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12
CHAPTER
DYNAMIC P OWERP OINT™ S LIDES BY S OLINA L INDAHL
Inflation and the Quantity
Theory of Money
CHAPTER OUTLINE
Defining and Measuring Inflation
The Quantity Theory of Money
The Costs of Inflation
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questions
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Food for Thought….
Some good blogs and other sites to get the juices flowing:
"Americans are getting stronger. Twenty years ago,
it took two people to carry ten dollars worth of
groceries. Today, a five-year-old can do it."
- Henny Youngman
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Introduction
In this chapter:
How is inflation
defined and
measured?
What causes
inflation?
The costs and
benefits of
inflation?
Why do
governments
sometimes
resort to
inflation?
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Defining and Measuring Inflation
Inflation: an increase in the average level of
prices.
Measured using the following formula:
P2  P1
Inflation rate 
 100
P1
Where P2 is the index
value in year 2 and P1 is
the index value in year 1
Inflation is the average change of all prices.
Some prices go up and some go down.
Think of an elevator containing many prices that
change relative to each other. As the elevator
rises, all of the prices rise.
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Try it!
Year
2005
2006
2007
2008
2009
CPI Value
100
107
113
121
129
What was the approximate inflation rate
over the period 2007 to 2008?
a) 6.6%
b) 8%
c) 21%
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d) 7.1%
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Year
CPI Value
2005
100
2006
107
2007
113
2008
121
2009
129
In which year was the inflation rate the
highest?
a) 2006
b) 2007
c) 2008
d) 2009
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Defining and Measuring Inflation
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.
An index is only a number; it is not expressed in
dollars.
There are several price indexes:
Consumer price index (CPI)
GDP deflator
Producer price index (PPI)
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Defining and Measuring Inflation
1.CPI: The average price of goods bought by a
typical American consumer.
Covers 80,000 goods.
Weighted so that major items (housing) count more.
2.GDP deflator: Measures the average price of
all final goods and services.
3.Producer price indexes (PPI): The average
price received by producers.
Includes intermediate goods as well as final goods.
PPI’s exist for different industries.
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The Inflation Rate in the United States,
1950–2010
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The Effect of Inflation on the
Price of a Basket of Goods
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Defining and Measuring Inflation
Inflation in the U.S. and Around the World
Using the CPI to calculate real prices
Real price is the price of a good that has
been corrected for inflation.
Example:
1982 price of gasoline was $1.25/gal.
2006 it was double that at $2.50/gal.
CPI was 100 in 1982 and 202 in 2006.
Conclusion: The real price of gasoline was about
the same in 2006 as it was in 1982.
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Defining and Measuring Inflation
Inflation in the United States and Around the
World
Hyperinflation: extremely high rates of
inflation
Many governments have fallen into the trap of
inflating their currency in order to pay debts.
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Defining and Measuring Inflation
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Defining and Measuring Inflation
Inflation in the United States and
Around
the
The worthless
Hungarian
Pengo, 1946
World
Hungary’s hyperinflation is the highest on record.
What cost 1 Hungarian pengo in 1945 cost 1.3 septillion
pengos at the end of 1946.
Prices doubled every 15 hours!
100,000,000,000,000,000,000 Pengo
World's highest denomination
banknote: Hungary (1946)
100 Quintillion pengo
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Causes of Inflation
Zimbabwe’s Robert Mugabe: A penny
thousand pennies for his thoughts.
What caused Zimbabwe’s hyperinflation?
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Take a look…..
“Commanding Heights” (PBS) looks at prices. The first few minutes
of the clip focus on Germany’s hyperinflation, the second half of the
8-minute clip focuses on the U.S. Great Depression
The Quantity Theory of Money
The quantity theory of money does two things:
1. Sets out the general relationship between
inflation, money, real output, and prices.
2. Presents the critical role of the money supply in
regulating the level of prices.
For the nation as a whole…
M x v = P x YR
Where M = Money supply, v = Velocity of money,
P = Price level and YR = Real GDP
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The Quantity Theory of Money
Velocity (v): average number of times that
a dollar is spent on goods and services in
a year.
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The Quantity Theory of Money
The quantity theory of money
depends on two assumptions…
1. Real GDP is stable compared to the
money supply.
Real GDP is fixed by the real factors of
production—capital, labor, and
technology.
The growth rate of real GDP is limited
by how fast these factors can
increase.
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The Quantity Theory of Money
2. The velocity of money, v, is stable
compared to the money supply.
It is determined by various factors such as:
 Whether workers are paid monthly or
biweekly.
 How long it takes to clear a check or
electronic transaction.
 How easy it is to find an ATM.
Factors like these may change, but
slowly.
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The Quantity Theory of Money
The Cause of Inflation
The quantity theory: 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
Which translates as:
Growth rate of money + growth rate of v equals the
rate of inflation + growth rate of real GDP.
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The Quantity Theory of Money
Important implication: If the growth rates of
v and YR are small compared to the growth
rate of M, the rate of inflation will be
approximately equal to the increase in
money supply.
PM
Or more generally:
Rate of Inflation, P  M  YR  v
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SEE THE INVISIBLE HAND
Source: www.freetochoosemedia.org
“Inflation is always and everywhere a
monetary phenomenon.”
Milton Friedman (1912-2006), Nobel Prize Winner , Leader
of the “Chicago school of economics”
The Quantity Theory of Money
How well does the theory hold up?
In Peru, very well….
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The Quantity Theory of Money
More money means more inflation.
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The Quantity Theory of Money
Some Important Caveats:
1. If M and v grow more slowly than YR, prices
will fall; this is called deflation.
2. Changes in velocity will affect prices.
Hyperinflation: People will spend their money
faster (increase v) → even faster increase in
prices.
Great Depression: Fear → ↓spending (decreased
v) → deflation → worse depression.
3. In the long run, money is neutral.
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Deflation and Disinflation
Don’t be confused:
Deflation: a decrease in the average level
of prices (negative inflation)
E.g. if the CPI falls from 100 to 95, the inflation
rate is negative.
Disinflation: a reduction in the inflation
rate
E.g. if the CPI rose from 100 to 110, and the
next year to 112, the inflation rate is positive
but slowing down.
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Year
Inflation Rate (Annual Percent Change)
1985
15.1%
1990
585.8%
1999
7.3%
2002
1.9%
2003
0.8%
This table shows actual inflation data for different
periods of Polish history. Which year can you identify
as deflationary?
a) 1990
b) 1999
c) 2003
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d) No year was deflationary.
The Quantity Theory of Money
An Inflation Parable
Under some circumstances, changes in M can temporarily
change YR. Let’s see how…
Consider a mini-economy consisting of a baker, tailor, and
carpenter who buy and sell products among themselves.
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
All three work harder to
increase output and raise their
prices.
Eventually they catch on and stop
working harder to produce more output.
Conclusion: Increase in M can boost the economy in the short run but as
firms and workers come to expect and adjust to the influx of new money,
output (real GDP) will not grow any faster than normal.
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The Costs of Inflation
If all prices (including wages) are going up,
then why is inflation a problem?
Four problems with inflation:
1. Inflation causes price confusion and money
illusion.
2. Inflation redistributes wealth.
3. Inflation interacts with other taxes.
4. Inflation is painful to stop.
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The Costs of Inflation:
Price Confusion and Money Illusion
1. Price Confusion and Money Illusion
Price confusion:
Inflation makes price signals more difficult
to interpret.
A consumer may not know if the price of a
product is increasing…
Because of increased demand? or
As a result of all prices going up with
inflation.
Making sense of prices…
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The Costs of Inflation:
Price Confusion and Money Illusion
Money Illusion: when people mistake
changes in nominal prices for changes in
real prices.
Example: Mary receives a 10% increase in
salary and takes on a higher mortgage
payment.
The rate of inflation is 10%: she is no better off in
terms of real salary.
She now has a higher house payment and is in
danger of losing her home.
Result: resources are wasted in unprofitable
activities.
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The Costs of Inflation:
Wealth Redistribution
2. 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.
The real rate of return for a lender is given by:
ractual = i – p
where ractual = actual rate of return, i = nominal
interest rate and p = inflation rate
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The Costs of Inflation:
Wealth Redistribution
Example:
Suppose a bank makes a 30-year home
loan at an interest rate of 7%. If 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), the actual rate of return =
7% - 13% = -6%!
The lender is now losing money on the loan.
The borrower gains.
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The Costs of Inflation:
Wealth Redistribution
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.
The nominal rate of interest will be equal
to expected inflation rate plus the
equilibrium rate of return.
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The Costs of Inflation:
Wealth Redistribution
Nominal Interest Rates Tend to Increase
with Inflation Rates
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The Costs of Inflation:
Wealth Redistribution
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  π (1)
and
i  Ep  requilibrium (2)
Substituting i from equation (2) into equation (1) we get:
ractual  (Ep  p )  requilibriu m
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Year Predicted
inflation rate
2000
3%
2001
3%
2002
7%
2003
5%
2004
4%
Actual
inflation rate
3%
2%
9%
4%
7%
Using the inflation data in the table above, assume
that all loan contracts matured after one year, and
that they all had fixed nominal interest rates of 10%. In
which of the years given below did lenders gain
relative to borrowers?
a) 2000
b) 2002
c) 2003
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d) 2004
The Costs of Inflation:
Wealth Redistribution
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The Costs of Inflation:
Wealth Redistribution
Monetizing the debt: when the government
pays off its debts by printing money.
Why don’t they always inflate their debt
away? Two reasons:
1. The Fisher effect: if banks know the
government is doing this, they will simply
raise interest rates.
2. Political cost: People who buy
government bonds usually vote.
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The Costs of Inflation:
Wealth Redistribution
Workers and firms are affected by inflation.
Wage agreements are often made
several years in advance.
Underestimating inflation → wages are too
low → supply of labor: too low.
Overestimating inflation → wages are too
high → demand for labor: too low.
Conclusion: errors in estimating the rate of
inflation → a misallocation of resources →
lower economic growth.
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The Costs of Inflation:
Wealth Redistribution
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.
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The Costs of Inflation:
Wealth Redistribution
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.
As recently as 2002, 90% of debt matured within one
year.
Since the 1990s: inflation has been tamed.
Result: rapidly growing capital markets and
increased investment: Economic growth
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The Costs of Inflation
Conclusions:
1. Unexpected inflation redistributes
wealth throughout society in arbitrary
ways.
2. When inflation is high and volatile
Unexpected inflation is difficult to
avoid.
Long-term contracting grinds to a halt.
Result: economic growth suffers.
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Unanticipated high inflation always
means:
a) a loss in purchasing power for
lenders.
b) a decrease in the amount of real
taxes paid by citizens and firms.
c) a redistribution of wealth from the
rich to the poor.
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d) All of the answers are correct.
The Costs of Inflation
3. 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 (e.g. not real gains)
Results:
Longer-run effect is to discourage investment
in the first place.
Inflation increases the costs of complying with
the tax system.
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The Costs of Inflation
4. 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.
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The average number of times a dollar is
spent on final goods and services during
a year is:
a) the velocity of money.
b) the consumption rate.
c) the money supply.
d) the quantity theory of money.
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