5

Inflation: Its Causes, Effects, and

Social Costs

MACROECONOMICS
N. Gregory Mankiw
PowerPoint ® Slides by Ron Cronovich
© 2013 Worth Publishers, all rights reserved
 IN THIS CHAPTER, YOU WILL LEARN:

 The classical theory of inflation

 causes
 effects
 social costs
 “Classical” – assumes prices are flexible &
markets clear
 Applies to the long run

1
 U.S. inflation and its trend,
1960–2012
12%

% change in
% change from 12 mos. earlier

10%
GDP deflator
8%

6%

4%

2%

0%
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
 U.S. inflation and its trend,
1960–2012
12%
% change from 12 mos. earlier

10%

8%

long-run trend
6%

4%

2%

0%
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
 Key Concepts
 Inflation
 Price Index (Level)
 Deflation
 Disinflation
 Hyperinflation
 Price Level vs. Inflation Rate

CHAPTER 5 Inflation 4
Why is it Important to Study Inflation?
 People dislike it
 Impacts political races
 The Fed directs policymaking at controlling
inflation
 Policymakers watch it carefully

CHAPTER 5 Inflation 5
 The quantity theory of money
 A simple theory linking the inflation rate to the
growth rate of the money supply.
 Begins with the concept of velocity…

CHAPTER 5 Inflation 6
 Velocity
 basic concept:
the rate at which money circulates
 definition: the number of times the average
dollar bill changes hands in a given time period
 example: In 2012,
 $500 billion in transactions
 money supply = $100 billion
 The average dollar is used in five transactions
in 2012
 So, velocity = 5
CHAPTER 5 Inflation 7
 Transactions Velocity of Money
 This suggests the following definition:
PT
V
M
where
V = velocity
PT = value of all transactions
M = money supply

CHAPTER 5 Inflation 8
 Income Velocity of Money
 Use nominal GDP as a proxy for total
transactions.
Then, P Y
V
M
where
P = price of output (GDP deflator)
Y = quantity of output (real GDP)
P  Y = value of output (nominal GDP)

CHAPTER 5 Inflation 9
 The Quantity Equation
 The quantity equation
MV = PY
follows from the preceding definition of velocity.
 It is an identity:
it holds by definition of the variables.
 Useful because it shows if one of the variables
changes, one or more of the other variables
must change to maintain the equality.

CHAPTER 5 Inflation 10
 Money Demand & the Quantity Equation

 M/P = real money balances, the purchasing

power of the money supply; quantity of goods &
services that can be bought.
 A simple money demand function:
(M/P )d = kY
where
k = how much money people wish to hold for
each dollar of income.
(k is a constant & exogenous)

CHAPTER 5 Inflation 11
 Money Demand & the Quantity Equation

 money demand: (M/P )d = kY

 quantity equation: M  V = P  Y
 The connection between them: k = 1/V
 When people hold lots of money relative
to their incomes (k is large),
money changes hands infrequently (V is small).

CHAPTER 5 Inflation 12
 Back to the quantity theory of money

 starts with quantity equation

 assumes V is constant & exogenous: V  V
Then, quantity equation becomes:

M V  P Y

CHAPTER 5 Inflation 13
Nominal GDP, the Quantity of Money, and the Velocity of Money

CHAPTER 5 Inflation 14
14
 The quantity theory of money, cont.
M V  P Y
How the price level is determined:
 With V constant, the money supply determines
nominal GDP (P  Y ).
 Real GDP is determined by the economy’s
supplies of K and L and the production
function (Chap. 3).
 The price level is
P = (nominal GDP)/(real GDP).
CHAPTER 5 Inflation 15
 The quantity theory of money, cont.

 Recall from Chapter 2:

The growth rate of a product equals
the sum of the growth rates.
 The quantity equation in growth rates:
M V P Y
  
M V P Y

The quantity theory of money assumes

V
V is constant, so = 0.
V
CHAPTER 5 Inflation 16
 The quantity theory of money, cont.

 (Greek letter pi ) P
denotes the inflation rate:  
P
The result from the M P Y
 
preceding slide: M P Y

Solve this result M Y

for :   
M Y

CHAPTER 5 Inflation 17
 The quantity theory of money, cont.
M Y
  
M Y

 Normal economic growth requires a certain

amount of money supply growth to facilitate the
growth in transactions.
 Money growth in excess of this amount leads
to inflation.

CHAPTER 5 Inflation 18
 The quantity theory of money, cont.
M Y
  
M Y

Y/Y depends on growth in the factors of

production and on technological progress
(all of which we take as given, for now).

Hence, the quantity theory predicts

a one-for-one relation between
changes in the money growth rate and
changes in the inflation rate.
CHAPTER 5 Inflation 19
 Confronting the quantity theory with
data
The quantity theory of money implies:
1. Countries with higher money growth rates
should have higher inflation rates.
2. The long-run trend in a country’s inflation rate
should be similar to the long-run trend in the
country’s money growth rate.
Are the data consistent with these implications?

CHAPTER 5 Inflation 20
 1. International data on inflation and
money growth
40
Belarus
35
30
Zambia
Inflation rate

25 Iraq
Turkey
(percent)

Serbia
20 Suriname
Mexico
15
U.S. Russia
10 Malta
5
0
Cyprus China
-5
-10 0 10 20 30 40 50
Money supply growth
(percent)
 2. U.S. inflation and money growth,
1960–2012 (short-run)
14%

M2 growth rate
12%
% change from 12 mos. earlier

10%

8%

6%

4%

2%
inflation
rate
0%
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
 2. U.S. inflation and money growth,
1960–2012 (long-run trend)
14% Inflation and money growth
have the same long-run trends,
12%
% change from 12 mos. earlier

as the quantity theory predicts.

10%

8%

6%

4%

2%

0%
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
 Seigniorage
 To spend more without raising taxes or selling
bonds, the gov’t can print money.
 The “revenue” raised from
printing money is called
seigniorage
(pronounced SEEN-your-idge).
 The inflation tax:
Printing money to raise revenue causes inflation.
Inflation is like a tax on people who hold money.

CHAPTER 5 Inflation 24
 Inflation and interest rates
 Nominal interest rate, i
not adjusted for inflation
 Real interest rate, r
adjusted for inflation:
r = i 

CHAPTER 5 Inflation 25
 The Fisher Effect
 The Fisher equation: i = r + 
 Chap. 3: S = I
determines r.

 Hence, an increase in  causes an equal increase

in i.
 This one-for-one relationship is called the Fisher
effect.
CHAPTER 5 Inflation 26
U.S. inflation and nominal interest rates,
1960–2012
18%

14% nominal
interest rate
10%

6%

2%

inflation rate
-2%
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
 Inflation and nominal interest rates
in 96 countries
40
Nominal Turkey
interest rate 35
(percent) 30
Georgia Malawi
25
Ghana
Mexico
20
Brazil
15
Poland
10 Iraq
U.S.
5
Japan Kazakhstan
0
-5 0 5 10 15 20 25
Inflation rate
(percent)
 Combining the Quantity Theory of
Money & the Fisher Effect
 The quantity theory of money shows how money
supply growth results in inflation (%ΔM = %ΔP).
 The Fisher Effect shows how inflation leads to
higher nominal interest rates (i = r + π).
 Thus, together the Quantity Theory of Money
and the Fisher Effect tells us how money supply
growth affects nominal interest rates.
 QTM: 1%↑M → 1% π
 FE: 1% π → 1% i

CHAPTER 5 Inflation 29
NOW YOU TRY
Applying the theory
Suppose V is constant, M is growing 5% per year,
Y is growing 2% per year, and r = 4.
a. Solve for i.
b. If the Fed increases the money growth rate by
2 percentage points per year, find i.
c. Suppose the growth rate of Y falls to 1% per
year.
 What will happen to  ?
 What must the Fed do if it wishes to
keep  constant?
30
ANSWERS
Applying the theory
V is constant, M grows 5% per year,
Y grows 2% per year, r = 4.
a. First, find  = 5  2 = 3.
Then, find i = r +  = 4 + 3 = 7.
b. i = 2, same as the increase in the money
growth rate.
c. If the Fed does nothing,  = 1.
To prevent inflation from rising,
Fed must reduce the money growth rate by
1 percentage point per year. 31
 Two real interest rates
Notation:
  = actual inflation rate
(not known until after it has occurred)
 E = expected inflation rate
Two real interest rates:
 i – E = ex ante real interest rate:
the real interest rate people expect
at the time they buy a bond or take out a loan; will
impact the Fisher Effect.
 i –  = ex post real interest rate:
the real interest rate actually realized
CHAPTER 5 Inflation 32
 Money demand and
the nominal interest rate
 In the quantity theory of money,
the demand for real money balances
depends only on real income Y.
 Another determinant of money demand:
the nominal interest rate, i.
 the opportunity cost of holding money (instead
of bonds or other interest-earning assets).
 Hence, i   in money demand.

CHAPTER 5 Inflation 33
 The money demand function
(M P )  L (i , Y )
d
- +
(M/P)d = real money demand, depends
 negatively on i
i is the opportunity cost of holding money
 positively on Y
higher Y  more spending
 so, need more money
(“L” is used for the money demand function
because money is the most liquid asset.)
CHAPTER 5 Inflation 34
 The money demand function
(M P )  L (i , Y )
d

 L (r  E  , Y )
- +
When people are deciding whether to hold
money or bonds, they don’t know what inflation
will turn out to be.
Hence, the nominal interest rate relevant for
money demand is r + E.

CHAPTER 5 Inflation 35
 Equilibrium

Let supply = demand:

d
M M 
  
P P 
M
 L (r  E  , Y )
P
The supply of real
money balances Real money
demand

CHAPTER 5 Inflation 36
 What determines what
M
 L (r  E  , Y )
P
variable how determined (in the long run)
M exogenous (the Fed)
r adjusts to ensure S = I
Y Y  F (K , L )
M
P adjusts to ensure  L (i , Y )
P

CHAPTER 5 Inflation 37
 How P responds to M
M
 L (r  E  , Y )
P
 For given values of r, Y, and E ,
a change in M causes P to change by the
same percentage—just like in the quantity
theory of money.

CHAPTER 5 Inflation 38
 What about expected inflation?
 Over the long run, people don’t consistently
over- or under-forecast inflation,
so E =  on average.
 In the short run, E may change when people
get new information.
 EX: Fed announces it will increase M next year.
People will expect next year’s P to be higher,
so E rises.
 This affects P now, even though M hasn’t
changed yet….
CHAPTER 5 Inflation 39
 How P responds to E
M
 L (r  E  , Y )
P
 For given values of r, Y, and M ,
 E    i (the Fisher effect)
  M P 
d

  P to make M P  fall
to re-establish equilibrium

CHAPTER 5 Inflation 40
NOW YOU TRY
Discussion question
Why is inflation bad?
 What costs does inflation impose on society?
List all the ones you can think of.
 Focus on the long run.
 Think like an economist.

41
 A common misperception
 Common misperception:
inflation reduces real wages
 This is true only in the short run, when nominal
wages are fixed by contracts.
 (Chap. 3) In the long run,
the real wage is determined by
labor supply and the marginal product of labor,
not the price level or inflation rate.
 Consider the data…
CHAPTER 5 Inflation 42
 The CPI and Average Hourly Earnings,
1965–2012
900
Real average hourly earnings

Hourly wage in May 2012 dollars

800 in 2012 dollars, right scale $20

700

600 $15
1965 = 100

500

400 $10
Nominal average
300 hourly earnings,
(1965 = 100)
200 $5

100 CPI (1965 = 100)

0 $0
1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
 The classical view of inflation

 The classical view:

A change in the price level is merely a change
in the units of measurement.

Then, why is inflation

a social problem?

CHAPTER 5 Inflation 44
 The social costs of inflation

…fall into two categories:

1. costs when inflation is expected

2. costs when inflation is different than

people had expected

CHAPTER 5 Inflation 45
 The costs of expected inflation:
1. Shoeleather cost

 def: the costs and inconveniences of reducing

money balances to avoid the inflation tax.
   i
  real money balances
 Remember: In long run, inflation does not
affect real income or real spending.
 So, same monthly spending but lower average
money holdings means more frequent trips to
the bank to withdraw smaller amounts of cash.
CHAPTER 5 Inflation 46
 The costs of expected inflation:
2. Menu costs

 def: The costs of changing prices.

 Examples:
 cost of printing new menus
 cost of printing & mailing new catalogs
 The higher is inflation, the more frequently
firms must change their prices and incur
these costs.

CHAPTER 5 Inflation 47
 The costs of expected inflation:
3. Relative price distortions

 Firms facing menu costs change prices infrequently.

 Example:
A firm issues new catalog each January.
As the general price level rises throughout the year,
the firm’s relative price will fall.
 Different firms change their prices at different times,
leading to relative price distortions…
…causing microeconomic inefficiencies
in the allocation of resources.

CHAPTER 5 Inflation 48
 The costs of expected inflation:
4. Unfair tax treatment
Some taxes are not adjusted to account for
inflation, such as the capital gains tax.
Example:
 Jan 1: you buy $10,000 worth of IBM stock
 Dec 31: you sell the stock for $11,000,
so your nominal capital gain is $1,000 (10%).
 Suppose  = 10% during the year.
Your real capital gain is $0.
 But the government requires you to pay taxes
on your $1,000 nominal gain!!
CHAPTER 5 Inflation 49
 The costs of expected inflation:
5. General inconvenience

 Inflation makes it harder to compare nominal

values from different time periods.
 This complicates long-range financial
planning.

CHAPTER 5 Inflation 50
 Additional cost of unexpected inflation:
Arbitrary redistribution of purchasing power
 Many long-term contracts not indexed,
but based on E .
 If  turns out different from E ,
then some gain at others’ expense.
Example: borrowers & lenders
 If  > E , then (i  ) > (i  E )
and purchasing power is transferred from lenders
to borrowers (loan based on E at time of
contract).
 If  < E , then purchasing power is transferred
from borrowers to lenders.
CHAPTER 5 Inflation 51
 Additional cost of high inflation:
Increased uncertainty
 When inflation is high, it’s more variable and
unpredictable:
 turns out different from E more often,
and the differences tend to be larger
(though not systematically positive or negative)

 So, arbitrary redistributions of wealth more

likely.
 This creates higher uncertainty,
making risk-averse people worse off.

CHAPTER 5 Inflation 52
 One benefit of inflation
 Nominal wages are rarely reduced, even when
the equilibrium real wage falls.
This hinders labor market clearing.
 Inflation allows the real wages to reach
equilibrium levels without nominal wage cuts.
 Therefore, moderate inflation improves the
functioning of labor markets.

CHAPTER 5 Inflation 53
 Hyperinflation

 Common definition:   50% per month

 All the costs of moderate inflation described
above become HUGE under hyperinflation.

 Money ceases to function as a store of value,

and may not serve its other functions (unit of
account, medium of exchange).
 People may conduct transactions with barter
or a stable foreign currency.
CHAPTER 5 Inflation 54
 What causes hyperinflation?
 Hyperinflation is caused by excessive money
supply growth:
 When the central bank prints money, the price
level rises.
 If it prints money rapidly enough, the result is
hyperinflation.

CHAPTER 5 Inflation 55
A few examples of hyperinflation
CPI Inflation M2 Growth
country period
% per year % per year
Israel 1983-85 338% 305%
Brazil 1987-94 1,256 1,451
Bolivia 1983-86 1,818 1,727
Ukraine 1992-94 2,089 1,029
Argentina 1988-90 2,671 1,583
Dem. Republic
1990-96 3,039 2,373
of Congo / Zaire
Angola 1995-96 4,145 4,106
Peru 1988-90 5,050 3,517
Zimbabwe 2005-07 5,316 9,914
 Why governments create hyperinflation
 When a government cannot raise taxes or sell
bonds, it must finance spending increases by
printing money.
 In theory, the solution to hyperinflation is simple:
stop printing money.
 In the real world, this requires drastic and painful
fiscal restraint.

CHAPTER 5 Inflation 57
 The Classical Dichotomy
Real variables: Measured in physical units –
quantities and relative prices, for example:
 quantity
Nominal of outputMeasured
variables: produced in money units, e.g.,
nominal
real wage:
wage:output earned
Dollars per per
hourhour of work
of work.
nominal
real interest rate:
interest output
rate: earned
Dollars in the
earned in future
future
bylending
by lendingoneonedollar
unit oftoday.
output today
 the price level: The amount of dollars needed
to buy a representative basket of goods.

CHAPTER 5 Inflation 58
 The Classical Dichotomy
 Note: Real variables were explained in Chap. 3,
nominal ones in Chap. 5.
 Classical dichotomy:
the theoretical separation of real and nominal
variables in the classical model, which implies
nominal variables do not affect real variables.
 Neutrality of money: Changes in the money
supply do not affect real variables.
In the real world, money is approximately neutral
in the long run.
CHAPTER 5 Inflation 59
 CHAPTER SUMMARY

 Velocity: the ratio of nominal expenditure to

money supply, the rate at which money changes
hands
 Quantity theory of money
 assumes velocity is constant
 concludes that the money growth rate determines
the inflation rate
 applies in the long run
 consistent with cross-country and time-series
data

60
 CHAPTER SUMMARY

 Nominal interest rate

 equals real interest rate + inflation rate
 the opp. cost of holding money
 Fisher effect: Nominal interest rate moves
one-for-one with expected inflation.
 Money demand
 depends only on income in the quantity theory
 also depends on the nominal interest rate
 if so, then changes in expected inflation affect the
current price level.
61
 CHAPTER SUMMARY

Costs of inflation
 Expected inflation
shoeleather costs, menu costs,
tax & relative price distortions,
inconvenience of correcting figures for inflation
 Unexpected inflation
all of the above plus arbitrary redistributions of
wealth between debtors and creditors

62
 CHAPTER SUMMARY

Hyperinflation
 caused by rapid money supply growth when
money printed to finance govt budget deficits
 stopping it requires fiscal reforms to eliminate
govt’s need for printing money

63
 CHAPTER SUMMARY

Classical dichotomy
 In classical theory, money is neutral—does not
affect real variables.
 So, we can study how real variables are
determined w/o reference to nominal ones.
 Then, money market eq’m determines price level
and all nominal variables.
 Most economists believe the economy works this
way in the long run.

64