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Chapter 7: Money, Prices, and Inflation
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J. Bradford DeLong
http://econ161.berkeley.edu/
[email protected]
7,825 words
Contents
7.1 Money
7.1.1 What Money Is
7.1.2 The Usefulness of Money
7.1.3 Units of Account
7.2 The Quantity Theory of Money
7.2.1 Demand for Money
7.2.2 The Quantity Equation
7.2.3 Money and Prices
7.2.3.1 The Price Level
7.2.3.2 The Money Stock
7.2.4 Inflation
7.3 The Interest Rate and Money Demand
7.3.1 Money Demand
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7.3.2 Money, Prices, and Inflation
7.4 Costs of Inflation
7.4.1 Costs of Moderate Expected Inflation
7.4.2 Costs of Moderate Unexpected Inflation
7.4.3 Hyperinflation and Its Costs
Box 7.1--Policy: Hyperinflation in Weimar Germany
7.5 Chapter Summary
7.5.1 Main Points
7.5.2 Important Concepts
7.5.3 Analytical Exercises
7.5.4 Policy-Relevant Exercises
Questions
What do economists mean by "money"?
Why is money useful?
What do economists mean when they call money also a unit of account?
What determines the price level and the inflation rate?
Why would a government ever generate a hyperinflation--a period in which prices
rise by more than 20 percent a month?
What determines the level of money demand?
What determines the level of money supply?
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Why is inflation thought of as costly--something to be avoided?
7.1 Money
Newspaper and television coverage of the economy spends a lot of time and space talking
about inflation. At any moment inflation may be ongoing and causing various forms of
economic disruption, or the actions of economic policy-making agencies like the Federal
Reserve may be tightly constrained by fear that certain courses of action will lead to
inflation. The U.S. experienced an episode of relatively mild inflation--prices that rose at
a rate of between five and ten percent per year--in the 1970s, yet that was large enough to
cause significant economic and political trauma. Avoiding a repeat of the inflation of the
1970s remains a major goal of economic policy.
Many countries have experienced inflations that are definitely not mild. In Russia in 1998
the price level rose at a rate of 60 percent per year. In Germany in 1923 prices rose at a
rate of 60 percent per week. So-called hyperinflations have been seen in many other
countries in this century, from Argentina to Ukraine, from Hungary to China. They are
extremely destructive because they inflict severe damage on the ability of money to
grease the wheels of the social mechanism of exchange that is the market economy.
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Figure 7.1: Post-WWII Inflation in the United States [to be updated]
Legend: All measures of price changes show a burst of inflation in the U.S. in the
1970s.
Source: 2000 Economic Report of the President (Washington: GPO).
Chapter 6 did not discuss the determination of the overall level of prices and of the
inflation rate because it did not have to. It was perfectly possible to figure out what the
real interest and exchange rates, the level of real GDP, and the division of real GDP into
its components were without ever once mentioning the overall price level or the rate of
inflation.
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The power to analyze real variables without ever referring to the price level is a special
feature of the full-employment model of the economy in chapter 6. Economists call this
the classical dichotomy: the determination of real variables (like real GDP, real
investment spending, or the real exchange rate) is separate from the determination of
nominal variables like the price level. You will also hear economists speak of this as the
property that "money" is neutral, or that "money" is a veil--a covering that does not
determine the shape of the face underneath.
In chapter 8 and its successors the classical dichotomy will fail. "Money" will not be
neutral. The determination of the price level and its changes will be intimately tied up
with fluctuations in production and employment. The source of this difference is that in
chapters 8 and its successors prices are sluggish, or sticky, or fixed. Hence they cannot
adjust smoothly and instantaneously to changes in nominal variables like the money stock
and the price level.
But here in chapters 6 and 7 prices are fully flexible--that is part of the underpinning of
the full-employment assumption. And the classical dichotomy holds.
This chapter explores what determines the overall level of prices and the rate of inflation
(or deflation) in our full-employment flexible-price consistent-expectations economy in
which the classical dichotomy does hold. This is worth doing for two reasons. First, it
provides a useful baseline analysis against which to contrast the conclusions of future
chapters. Second, when we look over relatively long spans of time--decades, perhaps-wages and prices are effectively flexible, they do have time to move in response to
shocks, and the full-employment assumption is a fruitful and useful one.
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7.1.1 What Money Is
When normal people use the word "money," they may mean one of a number of things.
"Money" may be used as a synonym for wealth: when we say "she has a lot of money,"
we mean that she is wealthy. "Money" may be used as a synonym for income: when we
say "he makes a lot of money," we mean that he has a high income.
Table 7.1: Measurements of the Money Stock [to be updated every year]
Concept of Money
C
H
M1
M2
M3
L
Assets Included in Concept
Currency.
Monetary base: assets that can serve as
reserves for banks. Equals currency plus
reserve deposits at Federal Reserve Banks.
Currency plus checking account deposits
and travelers' checks.
M1 plus savings account deposits, small
time deposits, and household money-market
funds.
M2 plus institutional money-market funds,
eurodollar accounts, large time deposits,
and repurchase agreements.
M3 plus short-term Treasury securities and
other liquid financial assets
Amount in Billions
$460
$514
$1,092
$4,412
$5,982
$7,065
When an economist uses the word "money," however, he or she means something
different from the colloquial use of the word. To an economist, "money" is wealth in the
form of readily-spendable purchasing power. It is that kind of wealth that others will
accept as payment in return for commodities. Today the economy's stock of money is
made up of:
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coin and currency transferred by handing the cash over to the seller (which almost
everyone will accept as payment for goods and services.

checking account balances transferred by writing a check (which most people will
accept as payment for goods and services).

assets--like savings account balances--that can be turned into cash or demand deposits
nearly instantaneously, risklessly, and costlessly.
Why do economists adopt this special, "technical" definition of money? It is probably a
bad idea to take normal words and give them special definitions. Yet economists do so
for not only "money" but also "investment" and "utility."
Whether assets like savings account balances, money market mutual funds, liquid
Treasury securities, and so forth that can be quickly and cheaply turned into cash are
included in one's measure of the money stock is largely a matter of taste and judgment.
At what level of cost and inconvenience is an asset no longer "readily spendable"? There
is no clear, hard, bright-line, unambiguous answer. Thus economists have a number of
different measures of the money stock--C, H, M1, M2, M3, and L--each of which draws
the line around a different set of assets that it counts as wealth in a form in which it can
be readily enough spent to count as "money."
7.1.2 The Usefulness of Money
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Try to imagine a barter economy without the social convention of money. In our world all
you need to carry out a market transaction--whether you want to buy or sell some good or
service--is to either have money (if you want to buy) or for the purchaser to have money
(if you want to sell). In a barter economy market exchange would require the so-called
coincidence of wants: you would have to have physically in your possession some good
or service that they wanted, and they would have to have in their possession some good
or service that you wanted.
Figure 7.2: Coincidence of Wants
Farmer
wants
haircut
needs to eat
Cook
Mover
wants
furniture
needs to
move
wants to read novel
Writer
Barber
wants
corn
Carpenter
Legend: Without money, how is the carpenter to persuade the farmer to
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give him corn when the farmer wants a haircut but doesn't need furniture--which
the cook wants? How is the mover going to persuade the cook to feed him when
the cook doesn't need the moving truck--the writer does? With money, all can
sell what they have for cash with the confidence that they can then turn around
and use the cash to buy what they need.
Unless huge stocks of commodities are wasted in transaction inventories as everyone lugs
around grocery carts full of items potentially-useful to others, such a coincidence of
wants is unlikely.
7.1.3 Units of Account
There is one other feature of the nominal side of the economy worth noting. The same
assets that serve as the most common form of readily-spendable purchasing power also
serve us as units of account. Dollars or euros or yen are not only what we use to settle
transactions, but also what we use to quote prices to one another. At some times and
places the function of money as a medium of exchange and of money as a unit of account
have been separated. But today it is almost always the case that they go together.
This is a potential cause of trouble: anything that alters the real value of the domestic
money in terms of purchasing power over goods and services will also alter the terms of
existing contracts that have used the domestic money as the unit of account. The effect of
changes in the price level on contracts that have used the domestic money as a unit of
account is a principal source of the social costs of inflation and deflation. The effect of
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changes in the exchange rate on contracts that have used foreign monies as units of
account is a principal source of the social costs of currency crises.
7.2 The Quantity Theory of Money
7.2.1 Demand for Money
People in the economy have a demand for money just as they have a demand for any
other good or service. They want to have a certain amount of wealth in the form of
readily-spendable purchasing power in their possession and at their disposal because the
stuff is useful. The more money in your portfolio, the easier it is to buy things. Too little
money makes living one's life pointlessly difficult as you have to waste time running to
the bank for extra cash or waste energy (and possibly interest!) liquidating pieces of your
portfolio before you can carry out transactions.
On the other hand, you don't want to have too much of your wealth in the form of readilyspendable purchasing power. Cash sitting in your pocket is not earning interest at the
bank. Wealth that you know that you will not want to spend for five years could earn a
higher return as a certificate of deposit or invested in the stock market than sitting in your
immediate-access checking account.
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Figure 7.3: Reasons for and Opportunity Cost of Holding Money
Expensive
because you
lose interest
and profits
Wealth in
readilyspendable
form
Needed
to make
transactions
go smoothly
Where the costs and benefits of holding the marginal dollar of wealth in the form of
"money" will be equalized--and thus what amount of money holdings will maximize the
utility of a consuming household--depends on the transactions technology of the
economy: what businesses will take credit cards, how easy it is to get checks approved,
how long the float is, and so forth. One thing that is clear is that the higher the flow of
spending, the more money the households and businesses in the economy will want to
hold.
In this section we ignore all the other determinants of money demand, and we focus on
the flow of spending as the determinant of changes in money demand.
7.2.2 The Quantity Equation
The economic theory that the only important determinant of demand for money is the
flow of spending is called the quantity theory of money. It is summarized in either the
Cambridge (England) money-demand function:
M
1
 (P  Y )
V
or in the (American-style) quantity equation:
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MV  PY
In either form of the quantity theory, P x Y is the total nominal flow of spending. For
each dollar of spending on final goods and services households want to hold 1/V dollars'
worth of money. This parameter V--constant or with a slow trend in this section because
it is determined by the transactions-processing technology of the economy--is called the
velocity of money. It is a measure of how "fast" money moves through the economy: how
many times a year the average unit of money shows up in someone's income and is then
used in a transaction that buys a final good or service.
7.2.3 Money and Prices
7.2.3.1 The Price Level [update every year]
The quantity theory of money and the full-employment assumption from chapter 6 thus
give us a way of determining the price level when wages and prices are fully flexible.
The level of real GDP Y is simply equal to potential output as given by the production
function: Y = Y*. The velocity of money V is determined by the current level of
transactions technology--the sophistication of the banking system and the social
conventions that govern payment and settlement. For the "M1" concept of money-currency plus checking account deposits--the current velocity of money V is about 7.5:
businesses and households wish to hold about $1 of their wealth in the form of M1 for
every $7.50 of real GDP produced. Changes in financial sophistication have raised this
velocity sharply over time. Back in the years immediately after World War II, the M1
velocity of money was not 7.5 but 3.
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Thus if we know real GDP Y, the velocity of money V, and the money stock M, we can
immediately calculate the price level:
P
V 
M
Y 
For example, in the third quarter of 1998 with real GDP (in chained 1992 dollars) equal
to $7,566 billion, with the M1 measure of the money stock equal to $1,072 billion, and
with the velocity of money equal to 7.964
P
 7.964 
 $1,072  1.1284
$7,556 
the price level was equal to 112.84% of its 1992 level.
Should the price level be for some reason momentarily higher than the quantity equation
predicts, households and businesses will note that they have less wealth in the form of
readily-spendable purchasing power they wish. They will hold back on purchases for a
little while to build up their liquidity. As they hold back on purchases, sellers will note
that demand is weak and cut their prices. The price level will fall.
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Figure 7.4: The Velocity of Money
Legend: Between 1960 and 1980 it looked as though the velocity of money
was slowly and steadily increasing over time as the banking system improved its
efficiency and the technology available for conducting transactions. But in the
1980s and 1990s the velocity of money has fallen far short of its pre-1980 trend.
Economists attribute this to lower inflation rates in the 1980s and 1990s that
diminished incentives to economize on cash and checking account balances.
Source: Economic Report of the President (Washington, DC: Government
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Printing Office), 1999 edition.
Should the price level be for some reason momentarily lower than the quantity equation
predicts, households and businesses will note that they have more wealth in the form of
readily-spendable purchasing power they wish. They will accelerate their purchases for a
little while to reduce their liquidity. As they accelerate purchases, sellers will note that
demand is strong and raise their prices. The price level will rise. As long as prices are
free to shift smoothly and instantaneously, the balance of demand and supply in the
markets for goods and services will keep the economy's price level at its quantity-theory
equilibrium.
On a day-to-day or even year-to-year variable changes in the money stock do not
necessarily produce equivalent proportional changes in the price level. The velocity of
money is variable and volatile. But on a decade-to-decade time scale the quantity theory
of money is a very reliable guide to and predictor of large movements in prices.
But this is if we know the level of the money stock. What determines the level of the
money stock?
7.2.3.2 The Money Stock
The quick answer is that the central bank--in the United States the Federal Reserve, for
the Federal Reserve is America's central bank--determines the money stock. That is what
monetary policy is: the determination of the money stock.
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The central bank determines the monetary base directly. When the central bank wants to
reduce the monetary base it sells short-term government bonds, accepting cash or
reserves on deposit at its regional branches as payment, and then simply extinguishes the
assets by storing the cash in a basement somewhere or wiping the reserve deposit off of
its books. When it wants to increase the monetary base it buys short-term government
bonds, paying for them with either cash that had been in a basement or by crediting the
seller with a reserve deposit at one of its regional branches. These transactions are called
open-market transactions. The procedures that govern when and how the U.S. central
bank, the Federal Reserve, undertakes these transactions are decided at periodic meetings
of the Federal Reserve Open Market Committee [FOMC].
Figure 7.5: Open Market Operations
To Increase the Monetary Base...
To Decrease the Monetary Base...
sells bonds...
buys bonds...
Federal
Reserve
... for cash
Federal
Reserve
... for cash
The levels of the other measures of the money stock besides the monetary base are
determined by the interaction of the monetary base with the banking sector and the rest of
the financial system. Banks like to accept checking and savings account deposits. They
loan out the purchasing power deposited, earn interest, and also provide the depositor
with a claim to wealth in readily-spendable form. But central banks limit private banks'
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ability to accept deposits by requiring that they hold a certain amount of reserves at the
Fed for each unit of deposits that they accept. Financial institutions think it prudent to
hold extra liquid reserves in case an unexpectedly large number of depositors or clients
will seek to withdraw their money or liquidate their account on any one day: there is
nothing worse for a financial institution in the business of providing depositors or clients
with a place to put their wealth in which it remains in readily-spendable form.
Hence broader measures of the money stock are larger than but limited in their growth by
the size of the monetary base, the regulatory reserve requirements imposed on banks and
other financial institutions, and financial institutions' extremely powerful incentive never
to be caught in an "illiquid" position in which they lack the cash to satisfy borrowers'
withdrawals or the checking balances to satisfy clients' liquidations.
In this chapter (and, if truth be told, in later chapters too) we will sweep potential
complications under the rug, and assume that the central bank can easily and
unproblematically set the money stock at whatever level it wishes.
7.2.4 Inflation
The quantity equation:
P
V 
M
Y 
leads immediately to an equation for the inflation rate π--the proportional rate-of-change
of the price level. Simply recall that the proportional rate-of-change of a product is the
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sum, and the proportional rate-of-change of a quotient is the difference, of the
proportional rates of change of its components. Thus:
(inflation) = (velocity growth rate) + (money growth rate) - (real GDP growth rate)
Representing the proportional growth rate of the money stock by a lower-case m, the
proportional rate-of-change of velocity by a lower-case v, and the proportional growth
rate of real GDP by a lower-case y:
π=m+v-y
Thus suppose the proportional growth rate of real GDP averages 4% per year, that the
velocity of money V increases at a proportional rate of 2% per year, and the money stock
M grows at 5% per year, then we would expect the inflation rate to be:
π = 5% + 2% - 4% = 3%
Three percent per year.
Of the factors that determine the rate of inflation, the rate of growth of real GDP is--in the
long run at least--equal to the rate of growth of the labor force n and the rate of growth of
the efficiency of labor g; and the proportional rate of change of velocity is determined by
the slow pace of institutional and technological change in the banking system. These
factors are both relatively constant, or at least slow to change and largely unaffected by
shifts in macroeconomic policy.
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Figure 7.6: Inflation and Money Growth in the U.S. [to be updated]
Legend: As the rate of money growth in the U.S. increased from the early
1960s to the end of the 1970s, inflation increased as well. (The inflation-money
growth correlation in the U.S., however, broke down after the end of the 1970s.)
Source: Economic Report of the President (Washington, DC: Government
Printing Office), 1999 edition.
The only determinant of the rate of inflation that is either capable of wide and
unanticipated variation or profoundly and rapidly influenced by policy is the rate of
growth of the money stock. If the central bank keeps the money stock relatively stable,
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prices will be relatively stable. Inflation will be low. If the central bank lets the money
stock grow quickly, then prices will be unstable and inflation will be high.
7.3 The Interest Rate and Money Demand
7.3.1 Money Demand
In this section we think a little bit more systematically about the determinants of money
demand, because it is clearly not enough to say that the velocity of money is a constant or
a slowly-moving steady trend, and thus that inflation will always be roughly proportional
to money growth.
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Figure 7.7: Money Growth and Inflation Are Not Always Parallel
In the 1980s in the United States the velocity of money fell sharply, and inflation
declined even though decade-to-decade money growth did not. The first half of the 1990s
saw further rapid declines in velocity, while the second half saw equally rapid increases
as nominal money supply growth dipped well below zero.
Money demand should be proportional to nominal national income P x Y. If you double
your real income (and keep the price level unchanged) you would need twice as large a
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nominal stock of readily-spendable purchasing power to carry out your transactions. If
you double the price level (and keep real income unchanged) you would also need twice
as large a nominal stock of reality-spendable purchasing power to carry out your
transactions.
Moreover, money demand should be inversely related to the nominal interest rate--the
sum of the real interest rate and the current inflation rate. The cash in your purse (or
wallet) does not earn any interest. Instead, its purchasing power over real goods and
services erodes at the rate of inflation. Similarly, the interest paid on your checking
account balances is zero or very low. Thus the purchasing power over your real goods
and services erodes with inflation as well.
By contrast, were you to take the last marginal dollar of your money balances and put it
into some other part of your portfolio, its real return would be the real interest rate r. Thus
the nominal interest rate--the sum of the real interest rate and the inflation rate--is the
opportunity cost of holding money. The higher is this opportunity cost, the lower is
demand for money balances. Thus we can think of nominal money demand as the
function:
M
PY
V  (V0  Vi  (r   ))
L
where VL is a financial technology-driven trend in the velocity of money, and V(r+π) =
V0 + Vi(r+π) is an increasing function that captures the dependence of households' and
businesses' preference for liquidity on the nominal interest rate: the higher is r+π, the
higher is the function V.
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Figure 7.8: Money Demand and the Inflation Rate
r+
nominal
interest
rate
Relative Money Demand: L(r+ ) =
M x VL
PxY
We can use this function plus the central bank's determination of the money stock and the
production function's determination of real GDP to analyze the price level and inflation.
7.3.2 Money, Prices, and Inflation
Once the level of money demand depends on the current rate of inflation, we have to
keep track of two equations in order to determine the behavior of money, prices, and
inflation. The first equation comes directly from the money demand function, and tells us
the price level:
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PY
V  (V0  Vi  (r   ))
L
The second equation comes from the rate of change of the money demand function. If we
assume that inflation is constant, and call (as before) the proportional rate of change of
the velocity trend v, then we have, as before:
 m v y
Thus if the velocity trend is +1% per year, real GDP growth is +4% per year, and the rate
of growth of the money stock is +6% per year, then inflation is 3% per year.
Now suppose that the rate of growth of the money stock suddenly, discontinuously, and
permanently increases from 6% per year to 10% per year. When the economy settles
down, the new inflation rate will be 4% per year higher--7% per year instead of 3% per
year. But at an inflation rate of 7% per year, the opportunity cost of holding money was
higher. If the real interest rate is stable at 3% per year, then the opportunity cost of
holding money has just jumped from 6% to 10% per year.
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Figure 7.9: Effects of an Increase in Money Growth with Interest-Elastic Money
Demand
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Such a higher opportunity cost of holding money will reduce the quantity of money
demanded per unit of nominal GDP. How can this reduction be accomplished? Unless the
central bank reduces the money stock, the only way to reduce the quantity of money
demanded per unit of nominal GDP is for nominal GDP--and the price level--to suddenly
and discontinuously jump! By how much will the price level jump? It depends on how
sensitive the liquidity preference function L() that governs money demand is to changes
in inflation.
Thus if money demand is sensitive to the interest rate, an increase in the expected rate of
money growth causes a large sudden and instantaneous upward jump in the price level, in
addition to an upward jump thereafter in the inflation rate; and a decrease in the expected
rate of money growth causes a sudden and discontinuous downward jump in the price
level, in addition to a downward jump thereafter in the inflation rate.
7.4 Costs of Inflation
Why should we care whether the central bank controls the money supply--and thus keeps
inflation low and stable--or lets the money supply run loose, and allow inflation to be
higher and unstable?
One thing that is not a reason to care about inflation is the fear that inflation makes us as
a society directly and significantly poorer. Any claim by a politician that inflation is the
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"cruelest tax" because its higher prices rob Americans of the benefits of their wages is
\incoherent. Inflation raises all prices and wages in the economy--the higher prices that a
worker has to pay because of inflation are, in total and on average, offset by the higher
wages that his or her employer can pay because of inflation. Higher living standards
come from better technology and more capital-intensive production processes, not from
reduced inflation.
There are costs of inflation, but they are subtle--and for the most part the costs of
moderate inflation appear to be relatively small, smaller than one would guess given the
strength of today's political consensus that price stability is a very good thing.
7.4.1 Costs of Moderate Expected Inflation
The costs of expected inflation are especially small. Expected inflation will raise nominal
interest rates--recall that the nominal interest rate is equal to the real interest rate plus the
rate of inflation. The gap between the nominal interest rate you get on the money in your
pocket (zero) and the nominal interest rate you would get if you put your money in the
bank goes up. Thus holding wealth in the form of readily-spendable purchasing power in
your pocket is more costly, and you devote more time and energy to managing your cash
balances.
From the viewpoint of the economy as a whole, this extra time and energy is just wasted:
nothing useful is produced, while valuable resources that could be used to add to output
or simply spent enjoying yourself are consumed.
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Expected inflation wastes time and energy in other ways as well. Firms find that they
have to spend resources changing their prices not because of any change in their business
situation but just because of inflation. Households find that it is harder to figure out what
is a good and what is a bad buy if inflation keeps pushing actual prices away from what
they had perceived normal prices to be. The most serious costs of expected inflation
surely come from the fact that our tax laws are not designed to deal well with inflation.
Lots of productive activities are penalized, and lots of unproductive ones rewarded,
simply because of the interaction of inflation with the tax system.
When the rate of inflation is low, however--perhaps when inflation is less than ten
percent per year, and certainly when inflation is less than five percent per year--these
costs are almost surely too small to worry about.
7.4.2 Costs of Moderate Unexpected Inflation
Unexpected inflation has additional costs: unexpected inflation redistributes wealth from
creditors to debtors. Those who were expecting to be paid receive much less purchasing
power than they had anticipated if the duration of a loan they made covered a time of
significant inflation. Those who pay find the debts they contracted much less burdensome
than they had anticipated if they had borrowed over a period of significant inflation. The
process works in reverse as well: if inflation is less than had been expected, creditors
receive a windfall and debtors go bankrupt.
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Most people are averse to risk. We do buy fire insurance, after all. People who are averse
to risk dislike uncertainty and unpredictability--and unexpected inflation certainly creates
uncertainty and unpredictability.
Yet there is a powerful economic argument that these costs of moderate inflation, even
moderate unexpected inflation, must be relatively low. Even though there is inflation,
people continue to use the currency undergoing the inflation as their units of account.
Why don't debtors and creditors want to insure themselves against inflation risk by
indexing their contracts and using some alternative, more stable unit of account? In
economies with high and variable inflation, we do see such indexation. The fact that we
do not in countries with moderate and low inflation suggests that the social costs of
inflation must be pretty low.
On the other hand, there is a powerful political argument that the costs of moderate
inflation are relatively high. Voters don't like it. The 1970s saw government after
government in the industrialized world voted out of office in large part because voters
interpreted the rising rates of inflation then prevalent as signs that political parties in
power were incompetent at managing the economy. Ever since the end of the 1970s no
major political party in the industrialized world has dared run on a platform of less price
stability, and more inflation.
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7.4.3 Hyperinflation and Its Costs
We can see the costs of inflation mount to economy-destroying levels in episodes of socalled hyperinflation, when rates of inflation rise to more than 20 percent per month.
Hyperinflations arise when governments attempt to get revenue to spend by printing
money, and overestimate how much they can raise through money printing.
For some governments the fact that in modern times the government prints the money is
an important source of revenue. Governments usually obtain money by taxing their
citizens, or by borrowing from people who think that the government will pay them back.
But a government finds that it does not have the administrative reach to increase its
explicit tax take and that no one will lend to it because no one trusts it to pay them back
can print money. It can then spend the money it prints, using that money to purchase
goods and services.
Where do the resources--the power to buy goods and services--that the government
acquires by printing money come from? The answer is that a government that finances its
spending by printing money is almost exactly the same as a government that finances its
spending by levying a special tax on holdings of cash.
Think of it this way. Suppose that I have $500 in cash in my pocket, and the government
suddenly announces that it has printed up enough extra dollar bills to double the supply
of cash money in the economy, and that it is going to spend them. The quantity theory of
money tells us that--with the level of output Y and the velocity of money V unchanged-this doubling of the money supply will double the price level. So the $500 in my pocket
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will buy only as much after the government's money-printing spree as $250 would have
bought before.
Figure 7.10: The Inflation Tax
Households and businesses have
$500 billion in cash and reserves...
$50
0
...the government prints an extra $500
billion in cash...
0
$50
...the price level doubles, and so household and
business cash and reserves loses half its real
value: it's now worth only $250 billion in
pre-inflation terms...
$25
0
...where did the other $250
billion in real purchasing power
go? The government now has
it--has raised it through the
"inflation tax."
$25
0
Where have the $250 real dollars in my pocket gone? Who know has them? The
government now has them: it has $500 newly-printed dollars--each of them worth half a
pre-inflation dollar in real terms--to spend, after all. It has taxed me of them just as if IRS
agents had imposed a 50% tax on all holdings of cash and had ordered me to write a $250
(pre-money-printing) check to the government.
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Printing money is easier than imposing a 50% explicit tax. To collect an explicit tax a
government needs need an entire wealth-tracking, money-collecting, and compliancemonitoring bureaucracy. To print money all a government needs is a printing press, some
ink, some paper, and a working connection to the electric power grid.
Almost everyone agrees that such a resort to this inflation tax--also called seigniorage
because the right to coin money was originally a right reserved to certain feudal lords,
certain seigneurs--is a bad thing. One of the first principles of public finance is that taxes
should be broad-based and lie relatively lightly on a broad base of taxable economic
activity. The inflation tax is a heavy tax on a narrow base of economic activity, the
activity of holding money.
Moreover, the inflation tax is a heavy tax on one small slice of money-holding. Only
those readily-spendable liquid assets that are created by the government are potential
sources of revenue for the inflation tax. Other components of the money stock--your
checking account, say--is not a potential source of purchasing power for the government
through the inflation tax. Suppose that you deposited your money in your checking
account and the bank then took that purchasing power and used it to buy an office
building. If the price level doubles you have lost half the real value of your checking
account, yes. But the gainer in real terms is not the government but the bank that now
finds the value of the office building it owns to be twice as large relative to the value of
the deposits that can be made on it. So the inflation tax is even a worse tax--imposed on
an even narrower base--than it looks at first glance.
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However, this inflation tax is also the last resort of a government that is falling apart.
Even if a government lacks the administrative capacity to do anything else, it can still run
a printing press in the basement.
A government that resorts to hyperinflation finds that eventually prices are rising so
rapidly that the monetary system breaks down. People would rather deal with each other
in barter terms--even with the problem of the coincidence of wants--than use a form of
cash whose value is shrinking measurably every day. GDP starts to fall as the economy
begins to lose the benefits of the division of labor. And a falling level of Y pushes prices
up even more rapidly.
In the end the government finds that its currency is next to worthless. It runs the printing
presses faster and faster and yet finds that the money it prints buys less and less. At the
end of the German hyperinflation of the 1920s, one trillion marks were needed to buy
what one mark had bought less than ten years before.
Box 7.1--Policy: Hyperinflation in Weimar Germany
The military defeat in World War I of the "Central Power" alliance of Imperial
Germany and the Austro-Hungarian Empire was followed by a democratic
revolution in Germany. At the end of 1918 the semi-democratic imperial regime
was overthrown, the ex-German Emperor Wilhelm II was sent off to exile in
Holland, and a democratic republic was proclaimed.
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The "Allied Powers"--the victorious alliance of France, Britain, Italy, and the
United States--did not welcome the new German government as a potential future
partner that needed to be supported and strengthened. Instead, they saw simply the
old Germany that had eagerly turned a Balkan crisis into a pan-European war that
killed more than ten million because the military balance looked advantageous,
and that had turned northern France into a moonscape with machine guns, barbed
wire, explosives, and poison gas. The Allied Powers demanded that the German
government pay them mammoth reparations to pay for the rebuilding of northern
France and Belgium, and to partially compensate other Allied Powers for the
costs of the war.
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Figure: German Federal Spending and Deficits in the Weimar
Hyperinflation
The democratic German government thus began the post-World War I period in
deficit, owing large but not fully specified reparations payments to the Allied
Powers. The democratic German government soon found that its ability to levy
taxes was limited while the demand from its supporters for expanded socialinsurance expenditures could not be put off.
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Figure: German Money Growth and Price Inflation in the Weimar
Hyperinflation
The situation reached total collapse in early 1923 when the French government,
eager to demonstrate to its people that it was taking a hard line against Germany
on the reparations question and tired of delays in payments, sent the French army
to occupy the German industrial region of the Ruhr Valley. The German
government called for a general strike against the French, and promised to pay the
wages of striking workers. Tax collections plummeted further.
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The German government's resort to money-printing to try to close the deficit
between its limited taxing reach and the reparations payments and socialinsurance spending demanded by the Allies and its supporters had already
generated a hyperinflation. The monthly rate of increase of prices in Germany had
crossed 20 percent in late 1921. Throughout 1922 the rate of price increase
averaged 34 percent per month.
But in 1923, as taxes fell further and desired real expenditures rose further as a
result of the Ruhr crisis, the hyperinflation hyperinflated. At is peak in the late
summer of 1923, prices in Germany were doubling every month. In July 1914 it
had taken 4 German marks to equal 1 American dollar. By December 1923 it took
4,000,000,000,000 German marks to equal 1 American dollar.
Germany's hyperinflation came to an abrupt end at the end of 1923. By then the
French army had withdrawn from the Ruhr Valley, and the strike was over. The
Allied Powers suspended (and later reduced) their demands for reparations
payments. One-quarter of the employees of Germany's federal government were
laid off. The old central bank, the Reichsbank, was replaced by a new central
bank, the Rentenbank. The new central bank was prohibited by its organic statute
from using the printing press to increase the supply of money. And the old
German mark was replaced by a new currency, the rentenmark.
All that was required to end Germany's hyperinflation was for there to be a reform
of the central bank so that it would no longer keep increasing the money supply.
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Of course, the politics of reaching such a point--with a new central bank that
would no longer allow the use of the printing press, and with everyone having
confidence in this new central bank--was extremely difficult. That is why it took
five years after the end of World War I to reach this point.
The German military analyst Karl von Clausewitz wrote that in war "…everything
is very simple, but even the simplest things are very difficult…" So it almost
always proves in the politics of controlling hyperinflation. What has to be done is
very simple: simply stop the rate of growth of the money stock. But even the
simplest thing can be very difficult…
7.5 Chapter Summary
7.5.1 Main Points
By "money" economists mean something special: wealth in the form of readilyspendable purchasing power.
Without money it is hard to imagine how our economy could successfully function.
The fact that everyone will accept money as payment for goods and services is
necessary for the market economy to function.
Money is not only a medium of exchange, it is also a unit of account: a yardstick that
we use to measure values and to specify contracts.
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Money demand is determined by (a) businesses' and households' desire to hold wealth
in the form of readily-spendable purchasing power in order to carry out transactions,
and (b) businesses' and households' recognition that there is a cost to holding money-wealth in the form of readily-spendable purchasing power pays little or now interest.
The velocity of money is how many transactions a given piece of money manages to
facilitate in a year. The principal determinant of the velocity of money is the
economy's "transactions technology": the organization of its financial system.
The stock of money is determined by the central bank.
The price level is equal to the money stock times the velocity of money divided by
the level of real GDP.
The inflation rate is equal to the proportional growth rate of the money stock plus the
proportional growth rate of velocity minus the proportional growth rate of real GDP.
Governments cause hyperinflations because printing money is a way of taxing the
public, and a government that cannot tax any other way will be strongly tempted to
resort to it.
7.5.2 Important Concepts
Chapter 7
Medium of exchange
Classical dichotomy
Neutrality
Price level
Inflation
Hyperinflation
Money
Unit of account
Money stock
Central bank
Federal Reserve
Open market operations
Monetary policy
Cash
Checking account deposits
Savings account deposits
Monetary base
Reserve requirements
Reserve deposits
Illiquidity
Readily-spendable
Velocity
Quantity theory of money
Quantity equation
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Seigniorage
7.5.3 Analytical Exercises
1. Economists say that a government can raise real revenue--real power to buy goods and
services--through the "inflation tax." Who is it that pays this inflation tax? How is it that
the government collects it?
2. Milton Friedman would say that the German hyperinflation of 1923 ended because the
government and central bank stopped printing money and so stopped expanding the
money stock. Carlo Bresciani-Turroni would say that the German hyperinflation of 1923
ended because the government balanced its budget. Who is right?
3. Suppose that real GDP is $10,000 billion, the velocity of money is 5, and the money
stock is $2,500 billion. What is the price level?
4. Suppose that the rate of labor force growth is 1% per year, the rate of growth of the
efficiency of labor is 3% per year, the economy is on its steady-state growth path, and the
velocity of money is increasing at 1% per year. Suppose that the Chair of the Federal
Reserve calls you into his or her office and asks how fast money growth should be to
achieve a stable price level. What answer do you give?
5. Suppose that the rate of labor force growth is 3% per year but the efficiency of labor is
stable, and the economy is on its steady state growth path. Suppose also that the rate of
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growth of the nominal money stock is 10% per year. Do you think that it is likely that the
inflation rate is less than 5% per year? Why or why not?
6. What would the Federal Reserve have to do if it wanted to raise the monetary base
today by $10 billion? What do you guess would happen to the price of short-term
government bonds if the Federal Reserve did this?
7. Why might a country that recently underwent a hyperinflation decide that it should
dollarize--that is, abandon its own currency and use the U.S. dollar as its currency
instead.
8. Suppose that the economy is on its steady-state growth path, the rate of increase of the
labor force is 2% per year, the rate of increase of the efficiency of labor is 1% per year,
the velocity of money is rising at 2% per year, the rate of growth of the money stock is
10% per year, and the real interest rate is 4% per year. What is the nominal interest rate?
9. Do you think that unspent balances on credit cards--the difference between what you
currently owe on your credit card and the limit that the credit card company allows you-should be counted as "money"? Why or why not?
10. What arguments can you think of for why it would be good to have a single, global
currency? What arguments can you think of that would make nation-specific currencies a
good idea?
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7.5.4 Policy-Relevant Exercises [to be updated every year…]
1. In early September of 1998 the U.S. monetary base was $500 billion. Suppose that the
U.S. government decided to raise $250 billion in real purchasing power (in the dollars of
September 1998) from the inflation tax. What would happen to the price level?
2. In the third quarter of 1998 nominal GDP was $8,574 billion. The monetary base H
was $494 billion; M1 was $1,072 billion; M2 was $4,210 billion. Calculate the velocities
of the monetary base, of M1, and of M2.
3. Between 1990 and 1998 M1 increased from $826 billion to $1092 billion, while
nominal GDP increased from $5,744 billion to $8,507 billion. What was the average
annual rate of increase of the M1 money stock? What was the average annual rate of
increase of nominal GDP? What was the average annual rate of increase of M1 velocity?
4. Between 1980 and 1990 and 1998 M1 increased from $409 to $826 billion to $1092
billion; M2 rose from $1601 to $3280 to $4412 billion, and M3 rose from $1992 to
$4066 to $5983 billion, while nominal GDP rose from $2784 to $5744 to $8507 billion.
Calculate the average annual rates of increase of M1, M2, M3, and nominal GDP PxY
between 1980 and 1990, and between 1990 and 1998. Calculate the average annual rates
of increase of the velocity of M1, M2, and M3 between 1980 and 1990, and between
1990 and 1998. How constant do these velocity trends appear to be both across time and
across different measures of the money stock?
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5. Suppose that you were told that the rate of inflation was about to decline significantly
over the next decade. Would you expect the velocity of money to rise unusually fast,
behave normally, or fall over the course of that subsequent decade?