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Chapter 15
Inflation: A Monetary Phenomenon
What's in This Chapter and Why
This chapter deals with inflationits costs, causes, and cures. It emphasizes that inflation, a longrun phenomenon, is caused by high money supply growth rates.
In discussing the various measures of inflation, considerable space is devoted to the consumer
price index because of its importance and the attention paid to it by the news media.
Considerable space is also devoted to the effects of inflation because of their importance and
subtlety. (The costs of inflation are less obvious than those of unemployment.)
Attention is also paid to the money supply and the Federal Reserve. The appendix to this
chapter elaborates on the money supply process and the means by which the Federal Reserve can
alter the money supply.
The causes of inflation are examined within the quantity theory and aggregate supplyaggregate demand contexts. The conclusion is that inflation is a monetary phenomenon. It is
emphasized, however, that both the income velocity of money and the output growth rate vary in
the short run. Consequently, the relationship between the inflation and money supply growth rates
is weaker in the short run than in the long run.
Although it is argued that inflation is a monetary phenomenon, the claim that firms and labor
unions cause inflation is outlined and critically evaluated.
Various policy alternatives--monetary, fiscal, supply-side, and incomesare considered as a
means to reduce or eliminate inflation.
Instructional Objectives
After completing this chapter, your students should know:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
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How inflation is defined and measured.
That the consumer price index has a number of limitations as a measure of the cost of living.
That it is important to distinguish between unanticipated and anticipated inflation.
That inflation affects the economy in many different ways.
How the money supply is defined and that the Federal Reserve controls the nation's money
supply.
How to explain inflation in terms of the quantity theory and aggregate supply-aggregate
demand frameworks.
That with the income velocity of money and output growth rates constant, the inflation rate is
determined by the growth rate of the money supply.
That to reduce the inflation rate the growth rate of the money supply must be reduced.
That supply-side policies, even if they are successful in raising the nation's output growth rate,
are unlikely to significantly reduce the inflation rate.
That incomes policy has many shortcomings as a means to control inflation and that the
experience of the United States with wage-price guidelines and controls has been very
discouraging.
Instructor’s Manual  199
Key Terms
These terms are introduced in this chapter:
Inflation
Deflation
Consumer price index (CPI)
Debtor
Hyperinflation
Medium of exchange
Central bank
Quantity theory of money
Equation of exchange
Unanticipated inflation
Indexing
Creditor
Money
Currency (cash)
Demand deposits
Money supply
Income velocity of money
Supply-side policies
Incomes policy
Suggestions for Teaching
Because the inflation rate is unlikely to remain low, most instructors will probably wish to cover
this topic in some detail. Four or five sessions will be required to cover this chapter. If instructors
elect to cover the appendix (Money Creation and Monetary Policy), another session or two will be
required.
In defining inflation, it is important that students understand that inflation is a continuing, or
long-run, phenomenon. Once-and-for-all increases in the price level are excluded because no
policy action is necessary to achieve price stability once the effects have worked their way through
the economy.
In discussing the effects of inflation, it is important to distinguish between unanticipated and
anticipated inflation.
If instructors wish to spend more time on money creation and monetary policy, they may do so
by assigning the appendix in conjunction with the section on the money supply. This material
could also be assigned in conjunction with Chapter 13 or prior to the discussion on inflation.
Some instructors may wish to spend more time on the U.S. experience with income policies.
Most of these episodes, however, are ancient history to today's students.
Additional References
In addition to the references in the text, instructors may wish to read or assign one or more of the
following:
1. Roger E. Brinner, “Is Inflation Dead?” Federal Reserve Bank of Boston, New England
Economic Review (January/February 1999), pp. 37-49.
2. Todd E. Clark, “A Comparison of the CPI and the PCE Price Index,” Federal Reserve Bank of
Kansas City, Economic Review 84 (Q 3 1999), pp. 15-29.
3. Dean Croushore, “Low Inflation: The Surprise of the 1990s,” Federal Reserve Bank of
Philadelphia, Business Review (July/August 1998), pp. 3-12.
4. Andrew J. Filardo, “New Evidence on the Output Cost of Fighting Inflation,” Federa; Reserve
Bank of Kansas City, Economic Review 83 (Q 3 1998), pp. 33-61.
5. Stanley Fischer and Franco Modigliani, "Towards an Understanding of the Real Effects and
Costs of Inflation," Weltwirtschaftliches Archiv, 114 (1978), pp. 810-833.
200  Chapter 15/Inflation: A Monetary Phenomenon
6. Robert E. Hall, ed., Inflation: Causes and Effects (Chicago: University of Chicago Press,
1982).
7. George A. Kahn and Klara Parrish, “Conducting Monetary Policy with Inflation Targets,”
Federal Reserve Bank of Kansas City, Economic Review 83 (Q 3 1998), pp. 5-32.
8. Alvin L. Marty and Daniel L. Thornton, "Is There a Case for 'Moderate' Inflation?" Federal
Reserve Bank of St. Louis, Review 77 (July/August 1995), pp. 27-37.
9. "Price Stability and Economic Growth," Federal Reserve Bank of St. Louis, Review 78
(May/June 1996).
10. Marvin E. Wolfgang, ed., "Social Effects of Inflation," The Annals of the American Academy of
Political Science 456 (July 1981), pp. 1-153.
11.
“Special Issue on Inflation Targeting,” Federal Reserve Bank of New York, Economic
Policy Review, 3 (August 1997), pp. 1-110.
Outline
I.
DEFINING INFLATION
A. Definitions and General Comments
1. Inflation is defined as a continuing increase in the price level.
2. It is important to distinguish inflation from a once-and-for-all increase in the price
level.
a. This distinction is important because in cases of inflation, policies are needed to
keep the price level from continuing in an upward spiral; such policies are
unnecessary with a one-time increase in the price level.
3. During inflationary periods, prices in general are increasing.
a. Inflation does not mean that all prices are increasing.
4. Deflation is a continuing fall in the price level.
II. MEASURING INFLATION
A. The GDP Deflator
1. The GDP deflator is a weighted average of the prices of all final goods and services
produced in the economy.
2. The GDP deflator is the broadest based measure of the nation's price level.
a. Because of its comprehensiveness, the GDP deflator is often considered the best
measure of the nation's inflation rate.
B. The Consumer Price Index
1. The consumer price index, CPI, is a weighted average of the prices of goods and
services purchased by a typical urban household.
2. The CPI is the most widely cited measure of inflation in the United States.
3. Although the CPI is often regarded as a cost of living index, there are several problems
with this interpretation.
a. The CPI is not accurate for a household that is atypical.
b. The CPI overstates increases in the cost of living because it is based on a fixed
basket of goods and services.
1. This overestimate occurs because households change their buying patterns in
response to price changes.
Instructor’s Manual  201
c. The CPI overstates increases in the cost of living because it doesn't fully account
for changes in quality.
4. Despite its shortcomings as a measure of the cost of living, the CPI is used as the basis
for cost-of-living adjustment clauses.
C. Calculating the Inflation Rate
1. To determine the rate of inflation, the following formula is used:
Inflation rate 
Current period's price level  Previous period's price level
100
Previous period's price level
D. Recent Experience
1. Inflation is a relatively new phenomenon in the United States.
a. Since 1940 the price level has increased steadily.
III. EFFECTS OF INFLATION
A. The Redistribution of Income and Wealth
1. Unanticipated inflation, inflation that is not expected, will redistribute income and
wealth.
a. Redistribution of income occurs because some wages and salaries increase more
rapidly than the price level while other wages and salaries increase more slowly
than the price level.
b. Redistribution of wealth occurs because some asset prices increase more rapidly
than the price level while other asset prices increase more slowly than the price
level.
2. One important redistribution of income and wealth that occurs during unanticipated
inflation is the redistribution between debtors and creditors.
a. Debtors gain from inflation because they repay creditors with dollars that are worth
less in terms of purchasing power.
3. Anticipated inflation, inflation that is expected, results in a much smaller redistribution
of income and wealth.
a. When inflation is anticipated individuals take actions to protect themselves from
the effects of inflation.
4. Inflation can decrease the production of goods and services.
a. Because inflation erodes the purchasing power of money, people devote more
resources to reducing money holdings and fewer resources to the production of
goods and services.
B. Inflation and Government
1. Unanticipated inflation benefits government because government is a huge debtor.
2. Unanticipated inflation benefits government because government gains tax revenue as
nominal income increases.
a. The increase in nominal income pushes people into higher tax brackets.
1. To prevent this redistribution of income, the personal income tax system is
now indexed; however, the rest of the federal tax system is not.
202  Chapter 15/Inflation: A Monetary Phenomenon
3. Some argue that the benefits of inflation decrease government's incentive to vigorously
pursue anti-inflationary policies.
C. Inflation and Net Exports
1. Unanticipated inflation can cause net exports to fall.
a. Inflation makes goods produced in the United States relatively more expensive,
resulting in a decrease in exports.
b. Inflation makes goods produced abroad relatively less expensive, resulting in an
increase in imports.
D. Other Effects
1. As the inflation rate increases and becomes more variable, more resources may be
devoted to predicting inflation and fewer devoted to the production of goods and
services.
2. As the inflation rate increases and becomes more variable, firms may concentrate on
short-term projects rather than long-term projects.
3. As the inflation rate increases and becomes more variable, there may be speculation in
real estate, gold, and art, causing funds to flow away from investment in plant and
equipment.
4. As the inflation rate increases and becomes more variable, the nation's monetary
system may disintegrate.
IV. MONEY AND THE MONEY SUPPLY
A. Money's Functions
1. Money serves as a unit of account.
a. This allows the value of many different types of goods and services to be
compared.
2. Money serves as a medium of exchange.
a. A medium of exchange is something that can be used to purchase goods and
services and pay debts.
b. When money functions as a medium of exchange, goods and services can be
exchanged without resorting to barter.
3. Money serves as a store of value.
a. Money is a way for households to hold their savings.
B. The Money Supply
1. Money is anything generally accepted as final payment for goods, services, and debt.
2. The nation's money supply is defined as currency, travelers' checks, demand deposits,
and other checkable deposits.
a. Demand deposits are the largest component of the money supply.
b. This definition of the money supply is referred to as M1.
3. Other definitions of the money supply are M2 and M3.
a. These money supply definitions are broader.
C. The Federal Reserve
1. The Federal Reserve is the United States' central bank.
a. A central bank is a government-established agency that controls the nation's money
supply, conducts monetary policy, and supervises the nation's monetary system.
Instructor’s Manual  203
V. CAUSES OF INFLATION
A. The Quantity Theory of Money
1. The quantity theory of money emphasizes that the money supply is the main
determinant of nominal GDP.
2. The quantity theory of money is explained by referring to the equation of exchange (M
x V = P x GDP).
a. The equation of exchange shows the relationship between the money supply, the
income velocity of money, the GDP deflator, and real GDP.
1. The income velocity of money is the number of times the money supply is
used to purchase final goods and services during a year.
b. The equation of exchange states that the money supply times the income velocity
of money is equal to the GDP deflator times real GDP.
3. The quantity theory of money assumes that the velocity of money is constant.
a. If velocity is constant, its growth rate is zero and the growth rate in the money
supply will equal the inflation rate (the growth rate of the GDP deflator) plus the
growth rate in real GDP.
1. This also means that the inflation rate is equal to the growth rate of the money
supply minus the growth rate of output.
a. If the money supply grows at the same rate as output, the price level will
be stable.
b. If the money supply grows faster than output, the economy will experience
inflation.
B. Inflation Is a Monetary Phenomenon
1. Inflation is said to be a monetary phenomenon because excessive growth rates of the
money supply cause inflation.
C. Inflation as a Monetary Phenomenon: Two Qualifications
1. If output does not grow at a constant rate, the relationship between inflation and the
money supply is not as strong.
a. If the growth rate of output is not constant, inflation will vary even if the growth
rate in the money supply is constant.
2. If the income velocity of money is not constant, the relationship between inflation and
the money supply is not as strong.
a. If the growth rate in velocity is not constant, inflation will vary even if the growth
rate in the money supply is constant.
D. Labor Unions, Monopolies, and Inflation
1. Some economists argue that inflation occurs as labor unions force wages up and firms
pass the increased cost on to consumers in the form of higher prices.
2. Many economists feel that labor unions do not make a major contribution to inflation.
a. Many unions lack significant bargaining power.
b. Less than 15 percent of the nonagricultural labor force belongs to unions.
c. Workers who cannot find jobs in the union sector turn to nonunionized sectors of
the economy where wages are forced down.
3. Some economists argue that monopolies contribute to inflation by restricting output
and charging higher prices for products than would occur under competition.
204  Chapter 15/Inflation: A Monetary Phenomenon
a. Increases in prices would cease once the monopolist reached the profit-maximizing
price; hence, inflation (a continuing increase in the price level) would not be a
problem in monopolistic settings. Inflation is about rising prices, not high prices.
VI. INFLATION AND POLICY
A. Monetary Policy
1. Because inflation is a monetary phenomenon, the growth rate in the money supply
must decrease if the rate of inflation is to fall.
a. Decreasing the rate of inflation can result in a redistribution of income and wealth
and increases in unemployment.
B. Fiscal Policy
1. In the short run, contractionary fiscal policy can reduce the rate of inflation.
2. Over the long run, if the rate of growth in the money supply is not reduced, fiscal
policy will not be able to affect inflation.
a. Policymakers cannot indefinitely increase taxes or decrease government spending.
C. Supply-Side Policies
1. Supply-side policies increase the growth rate of aggregate supply, thereby reducing the
rate of inflation.
a. Because of the difficulties associated with substantially increasing aggregate
supply, supply-side policies will not have a significant effect on inflation.
D. Incomes Policies
1. Incomes policy is a governmental action, other than fiscal and monetary policy, aimed
at influencing or controlling the rate of increase in prices, wages, and other forms of
income.
a. The most common incomes policies are wage-price guidelines and controls.
2. The use of incomes policy is based on the view that inflation is caused by the exercise
of monopoly power by labor unions and firms.
3. In general, economists oppose the use of wage and price controls.
a. These policies tend to be ineffective.
b. These policies can distort the allocation of resources.
c. These policies are costly to administer.
d. These policies may result in inequities.
Answers to Review Questions
1. What is the difference between an increase in the general price level and inflation? Why
is it necessary to make this distinction?
An increase in the price level refers to a once-and-for-all increase in the price level. Inflation,
on the other hand, refers to a continuing increase in the price level. Such a distinction is
important because an increase in the price level requires no policy action while inflation does.
For example, suppose the government initiates a permanent 10 percent decrease in taxes. As
taxes decrease, disposable income and hence consumption will rise. Because consumption is a
component of aggregate demand, aggregate demand will increase. As aggregate demand
increases, the price level will rise; however, once the economy has adjusted to the lower taxes,
Instructor’s Manual  205
the price level will cease to increase. A policy designed to prevent the price level from
increasing is unnecessary. When inflation occurs, the price level will continue to rise until
action is taken to stop it. Hence, the distinction between an increase in the price level and
inflation is an important one.
2. Why is the CPI the most widely cited measure of inflation in the United States? Why is
this index an imprecise measure of the cost of living?
The consumer price index or CPI is a weighted average of the prices of goods and services
purchased by a typical urban household. It is the most widely cited measure of inflation in the
United States. Its focus upon the prices of goods and services purchased by households is the
main reason for its popularity.
The CPI is widely regarded as a measure of the cost of living, however, there are several
shortcomings associated with this interpretation. First, the CPI is an index for the typical urban
household. To the extent that a household's consumption patterns differ from the "typical"
household's patterns, the CPI will be an inaccurate indicator of the cost of living. Second, the
CPI is based on a fixed market basket of goods and services. Generally, households change
their consumption patterns in response to changes in prices. For example, if the prices of some
goods and services rise, households will substitute relatively cheaper goods for the now more
expensive goods and services. Since the CPI is based on a fixed basket, it cannot take these
substitutions into account. As a result, it will overstate the cost of living. Finally, the CPI does
not account for changes in quality. Improvements in quality are generally reflected in a higher
product price. The absence of adjustments for quality make the CPI higher than would
otherwise be the case. Hence, it can be seen that care must be taken in interpreting the CPI as a
measure of the cost of living.
3. "Inflation will always cause some economic agents to gain and others to lose." Is this
statement true or false? Defend your answer.
Inflation will cause some economic agents to gain and others to lose only if it is unanticipated
(unexpected or higher than expected). If inflation is anticipated economic agents can take
action to protect themselves from the effects of inflation. For example, suppose workers who
expect no inflation ratify a contact that gives them a 3 percent increase in wages. If inflation of
5 percent then occurs, the workers are made worse off because the purchasing power of their
wages falls. If workers had anticipated this inflation, they would have insisted upon at least a 5
percent increase in wages. If they had received such an increase, their purchasing power would
not have been eroded by the inflation. Instead, their actions would have protected them from
the effects of the inflation. Thus, when discussing inflation it is important to distinguish
between anticipated and unanticipated inflation. The effects of anticipated inflation will be
much less severe than the effects of unanticipated inflation.
4. How might unanticipated inflation result in a redistribution of income and wealth?
Unanticipated inflation, inflation that is unexpected or higher than expected, can lead to a
redistribution of income and wealth. A redistribution of income can occur because some
individuals' wages and salaries will increase at a rate greater than the rate of inflation while
other individuals' wages and salaries will increase at a rate less than the rate of inflation. For
example, suppose an unanticipated rate of inflation of 5 percent occurs. Further, suppose the
United Auto Workers union had consulted an economist who accurately predicted this new
inflation rate. As a result of reliance upon this prediction, the union negotiated a new contract
206  Chapter 15/Inflation: A Monetary Phenomenon
that gave its members a 6 percent increase in wages. Members of the union gain. Their wage
rate is increasing at a rate faster than the inflation rate. As a result, their purchasing power
increases. However, suppose that the teachers' union negotiated a contract believing that the
rate of inflation would remain constant. Based upon this belief it accepted a contract giving
members a 3 percent increase in salary. Teachers as a group will lose. Their wages are
increasing at a rate less than the rate of inflation and their purchasing power will fall.
A redistribution of income can also occur if an individual is living on a fixed income. Retired
persons dependent on pensions may find their purchasing power being eroded during
inflationary periods. For example, Gus receives a $600 monthly pension check. If inflation
caused the price level to double, Gus would have the ability to purchase only one-half the
goods and services he purchased prior to the inflation.
Unanticipated increases in inflation can also cause a redistribution of wealth from debtors to
creditors. Suppose Mitch borrows $1,000 from Tony. Mitch must repay Tony the $1,000 at
the end of the year plus 5 percent interest. Suppose that the price level doubles during the year.
Mitch repays Tony the $1,000 plus $50 in interest. Note, however that this money is worth
much less than it was at the beginning of the year. The same goods and services that cost
$1,000 at the beginning of the year now cost $2,000. The purchasing power of the money has
fallen, and wealth has been redistributed from the creditor to the debtor. Obviously, if Tony
had expected this rate of inflation to occur he either would not have loaned Mitch the money or
would have charged a much higher rate of interest on the loan.
Finally, a redistribution of wealth may occur if there is unanticipated inflation because the
price of many assets will be affected by the inflation; however, not all prices are equally
affected. For example, during a period of inflation there is a tendency for the price of land to
increase at a rate that exceeds the inflation rate while the price of other assets, say, saving
accounts (interest paid), increases at a rate that is less than the inflation rate. Suppose Carrie
does not expect the inflation rate to increase and puts $1,000 in a savings account that pays 4
percent interest. Allison, on the other hand, believes that the inflation rate will increase
dramatically this year and spends her $1,000 on a piece of land. Suppose an inflation rate of 8
percent occurs. The value of Carrie's asset falls. Suppose, however, that the land appreciates
by 10 percent. The value of Allison's asset rises. As a result, a redistribution of wealth occurs.
5. Inflation can be detrimental to the economy. Therefore, the proper role of government is
to enact policies to deal with inflation. Why might government be reluctant to undertake
anti-inflationary policies?
To understand why government may be reluctant to undertake anti-inflationary policies, it must
be noted that inflation has two major impacts on government. First, recall that government is a
huge debtor owing, over 4 trillion dollars. As previously discussed, inflation causes debtors to
repay loans with dollars that are worth less than the dollars they originally borrowed. This
occurs because inflation erodes the purchasing power of the dollar. Thus, inflation causes
debtors to benefit and creditors to lose. In its role as a debtor, government finds inflation to be
beneficial.
Second, inflation causes governmental revenues to increase. Part of the nation's tax system is
based on nominal rather than real income. Generally, inflation causes nominal income to
increase. As nominal income rises, economic agents are pushed into higher tax brackets
thereby causing them to pay more in taxes. Further, this increase in governmental revenue
comes about without any action on the part of Congress. This means that government can
Instructor’s Manual  207
increase its revenues without having to explain to constituents why a tax increase was passed.
The fact that inflation helps government's debtor position and the fact that it may increase
government revenue both work to lessen incentives to pursue anti-inflationary policies. (Note:
In 1985 the federal personal income tax system was indexed for inflation. This means that
individuals are no longer pushed into a higher tax bracket simply because their nominal income
has increased. However, the rest of the tax system is not indexed. For example, corporations
may find that inflation will push up profits thereby increasing their tax liability and decreasing
their after-tax profits. This decrease in profits may decrease the incentive to invest in new
plant and equipment and lead to a lower economic growth rate.)
6. Aside from its effects on income, wealth, and the government, in what other ways might
inflation affect the economy?
In addition to affecting income, wealth, and the government, there are several other ways in
which inflation can affect the economy. First, inflation can affect net exports. Suppose the
United States is experiencing an inflation rate that exceeds the inflation rate in the rest of the
world. This will cause the exports of the United States to become relatively more expensive
while imports will become relatively less expensive. Domestic firms will sell less abroad,
domestic consumers will buy more foreign goods, and net exports will fall. It is true that over
time inflation will cause the dollar to depreciate; however, it may take several years for this
depreciation to fully compensate for the effects of inflation on net exports. In the meantime,
the export producing and the import competing sectors of the economy will endure hardship.
A high and variable inflation rate can impose costs on society by reducing gross domestic
product. First, if the rate of inflation is high and variable, economic agents will attempt to
protect themselves from the consequences of inflation by predicting what the rate will be. This
means that more of society's resources will be devoted to predicting inflation and to devising
ways to protect real income and wealth. As more resources are devoted to these activities,
fewer will be devoted to the production of goods and services and gross domestic product will
fall.
Second, because inflation may be easier to predict in the short run, a high and variable inflation
rate may cause firms to concentrate on short-term investment projects. These firms (and hence
society) may be foregoing significant benefits that could be had from longer-term projects.
Workers may also be reluctant to enter into long-term contracts. More resources must be
devoted to frequent, time-consuming labor negotiations and gross domestic product will fall.
Third, a high and variable inflation rate may cause economic agents to invest in assets such as
real estate, gold, antiques, and art whose value tends to increase at a rate exceeding the rate of
inflation. These actions divert funds away from investment in assets such as plant and
equipment that cause the nation's capital stock to grow. This will lead to a fall in the growth
rate of gross domestic product and a decrease in living standards.
Finally, inflation may cause the monetary system to disintegrate. Rapid increases in prices lead
to a deterioration in the purchasing power of money. As a result, people are less willing to
hold money. At some point money may become worthless, and people will only exchange
goods and services for other goods and services. The system will turn to barter. This
arrangement is inefficient as it requires a great deal of time and effort to find appropriate
trading partners. Output of goods and services will fall and the economy may collapse.
208  Chapter 15/Inflation: A Monetary Phenomenon
7. What is money? What basic functions does it perform?
Money is anything that is generally accepted as payment for goods, services, and debt. It has
three basic functions: a medium of exchange, a unit of account, and a store of value.
A medium of exchange is something used to purchase goods and services and to pay debts. In
early times, households were largely self-sufficient and few goods and services were
exchanged. In those times, there was little need for a medium of exchange. As time passed,
households began to specialize in a small number of activities and trade the goods they
produced for other goods and services. The need for a medium of exchange began to develop.
Today, money acts as this medium and facilitates the exchange of goods and services by
eliminating the "double coincidence of wants." There is no longer any need to find an
individual who simultaneously has the exact bundle of goods and services you desire and who
wants the exact bundle of goods and services you have to trade. Instead, you simply exchange
money for the goods and services you want. The other individual takes your money and
exchanges it for the goods and services he or she desires. Thus, money facilitates exchange.
A unit of account allows individuals to keep track of the value of goods and services in terms
of money. It provides a common measure of value for many different goods and services. For
example, a Ford may cost $20,000 while a Cadillac may cost $40,000. We know the Cadillac
is twice as costly as the Ford. The ease with which such comparisons can be made greatly
facilitates decision making.
The store of value function allows households to use money as a form of savings. It allows
them to convert current income into future purchases. For example, John earns $4,000 per
month, but he does not have to spend it all on the day he is paid. Instead, he may save part of it
each month and at the end of the year use it to purchase a Hawaiian vacation. Money is not
unique as a store of value. Bonds, common stocks, and real estate also function in this
capacity. Further, during inflationary periods the purchasing power of money is eroded and it
becomes a very unsatisfactory store of value.
8. "Inflation is a long-term phenomenon caused by a too-rapid growth in the money
supply." Is this statement true or false? Use the quantity theory of money in defense of
your answer.
In order to determine the veracity of the above statement, it is helpful to first discuss the
quantity theory of money. The quantity theory of money emphasizes that the money supply is
the main determinant of nominal gross domestic product. To understand this theory, the
equation of exchange must first be examined. This equation shows the relationship between
the money supply, M, the income velocity of money, V (where V is defined as the number of
times the money supply is used to purchase final goods and services during the year), the GDP
deflator, P, and real gross domestic product, GDP. The equation is written as:
M x V = P x GDP.
The left hand side of the equation represents the amount spent on final goods and services
while the right hand side represents the amount received for these final goods and services. By
definition, these two sides must be equal.
The quantity theory of money assumes that the income velocity of money, V, is constant. If V
is constant then an increase in nominal gross domestic product, P x GDP, occurs because of an
increase in the money supply, M.
Instructor’s Manual  209
The effect of a change in the money supply on inflation can now be determined. First, rewrite
the equation in terms of growth rates. When this is done the equation becomes:
M/M + V/V = P/P + GDP/GDP.
M/M is the growth rate of the money supply, V/V is the growth rate of velocity, P/P is the
growth rate of the GDP deflator (inflation rate), and GDP/GDP is the growth rate of real gross
domestic product. If velocity is constant, its growth rate is zero. Thus it will drop out and the
equation becomes:
M/M = P/P + GDP/GDP.
Now solve the equation for the growth rate in the GDP deflator (inflation rate). This is done by
rearranging terms to derive:
P/P = M/M - GDP/GDP.
This equation shows that the rate of inflation is equal to the growth rate of the money supply
less the growth rate of real output. The growth rate of the money supply is determined by the
Federal Reserve. The growth rate of real output is determined by resources and technology.
Historically the long-term growth rate in real output has been approximately 3 percent per year.
If the Federal Reserves allows the money supply to grow at an annual rate of approximately 3
percent, no inflation will occur. However, if the Federal Reserves allows the growth rate of the
money supply to exceed the growth rate of real output, inflation will occur. Thus, according to
the quantity theory of money inflation is caused by the Federal Reserve allowing the money
supply to grow too rapidly.
9. Use the aggregate demand-aggregate supply framework to demonstrate how increases in
the money supply can result in inflation.
Using the aggregate demand-aggregate supply framework, it is possible to illustrate the
proposition that inflation is caused by a too rapid increase in the money supply. Observe the
following graph.
GDP Deflator
AS
1
AS
2
AS
.C
P2
P1
3
.A
.B
AD
AD1
0
Q1
Q2
Q3
3
AD2
Real GDP
210  Chapter 15/Inflation: A Monetary Phenomenon
Suppose aggregate demand and aggregate supply are initially given by AD1 and AS1,
respectively. Equilibrium will occur at point A with the price level equal to P1 and real GDP
equal to Q1. Suppose real GDP grows by 3, percent thereby shifting AS1 to AS2. If the money
supply grows at this same rate, aggregate demand will increase from AD1 to AD2. (Recall that
increases in the money supply lead to a fall in the interest rate. As the interest rate falls both
investment and consumption increase. Because these are both components of aggregate
demand, aggregate demand also increases.) A new equilibrium occurs at point B. Real GDP
increases to Q2, however, the price level remains constant at P1.
Again, assume that real GDP grows at a rate of 3 percent. AS2 is shifted to AS3. Suppose at
the same time the Federal Reserve allows the money supply to grow at an annual rate of 7
percent. AD2 will shift to AD3. A new equilibrium will occur at point C. Real output will
increase to Q3 and the price level will rise to P2. Thus, anytime the money supply grows at a
rate that exceeds the growth rate of real output there will be continuing increases in the price
level and inflation will occur.
10. "If the growth rate of the money supply is constant, there will be no inflation." Is this
statement true or false? Defend your answer.
The above statement is false. In the long run, the annual growth rate of real GDP is
approximately 3 percent. Over the business cycle, however, the growth rate varies. Generally,
the rate of growth will exceed 3 percent during expansions and be less than 3 percent during
contractions. This means that even if the Federal Reserve allows the money supply to grow at
an annual rate of 3 percent, the inflation rate will vary over the business cycle. For example,
suppose the economy is currently recovering from a recession. Unemployment and excess
capacity will be high. Firms will easily be able to hire more workers and output will increase
relatively rapidly. Assume that the growth rate of output is 6 percent. If the Federal Reserve is
allowing the money supply to grow at 3 percent, the inflation rate will fall. Eventually, the
growth rate of output will fall below 6 percent. Suppose that just prior to the peak of the
expansion, economic growth falls to 2 percent. If the growth rate of the money supply is still
constant, inflation will now occur.
The fact that the income velocity of money varies in the short run may also lead to inflation in
the face of a constant money supply growth rate. Suppose that households and firms become
more optimistic about the future. Velocity will increase as these economic agents increase
their purchases of goods and services. As a result, aggregate demand, and hence the price level
will increase.
The reader should note that although these variations in output and velocity can cause the
inflation rate to change in the short run, they are less important in the long run. Because
inflation is a long-term phenomenon, it is appropriate to use both the long-run rates of growth
in output and velocity in analyzing inflation. In so doing, the basic conclusion, inflation is a
monetary phenomenon, holds.
11. Using the aggregate demand-aggregate supply model, explain how labor unions can cause
inflation. Is such a scenario likely? Why or why not?
It is sometimes argued that labor unions, through the collective bargaining process, force
wages up more rapidly than would otherwise be the case thereby causing inflation. This
Instructor’s Manual  211
scenario is illustrated below.
GDP Deflator
B
.
P2
P1
.A
AS
2
AS
0
AD
1
Q
2
Q
1
Real GDP
Initially, equilibrium occurs at point A with the price level equal to P1 and real GDP equal to
Q1. If labor unions cause a too rapid increase in wages, AS1 will decrease to AS2. A new
equilibrium will occur at point B. Real GDP will fall to Q2 and the price level will increase to
P2. If labor unions continue with these actions, the price level will continue to increase and
inflation will occur.
While such a scenario is possible, most economist do not think it is probable. Many unions
lack the bargaining power necessary to force wages up too rapidly. Also, even if unions did
possess such power and were able to force up their members' wages, it is not likely that wages
in general would rise. The overwhelming majority of workers are not covered by union
contracts. In fact, less than 15 percent of the nonagricultural labor force belongs to unions.
Only by limiting employment opportunities in the unionized sector can unions force wages up.
Those unable to find employment in this sector will be forced to turn to the nonunionized
sector for employment. This will depress nonunion wages. Thus, even if unions can force up
their members' wages it is unlikely that the average wage rate will be significantly altered.
This means that labor unions are an unlikely cause of inflation.
12. "A monopolist charges higher prices for its products than does a pure competitor; hence,
an economy characterized by a large number of monopolies is more likely to experience
inflation than an economy characterized by a large number of competitive firms." Is this
statement true or false? Defend your answer.
This statement is false. It is true that compared to a pure competitor a monopolist does restrict
output and charge a higher price. This is illustrated below.
212  Chapter 15/Inflation: A Monetary Phenomenon
Dollars
MC
Pm
P
.
c
A
.B
D
MR
0
Q
m
Q
c
Q
If the industry were competitive, equilibrium would occur at point A. Output would equal Qc
and the price would be Pc. A monopolist would maximize profits by setting marginal revenue
equal to marginal cost at point B. It would produce output Qm and charge a price of Pm. It is
obvious that the price is higher under monopoly. Inflation, however, is not concerned with
"high" prices. Its focus is upon increasing prices. While the monopolist does charge a higher
price, it does not increase price indefinitely. Hence, inflation should not a greater problem in
an economy characterized by imperfectly competitive markets.
13. Explain and graphically show how monetary policy may be used to reduce inflation. Are
there any problems associated with the use of this policy?
It has been established previously that inflation is a monetary phenomenon. If, in the long run,
the growth rate in the money supply is greater than the growth rate in real output, inflation will
result. By decreasing the growth rate of the money supply, aggregate demand will grow less
rapidly and the inflation rate will be lowered. The following graph illustrates this idea.
Instructor’s Manual  213
GDP Deflator
AS
1
.B
P2
P1
AS 2
.
AS
3
.C
AD3
A
AD2
AD 1
0
Q1
Q
2
Q3
Real GDP
Equilibrium initially occurs at point A with real GDP equal to Q1 and the price level equal to
P1. Suppose that output grows at a 3 percent rate while the Federal Reserve allows the money
supply to grow at an 8 percent rate. This will result in an inflation rate of 5 percent.
Graphically, this scenario is illustrated by the increase in aggregate supply to AS2 and the
increase in aggregate demand to AD2. A new equilibrium occurs at point B. Real GDP
increases to Q2 while the price level increases to P2.
Suppose that real GDP continues to grow at a 3 percent rate, but the Federal Reserve reduces
the growth rate of the money supply from 8 to 3 percent. There will now be no inflation.
Graphically, aggregate supply and aggregate demand shift to AS3 and AD3, respectively. There
is a new equilibrium at point C. Real GDP rises to Q3, and the price level is constant at P2.
The lower growth rate of the money supply results in a smaller increase in aggregate demand
and thereby eliminates inflation.
There are some problems associated with the use of this policy. First, unexpected decreases in
inflation can result in short-term unemployment. Firms may have agreed to a large wage
increase because inflation was anticipated. As inflation falls, the prices of firms' products will
increase less rapidly. Firms may find it difficult to fulfill their contractual obligations and lay
workers off, thereby increasing the unemployment rate.
Debtors may also be harmed by unexpected decreases in inflation. Individuals who borrowed
at high interest rates in anticipation of continued inflation may find it difficult to repay loans as
the inflation rate falls. Many may default on their obligations. Because firms and households
are adversely affected, there may be some resistance to using anti-inflationary policies.
14. In the long term, why can't fiscal policy be used to reduce the inflation rate?
Inflation is caused by a too rapid increase in the money supply. As the money supply
increases, aggregate demand is increased, thereby resulting in inflation. Because fiscal policy
affects aggregate demand, it may be possible to use such policy as a short-term cure for
inflation. However, it is not possible to use fiscal policy as a long-term remedy for inflation.
214  Chapter 15/Inflation: A Monetary Phenomenon
Recall that fiscal policy can alter aggregate demand either through changes in government
spending or taxation. In order to decrease the growth rate of aggregate demand, either
government spending must fall or taxes must increase. So long as the Federal Reserve is
maintaining the growth rate of the money supply above the growth rate of real output,
policymakers must continue to decrease spending or increase taxes. Government spending
cannot be decreased indefinitely. The majority of government spending is for social security,
national defense, interest on the national debt, and assistance to the poor. It is obvious that
such programs cannot be cut indefinitely. It is also obvious that there are limits on how many
tax increases can be passed by government. Government may find it difficult to pass even a
one-time increase. Thus, although fiscal policy may be used to temporarily offset the effects of
a too rapid growth rate in the money supply, it cannot be used indefinitely. Instead, in the long
run, contractionary monetary policy must be used to deal with inflation.
15. Show and explain how supply-side policies could be used to lessen inflation. Are such
policies a viable alternative for policymakers? Why or why not?
Inflation occurs because the growth rate of the money supply exceeds the growth rate of real
output. Thus far, it has been argued that decreasing the growth rate of the money supply is the
only viable option for dealing with inflation. However, some economists have argued that
another option for dealing with inflation would be to use supply-side policies in order to
increase the growth rate of real output. For example, suppose the growth rate of real output is
3 percent and the inflation rate is 8 percent. If the annual growth rate of real output could be
increased to 5 percent, the inflation rate would fall from 5 percent to 3 percent. This idea is
illustrated below.
GDP Deflator
AS
P
!
AS AS
2
.B
3
P2
P
!
A
.
3
.C
AD
2
AD
!
0
Q
!
Q
2
Q
3
Real GDP
Equilibrium is initially given by point A with real output equal to Q1 and the price level equal
to P1. If the growth rate of output is 3 percent and the growth rate of aggregate demand is 8
percent, aggregate supply will increase to AS2 while aggregate demand will increase to AD2.
Instructor’s Manual  215
A new equilibrium will occur at point B. Real GDP will increase to Q2 and the price level will
increase to P3.
Suppose that instead of growing at a rate of 3 percent, supply-side policies are enacted which
increase the annual growth rate of aggregate supply to 5 percent. Instead of increasing to AS2,
aggregate supply will increase to AS3. Equilibrium occurs at point C. The level of output will
be Q3 and the price level will be P2. Note that the increase in the price level is less than the
original increase from P1 to P2. Thus, supply-side policies do seem to offer a viable alternative
to monetary policy.
The problem of using supply-side policies arises because of the nature of the determinants of
the long-run growth rate of real output. The growth rate of real output is dependent upon the
rate of capital accumulation, and the rate of technological progress. Given this rate of labor
supply growth, it can be seen that government may have difficulties enacting policies that can
significantly affect the growth rate of real output. Most economists argue that increasing the
long-run growth rate of real output by 1 percent would be a tremendous achievement. A 1
percent increase in the growth rate of real output would result in a 1 percent decrease in the rate
of inflation. If the inflation rate were relatively low, this may represent a significant decrease;
however, if the inflation rate were relatively high, a 1 percent decrease may have only a minor
impact on the economy. Thus, supply-side policies are not likely to be a viable antiinflationary policy.
16. What is an incomes policy? Why have such policies generally been unsuccessful in
dealing with inflation?
An incomes policy is a governmental action, other than fiscal and monetary policy, aimed at
influencing or controlling the rate of increase in prices, wages, and other forms of income. The
most common policy is the use of wage-price guidelines and controls.
The United States has, at various times, experimented with the use of such policy; however, the
results of these experiments have been far from successful. The basic reason for the lack of
success stems from the fact that incomes policy does not deal with the cause of inflation, only
the symptom. The basic cause of inflation is a too rapid growth rate in the money supply.
Incomes policy does nothing to affect this. The outcome of inflation is the continuing increase
in the price level. Incomes policy stops this increase (or slows it) by using such methods as
wage and price guidelines or freezing wages and prices. Once the policy is discontinued,
inflation returns because the basic problem, a too rapid growth rate in the money supply, still
exists.
17. Go to http://www.swcollege.com/bef/econ_news.html--Economic News on Line and choose
either Employment, Unemployment, and Inflation or Monetary Policy under the
macroeconomics category; choose an EconNews story that interests you. Read the full
summary, and answer the questions posed.
Choices of articles and answers will vary.