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Chapter 16 Money Growth and Inflation
• The Classical Theory of Inflation
• The Costs of Inflation
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• Over the past sixty years, prices have risen on average about
4 percent per year.
• Deflation, a situation of decreasing prices. The average level
of prices in the Canadian economy was 37% lower in 1933
than in 1920.
• In the 1970’s prices rose by 7 percent per year.
• In the 1990’s prices rose about 2 percent per year.
• Hyperinflation, an extraordinarily high rate of inflation. Eg,
in Germany after WW I, the price of a news paper rose from
0.3 marks in January 1921 to 70,000,000 marks less than
two years later
The classical Theory of Inflation
• Inflation is a sustained increase in the price level. It is a
continuous increase versus a “once-and-for-all” increase2 in
prices.
• Inflation deals with the increase in the average of prices and
not just significant increases in the price of a few goods.
• So, when the price level rises, people have to pay more for
the goods and services they buy.
• Or alternatively, we can say that a rise in the price level
means a lower value of money because each dollar in your
wallet now buys a smaller quantity of goods and services.
• Therefore, inflation is an economy-wide monetary
phenomenon that concerns, first and foremost, the value of
an economy’s medium of exchange.
• To understand the cause of inflation as a monetary
phenomenon we must understand the concepts of Money
Supply, Money Demand, and Monetary Equilibrium.
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• Money Demand has several determinants including:
– interest rates
– average level of prices in the economy ( the most
important one)
• People hold money because it is the medium of exchange.
People can use money to buy the goods and services on
their shopping lists. How much money they choose to hold
for this purpose depends on the prices of those goods and
services. The higher prices are, the more money the typical
transaction requires, and the more money people will
choose to hold in their wallets and chequing accounts.
• That is, a higher price level ( a lower value of money)
increases the quantity of money demanded.
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• Money Supply is a variable of the Bank of Canada. Through
instruments such as open market operations, the B of C
directly controls the quantity of money supplied.
• In the long-run, the overall level of prices adjusts to the
level at which the demand for money equals the supply.
• See Figure 16-1
• At the equilibrium, point A, the level of money ( on the left
axis) and the price level ( on the right axis) have adjusted to
bring the quantity of money supplied and the quantity of
money demanded into balance.
• The effects of a monetary injection
• The B of C could inject money (monetary injection) into the
economy by buying government bonds. Results would be:
– The supply curve shifting to the right
– The equilibrium value of money decreasing
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– The equilibrium price level increasing
• This process is referred to as the quantity theory of money.
• According to the quantity theory, the quantity of money
available in the economy determines the value of money,
and growth in the quantity of money is the primary cause of
inflation.
• See Figure 16-2
• The injection of money increases the demand for goods and
services. Thus, the greater demand for goods and services
causes the prices of goods and service to increase. The
increase in the price level, in turn, increases the quantity of
money demanded because people are using more dollars for
every transaction.
• When an increase in the money supply makes dollars more
plentiful, the price level increases, making each dollar less
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valuable.
• The classical Dichotomy and monetary neutrality
• We have seen how changes in the money supply lead to
changes in the average level of prices of goods and services.
How do these monetary changes affect other important
macroeconomic variables, such as production, employment,
real wages, and real interest rates?
• David Hume suggested that all economic variables should
be divided into two groups.
– Nominal variables: variables measured in monetary units
; Eg: income of corn farmers, nominal GDP
– Real variables: variables measured in physical units; Eg:
real GDP, relative prices ( a number without dollar sign)
– Classical dichotomy: the theoretical separation of
nominal and real variables.
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– He argued, nominal variables are heavily influenced by
development in the economy’s monetary system, whereas
the monetary system is largely irrelevant for
understanding the determinants of important real
variables.
• Changes in the supply of money, according to Hume, affect
nominal variables but not real variables.
• An increase in the rate of money growth raises the inflation
but does not affect any “real” variables (e.g. production,
employment, real wages, and real interest rates.) Such
irrelevance of monetary changes for “real” variables is
called monetary neutrality.
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• Velocity and The Quantity Equation
• “How many times per year is the typical dollar bill used to
pay for a newly produced good or service?”
• The velocity of money refers to the speed at which the
typical dollar bill travels around the economy from wallet to
wallet.
• V = (P x Y) ÷ M
Where: V = Velocity
P = The average price level
Y = the quantity of output
M = the quantity of money
• Rewriting the equation gives the quantity equation.
MxV=PxY
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• The quantity equation shows that an increase in the quantity
of money in an economy must be reflected in one of the
other three variables: the price level must rise, the
quantity of output must rise, or the velocity of money
must fall.
• See Figure 16-3.
• Five Step Foundation to The Quantity Theory of Money
The velocity of money is relatively stable over time.
 A proportionate change in the nominal value of output is
related to changes in the quantity of money by the B of
C.
 Because money is neutral, money does not affect output.
Changes in the money supply which induce parallel
changes in the nominal value of output are also reflected
in changes in the price level.
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When the B of C increases the money supply rapidly, the
result is a high rate of inflation.
• Hyperinflation is inflation that exceeds 50 percent per
month. This means that the price level increases more than
100-fold over the course a a year.
• Hyperinflation in some countries is caused because the
government prints too much money to pay for their
spending.
• See Figure 16-4. This figure shows the quantity of money
and the price level during four hyperinflations. The slope of
the money line represents the rate at which the quantity of
money was growing, and the slope of the price line
represents the inflation rate. The steeper the lines, the higher
the rates of money growth or inflation. It is worth noting
that in each graph the quantity of money and the price level
are almost parallel.
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• 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.
• When the B of C increases the rate of money growth, the
result is both a high inflation rate and a higher nominal
interest rate. This is called the Fisher Effect.
• Nominal Interest Rate = Real Interest Rate + Inflation
Rate
• Over the long run, a change in the money growth should not
affect the Real Interest Rate. Thus, the Nominal Interest
Rate must adjust one-for-one to changes in the Inflation
Rate.
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• See Figure 16-5
The inflation fallacy
• Why is inflation bad? “ Inflation robs people of the
purchasing power of their hard-earned dollars.” Is it true?
• When prices rise, buyers of goods and services pay more for
what they buy. However, at the same time, sellers of goods
and services get more for that they sell. Because most
people earn their incomes by selling their services, such as
their labour, inflation in incomes goes hand in hand with
inflation in prices.
• Fact: “One person’s inflated price is another’s inflated
income.” Unless incomes are fixed in nominal terms, the
higher prices paid by consumers are exactly offset by the
higher incomes received by sellers.
• Thus, inflation does not in itself reduce people’s real
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purchasing power.
Why is inflation a problem? Economists have identified
several costs of inflation. They are:
• 1. Shoeleather costs.
• 2, Menu Costs.
• 3, Increased variability of relative prices.
• 4, Tax liabilities.
• 5, Confusion and inconvenience.
• 6, Arbitrary redistribution of wealth
Shoeleather costs
• Inflation reduces the real value of money, so people have an
incentive to minimize their cash holdings. Less cash
requires people to make frequent trips to the bank because
they keep their money in interest bearing accounts.
• Extra trips to the bank takes time away from productive
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activities.
Menu Costs
• 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.
Unintended Changes in Tax Liability
• With inflation, unadjusted incomes are treated as real gains.
Consequently, with progressive taxation, rising nominal
incomes are taxed more heavily.
• See Table 16-1
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Confusion and Inconvenience
• With rising prices, it is necessary to constantly make
corrections in order to compare real revenues, costs, and
profits over time. The time spent making these adjustments
could have been spent producing more goods and services.
Increased Variability of Relative Prices
• During times of rising prices, there will be a delay between
price increases. While these prices are constant, other
prices will be rising. It then becomes difficult to know
exact relative prices as prices change irregularly.
Arbitrary Redistribution of Wealth
• With unanticipated or incorrectly anticipated inflation,
wealth is redistributed between net monetary debtors and
creditors. This may result in wealth transfers that would not
otherwise be acceptable.
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– Recall the Fisher Effect.