Money Growth & Inflation (Ch:17 P.O.M.E) : ECO 104 Faculty: Asif Chowdhury

Lecture 8
Money Growth & Inflation

(Ch:17; P.O.M.E)
ECO 104
Faculty: Asif Chowdhury
Inflation: Increase in the overall level of

prices. Measured by CPI, GDP Deflators &
other indexes.
Deflation: Decrease in the overall level of
prices.
Hyperinflation: an extraordinarily high rate
of inflation.
Through the Quantity Theory of Money
we can see how increase in money supply
can lead to inflation.
Recalling that people hold money to conduct

transactions, price level of goods & services
can be interpreted in terms of value of
money held by somebody. If price level is
represented by the GDP Deflator & denoted
as P then the quantity of goods & services
that can be bought with $1 will be expressed
as 1/P. This relationship shows that as price
level increases the value of money, in terms
of purchasing of goods & services decreases.
Money Supply, Money

Demand & Monetary
Equilibrium:
Money Supply is controlled by the CB & in this
analysis we shall take the money supply as
given. Money demand depend on a number of
factors,
one
of
the
most
important
determinant of money demand is the overall
price level. As price level rises people will
want to hold more money since the value of
money decreases in terms of purchasing of
goods & services. In the long run, the overall
price level adjust to bring the money demand
& money supply to equilibrium.
The
Money
Demand
curve
is
downward sloping because value of
money & price level are inversely
related, higher the price level, lower
the value of money, hence quantity
demand for money will go up.
The Money Supply Curve is vertical
because in this analysis the money
supply is taken as fixed by the CB.
Effects of changing the

Money Supply:
Any change in the money supply will
affect the price level. This linking between
money supply & price level is illustrated
through the Quantity Theory of Money
Quantity Theory of Money: The theory
asserting that the quantity of money
available determines the price level & that
the growth rate in the quantity of money
available determines the inflation rate.
If the CB increases the

Money Supply:
An increase in money supply will shift the money
supply curve to the right. At current price level people
will have more money at hand than before, they will
want to buy more goods & services in order to get rid
of the extra money stock. Since production of goods &
services doesnt change ( Y depends on other factors)
these leads to situation of excess demand for goods &
services over supply of goods & services & so price
level rise. The rise in price level raises the QD for
money stock since money has lower value now &
eventually the money demand & money supply move
to equilibrium at the new price level.(QD of money
equals QS of money.)
Classical Dichotomy &

Monetary Neutrality:
Nominal Variables: Variables measured in money
terms/monetary units ( e.g.. Nominal GDP)
Real Variable: Variables measured in Physical
units ( e.g. Real GDP)
Classical Dichotomy: the theoretical separation
of nominal & real variable.
o The fact that changes in money supply ( nominal
variable) leads to change in another nominal
variable ( price level) but doesnt affect output
( real variable) is what Classical Dichotomy
implies.
Another concept that's linked to the

Classical Dichotomy is known as the
Monetary Neutrality.
Monetary Neutrality: holds that
changes in money supply do not
affect real variables.
Velocity & The Quantity

Equation:
Another concept linked to the Quantity Theory
of Money is known as the Velocity of Money.
Velocity of Money: the rate at which money
changes hands.
Velocity of Money is expressed as:
V = (P X Y)/ M
V= Velocity of Money, P= GDP Deflator, Y= Real
GDP, M =Quantity of Money. In short Velocity of
Money equals Nominal GDP over money stock.
Rewriting the Velocity of Money equation:

MV = PY
This equation is known as the Quantity Equation
since it relates quantity of money to a nominal
variable like Nominal GDP.
V has seen to exhibit constant trend over time
Y ( Real GDP) is a function of other variables
( labor, capital, human capital etc.)
Thus holding V & Y constant we can see that
an increase in money stock M will lead o
increase in price level P
In other words the Quantity

Equation implies that if the CB
keeps on raising the level of money
stock ( growth in money stock) will
lead to raise in the price level
( Inflation). Thus Quantity Equation
ties up money stock with inflation.
Fisher Effect:
An application of Monetary Neutrality is the
impact of money on interest rate.
RIR = NIR- Inflation Rate

Rearranging the terms:
NIR = RIR + Inflation Rate
NIR = Nominal Interest Rate
RIR= Real interest Rate
o RIR is determined in the market for loanable funds,
where demand for loanable funds adjust with
supply of loanable funds at an equilibrium real
interest rate.
Thus holding RIR constant in the previous equation we

can see that rate of inflation has a direct one to one
effect on nominal interest rate. If inflation rate is on
the high NIR is also on the high & vice versa. This is
known as the Fisher Effect
Fisher Effect: the one for one adjustment of the
nominal interest rate to the inflation rate.
Fisher Effect is based on the long run time frame since
in the short run inflation rate is unknown so while
negotiating the nominal interest rate, the inflation rate
cant be predicted accurately & thus wont have the
same effect on NIR as laid down by the Fisher Effect.
Cost of Inflation:
o Shoe leather Cost: the resources wasted
when inflation causes people to reduce their
money holdings.
o Menu Cost: The cost of changing price
o Relative Price Variability & Misallocation of
Resources: If one product price is adjusted
at a different time compared to another
product/s then there will be variation in the
relative price & cause misallocation of
resources.
o Inflation Induced Tax Distortions: has

implication for savings; in terms of
savings in the form of financial assets
( corporate stock) & savings in the form of
bank deposits. Tax are based on nominal
capital gains or nominal interest income &
this tends to discourage savings. This has
farther implication for the economys
productivity
since
lower
savings
eventually leads to lower investment.
Confusion
&
Inconvenience:
With
prevailing inflation money loses its value
in terms of purchasing power & people
tend to lose confidence on money as an
Unit of Account. Also, while computing
corporate profits, accountants focus on
nominal profit rather than real profit, this
cause confusion among investors to
differentiate properly between successful
& unsuccessful firms.
Arbitrary Redistribution of
Wealth:
Unexpected
inflation
makes
borrowers well off at the expense of
the lenders since the returned
amount is lesser in terms of real
value. The opposite happens in case
of disinflation.

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Lecture 8

Money Growth & Inflation

Inflation: Increase in the overall level of

Recalling that people hold money to conduct

Money Supply, Money

Effects of changing the

If the CB increases the

Classical Dichotomy &

Another concept that's linked to the

Velocity & The Quantity

Rewriting the Velocity of Money equation:

In other words the Quantity

RIR = NIR- Inflation Rate

Thus holding RIR constant in the previous equation we

o Inflation Induced Tax Distortions: has

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