
Equilibrium Price Level
Value of
Money
Money Supply
Equilibrium
Price Level
Equilibrium
Value of
Money
Money
Demand
QFixed
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Price
Level
Monetary Equilibrium
The
Fed could inject money (monetary
injection) into the economy by buying
government bonds. Results would be:
– The supply curve shifting to the right
– The equilibrium value of money
decreasing
– The equilibrium price level increasing
This
process is referred to as the
quantity theory of money.
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The Effects of Monetary Injection
Value of
Money
MS1
Price
Level
Money
Demand
QFixed
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The Effects of Monetary Injection
Value of
Money
MS1
Price
Level
PE
VME
Money
Demand
QFixed
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The Effects of Monetary Injection
Value of
Money
(High)
MS1
Price
Level
(Low)
PE
VME
Money
Demand
Low
QFixed
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High
The Effects of Monetary Injection
Value of
Money
(High)
MS1 MS2
Price
Level
(Low)
PE
VME
Money
Demand
Low
QFixed
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High
The Effects of Monetary Injection
Value of
Money
(High)
MS1 MS2
Price
Level
(Low)
VME
PE
VME
PE
Money
Demand
Low
QFixed
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High
Cause of Inflation:
The Quantity of Money Theory
The
quantity of money available in the
economy determines the value of
money. Growth in the quantity of
money is the primary cause of
inflation.
Some macroeconomic variables are
unchanged, given changes in the
supply of money. (Hume)
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Monetary Neutrality
An increase in the rate of money
growth raises the inflation but does
not affect any “real” variables (e.g.
production, employment, real wages,
and real interest rates.) Such
irrelevance of monetary changes for
“real” variables is called monetary
neutrality.
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Velocity and The Quantity Equation
“How
many times per year is the
typical dollar bill used to pay for a
newly produced good or service?”
The velocity of money refers to the
speed at which the typical dollar bill
travels around the economy from
wallet to wallet.
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Velocity and The Quantity Equation
V = (P x Y) ÷ M
Where: V = Velocity
P = The average price level
Y = the quantity of output
M = the quantity of money
Rewriting
the equation gives the
quantity equation.
MxV=PxY
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Five Step Foundation to The Quantity
Theory of Money
The velocity of money is relatively
stable over time.
A proportionate change in the nominal
value of output is related to changes in
the quantity of money by the Fed.
Because money is neutral, money
does not affect output. (Chapter 12)
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Five Step Foundation to The Quantity
Theory of Money
Changes in the money supply which
induce parallel changes in the nominal
value of output are also reflected in
changes in the price level.
When the Fed increases the money
supply rapidly, the result is a high rate
of inflation.
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Hyperinflation & Inflation Tax
Hyperinflation
is inflation that exceeds
50 percent per month.
– Figure 16-4: Note the relationship
between the growth rate of the quantity of
money and the price level.
Hyperinflation
in some countries is
caused because the government prints
too much money to pay for their
spending.
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Hyperinflation & 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.
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Relationship Between Money, Inflation
and Interest Rates
Nominal
Interest Rate =
Real Interest Rate + Inflation Rate
Over the long run, a change in the
money growth should not affect the
Real Interest rate thus, the Nominal
Interest Rate must adjust one-for-one
to changes in the Inflation Rate.
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Relationship Between Money, Inflation
and Interest Rates
When
the Fed increases the rate of
money growth, the result is both a high
inflation rate and a higher nominal
interest rate. This is called the,
Fisher Effect
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Quick Quiz!
 The
government of a
country increases the
growth rate of the money
supply from 5 percent per
year to 50 percent per year.
What happens to prices?
 What happens to nominal
interest rates?
 Why would the government
be doing this?
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The Costs of Inflation
At
least six costs of inflation are
identified as:
1 . Shoeleather costs
2 . Menu Costs
3 . Increased variability of relative prices
4 . Tax liabilities
5 . Confusion and inconvenience
6 . Arbitrary redistribution of wealth
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The Costs of Inflation:
Shoeleather Costs
Inflation
reduces the real value of
money, so people have an incentive to
minimize their cash holdings. Less
cash requires people to make frequent
trips to the bank because they keep
their money in interest bearing
accounts.
Extra trips to the bank takes time away
from productive activities. (Mr. Miranda)
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The Costs of Inflation:
Menu Costs
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.
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The Costs of Inflation:
Increased Variability of Relative Prices
During
times of rising prices, there will
be a delay between price increases.
While these prices are constant, other
prices will be rising. It then becomes
difficult to know exact relative prices
as prices change irregularly.
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The Costs of Inflation:
Unintended Changes in Tax Liability
With
inflation, unadjusted incomes are
treated as real gains. Consequently,
with progressive taxation, rising
nominal incomes are taxed more
heavily.
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The Costs of Inflation:
Confusion and Inconvenience
With
rising prices, it is necessary to
constantly make corrections in order
to compare real revenues, costs, and
profits over time. The time spent
making these adjustments could have
been spent producing more goods and
services.
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The Costs of Inflation:
Arbitrary Redistribution of Wealth
With
unanticipated or incorrectly
anticipated inflation, wealth is
redistributed between net monetary
debtors and creditors. This may result
in wealth transfers that would not
otherwise be acceptable.
– Recall the Fisher Effect.
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The Inflation Fallacy
Fallacy:
“Inflation reduces individuals’
incomes and causes living standards
to decline.”
Fact: “One person’s inflated price is
another’s inflated income.” Unless
incomes are fixed in nominal terms,
the higher prices paid by consumers
are exactly offset by the higher
incomes received by sellers.
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