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Money Growth and Inflation
Copyright © 2004 South-Western
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“Inflation is at all times and everywhere
a monetary phenomenon…
… in the sense that it cannot occur without a more rapid
increase in the quantity of money than in output.”
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The Meaning of Money
• Money is the set of assets in an economy
that people regularly use to buy goods and
services from other people.
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Definitions
• Inflation is a general increase in the overall
level of prices of goods and services over
time. Inflation is everywhere, at all times.
• Hyperinflation is an extraordinarily high rate
of inflation.
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Measuring It
• Inflation is measured in many ways, but the
most commonly used measuring tool is the
Consumer Price Index, or CPI.
• The CPI reveals changes in retail prices of
a basket of consumer goods such as food,
clothing, and cars. The index compares the
value of the same basket each year to
calculate the level of inflation for that
period.
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Inflation: Historical Aspects
• Over the past 60 years, prices have risen
on average about 5 percent per year.
• Hyperinflation refers to high rates of
inflation such as Germany experienced in
the 1920s.
• In the 1970s prices rose by 7 percent per
year.
• During the 1990s, prices rose at an
average rate of 2 percent per year.
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Accounting for Gimmickry
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THE CLASSICAL THEORY OF
INFLATION
• Inflation is an economy-wide phenomenon
that concerns the value of the economy’s
medium of exchange.
• When the overall price level rises, the value
of money falls.
• The quantity theory of money is used to
explain the long-run determinants of the
price level and the inflation rate.
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THE CLASSICAL THEORY OF
INFLATION
• The Quantity Theory of Money
• How the price level is determined and why it
might change over time (the long term) is
called the quantity theory of money:
• The quantity of money available in the economy
determines the value of money.
• The primary cause of inflation is the growth in the
quantity of money.
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Money Supply, Money Demand, and
Monetary Equilibrium
• The money supply is a policy variable that
is controlled by the Fed.
• Through instruments such as open-market
operations, the Fed directly controls the
quantity of money supplied.
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Money Supply, Money Demand, and
Monetary Equilibrium
• Money demand has several determinants,
including interest rates and the average
level of prices in the economy.
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Money Supply, Money Demand, and
Monetary Equilibrium
• People hold money because it is the
medium of exchange.
• The amount of money people choose to hold
depends on the prices of goods and services.
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Money Supply, Money Demand, and
Monetary Equilibrium
• In the long run, the overall level of prices
adjusts to the level at which the demand for
money equals the supply.
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Figure 1 Money Supply, Money Demand, and the
Equilibrium Price Level
Value of
Money, 1/P
(High)
Price
Level, P
Money supply
1
1
3
1.33
/4
12
/
Equilibrium
value of
money
(Low)
A
(Low)
2
Equilibrium
price level
14
4
/
Money
demand
0
Quantity fixed
by the Fed
Quantity of
Money
(High)
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Figure 2 The Effects of Monetary Injection
Value of
Money, 1/P
(High)
MS1
MS2
1
1
1. An increase
in the money
supply . . .
3
2. . . . decreases
the value of
money . . .
Price
Level, P
/4
12
/
1.33
A
2
B
14
/
(Low)
3. . . . and
increases
the price
level.
4
Money
demand
(High)
(Low)
0
M1
M2
Quantity of
Money
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Variables in Inflation
• Nominal variables are variables measured
in current monetary units. (nominal GDP,
Nominal wages measured in $ earned
/hour, rate of return in $, etc.)
• Real (or physical) variables are measured
in physical units – real GDP, real interest
rates (measured in output), real wages
(measured in output) – the term can also
refer to inflation-adjusted variables.
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Real vs. Nominal Variables
Prices are normally measured in terms of money.
• Price of a school lunch:
$2.50/svng
• Price of a fast food lunch:
$5.00/svng
A relative price is the price of one good relative to (divided
by) another:
• Relative price of school meal in terms of fast food:
price of ff
price of sl
=
$5.00/svng
$2.50/svng = 2.0 sl per ff
Relative prices are measured in physical units, so
they are real variables.
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Real vs. Nominal Wage
An important relative price is the real wage:
W = nominal wage = price of labor, e.g., $10/hour
P = price level = price of g & s, e.g., $5/unit of output
Real wage is the price of labor relative to the price
of output:
W
$10/hour
=
P
$5/unit of output
= 2 units output per hour
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The Classical Dichotomy
• According to Hume and others, real
economic variables do not change with
changes in the money supply.
• According to the classical dichotomy,
different forces influence real and nominal
variables.
• Changes in the money supply affect
nominal variables but not real variables.
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The Classical Dichotomy
& Monetary Neutrality
• The irrelevance of monetary changes for
real variables is called monetary neutrality.
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The Classical Dichotomy
• So, if a central bank doubles the money
supply, according to the theory, then
• all nominal variables – including prices –
will double.
• all real variables – including relative prices –
will remain unchanged.
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The Neutrality of Money
Monetary neutrality holds that a change in the money
supply will not affect real variables
• Doubling the money supply causes all nominal prices
to double, but what about relative prices?
• Initially, relative price of hot dogs in terms of burgers is
price of hd
=
price of burger
$1.00/hd
=
$2.00/brgr
 After nominal prices double,
price of hd
=
price of burger
2 hd per brgr
Relative price
$2.00/hd
= 2 hd per brgr
$4.00/brgr
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Keynsian and Monetarist Argument
• Money neutrality may hold true over the long term, but not
over the short term…
• Prices, including wages, are “sticky”: market forces might
reduce the value of wages, but the wages paid will tend to
remain at previous levels in the short run
• Causes: Menu costs (Can’t easily change prices), money
illusion (do not distinguish between real and nominal),
imperfect information (people don’t realize they should
change prices)
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Keynsian and Monetarist Argument
• Post-Keynsians and Monetarists reject the neutrality of
money in favor of the role that credit money plays in the
economy. Post-Keynesians also emphasize the role that
nominal debt plays: since nominal amounts of debt are
not in general linked to inflation, inflation erodes the real
value of nominal debt, and deflation increases it, causing
real economic effects, as in debt-deflation.
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Velocity and the Quantity Equation
• The velocity of money refers to the speed
at which the typical dollar bill travels around
the economy from wallet to wallet; in other
words, it describes how quickly people
spend money.
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The Velocity of Money
V = (P  Y)/M
Where:
V = velocity
P = the price level
Y = the quantity of output
M = the quantity of money
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An Example
Y = Real GDP = 100,000 hot dogs
P = Price level = Price/hotdog = $1.00
P x Y = Nominal GDP = Value of hot dogs =
$100,000
M = Money Supply = $50,000
V = $100,000 / $50,000 = 2
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What It Means
• When the economy is doing well, and
especially when interest rates are high, this
number is higher;
• When the economy is recessionary, the
number is lower.
• The Velocity of Money can be used to
predict the threat of inflation – what do you
think is the current V?
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Trends, M1
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Trends, M2
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Trends, M2
• On 9/21/09, M2 V was 9.11
• On 08/31/11, M2 V was 1.85
• For a look at M2 V, go here!
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Velocity and the Quantity Equation
• Rewriting the equation gives the quantity
equation:
MV=PY
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Velocity and the Quantity Equation
• The quantity equation relates the quantity
of money (M) to the nominal value of output
(P  Y).
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Velocity and the Quantity Equation
• The quantity equation shows that an
increase in the quantity of money in an
economy must be reflected in one of three
other variables:
• the price level must rise,
• the quantity of output must rise, or
• the velocity of money must fall.
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Figure 3 Nominal GDP, the Quantity of Money,
and the Velocity of Money
Indexes
(1960 = 100)
2,000
Nominal GDP
1,500
M2
1,000
500
Velocity
0
1960
1965
1970
1975
1980
1985
1990
1995
2000
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Velocity and the Quantity Equation
• The Equilibrium Price Level, Inflation Rate,
and the Quantity Theory of Money
• The velocity of money is relatively stable over
time.
• When the Fed changes the quantity of money,
it causes proportionate changes in the nominal
value of output (P  Y).
• Because money is neutral, money does not
affect output.
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The Fisher Effect
• The Fisher effect refers to a one-to-one
adjustment of the nominal interest rate to
the inflation rate.
• According to the Fisher hypothesis, when
the rate of inflation rises, the nominal
interest rate rises by the same amount.
• The real interest rate stays the same:
(n = i + r where i = Rate of Inflation, n =
nominal interest rate, and r = the real
interest rate)
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Figure 5 The Nominal Interest Rate and the
Inflation Rate
Percent
(per year)
15
12
Nominal interest rate
9
6
Inflation
3
0
1960
1965
1970
1975
1980
1985
1990
1995
2000
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THE COSTS OF INFLATION
• A Fall in Purchasing Power?
• Inflation does not in itself reduce people’s real
purchasing power.
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The Costs of Inflation: The Inflation Tax
• When the government raises revenue by
printing money, it is said to levy an inflation
tax.
• An inflation tax is like a tax on everyone
who holds money.
• The inflation ends when the government
institutes fiscal reforms such as cuts in
government spending.
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THE COSTS OF INFLATION
•
•
•
•
•
•
Shoeleather costs
Menu costs
Relative price variability
Tax distortions
Confusion and inconvenience
Arbitrary redistribution of wealth
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Shoe leather Costs
• Shoeleather costs are the resources
wasted when inflation encourages people
to reduce their money holdings.
• Inflation reduces the real value of money,
so people have an incentive to minimize
their cash holdings.
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Shoe leather Costs
• Less cash requires more frequent trips to
the bank to withdraw money from interestbearing accounts.
• The actual cost of reducing your money
holdings is the time and convenience you
must sacrifice to keep less money on hand.
• Also, extra trips to the bank take time away
from productive activities.
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Menu Costs
• Menu costs are the costs of adjusting
prices.
• During inflationary times, it is necessary to
update price lists and other posted prices.
• This is a resource-consuming process that
takes away from other productive activities.
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Relative-Price Variability and the
Misallocation of Resources
• Inflation distorts relative prices.
• Consumer decisions are distorted, and
markets are less able to allocate resources
to their best use.
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Inflation-Induced Tax Distortion
• Inflation exaggerates the size of capital
gains and increases the tax burden on this
type of income.
• With progressive taxation, capital gains are
taxed more heavily.
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Inflation-Induced Tax Distortion
• The income tax treats the nominal interest
earned on savings as income, even though
part of the nominal interest rate merely
compensates for inflation.
• The after-tax real interest rate falls, making
saving less attractive.
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Table 1 How Inflation Raises the Tax Burden on
Saving
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Confusion and Inconvenience
• When the Fed increases the money supply
and creates inflation, it erodes the real
value of the unit of account.
• Inflation causes dollars at different times to
have different real values.
• Therefore, with rising prices, it is more
difficult to compare real revenues, costs,
and profits over time.
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A Special Cost of Unexpected Inflation:
Arbitrary Redistribution of Wealth
• Unexpected inflation redistributes wealth
among the population in a way that has
nothing to do with either merit or need.
• These redistributions occur because many
loans in the economy are specified in terms
of the unit of account—money.
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Summary
• 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.
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Summary
• The principle of money neutrality asserts
that changes in the quantity of money
influence nominal variables but not real
variables.
• A government can pay for its spending
simply by printing more money.
• This can result in an “inflation tax” and
hyperinflation.
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Summary
• According to the Fisher effect, when the
inflation rate rises, the nominal interest rate
rises by the same amount, and the real
interest rate stays the same.
• Many people think that inflation makes
them poorer because it raises the cost of
what they buy.
• This view is a fallacy because inflation also
raises nominal incomes.
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Summary
• Economists have identified six costs of
inflation:
•
•
•
•
•
•
Shoe leather costs
Menu costs
Increased variability of relative prices
Unintended tax liability changes
Confusion and inconvenience
Arbitrary redistributions of wealth
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Summary
• When banks loan out their deposits, they
increase the quantity of money in the
economy.
• Because the Fed cannot control the
amount bankers choose to lend or the
amount households choose to deposit in
banks, the Fed’s control of the money
supply is imperfect.
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Looking Back: How to use the CPI
• It's fairly easy to use the CPI. Let's measure the rate of
inflation (how fast prices rose) from 2001 to 2002. The
annual CPI for 2001 is 177.1, and the annual CPI for 2002
is 179.9. Just calculate the percentage change between
the two index values ((179.9 - 177.1) / 177.1 )*100, and
you'll see that prices rose 1.6 percent from 2001 to 2002.
• Another way of thinking about the inflation rate is to ask
how much will a dollar buy now versus what a dollar
would have bought before? In our example, $1.00 in 2001
had the same value as $1.06 in 2002. In terms of what
you can buy with one dollar, you are worse off in 2002: to
buy what cost $1.00 in 2001, you needed $1.06 in 2002.
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• This relationship is easier to see if we use a
longer time period. One dollar of goods in
1980 would cost $2.29 in 2004. You can
calculate this measure for any two years
with the BLS Inflation Calculator.
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CASE STUDY: Money and Prices during
Four Hyperinflations
• Hyperinflation is inflation that exceeds 50
percent per month.
• Hyperinflation occurs in some countries
because the government prints too much
money to pay for its spending.
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Next Topic: Hyperinflation in History
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Figure 4 Money and Prices During Four
Hyperinflations
(a) Austria
(b) Hungary
Index
(Jan. 1921 = 100)
Index
(July 1921 = 100)
100,000
100,000
Price level
Price level
10,000
10,000
Money supply
1,000
100
Money supply
1,000
1921
1922
1923
1924
1925
100
1921
1922
1923
1924
Copyright © 2004 South-Western
1925
Figure 4 Money and Prices During Four
Hyperinflations
(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
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1925
Inflation in the United States
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Another Look at the Past: The Great Inflation
Percent
(per year)
Oil shocks: 1973 – oil
forced from $3 to $11 bbl;
1980, $13 to $28 bbl.
Generally rising trend in raw
mater1al prices due to global
boom.
Vietnam war financed by
borrowing
15
U.S. forced other nations
to accept
12dollars instead
of gold to settle foreign
obligations, building up
large dollar credits
9
abroad which were used
to buy U.S. exports.
Massive public sector
spending of 30% - 50%
or more of all public
expenditures.
The rise of institutions of
private power; less
agriculture, more
industry.
Inflation indexing (social
security, etc.).
6
Inflation
3
Global food shortages
The “Dot.Com Bubble”
0
1960
1965
1970
1975
1980
1985
1990
1995
2000
Copyright
© 2004 South-Western
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2004 South-Western
Another Look at the Past: Recessionary Disinflation
Percent
(per year)
Oil: Over-pricing leads to
lower consumption and a
steep price drop to just
over $10 bbl.
The global boom slows
down, material prices fall
(copper falls to levels seen
last before the Great
Depression
15
12
Slowdown in global
population growth, increased
agricultural production, better
weather
“Tough love” policies of
Reagan – a deliberate
decision to place the U.S.
in a business recession
through tight monetary
policy.
Soaring U.S. interest rates
lead foreigners to buy highyield U.S. bonds and choke
off access to capital for
domestic use. (Threemonth T-bill over 14%!)
9
6
Inflation
End of Vietnam War –
steep drop-off in defense
spending.
Japanese and Taiwanese markets crash.
3
0
1960
1965
1970
1975
1980
1985
1990
1995
2000
Copyright
© 2004 South-Western
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2004 South-Western
What about now?
How do we snap the recession?
Government spending and budget
deficits, along with such other fiscal
tools as credit, can stimulate the
economy, resulting in business
activity and profitability. A deficit
can help to create business and
investor optimism along with more
employment opportunities. But too
much of a good thing can also fuel
a rise of inflation. Deficit spending
may also create a rise in
unemployment, but lower the
inflation rate. The object is to
maintain a balance.
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$10,000,000 buys…
In 2008, the annual rate of inflation was
close to 90,000,000,000,000,000,000,000
percent. What is in your future?
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Works Cited
Harford, Tim. The Undercover Economist. New York: 2007, Random House.
Heilbroner, Robert and Lester Thurow. Economics Explained: Everything You
Need to Know About How the Economy Works and Where It’s Going. New
York; 1999, Touchstone.
McEacherm, William. Economics: A Contemporary Approach, 4th ed. Boston:
1996, South-Western College Pub.
Musgrave, Frank and Elia Kacapyr. Barron’s AP Advanced Placement Exam
Micro/Macro Economics 2007-2008. Ithaca: 2007, Barron’s.
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