Download Money and Inflation

Chapter 4: Money and Inflation
 Continued
CHAPTER 4
Money and Inflation
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One benefit of inflation
 Nominal wages are rarely reduced, even when
the equilibrium real wage falls.
This hinders labor market clearing.
 Sometimes the equilibrium real wage for an
industry may change
 Now, the firm needs to take the nominal wage
as given and hire workers to a point where
MPL= W/P
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Factor Price
Factor Supply
(W/P)1
(W/P)2
F-demand 1
F-demand 2
L
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 When this happens, the logical thing to do is to cut the
real wage from (W /P) 1 to (W /P) 2
 If prices are fixed, this implies a reduction in nominal
wages
 However, this is hardly done in practice because
workers feel offended.
 Inflation allows the real wages to reach equilibrium levels
without nominal wage cuts.
 Therefore, moderate inflation improves the functioning of
labor markets.
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Money and Inflation
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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.
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Money and Inflation
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German Hyperinflation
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Costs of Hyperinflation -1

Shoeleather costs: Business executives spend much
more time to manage the firms’ cash that they cannot
work on production and investment.

Menu costs: Prices change too fast.
 Ex: German hyperinflation (1920s) waiter announces
new prices every ½ hour.

Changing relative prices: Almost impossible to do a
price search when prices are changing very rapidly.
 Ex: German bar: order two pitchers of beer because
the price of the 2nd one increase before you finish 1st
pitcher.
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Costs of Hyperinflation -2
 Tax systems: The real value of our tax payment
↓ by the time government receives it.
 Overall inconvenience: Imagine carrying a bag
of money to the grocery store.
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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.
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Aside: “Money printing”
 “Money printing” is a technical term that refers to
an increase in money supply
 Central banks usually increase the money
supply through “open market operations”
 An “open market purchase” is the central banks
purchase of bonds from public
 In exchange for bonds, CB gives money to
public and the money supply increases
 During the financial crisis,the Fed increased the
money supply electronically.
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Money and Inflation
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 Literally printing money through the printing press is also
done to replace old currency with new ones.
 Because the old currency is replaced with new currency,
money supply does not change due to “money printing”
via the printing press.
 Printing money via printing press is under the autority of
the Government (Treasury department)
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A few examples of hyperinflation
money
growth (%)
inflation
(%)
Israel, 1983-85
295
275
Poland, 1989-90
344
400
Brazil, 1987-94
1350
1323
Argentina, 1988-90
1264
1912
Peru, 1988-90
2974
3849
Nicaragua, 1987-91
4991
5261
Bolivia, 1984-85
4208
6515
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Why governments create
hyperinflation
 Hyperinflations are caused by fiscal imbalances.
 G – T: Budget Deficit: Three ways to finance:
1) ↑ T
2) Issue bonds
3) Print money (via printing press)
 When a government cannot raise taxes or sell
bonds, it must finance spending increases by
printing money.
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 If the government cannot get the funds via T or bonds,
then it may rely on printing money which is inflationary.
This starts a circular act:
 Printing money → ↑  → ↓ Real tax revenue → Deficit
widens →print more money
 In theory, the solution to hyperinflation is simple: stop
printing money.
 In the real world, this requires drastic and painful fiscal
restraint.
 Hyperinflations usually end with a fiscal reform. ↑ T, ↓ G
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The Classical Dichotomy
Real variables: Measured in physical units –
quantities and relative prices, for example:
 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
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 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.
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 In chapter 3, we have seen real variables: Real
GDP, W/P: all in physical units.
 In this chapter, we have seen nominal variables:
Money and inflation.
 In chapter 3, we have produced and allocated
income without any money.
 This separation between the real and the
nominal side of the economy is called: Classical
Dichotomy.
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Neutrality of Money
 Recall the quantity theory:
__
__
M V  PY
 ∆M has no impact on ∆Y. The irrelevance of
money to real variables is called money
neutrality.
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Conclusions
 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.
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End of chapter problem 10
(in the answer key, this is question 8)
 Suppose consumption depends on the level of
real money balances.
 Show that if real money balances depend on the
nominal interest rate, an increase in the rate of
M growth affects C, I, and r.
 Does i adjust one for one to expected inflation?
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 C=C(M/P) and (M/P)d =L(i)
 M(up)P (up)Inflation (up)i (up)(M/P)d
(down)C (down)S=Y-C-G (up)r (down)
 i=r +  e
(down) (up)
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