Week 7

Inflation
8.1 Introduction
This week, we learn
• what inflation is, and how costly it can be.
• how the quantity theory of money and the classical dichotomy
help us understand inflation.
• the relationship of interest rates and inflation through the Fisher
equation.
• the important link between fiscal policy and high inflation.
Inflation—1
Inflation
• Percentage change in the overall price level
Hyperinflation
• Episode of extremely high inflation
• Greater than 500 percent per year
oIn November 1919 a loaf of bread cost about a quarter of
a mark in Germany
oIn November 1923 the same loaf of bread cost 80 billion
marks
Inflation—2
Inflation rate: annual percentage change in the price level

where 𝑃𝑡 is the price level in year t

The Consumer Price Index (CPI)
• Price index for a bundle of consumer goods
Inflation Rate in the United States
Inflation Rate in the United Kingdom
Case Study: How Much Is That?—1
We can use the CPI to evaluate the value of a good in
1950 in today’s dollars.
Case Study: How Much Is That?—2
Find the price of the good in 1950 in 2018 dollars.
• A gallon of gasoline cost 27 cents in 1950, and $2.50 in 2018.
100 in 2018 dollars
0.27 in 1950 dollars × = 2.82 in 2018 dollars
9.59 in 1950 dollars
CPI in 2018/CPI in 1950

Real difference is not as large as the nominal.

Other price indexes
• The CPI excluding food and energy prices
• The GDP deflator
 Case Study: How Much Is That?—3

Highest-grossing films
Current $ 2020 $
World World
wide wide
Title Year Title Year
Gross Gross
2020 $
1 Avatar $2,844 M 2009 1 Gone with the Wind $3,739 M 1939
2 Avengers: Endgame $2,798 M 2019 2 Avatar $3,286 M 2009
3 Titanic $2,194 M 1997 3 Titanic $3,108 M 1997
4 Star Wars: The Force Awakens $2,068 M 2015 4 Star Wars: A New Hope $3,071 M 1977
5 Avengers: Infinity War $2,048 M 2018 5 Avengers: Endgame $2,823 M 2019
8.2 The Quantity Theory of Money
We often think of money as paper currency.
Historically:
• Money was backed by gold.
Today:
• Currency is “fiat money.”
• Paper that the government declares worth a certain price.
• Money has value because of social convention.
300 years of inflation
Measures of the Money Supply—1
The monetary base includes currency and accounts (reserves).

Banks hold accounts with the economy’s central bank.

Banks ensure that they have cash on hand in case of withdrawals.
Measures of the Money Supply—2
Measures of the Money Supply—3

Monetary Aggregates as Defined by the Bank of England

M0 Currency + banks operational balances at the BoE

+Banks' retail deposits
+Building societies' shares and deposits
+Other interest-bearing bank deposits
M4 +Other building society deposits (including CDs)
Case Study: Digital Cash
Electronic forms of currency
• Debit cards, PayPal, travelers’ checks, Venmo etc.
• Makes up most money in advanced economies
• Cryptocurrencies
Case Study: Cryptocurrencies - 1

Market
capitalization
tops 3 trillion $
in Nov. 2021
Case Study: Cryptocurrencies - 2
Case Study: Cryptocurrencies - 3

Cryptocurrencies constitute a relatively small fraction of the world’s

financial assets.

Cryptocurrencies 2 trillion market capitalization is about

• 2% of world’s broad money supply
• 2% of the value of the world’s stocks
• 0.3% of the world’s derivate market

It is increasing relative to other markets

The Quantity Equation
Connects money and inflation
Velocity of money
• The average number of times per year that each piece of paper
currency is used in a transaction
The amount of money used in purchases is equal to nominal GDP.

Money Velocity Price Real

supply of money level GDP
The Classical Dichotomy and Constant Velocity—1
The classical dichotomy:
• In the long run, the real and nominal sides of the economy are
completely separate.
In the quantity theory of money:
• Real GDP is assumed as exogenously given.
• Determined by real forces (see previous weeks materials)
In other words:
The Classical Dichotomy and Constant Velocity—2
The velocity of money:
• Exogenously given constant
• Assumed to be constant over time

The money supply:

• Determined by the central bank
• Monetary policy is exogenously given.
The Quantity Theory of Money
The Quantity Theory for the Price Level
To solve the model
• Plug in all the exogenous variables.
• Solve for the price level.

Prices will rise as a result of

• Increases in the money supply
• Decreases in real GDP
In the long run, the key determinant of the price level
is the money supply.
The Quantity Theory for Inflation—1
We can express the quantity equation in terms of growth rates.

We assume and
The Quantity Theory for Inflation—2
Quantity Theory of Money:
• The growth rate of real GDP is some constant determined in the
long-run growth model.
• Changes in the growth rate of money lead to one-for-one to
changes in the inflation rate.
Deflation:
• Occurs when inflation rates are negative

• Empirically, this holds up both in U.S. and worldwide data.

Money Growth and Inflation in the United States, 1870–2012
Money Growth and Inflation around the World, 1990–2017
Revisiting the Classical Dichotomy—1
When all prices in the economy double, relative prices are unchanged.

When the relative prices of goods are unchanged, nothing real is affected.

This is known as the “neutrality of money.”

Revisiting the Classical Dichotomy—2
The neutrality of money says that changes in the money supply
• have no real effects on the economy.
• affect only prices.
Empirically
• Holds in the long run
• Does not hold in the short run
• Nominal prices do not respond immediately to changes in the
money supply.
8.3 Real and Nominal Interest Rates
The real interest rate
• is equal to the marginal product of capital. r=MPK

• is paid in goods.
The nominal interest rate
• is the interest rate on a savings account.
• is paid in dollars.
The Fisher Equation—1
The Fisher equation

where
• 𝑖: nominal interest rate
• 𝑅: real interest rate
• 𝜋: inflation rate
The nominal interest rate is generally high when inflation is high.
The Fisher Equation—2
If then

Empirically
• The real interest rate has been negative.
• This implies that in the short run the real interest rate need not
equal the MPK.
Real and Nominal Interest Rates in the United States, 1960–2021
Real and Nominal Interest Rates in the United Kingdom, 1960–2021
8.4 Costs of Inflation
Individuals who are hurt during inflation:
• An individual who has a pension that is not indexed
to inflation
• A bank that issues loans at fixed rates but that pays
interest rates that move with the market
• An individual with a variable rate mortgage
Costs of Inflation—1
Large surprise inflations can lead to large distributions
in wealth.
• People with debts can pay back their loans with new
cheaper dollars.
• Creditors wind up losers.
Costs of Inflation—2
Taxes
• Based on nominal incomes
Economic decisions
• Based on real variables
Tax distortions are more severe when inflation is high.
Costs of Inflation—3
Inflation also distorts relative prices.
• Some prices are faster at adjusting to inflation than other prices.
Shoe leather costs of inflation
• People want to hold less money when inflation is high.
Menu costs
• The costs to firms of changing prices frequently
Case Study: The Wage-Price Spiral
Higher firm
costs

Unions Firms
negotiate increase
higher w prices

Unions
Inflation demand
higher w

President Nixon’s Price Controls

• Froze wages and prices for 90 days to break the spiral—temporary success
• But high unemployment prompted an expansionary policy that brought the
return of inflation.
8.5 The Fiscal Causes of High Inflation
The government budget constraint

Government Tax revenue Borrowing Changes in

funds the stock of
money
The Inflation Tax—1
Seigniorage and the inflation tax
• Names for the revenue that the government obtains
from printing more money (ΔM)
The inflation tax
• Shows up as a rise in the price level
• Is paid by people holding currency
The Inflation Tax—2
If a government runs large budget deficits, as debt rises,
• lenders may worry the government will have trouble paying back
loans.
• they may stop lending to the government altogether.
Debt solution: Raising taxes?
• May not be politically feasible
The government may resort to printing currency to finance its budget.
• Lenders to the government will be paid back in currency that is
worth less than the dollars lent.
Central Bank Independence
Monetary policy
• Conducted by central banks
• Federal Reserve (USA), Bank of England (UK), ECB (euro zone)
Fiscal policy
• Government
• President and Congress (USA)
Central bank independence
• An attempt to prevent fiscal considerations from leading to
excessive inflation
• Bank of England is operationally independent since May 1997.
Case Study: Episodes of High Inflation—1
Episodes of high inflation tend to recur.
Hyperinflation can stop just as quickly as it starts.
Countries experiencing hyperinflation typically raise about 5
percent of GDP from the inflation tax.
• Argentina raised 10 percent of GDP this way.
• Significant when total government spending as a ratio of GDP is
about 20 or 30 percent.
Hyperinflations in Argentina, Brazil, and Russia
High Inflation in Mexico, Nigeria, and Venezuela
Case Study: Episodes of High Inflation—2
Hyperinflation
• Ends when the rate of money growth falls rapidly.
• The government gets its finances in order through lower
spending, higher taxes, and new loans.
The coordination problem
• People build their expectations into the prices they set.
• Credibility of the government is important to solve the
coordination problem
8.6 The Great Inflation of the 1970s
During the Great Inflation,
• the rate peaked below 15 percent.
• the inflation tax was a small fraction of government spending.
Inflation rose in the 1970s because
• OPEC coordinated increases in oil prices.
• the Fed increased the money supply too rapidly.
• policymakers were concerned about the productivity slowdown.
Inflation Rate in the United States
Oil prices
8.7 The Near Future of Inflation
Several observers worry about higher inflation in the aftermath of
pandemic
• Unprecedented money supply growth
• Unprecedented fiscal stimulus potentially signaling higher money
supply growth.
 8.7 The Near Future of Inflation - 1
Inflation and growth rate of the money supply, M2 in the United States (1868-2021)
8.7 The Near Future of Inflation - 2