Macroeconomics
Lecture 6
.
Money Growth &
Inflation
Chapter 28
.
In this chapter, you will study:
The definition and measures of inflation
Two types of inflation.
The causes of inflation and the quantity
theory of money.
The relationship between inflation and
interest rates.
The costs of inflation.
.
Inflation
Inflation
An increase in the overall level of prices in
the economy
Inflation rate
The percentage change in the price level
from the previous period
.
Inflation & Its Historical Aspects
Inflation
Deflation
A decrease in the overall level of prices in the
economy (the U.S. 1818-1821)
Disinflation
A reduction in the rate of inflation (Vietnam
2011-2013)
Hyperinflation
An extraordinary high rate of inflation
(Germany after World War I)
.
Hyperinflation in Venezuela
Replacing toilet paper with
cash would seem an
extremely affluent action in
most countries. But in
Venezuela, it's now the
financially prudent thing to
do.
.
Types of Inflation
Demand-pull inflation
Cost-push inflation
.
Demand-Pull Inflation
Occurs when Aggregate Demand grows up
quickly and runs ahead of Aggregate Supply
for goods and services
Supply cannot increase accordingly because
it is constrained by factor supplies (labor,
technology, natural resources and capital)
Excess demand enables suppliers to increase
the prices of their limited products
.
Demand-Pull Inflation
.
Cost-push Inflation
Occurs when there is a rise in production
costs (wage and salary, raw material and
components, government taxes, ect)
Profit margin decrease: a rationale for
reducing supply (the law of diminishing
marginal returns)
Suppliers increase prices to compensate
partly for deacrease in profit margin,
passing a part of their loss on to consumers
.
Cost-push Inflation
.
The level of prices and the
value of money
Price level (P): number of dollars needed
to buy a basket of goods and services
Value of money (1/P): number of goods
and services bought by each dollar
=> P => 1/P
=> When the price level rises, the value of
money falls.
.
Money Supply, Money Demand,
and Monetary Equilibrium
Money Supply (MS)
• Determined by the Central Bank and the
banking system
• Assumptions: The quantity of money
supplied is a policy variable that the
Central Bank controls directly and
completely
.
Money Supply, Money Demand,
and Monetary Equilibrium
Money Demand (MD)
Determined by many factors: the level of
reliability on credit cards, whether an
ATM is easy to find, the interest rate, the
overall price level in the economy
In the long-run, the overall price level
turns out to be the most important
determinants
.
Money Supply, Money Demand,
and Monetary Equilibrium
Monetary Equilibrium: The point at
which the quantity of money demanded
balances the quantity of money supplied
.
Money Supply, Money Demand, and
the Equilibrium Price Level
Value of Price
Money (1/P) Money supply
Level (P)
(High) 1 1 (Low)
3/4 1.33
value of money
price level
Equilibrium
1/2 2
Equilibrium
1/4 4
Money
demand
(Low) 0 (High)
Quantity fixed Quantity of
by the Central Bank Money
.
The Effects of Monetary Injection
Value of Price
Money (1/P) MS1 MS2
Level (P)
(High) 1 1. An increase 1 (Low)
in the money
supply...
3/4 1.33
2. ...decreases the
value of money ...
3. …and
increases the
price level
A
1/2 2
B
1/4 4
Money
demand
(Low) 0 (High)
M1 M2 Quantity of
Money
.
The Quantity Theory of Money
Quantity theory of money: explains how
the price level is determined and why it
might change over time
The quantity of money available in the
economy determines the price level.
The primary cause of inflation is the growth
in the quantity of money.
.
Classical Dichotomy and
Monetary Neutrality
Classical Dichotomy: the separation of
economic variables into two groups:
• Nominal variables: variables measured in
monetary units
• Real variables: measured in physical units
Monetary neutrality: changes in the
money supply affect nominal variables but
not real variables.
.
Velocity and the Quantity Equation
Velocity of money: the speed at which the typical
dollar bill travels around the economy from wallet
to wallet.
MxV=PxY
Where: V = velocity
P = the price level
Y = the quantity of output
M = the quantity of money
· P x Y = nominal value of output
.
The Quantity Theory of Money
M = (P x Y)/V
Anincrease in the quantity of money (M)
Changes in other three variables
.
Quantity of Money and the
Indexes
(1960 = 100)
Velocity of Money in USA
1,500
Nominal GDP
M2
1,000
500
Velocity
0
1960 1965 1970 1975 1980 1985 1990 1995 2000
.
The Quantity Theory of Money
• V: relatively stable.
• M (P x Y).
• Money is neutral does not affect Y
• M P
=> Rapid increase in money supply causes
high inflation rate
.
Case Study: Money and prices
during four hyperinflations
(a) Austria (b) Hungary
Index Index
(Jan. 1921 = 100) (July 1921 = 100)
100,000 100,000
Price level
Price level
10,000 10,000
Money supply
Money supply
1,000 1,000
100 100
1921 1922 1923 1924 1925 1921 1922 1923 1924 1925
. Copyright © 2004 South-Western
Case Study: Money and prices
during four hyperinflations
(c) Germany (d) Poland
Index Index
(Jan. 1921 = 100) (Jan. 1921 = 100)
100,000,000,000,000 10,000,000
Price level
1,000,000,000,000 Price level
Money 1,000,000
10,000,000,000
100,000,000 supply 100,000 Money
1,000,000 supply
10,000
10,000
100 1,000
1 100
1921 1922 1923 1924 1925 1921 1922 1923 1924 1925
. Copyright © 2004 South-Western
The inflation tax
Inflation tax: The revenue the
government raises by printing money
An inflation tax is like a tax on everyone
who holds money.
Most hyperinflations originated from
government’s high spending
Inflation ends when the government
institutes fiscal reforms such as cuts in
government spending.
.
The Fisher Effect
Fisher effect: when the rate of inflation
rises, the nominal interest rate rises by
the same amount and the real interest
rate stays the same.
Nominal Interest Rate = Real
Interest Rate + Inflation
.
Discussion
Techcombank doubles the deposit
interest rate from 7% to 14% per year
Meanwhile, the inflation rate rockets
from 3% to 20%
Should you put your money at the bank?
If not, what would you do instead?
.
The nominal interest rate
and the inflation rate
.
The Costs of Inflation:
A Fall in Purchasing Power?
Increasing overall price level erodes the
value of money.
People earn income by selling their services
• Pay more for what they buy.
• Get more for what they sell.
=> Nominal income tends to keep pace
with rising prices.
=> Inflation does not itself reduce people’s
real purchasing power.
.
The Costs of Inflation
Shoeleather costs
Menu costs
Relative price variability and the
misallocation of resources
Inflation-induced tax distortions
Confusion and inconvenience
Arbitrary redistribution of wealth – a
special cost of unexpected inflation
Self-study
.
Shoeleather Costs
The resources wasted when
inflation encourages people
to reduce their money holdings.
.
Shoeleather Costs
Inflation erodes the real value of money
People try to minimize their cash
holdings More frequent trips to the
bank to withdraw money from interest-
bearing accounts.
Costs of reducing money holdings:
time and convenience sacrificed to keep less
money on hand.
less productive activities.
.
Menu Costs
Menu costs: costs of price adjustment
(Eg: the cost of deciding on and printing
new price lists and catalogs)
Inflation increases menu costs as firms
must change their price more frequently
to keep up with other prices in the
economy => a resource-consuming
process that takes away from other
productive activities.
.
Relative-Price Variability and
the Misallocation of Resources
Relative price: the price of one good
compared to the price of others in the
economy
Inflation distorts relative prices
Distort consumer decisions
less able for markets to allocate
resources to their best use.
.
Inflation-Induced Tax Distortion
Inflation blows up the size of capital
gains
Tax law does not take account of
inflation and compute income tax
based on nominal income
=> Increase the tax burden on capital
gains
.
Inflation-Induced Tax Distortion
The income tax treats the nominal
interest earned on savings as income.
Part of the nominal interest rate merely
compensates for inflation.
=>The after-tax real interest rate is
reduced, making saving less attractive,
depressing economic growth in the long-
run
.
How Inflation Raises the Tax
Burden On Saving
Economy 1 Economy 2
(price stability) (inflation)
Real interest rate 4% 4%
Inflation rate 0 8
Nominal interest rate 4 12
(Real interest rate + inflation rate)
Reduced interest due to 25 percent tax 1 3
(.25 x nominal interest rate)
After-tax nominal interest rate 3 9
(.75 x nominal interest rate)
After-tax real interest rate 3 1
(after-tax nominal interest rate - inflation rate)
.
Confusion and Inconvenience
Money is used to measure economic
transactions, to quote prices and record
debts.
Inflation causes dollars to have different
real values at different times
Difficult to compare real revenues, costs,
and profits over time
Impede investors’ making right decisions
.
Arbitrary Redistribution of Wealth
Unexpected changes in prices redistributes
wealth among debtors and creditors
Inflation is taken into account when setting
nominal interest rate for loans
If inflation is not up to expectation:
• Unexpected hyperinflation enriches at the
expense of creditors
• Unexpected deflation enriches creditors at the
expense of debtors
.
Lecture Review
Definition and measures of inflation
Types of inflation
Causes of inflation and the quantity
theory of money
Inflation and interest rates
Costs of inflation
