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• The inflation rate is computed as the
annual percentage change in the price
level
Chapter 8
Inflation
By Charles I. Jones
Media Slides Created By
Price level in
year t
• The Consumer Price Index (CPI)
Dave Brown
Penn State University
– Price index for a bundle of consumer goods
8.1 Introduction
• In this chapter, we learn:
– What inflation is, and how costly it can be.
– How the quantity theory of money and the
classical dichotomy help us understand
inflation.
– The relationship of interest rates and
inflation through the Fisher equation.
– The important link between fiscal policy
and high inflation.
• Inflation
– The percentage change in an economy’s
overall price level
• Hyperinflation
– an episode of extremely high inflation
– Greater than 500 percent per year
– Example: Post World War I Germany
Case Study: How Much Is That?
• We can use the CPI to evaluate the
value of a good in 1950 in today’s
dollars.
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8.2 The Quantity
Theory of Money
• Today
– Currency is “fiat money.”
– Currency is paper that the government
simply declares is worth a certain price.
– Money has value because we expect others
will value it.
• Multiply the price of the good in 1950
times the ratio of the CPI in today’s
dollars to the CPI in 1950 dollars.
• It’s not as large of a difference as the
raw numbers may lead you to believe.
• Other price indexes
– The CPI excluding food and energy prices
– The GDP deflator
8.2 The Quantity
Theory of Money
• We often think of money as paper
currency.
Measures of the Money Supply
• The monetary base includes currency
and accounts, called reserves.
– Private banks hold accounts with the
economy’s central bank, which pay no
interest.
– These banks ensure that they have
sufficient cash on hand in case of money
withdrawals.
• Other measures of currency:
– M1
• adds demand deposits to the money base
• Historically
– Money was backed by gold or silver
– M2
• adds savings accounts and money market
account balances to M1
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• Velocity of money
– The average number of times per year that
each piece of paper currency is used in a
transaction
• The equation implies that the amount of
money used in purchases is equal to
nominal GDP.
Case Study: Digital Cash
• Electronic forms of currency
• The classical dichotomy
– Debit cards, PayPal, travelers’ checks
– Makes up most money in advanced
economies
The Quantity Equation
• The quantity theory of money allows us
to make the connection between money
and inflation.
Money
supply
Velocity
of money
Price
level
The Classical Dichotomy, Constant
Velocity, and the Central Bank
Real
GDP
– States that, in the long run, the real and
nominal sides of the economy are
completely separate.
• In the quantity theory of money
– Real GDP is assumed as exogenously given
– Determined by real forces.
• In other words:
Bar over the Y
means exogenous.
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• The velocity of money
– Exogenously given constant
– Assumed to be constant over time
• In other words:
No time
subscript
• The money supply
– Determined by the central bank
– Monetary policy is exogenously given
The Quantity Theory for the
Price Level
• To solve the model
• In other words:
– Plug all the exogenous variables
– Solve for the price level
• Prices will rise as a result of
– Increases in the money supply
– Decreases in real GDP
• In the long run, the key determinant of the
price level is the money supply.
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The Quantity Theory for Inflation
• We can express the quantity equation in
terms of growth rates.
• Using g as growth rate
Constant = 0
Rate of inflation,
represented as π
• Thus:
Rate of
inflation
Growth
rate in
money
supply
Growth
rate in
GDP
Revisiting the Classical Dichotomy
• Quantity Theory of Money
– Changes in the growth rate of money lead
one-for-one to changes in the inflation rate.
– Empirically, this holds up both in U.S. and
worldwide data.
• Deflation
• When all prices in the economy double,
relative prices are unchanged.
• When the relative prices of goods are
unchanged, nothing real is affected.
– Occurs when inflation rates are negative
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• The neutrality of money says that changes
in the money supply
– Have no real effects on the economy
– Only affect prices
• Empirically
– Holds in the long run
– Does not hold in the short run
• nominal prices do not respond immediately
to changes in the money supply
• Empirically
– The real interest rate has been negative
– This implies that in the short run the real
interest rate need not equal the MPK.
8.3 Real and Nominal Interest
Rates
• The real interest rate
– Is equal to the marginal product of capital
– Is paid in goods
• The nominal interest rate
– Is the interest rate on a savings account
– Is paid in dollars
• The Fisher equation
8.4 Costs of Inflation
• Individuals who are hurt during inflation:
Nominal
interest
rate
Real
interest
rate
Rate of
inflation
– An individual who has a pension that is not
indexed to inflation
– A bank that issues loans at fixed rates but
that pays interest rates that move with the
market
– An individual with a variable rate mortgage
• The nominal interest rate is generally high
when inflation is high.
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• Large surprise inflations can lead to large
distributions in wealth.
– People with debts can pay back their loans
with new cheaper dollars.
– Creditors wind up losers.
• Taxes
– Based on nominal incomes
• Economic decisions
– Based on real variables
• Tax distortions are more severe when
inflation is high.
• Inflation also distorts relative prices.
– Some prices are faster at adjusting to inflation
than other prices are.
Case Study: The Wage-Price Spiral and
President Nixon’s Price Controls
• At the time, the view was:
– Strong unions pushed for high wages
– Strong corporations translated rising costs
to rising prices
– Strong unions demanded even higher
wages.
– Wage-price spiral, resulting in inflation
• Nixon froze wages and prices for 90 days
to break the spiral.
– High unemployment resulted from an
expansionary policy that brought the return of
inflation.
• Price controls also distort economic
decisions.
8.5 The Fiscal Causes of High
Inflation
• The government budget constraint
• Shoe leather costs of inflation
– People want to hold less money when
inflation is high.
Government
funds
Tax revenue
Changes in
the stock of
Borrowing money
• Menu costs
– The costs to firms of changing prices
frequently.
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The Inflation Tax
• Seignorage and the inflation tax
– Names for the revenue that the
government obtains from printing more
money (ΔM)
• The inflation tax
– Shows up as a rise in the price level
– Is paid by people holding currency
Case Study: Episodes of High
Inflation
• Episodes of high inflation tend to recur.
• Hyperinflations can stop just as quickly
as they start.
• Countries experiencing hyperinflation
typically raise about 5 percent of GDP
from the inflation tax.
– Argentina raised 10 percent of GDP this
way.
• If a government runs large budget deficits,
as debt rises
– Lenders may worry the government will have
trouble paying back loans
– They may stop lending to the government
altogether.
• Debt solution: Raising taxes?
– May not be politically feasible
• The government may resort to printing
currency to finance its budget.
– Lenders to the government will be paid back
in currency that is worth less than the dollars
lent.
Central Bank Independence
• Monetary Policy
– Conducted by Federal Reserve
• Fiscal Policy
– President and Congress
• Central Bank Independence
– An attempt to prevent fiscal considerations
from leading to excessive inflation
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• Hyperinflation
– Ends when the rate of money growth falls
rapidly
– The government gets its finances in order
through lower spending, higher taxes, and
new loans
• The coordination problem
– People build their expectations into the prices
they set.
8.6 The Great Inflation of the
1970s
• During the Great Inflation,
– The rate peaked below 15 percent
– Yet the inflation tax was a small fraction of
government spending
• Inflation rose in the 1970s for the following
reasons:
– OPEC coordinated increases in oil prices that
spurred inflation.
– The Federal Reserve grew the money supply
too rapidly.
– Policymakers pursued such a policy because
of the productivity slowdown.
Summary
• Inflation
– The annual percentage change in the
overall price level in an economy
– A dollar today is worth much less than it
was a decade ago.
• The quantity theory of money is our basic
model for understanding the long-run
determinants of the price level and
therefore of inflation. There are two ways
to express the solution.
– For the price level
– For the rate of inflation
• The classical dichotomy
– The real and nominal sides of the economy
are largely separate.
– Real economic variables, like real GDP, are
determined only by real forces—like the
investment rate and TFP.
– They are not influenced by nominal changes,
such as a change in the money supply.
– Classical dichotomy holds in the long run but
not necessarily in the short run.
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• The nominal interest rate
This concludes the Lecture
Slide Set for Chapter 8
– Paid in units of currency
• Real interest rate
Macroeconomics
– Paid in goods
• Related by the Fisher equation
Third Edition
by
Charles I. Jones
Nominal
interest
rate
Real
interest
rate
Rate of
inflation
W. W. Norton & Company
Independent Publishers Since 1923
• Inflation
– Can be very costly to an economy
– Generally transfers resources from lenders
and savers to borrowers
– Can cause
• high effective tax rates
• distortions to relative prices
• shoe-leather costs
• menu costs
• The government budget constraint says
that the government has three basic ways
to finance its spending.
– Taxes
– Borrowing
– Printing money
• If none of those methods work, the
government may be forced to print money
to satisfy the budget constraint.
• Hyperinflations are generally a reflection of
such fiscal problems.
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