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PRINCIPLES OF MACROECONOMICS
Chapter 30
Inflation
Overview
In the previous chapter we explained what money is and how the Central Bank (the Federal Reserve in the
United States) controls the quantity of money. In this chapter we establish the relationship between the rate
of growth of money and the inflation rate and investigate the causes and costs of inflation. We will establish
that, in the long run, there is a strong relationship between the growth rate of money and inflation. Students
will also find that there are numerous costs to the economy from high inflation, but that there is not a
consensus on the importance of these costs when inflation is moderate.
We also examine a number of issues connected with inflation – the quantity theory of money; the Philips
curve; Central Bank independence, and the role of the monetary policy committee. Each seem independent
from the other, and indeed each can be covered separately, but taken together they begin to give us a more
complete picture of policy makers thinking, particularly with regard to inflation and its relation to other real
issues in the economy such as unemployment.
Learning Outcomes
By the end of this chapter, students should understand:
¾
why inflation results from rapid growth in the money supply.
¾
the meaning of the classical dichotomy and monetary neutrality.
¾
why some countries print so much money that they experience hyperinflation.
¾
how the nominal interest rate responds to the inflation rate.
¾
the various costs that inflation imposes on society.
Key Points
1. The overall level of prices in an economy adjusts to bring money supply and money demand into
balance. When the central bank increases the supply of money, it causes the price level to rise.
Persistent growth in the quantity of money supplied leads to continuing inflation.
2. A government can pay for some of its spending simply by printing money. When countries rely heavily
on this “inflation tax,” the result is hyperinflation.
3. One application of the principle of monetary neutrality is the Fisher effect. According to the Fisher effect,
when the inflation rate rises, the nominal interest rate rises by the same amount, so that the real interest
rate remains the same.
4. Many people think that inflation makes them poorer because it raises the cost of what they buy. This
view is a fallacy, however, because inflation also raises nominal incomes.
5. Economists have identified six costs of inflation: shoeleather costs associated with reduced money
holdings, menu costs associated with more frequent adjustment of prices, increased variability of relative
prices, unintended changes in tax liabilities due to nonindexation of the tax code, confusion and
inconvenience resulting from a changing unit of account, and arbitrary redistributions of wealth between
debtors and creditors. Many of these costs are large during hyperinflation, but the size of these costs for
moderate inflation is less clear.
Dr. Savvas C Savvides-- School of Business, EUROPEAN UNIVERSITY CYPRUS
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Defining Inflation
Inflation is the consistent rise in the general price level.
So, we are not referring to a “once-off” increase in the average level of prices, but rather to a continuous
increase in the price level. Also you need to realize that inflation measures the increase in the average level
of prices in the economy. This does not mean that the prices of ALL goods are rising. The prices of some
may be stable or even be falling over the same period.
In Cyprus, the annual rate of change of the generals price level (the inflation rate) is shown in the graph
below. In the period 1960-2007, the average inflation rate was 4.1%. Notice from the graph that during some
years (especially in 1974 and 1980-81) Cyprus (and the World) experienced very rapid inflation rates due to
the quadrupling of oil prices then. Excluding those two periods, the average inflation rate is 3.5%
Inflation in Cyprus, 1960-2007
18
16
14
12
10
8
6
4
2
0
1950
-2
1960
1970
1980
1990
2000
2010
Calculating the Inflation Rate
We defined the inflation rate as the increase in the general price level. But, how is the general price level
measured. The answer is by the retail price index (RPI), also called consumer price index (CPI).
The retail price index (RPI): this is a measure of the overall cost of the goods and services bought by
a typical consumer.
How is the RPI calculated? First, Governments determine what the “typical” (or representative”) basket of
goods purchased by a typical consumer is by conducting surveys. The number of goods and services may
be 400-500 or more.
The formula for calculating the price index is:
⎛ cost of basket in current year ⎞
= ⎜
⎟ × 100
⎝ cost of basket in base year ⎠
Dr. Savvas C Savvides-- School of Business, EUROPEAN UNIVERSITY CYPRUS
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In the example below we will assume that the basket is comprised of three groups of goods in the following
quantities (units): 1000 units of food, 10 units of clothing, and one unit of education.
Year
2005
2006
2007
Price of Food
€1.0
1.2
1.5
Price of Clothing
€20
25
30
Price of Education
€6,000
6,500
7,000
1. In order to calculate the RPI, we first calculate the cost of the basket of goods and services. In our case
the basket is composed of the three goods shown in the table above:
Cost in 2005 = (1000 units of food x €1.0) + (10 units of clothing x €20) + (1 unit of education x €6,000) =
€7,200.
Cost in 2006 = (1000 units of food x €1.2) + (10 units of clothing x €25) + (1 unit of education x €6,500) =
€7,950.
Cost in 2007 = (1000 units of food x €1.5) + (10 units of clothing x €30) + (1 unit of education x €7,000) =
€8,800
2.
In order to compute the RPI we choose a base year. The base year is the benchmark against which
other years are compared.
3. Using 2005 as the base year, we now compute the RPI index. Note that the RPI in the base year is
always equal to 100.
RPI in 2005 = (€7200/€7200) × 100 = 1 × 100 = 100
RPI in 2006 = (€7950/€7200) × 100 = 1.104 × 100 = 110.4
RPI in 2007 = (€8800/€7200) × 100 = 1.222 × 100 = 122.2
4. We can now calculate the inflation rate, which is the percentage increase in the RPI from the previous
year. The formula used to calculate the inflation rate is:
⎛ CPI Year 2 - CPI Year 1 ⎞
⎟ × 100%
inflation rate = ⎜
CPI Year 1
⎝
⎠
So in terms of our example,
Inflation rate for 2006 = [(110.4 – 100)/100] × 100% = 10.4%
Inflation rate for 2007 = [(122.2 – 110.4)/110.4] × 100% = 10.69%
Hyperinflation and its effects
We have already talked about hyperinflation and how it hit Germany in the 1920s. It is obvious that inflation
does not occur in a vacuum. The historical study of inflation and hyperinflation, provide some interesting
observations.
Hyperinflation is an extraordinarily high rate of inflation, such as the one Germany experienced in the
1920s.
During such periods there tends to be a ‘flight from cash’ ie people hold as little cash as possible, e.g.
Germany in 1922-23, Hungary 1945-46, Brazil in the late 1980s. Large government budget deficits help to
explain such periods. Persistent inflation must be accompanied by continuing money supply growth.
Dr. Savvas C Savvides-- School of Business, EUROPEAN UNIVERSITY CYPRUS
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Hyperinflation in Germany and Poland
(c) Germany
(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
1923
1924
1925
3
Copyright © 2004 South-Western
Almost all hyperinflations follow the same pattern.
1. The government has a high level of spending and inadequate tax revenue to pay for its spending.
2. The government’s ability to borrow funds is limited.
3. As a result, it turns to printing money to pay for its spending.
4. The large increases in the money supply lead to large amounts of inflation.
5. The hyperinflation ends when the government cuts its spending and eliminates the need to create
new money.
The Level of Prices and the Value of Money
When the price level rises, people have to pay more for the goods and services that they purchase. A rise in
the price level also means that the value of money is now lower because each dollar now buys a smaller
quantity of goods and services.
If P is the price level, then the quantity of goods and services that can be purchased with $1 is equal to 1/P.
Money Supply, Money Demand and Monetary Equilibrium
The value of money is determined by the supply and demand for money. For the most part, the supply of
money is determined by the Central Bank, as we examined in the previous chapter. This implies that the
quantity of money supplied is fixed (until the Central Bank decides to change it). Thus, the supply of money
will be vertical (perfectly inelastic).
There are many determinants of the demand for money.
•
One variable that is very important in determining the demand for money is the price level.
•
The higher prices are, the more money that is needed to perform transactions.
Dr. Savvas C Savvides-- School of Business, EUROPEAN UNIVERSITY CYPRUS
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•
Thus, a higher price level (and a lower value of money) leads to a higher quantity of money
demanded.
In the long run, the overall price level adjusts to the level at which the demand for money and the supply of
money are equal.
•
If the price level is above the equilibrium level, people will want to hold more money than is available
and prices will have to decline.
•
If the price level is below equilibrium, people will want to hold less money than that available and the
price level will rise.
We can show the supply and demand for money using a graph. The left-hand vertical axis is the value of
money, measured by 1/P. The right-hand vertical axis is the price level (P). Note that it is inverted ― a high
value of money means a low price level and vice versa.
At the equilibrium, the quantity of money demanded is equal to the quantity of money supplied.
Money and Inflation
Recall that in Chapter 29 we defined the real money supply as the nominal money supply divided by the
price level (Ms/P). We have also concluded that people demand real money balances because they are
concerned with what money can buy, not money itself. Having in mind the various motives (reasons) for
holding real money balances (transaction, precautionary, and speculative), we can express the demand for
real money balances as
Ms/P = L (Y, r)
Let’s now ask the question: What is the effect of an increase in the nominal money supply? In the short run
we assume that prices do not adjust. Let’s examine the transmission process. Initially, this shifts the money
supply curve to the right, creating an excess supply of money at the current interest rates. In time, the
excess supply of real money bids down interest rates, thus boosting the demand for goods (through its
impact on spending on consumption and investment due to the wealth and credit effects).
Gradually this increased aggregate demand (spending) pushes up the prices of goods and services as well
as to increased output to satisfy this increased demand. Businesses demand to hire more labour and in the
process nominal wages start to rise. In the long run, after complete adjustment of wages and prices, the
once-off rise in nominal money has led to an equivalent once-off rise in wages and prices. Output,
employment, interest rates and real money revert to their original levels.
Dr. Savvas C Savvides-- School of Business, EUROPEAN UNIVERSITY CYPRUS
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The theoretical basis for this process is seen in the equation
MV = PT
Where M is the stock of money, V is the Velocity of money (that is, the number of times the stock of money
turns around to satisfy the volume of transactions, P is the price level, and T is the volume of transactions.
PT can also be represented as Y, the nominal value of GDP or national income, since the number of
transactions times the price level gives us the value of all transactions which is none other than GDP.
The above equation describes what is known as the quantity theory of money.
Definition of quantity theory of money: a theory asserting that the quantity of money available
determines the price level and that the growth rate in the quantity of money available determines the
inflation rate.
Briefly, the quantity theory of money states that changes in nominal money lead to equivalent changes in the
price level (and money wages), but have no effect on output and employment. This theory is espoused by
monetarists, who believe that if the demand for real money is constant, then the supply must likewise be
constant – thus changes in nominal money are matched by equivalent rises in price.
The real insight of the quantity theory of money is that (since real income and interests rates usually change
very slowly) real variables such as real money demand usually change slowly – i.e. in practice, large
changes in nominal money will be accompanied by large changes in other nominal variables such as prices
and wages, thus keeping real money and wages at or near their equilibrium values.
The Effects of a Monetary Injection
Dr. Savvas C Savvides-- School of Business, EUROPEAN UNIVERSITY CYPRUS
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Assume that the economy is currently in equilibrium and the Fed suddenly increases the supply of money.
The supply of money shifts to the right. The equilibrium value of money falls and the price level rises. When
an increase in the money supply makes dollars more plentiful, the result is an increase in the price level that
makes each dollar less valuable.
Velocity and the Quantity Equation
Definition of velocity of money: the rate at which money changes hands.
To calculate velocity, we divide nominal GDP by the quantity of money.
velocity = nominal GDP / money supply
If P is the price level (the GDP deflator), Y is real GDP, and M is the quantity of money:
velocity =
P × Y
M
Rearranging, we get the quantity equation.
M ×V = P× Y
Example
Suppose that:
Real GDP = $5,000
Velocity = 5
Money supply = $2,000
Price level = 2
We can show that:
MxV=PxY
$2,000 x 5 = 2 x $5,000
$10,000 = $10,000
The Fisher Hypothesis
Recall that the real interest rate is equal to the nominal interest rate minus the inflation rate.
Real interest rate = (nominal interest rate – inflation rate)
The above formula suggests that growth in the money supply determines the inflation rate. In other words, at
higher inflation rates, the nominal interest rates will also be higher (he suggests that real interest rates do not
in fact change very much). Another result of inflation -- particularly in its hyperinflation phase -- is the flight
from cash (remember the stealing of the wheelbarrow rather than the paper money in it, which suggests that
this is seen as a more valuable asset!). Secondly that money and prices can get quite out of line when
inflation and nominal interest rates are rising. Here we see faster money growth leading to higher inflation
Dr. Savvas C Savvides-- School of Business, EUROPEAN UNIVERSITY CYPRUS
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and higher (nominal) interest rates. Thus the demand for real money declines (as shown above) until the real
money supply adjusts to the change in real money demand.
Example
Real interest rate = 5%
Inflation rate = 2%
This means that the nominal interest rate will be 5% + 2% = 7%.
If the inflation rate rises to 3%, the nominal interest rate will rise to 5% + 3% = 8%.
The Costs of Inflation
Here we need to examine inflation illusion before going on to the real costs of inflation. We then look at the
costs of living with fully anticipated inflation – problems of institutions not adapting successfully (such as noninflation adjusted tax rates, allowing fiscal drag etc). Unexpected inflation causes additional specific
problems – redistribution (people with nominal assets gain, those with nominal liabilities lose; redistribution
tends to take place from the old to the young – older people tend to have more assets in the form of nominal
bonds etc). Finally uncertainties over inflation cause their own specific problems, due to the difficulty of
planning, which now needs more resources.
The Costs of Inflation
1. A Fall in Purchasing Power?
o The Inflation Fallacy. Most individuals believe that the major problem caused by inflation is
that inflation lowers the purchasing power of a person’s income. However, as prices rise, so
do incomes. Thus, inflation does not in itself reduce the purchasing power of incomes.
2. Shoeleather Costs.
o Definition of shoeleather costs: the resources wasted when inflation encourages
people to reduce their money holdings.
o Because inflation erodes the value of money that you carry in your pocket, you can avoid
this drop in value by holding less money. However, holding less money generally means
more trips to the bank.
o This cost can be considerable in countries experiencing hyperinflation.
3. Menu Costs.
o Definition of menu costs: the costs of changing prices. During periods of inflation, firms
must change their prices more often.
4. Relative-Price Variability and the Misallocation of Resources.
o Because prices of most goods change only once in a while (instead of constantly), inflation
causes relative prices to vary more than they would otherwise. When inflation distorts
relative prices, consumer decisions are distorted and markets are less able to allocate
resources to their best use.
5. Inflation-Induced Tax Distortions.
o Lawmakers rarely take into account inflation when they write tax laws. The nominal values of
interest income and capital gains are taxed (not the real values).
Dr. Savvas C Savvides-- School of Business, EUROPEAN UNIVERSITY CYPRUS
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