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Second Edition
Chapter 12
Inflation and the
Quantity Theory of
Money
Chapter Outline




Defining and Measuring Inflation
The Quantity Theory of Money
The Costs of Inflation
Appendix: Get Real! an Excellent
Adventure
2
Introduction
 Robert Mugabe, president of Zimbabwe
had a problem:
 His policies pushed his people to the
verge of starvation.
• With nothing left to tax he turned to the last
refuge of needy governments, the printing
press.
• Result: Hyperinflation
 Inflation went from 50 percent a year to 50 percent
a month to 50 percent a day!
3
Introduction
 In this chapter, we learn…
•
•
•
•
How inflation is defined and measured
What causes inflation
The costs and benefits of inflation
Why governments sometimes resort to
inflation.
4
Defining and Measuring Inflation
 Inflation – an increase in the average level
of prices.
 Inflation rate – the percentage change in
the average level of prices (as measured
by a price index) over a period of time.
 Measured using the following formula.
Pt  Pt -1
Inflation rate 
 100
Pt -1
5
Defining and Measuring Inflation
 A change in the average price level.
• Some prices go up and some go down relative
to each other.
• Think of an elevator containing many prices .
• As the elevator rises all of the prices rise. The
following figure may help.
6
Defining and Measuring Inflation
7
Price Indexes
 Price Indexes are used to measure
inflation.
• An index is a number that compares the price
level in one period relative to the prices in
some base year.
• There are several price indexes including:
 Consumer price index (CPI)
 Producer price index (PPI)
 GDP deflator
• Let’s take a closer look at each of these
8
Price Indexes
 Consumer price index (CPI) – measures
the average price of goods bought by a
typical American consumer.
•
•
•
•
Often referred to as the “cost of living index”.
Covers 80,000 goods.
Higher priced items count more.
Data can be found at the following link:
Consumer Price Indexes BLS.gov
9
Price Indexes
 GDP deflator – measures the average
price of all final goods and services.
Nominal GDPt
GDP Deflator t 
 100
Real GDPt
 Nominal and real GDP data can be found
at following link:
http://www.bea.gov national income data
10
Price Indexes
 PPI – measures the average price
received by producers.
• Includes intermediate goods as well as final
goods.
• Often used to calculate changes in the cost of
inputs.
• Data can be found at the following link:
PPI bls.gov
11
Inflation in the U.S.
Average
since 2000 = 2.6%
Average for 1950-2010
period = 3.9%
12
Calculating Real Prices
 Using the CPI to calculate real prices
• Real price – is the price of a good that has
been corrected for inflation.
 Example:
• 1982 price gasoline was $1.25/gal
• 2006 it was double that at $2.50/gal.
• CPI was 100 in 1982 and 202 in 2006 so that:
$1.25 
202
 $2.53
100
• Conclusion: The real price of gasoline was
slightly lower in 2006 than it was in 1982!
13
Inflation Around the World
 Average annual
inflation rates in
selected countries
(2002-2007)
14
Inflation Around the World
 Hyperinflation – extremely high rates of
inflation that make inflation in the U.S. look
pretty tame by comparison.
 A lot of governments have fell into the trap
of inflating their currency in order to pay
debts.
 The next table shows some pretty dramatic
examples.
15
Hyperinflation
16
Hyperinflation
500,000,000,000
dinar bank note,
Yugoslavia c.1993
would buy about
$5 worth of goods.
17
Check Yourself
 If the CPI was 120 this time last year and is
125 right now, what is the inflation rate?
 If the inflation rate goes from 1 percent to 4
percent to 7 percent over two years, what will
happen to the prices of the great majority of
goods: will they go up, stay the same, go
down, or do you not have enough information
to say?
 Why do we use real prices to compare the
price of goods across time?
18
The Quantity Theory of Money
 The quantity theory of money does two
things:
• Sets out the general relationship between
inflation, money, real output, and prices.
• Presents the critical role of the money supply
in regulating the level of prices.
M  n  P  YR
M = money supply, n = velocity, P = average
price level, YR = real GDP
19
The Quantity Theory of Money
 Velocity – the average number of times a
dollar is spent on final goods and services
in a year.
 Quantity theory of money depends on two
assumptions:
• Real GDP is stable compared to the money
supply.
• The velocity of money, v, is stable compared to
the money supply
20
The Cause of Inflation
 The quantity theory is a theory of inflation.
 If YR is fixed by real factors of production
and v is stable, then it follows that inflation is
caused by an increase in the supply of money.
• The quantity theory of money can also be
written in terms of growth rates:
M  v  P  YR
 Growth rate of money + growth rate of v is identically
equal to the rate of inflation + growth rate of real GDP
21
The Cause of Inflation
 Important implication: If the growth rates of
n and YR are small compared to the growth
rate of M, The rate of inflation will be
approximately equal to the inflation rate.
PM
• Or more generally:
P  M  YR  n
22
The Cause of Inflation
23
The Cause of Inflation
 One of the most important truths of
economics.
• “Inflation is always and everywhere a
monetary phenomenon”, Milton Friedman,
Nobel Prize Winner
 Milton Friedman (1912-2008)
24
The Cause of Inflation
25
The Cause of Inflation
 Deflation – a decrease in the average level
of prices (a negative inflation rate).
• If M and n grow more slowly than YR, prices
will fall.
• If M and n are fixed, an increase in YR, prices
will fall.
• Example: Gold standard 1834-1933
 Dollar was fixed at 1/20th of an ounce of gold.
 Supply of gold increases slowly
 Prices typically decrease a bit each year.
26
The Cause of Inflation
 Changes in velocity will affect prices.
• Hyperinflation: People will spend their money
faster (increase n) → even faster increase in
prices.
• Great Depression: Fear → ↓spending
(decreased n) → deflation → worse
depression.
 In the long run, money is neutral.
27
An Inflation Parable
 In the short-run increasing the money supply can
increase real GDP, YR.
Government
prints money
to pay army
Soldiers buy from
baker, tailor, and
carpenter
When the baker, tailor,
and carpenter go to buy
from each other, they find
they are no better off than
before because of higher
prices
At first
All three work
harder to increase
output and raise their
prices.
Eventually they catch on and stop
working harder to produce more output.
28
Check Yourself
 In the long run, what causes inflation?
 What is the equation that represents the
quantity theory of money?
29
The Costs of Inflation
 If all prices including wages are going up,
then what is the problem with inflation?
 We will look at four problems with inflation.
1.
2.
3.
4.
Price confusion and money illusion.
Inflation redistributes wealth.
Inflation Interacts with other taxes.
Inflation is painful to stop.
30
Price Confusion and Money Illusion
 Price confusion – inflation makes price
signals more difficult to interpret.
• A decision maker does not always know if the
price of a product is increasing because of
increased demand or simply as a result of all
prices going up with inflation.
 Money Illusion –people mistake changes in
nominal prices for changes in real prices.
 Results of both: resources are wasted
31
Inflation Redistributes Wealth
 Inflation is type of tax. It transfers wealth
to the government.
• Even tax cheats can’t avoid this tax!
• Governments that print money to pay their
bills are using this type of tax.
 Inflation redistributes wealth among the
public.
• Especially from lenders to borrowers
32
Inflation Redistributes Wealth
 Nominal rate of return – the rate of return
that does not account for inflation.
 Real rate of return – the nominal rate of
return minus the inflation rate.
rreal = i - p
Where: rreal = real rate of return,
i = nominal rate of interest, p = rate of inflation
33
Inflation Redistributes Wealth
 Suppose a bank makes a 30 year home
loan at an interest rate of 7%. If the rate of
inflation is 3% over that period: bank’s
actual rate of return = 7% - 3% = 4%
• If inflation rises unexpectedly to 13% as it did
in late 1970s. Now the actual rate of return =
7% - 13% = - 6%!
 The lender is now losing money on the loan.
 The borrow gains.
34
Inflation Redistributes Wealth
 What happens if people expect inflation to
go up?
• Lenders will increase nominal rates of interest.
 Fisher effect – the tendency for nominal
interest rates to rise with expected
inflation.
i  p  requilibriu m
E
The Fisher effect is shown in the next figure.
35
The Fisher Effect
36
Inflation Redistributes Wealth
 The actual rate of return: determined in
large part by the difference between
expected inflation and actual inflation.
 From earlier equations we have:
ractual  i  p (1) and i  pE  requilibriu m (2)
• Substituting i from equation (2) into equation
(1) we get:
ractual  (p  p)  requilibriu m
E
The following table summarizes what we learn from this result.
37
Inflation Redistributes Wealth
38
Inflation Redistributes Wealth
 Monetizing the debt – when the
government pays off its debts by printing
money.
• Why don’t they always inflate their debt away?
Two reasons…
 The Fisher effect: if banks know the government is
doing this, they will simply raise interest rates.
 Political cost: People who buy government bonds
usually vote (remember people who buy bonds are
lenders)
39
Hyperinflation and the Breakdown of
Financial Intermediation.
 If inflation is moderate and stable…
• Lenders and borrowers can forecast well.
• Loans can be signed with rough certainty
regarding the value of future payment.
 If inflation is high and volatile…
• Long-term risk becomes high and loans may
not be signed at all.
• Financial intermediation breaks down
• Let’s look at some examples
40
Hyperinflation and the Breakdown of
Financial Intermediation
 Peru (1987-1992)
• Private loans virtually disappeared.
• Investment fell and the economy collapsed.
 Mexico (1980s)
• Inflation rate at times exceeded 100%.
• Long-term loans were hard to get.
• Since the1990s inflation has been tamed.
 Results:
• Rapidly growing capital markets
• Increased investment
41
Inflation and the Breakdown of
Financial Intermediation
 What happens when real interest rates are
negative?
• People take their money out of banks and use
the cash to:
 Invest abroad
 Buy real assets like land or art that may appreciate
alongside inflation.
 Consume more.
• Supply of savings falls and financial
intermediation is less efficient.
• Result: slower economic growth
Let’s see.
Negative Interest Rates and
Economic Growth
43
Inflation Interacts with Other Taxes
 Inflation Interacts with Other Taxes
• Inflation will produce tax burdens and tax
liabilities that do not make economic sense.
• People pay taxes on illusory capital gains.
 Example: Taxes are collected on nominal capital
gains
 Results:
• Longer-run effect is to discourage investment in
the first place.
• Inflation increases the costs of complying with
the tax system.
44
Inflation is Painful to Stop
 Slowing down the money supply can
create a recession.
 A good lesson:
• Inflation in 1980 was 13.5%.
• Tough monetary policy reduced the rate of
inflation to 3%, but the consequence was…
 The worst recession since the Great Depression.
 Unemployment rate over 10%.
 The unemployment rate didn’t return to near 5.5%
until 1988.
45
Check Yourself
 Consider unexpected inflation and
unexpected disinflation. How is wealth
redistributed between borrowers and
lenders under each case?
 What happens to nominal interest rates
when expected inflation increases? What
do we call this effect?
 What does unexpected inflation do to price
signals?
46
Takeaway
 Inflation is an increase in the average
level of prices as measured by an index
such as the CPI.
 Sustained inflation is always and
everywhere a monetary phenomenon.
 Inflation makes price signals difficult to
interpret.
• This is especially true when people may
suffer from money illusion.
47
Takeaway
 Workers and firms adjust to predictable
inflation by incorporating inflation rates
into wages and contract agreements.
 Anything above a mild sustained inflation
is bad for the economy.
48
Appendix
Get Real! An Excellent Adventure
49
Appendix
Suppose you want to convert a nominal
data series into a inflation-corrected or
real data series.
Step I: Down load your data into a spread
sheet.
Source: http://www.census.gov/const/www/newressalesindex.html
50
Appendix
Suppose you want to convert a nominal
data series into a inflation-corrected or
real data series.
Step I: Down load your data into a spread
sheet.
Step II: We need a price index. Input your
data into your spreadsheet.
51
Appendix
Suppose you want to convert a nominal
data series into a inflation-corrected or
real data series.
Step I: Down load your data into a spread
sheet.
Step II: We need a price index. Input your
data into your spreadsheet.
Step III: Calculate your deflator. You do this
by dividing all of the CPIs by the CPI in the
period you use as the “base period”. In this
case it is August 2006. The deflator equals 1 in
the base period.
52
Appendix
Suppose you want to convert a nominal
data series into a inflation-corrected or
real data series.
Step I: Down load your data into a spread
sheet.
Step II: We need a price index. Input your
data into your spreadsheet.
Step III: Calculate your deflator. You do this
by dividing all of the CPIs by the CPI in the
period you use as the “base period”. In this
case it is August 2006. The deflator equals 1 in
the base period.
Step IV: Divide the average house price by the
deflator.
Result: There has been a real increase
In the price of housing. What would cause
this?
53
Second Edition
End of Chapter 12