Download 17 - Seattle Central College

Announcements & Chap 17
Purpose of Chapter 17:
• Attempts to establish a link between money
supply and the inflation rate.
• Inflation is an increase in the overall level of
prices.
• Hyperinflation is an extraordinarily high rate of
inflation.
• Zimbabwe article (2006)…
Zimbabwe Hyperinflation
• Source: New York Times article (May 2, 2006)
• Inflation rate: 1,000 %
• Jobless rate: 70%
• Annual interest rate on savings: 4 to 10%
• Mugabe government
• In 2000, seized commercial farms, which created a foreign
capital flee. Selling Zimbabwean dollars in abundance and
US dollars in short supply creating a fall in value.
• To support the fall in value, the government began printing
trillions of Zimbabwean dollars to pay salaries.
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THE CLASSICAL THEORY OF
INFLATION
• Inflation: Historical Aspects
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Money Supply, Money Demand, and
Monetary Equilibrium
• What determines the value of money?
• Over the past 60 years, prices 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. Bolivia in 1985 (High
inflation).
• US
• In the 1970s prices rose by 7 percent per year.
• During the 1990s, prices rose at an average rate of 2 percent
per year.
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• Supply and Demand.
• The money supply 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.
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Figure 1. Essentially, as prices increase, the
money is worth less.
Money Supply, Money Demand, and
Monetary Equilibrium
• People hold money because it is the medium of
exchange.
Value of
Money, 1/P
(High)
• The amount of money people choose to hold
depends on the prices of goods and services.
1
3
1.33
12
/
Equilibrium
value of
money
(Low)
A
Figure 2 The Effects of Monetary Injection
(High)
MS1
Equilibrium
price level
4
/
Money
demand
0
1
1
1. An increase
in the money
supply . . .
3
2. . . . decreases
the value of
money . . .
/4
12
/
2
B
14
/
(Low)
1.33
A
Quantity of
Money
(High)
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The Classical Dichotomy and Monetary
Neutrality
Price
Level, P
MS2
2
14
Quantity fixed
by the Fed
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(Low)
1
/4
• In the long run, the overall level of prices
adjusts to the level at which the demand for
money equals the supply.
Value of
Money, 1/P
Price
Level, P
Money supply
3. . . . and
increases
the price
level.
• Economic variables broken up into two
categories (Normal Inflation: Roughly 3%):
• Nominal variables are variables measured in
monetary units ($ value).
• Real variables are variables measured in physical
units (bushels…).
4
Money
demand
(High)
(Low)
0
M1
M2
Quantity of
Money
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Copyright © 2004 South-Western
2
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.
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.
V = (P × Y)/M
• Where: V = velocity
P = the price level
Y = the quantity of output
M = the quantity of money
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Copyright © 2004 South-Western
Velocity and the Quantity Equation
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).
• The quantity equation shows that an increase in
the quantity of money in an economy must be
reflected in one of three other variables:
M = (P × Y)/V
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• the price level must rise,
• the quantity of output must rise, or
• the velocity of money must fall.
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CASE STUDY: Money and Prices during
Four Hyperinflations
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.
• 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 (Germany).
Copyright © 2004 South-Western
Figure 4 Money and Prices During Four
Hyperinflations
(c) Germany
The Inflation Tax
(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
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1923
1924
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1925
• When the government raises revenue by
printing money (Zimbawe), it is said to levy an
inflation tax.
• An inflation tax is like a tax on everyone who
holds money (dollars in your wallet less
valuable).
• The inflation ends when the government
institutes fiscal reforms such as cuts in
government spending.
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THE COSTS OF INFLATION
• A typical inflation question (in a normal
situation)…
• Does inflation rob us of Purchasing Power? In
other words, when prices rise, each dollar of
income buys fewer goods and services.
• Inflation does not in itself reduce people’s real
purchasing power.
• Why not? Only real variables affect real incomes.
THE COSTS OF INFLATION
• Inflation: True costs of inflations.
•
•
•
•
•
Shoeleather costs
Menu costs
Relative price variability
Tax distortions (*Understand*)
Confusion and inconvenience
• Remember, in an environment of normal
inflation, most incomes are adjusted by
indexing.
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Copyright © 2004 South-Western
Shoeleather Costs
Menu Costs
• Shoeleather costs are the resources wasted when
inflation encourages people to reduce their money
holdings.
• Thus the more trips you make to the bank the quicker
you wear out your shoes, hence 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.
• 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.
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Copyright © 2004 South-Western
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Relative-Price Variability and the
Misallocation of Resources
Inflation-Induced Tax Distortion
• Inflation distorts relative prices.
• Consumer decisions are distorted, and markets
are less able to allocate resources to their best
use.
• 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 (See page 366 for example).
• 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.
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Copyright © 2004 South-Western
Microsoft Example (p. 366)
Confusion and Inconvenience
• Example of how inflation distorts savings.
• Buy Microsoft stock at $10 in 1980 and sold it at $50
in 2000.
• The capital gain is $40 and your taxed accordingly.
But, what if prices doubled during that time?
• Thus, the stock is worth $20 and essentially you only
make $30 capital gain, but you’re taxed for $40.
• 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.
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Copyright © 2004 South-Western
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