CH 30

Principles of
Economics
Wojciech Gerson (1831-1901)

N. Gregory Mankiw
CHAPTER Money Growth

30 and Inflation
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In this chapter,
look for the answers to these questions
• How does the money supply affect inflation and

nominal interest rates?
• Does the money supply affect real variables like
real GDP or the real interest rate?
• How is inflation like a tax?
• What are the costs of inflation? How serious
are they?
Introduction
 This chapter introduces the quantity theory of
money.
 Prices rise when the gov’t prints too much
money.
 Most economists believe the quantity theory
is a good explanation of the long run behavior
of inflation.
3
The Value of Money
 P = the price level
(e.g., the CPI or GDP deflator)
P is the price of a basket of goods, measured in
money.
 1/P is the value of $1, measured in goods.
 Example: basket contains one candy bar.
 If P = $2, value of $1 is 1/2 candy bar
 If P = $3, value of $1 is 1/3 candy bar
 Inflation drives up prices and drives down the
value of money.
4
The Quantity Theory of Money
 Developed by 18th century philosopher
David Hume and the classical economists.
 Advocated more recently by Nobel Prize Laureate
Milton Friedman.
 Asserts that the quantity of money determines the
value of money .
 We study this theory using two approaches:
1. A supply-demand diagram
2. An equation
5
Money Supply (MS)
 In the real world, determined by the Fed,
the banking system, and consumers.
 In this model, we assume the Fed precisely
controls MS and sets it at some fixed amount.
6
Money Demand (MD)
 Refers to how much wealth people want to hold
in liquid form.
 Depends on P:
An increase in P reduces the value of money,
so more money is required to buy g&s.
 Thus, quantity of money demanded
is negatively related to the value of money
and positively related to P, other things equal.
(These “other things” include real income,
interest rates, availability of ATMs.)
7
The Money Supply-Demand Diagram
Value of Price
Money, 1/P Level, P
As the value of
money rises, the
1 1
price level falls.
¾ 1.33
½ 2
¼ 4
Quantity
of Money
8
Value of Price
Money, 1/P MS1 Level, P
1 1
¾ 1.33
The Fed sets MS

½ 2
at some fixed value,
regardless of P.
¼ 4
$1000 Quantity
of Money
9
Value of A fall in value of money Price

Money, 1/P (or increase in P) Level, P
increases the quantity
1 of money demanded: 1
¾ 1.33
½ 2
¼ 4
MD1
Quantity
of Money
10
Value of P adjusts to equate Price

Money, 1/P MS1 quantity of money Level, P
demanded with
1 money supply. 1
¾ 1.33
eq’m eq’m
value A
½ 2 price
of
level
money
¼ 4
MD1
$1000 Quantity
of Money
11
The Effects of a Monetary Injection
Value of Price
Money, 1/P MS1 MS2 Level, P
Suppose the
1 Fed 1
Then the value
increases the of money falls,
money supply.
¾ and P rises.
1.33
A
½ 2
eq’m eq’m
value B
¼ 4 price
of MD1 level
money
$1000 $2000 Quantity
of Money
12
A Brief Look at the Adjustment Process
Result from graph: Increasing MS causes P to rise.
How does this work? Short version:
 At the initial P, an increase in MS causes an
excess supply of money.
 People get rid of their excess money by spending
it on g&s or by loaning it to others, who spend it.
Result: increased demand for goods.
 But supply of goods does not increase,
so prices must rise.
(Other things happen in the short run, which we will
study in later chapters.)
13
Real vs. Nominal Variables
 Nominal variables are measured in monetary
units.
Examples: nominal GDP,
nominal interest rate (rate of return measured in
$)
nominal wage ($ per hour worked)
 Real variables are measured in physical units.
Examples: real GDP,
real interest rate (measured in output)
real wage (measured in output)
14
Real vs. Nominal Variables
Prices are normally measured in terms of money.
 Price of a compact disc: $15/cd
 Price of a pepperoni pizza: $10/pizza
A relative price is the price of one good relative to
(divided by) another:
 Relative price of CDs in terms of pizza:
price of cd $15/cd
= = 1.5 pizzas per cd
price of pizza $10/pizza
Relative prices are measured in physical units,
so they are real variables.
15
Real vs. Nominal Wage
An important relative price is the real wage:
W = nominal wage = price of labor, e.g., $15/hour
P = price level = price of g&s, e.g., $5/unit of output
Real wage is the price of labor relative to the price
of output:
W $15/hour
= = 3 units output per hour
P $5/unit of output
16
The Classical Dichotomy
 Classical dichotomy: the theoretical separation
of nominal and real variables
 Hume and the classical economists suggested
that monetary developments affect nominal
variables but not real variables.
 If central bank doubles the money supply,
Hume & classical thinkers contend:
 all nominal variables—including prices—
will double.
 all real variables—including relative prices—
will remain unchanged.
17
The Neutrality of Money
 Monetary neutrality: the proposition that changes
in the money supply do not affect real variables
 Doubling money supply causes all nominal prices
to double; what happens to relative prices?
 Initially, relative price of cd in terms of pizza is
price of cd $15/cd
$10/pizza
price of pizza
The relative price
 After nominal prices double, is unchanged.
price of cd $30/cd
price of pizza $20/pizza
18
 Monetary neutrality: the proposition that changes
in the money supply do not affect real variables
 Similarly, the real wage W/P remains unchanged, so
 quantity of labor supplied does not change
 quantity of labor demanded does not change
 total employment of labor does not change
 The same applies to employment of capital and
other resources.
 Since employment of all resources is unchanged,
total output is also unchanged by the money supply.
19
 Most economists believe the classical dichotomy
and neutrality of money describe the economy in
the long run.
 In later chapters, we will see that monetary
changes can have important short-run effects
on real variables.
20
The Velocity of Money
 Velocity of money: the rate at which money
changes hands
 Notation:
P x Y = nominal GDP
= (price level) x (real GDP)
M = money supply
V = velocity
 Velocity formula: PxY
V =
M
21
The Velocity of Money
PxY
Velocity formula: V =
M
Example with one good: pizza.
In 2012,
Y = real GDP = 3000 pizzas
P = price level = price of pizza = $10
PxY = nominal GDP = value of pizzas =
$30,000
M = money supply = $10,000
V = velocity = $30,000/$10,000 = 3
The average dollar was used in 3 transactions.
22
ACTIVE LEARNING 1
Exercise
One good: corn.

The economy has enough labor, capital, and land to
produce Y = 800 bushels of corn.
V is constant.
In 2008, MS = $2000, P = $5/bushel.
Compute nominal GDP and velocity in 2008.
ACTIVE LEARNING 1
Answers
Given: Y = 800, V is constant,

MS = $2000 and P = $5 in 2008.
Compute nominal GDP and velocity in 2008.
Nominal GDP = P x Y = $5 x 800 = $4000
PxY $4000
V = = = 2
M $2000
U.S. Nominal GDP, M2, and Velocity
3,500
Velocity is fairly
3,000 stable over the
long run.
2,500
1960=100
Nominal GDP
2,000
M2
1,500
1,000
500
Velocity
0
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
The Quantity Equation
PxY
Velocity formula: V =
M
 Multiply both sides of formula by M:
MxV = PxY
 Called the quantity equation
26
The Quantity Theory in 5 Steps
Start with quantity equation: M x V = P x Y
1. V is stable.
2. So, a change in M causes nominal GDP (P x Y)
to change by the same percentage.
3. A change in M does not affect Y:
money is neutral,
Y is determined by technology & resources
4. So, P changes by same percentage as
P x Y and M.
5. Rapid money supply growth causes rapid
inflation.
27
ACTIVE LEARNING 2
Exercise
One good: corn. The economy has enough labor,

capital, and land to produce Y = 800 bushels of corn.
V is constant. In 2008, MS = $2000, P = $5/bushel.
For 2009, the Fed increases MS by 5%, to $2100.
a. Compute the 2009 values of nominal GDP and P.
Compute the inflation rate for 2008–2009.
b. Suppose tech. progress causes Y to increase to
824 in 2009. Compute 2008–2009 inflation rate.
ACTIVE LEARNING 2
Answers

MS = $2000 and P = $5 in 2008.
a. Compute the 2009 values of nominal GDP and P.
Compute the inflation rate for 2008–2009.
Nominal GDP = P x Y = M x V (Quantity Eq’n)
= $2100 x 2 = $4200
P = P x Y = $4200 = $5.25
Y 800
$5.25 – 5.00
Inflation rate = = 5% (same as MS!)
5.00
ACTIVE LEARNING 2
Answers

MS = $2000 and P = $5 in 2008.
b. Suppose tech. progress causes Y to increase 3%
in 2009, to 824. Compute 2008–2009 inflation rate.
First, use Quantity Eq’n to compute P in 2009:
MxV $4200
P = = = $5.10
Y 824
$5.10 – 5.00
Inflation rate = = 2%
5.00
ACTIVE LEARNING 2
Summary and lessons about the quantity
theory of money
 If real GDP is constant, then
inflation rate = money growth rate.
 If real GDP is growing, then
inflation rate < money growth rate.
 The bottom line:
 Economic growth increases the number of
transactions.
 Some money growth is needed for these extra
transactions.
 Excessive money growth causes inflation.
The Inflation Tax
 When tax revenue is inadequate and ability to
borrow is limited, gov’t may print money to pay
for its spending.
 Almost all hyperinflations start this way.
 The revenue from printing money is the
inflation tax: printing money causes inflation,
which is like a tax on everyone who holds
money.
 In the U.S., the inflation tax today accounts for
less than 3% of total revenue.
32
The Fisher Effect
 Rearrange the definition of the real interest rate:
Nominal Inflation Real
= +
interest rate rate interest rate
 The real interest rate is determined by saving &

investment in the loanable funds market.
 Money supply growth determines inflation rate.
 So, this equation shows how the nominal interest
rate is determined.
33
The Fisher Effect
= +
 In the long run, money is neutral:

a change in the money growth rate affects
the inflation rate but not the real interest rate.
 So, the nominal interest rate adjusts one-for-one
with changes in the inflation rate.
 This relationship is called the Fisher effect
after Irving Fisher, who studied it.
34
U.S. Nominal Interest & Inflation Rates
18
The close relation between
15 these variables is evidence
for the Fisher effect.
12
Nominal
9
interest rate
6
Inflation rate
0
-3
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
The Fisher Effect & the Inflation Tax
= +
 The inflation tax applies to people’s holdings of

money, not their holdings of wealth.
 The Fisher effect: an increase in inflation causes
an equal increase in the nominal interest rate,
so the real interest rate (on wealth) is unchanged.
36
The Costs of Inflation
 The inflation fallacy: most people think inflation
erodes real incomes.
 But inflation is a general increase in prices
of the things people buy and the things they sell
(e.g., their labor).
 In the long run, real incomes are determined by
real variables, not the inflation rate.
37
U.S. Average Hourly Earnings & the CPI
900
800 Inflation causes

the CPI and
700
nominal wages
600 to rise together
1965 = 100
over the long run.

500
Nominal wage
400
300
200
CPI
100
0
1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
 Shoeleather costs: the resources wasted when
inflation encourages people to reduce their
money holdings
 Includes the time and transactions costs of
more frequent bank withdrawals
 Menu costs: the costs of changing prices
 Printing new menus, mailing new catalogs, etc.
39
 Misallocation of resources from relative-price
variability: Firms don’t all raise prices at the
same time, so relative prices can vary…
which distorts the allocation of resources.
 Confusion & inconvenience: Inflation changes
the yardstick we use to measure transactions.
Complicates long-range planning and the
comparison of dollar amounts over time.
40
 Tax distortions:
Inflation makes nominal income grow faster than
real income.
Taxes are based on nominal income,
and some are not adjusted for inflation.
So, inflation causes people to pay more taxes
even when their real incomes don’t increase.
41
ACTIVE LEARNING 3
Tax distortions
You deposit $1000 in the bank for one year.

CASE 1: inflation = 0%, nom. interest rate = 10%
a. In which case does the real value of your deposit
grow the most?
Assume the tax rate is 25%.
b. In which case do you pay the most taxes?
c. Compute the after-tax nominal interest rate,
then subtract inflation to get the
after-tax real interest rate for both cases.
ACTIVE LEARNING 3
Answers
Deposit = $1000.
a. In which case does the real value of your
deposit grow the most?
In both cases, the real interest rate is 10%,
so the real value of the deposit grows 10%
(before taxes).
ACTIVE LEARNING 3
Answers
Deposit = $1000. Tax rate = 25%.

b. In which case do you pay the most taxes?
CASE 1: interest income = $100,
so you pay $25 in taxes.
CASE 2: interest income = $200,
so you pay $50 in taxes.
ACTIVE LEARNING 3
Answers

c. Compute the after-tax nominal interest rate,
then subtract inflation to get the
after-tax real interest rate for both cases.
CASE 1: nominal = 0.75 x 10% = 7.5%
real = 7.5% – 0% = 7.5%
CASE 2: nominal = 0.75 x 20% = 15%
real = 15% – 10% = 5%
ACTIVE LEARNING3
Summary and lessons

Inflation…
 raises nominal interest rates (Fisher effect)
but not real interest rates
 increases savers’ tax burdens
 lowers the after-tax real interest rate
Summary
• To explain inflation in the long run, economists use
the quantity theory of money. According to this
theory, the price level depends on the quantity of
money, and the inflation rate depends on the money
growth rate.
• The classical dichotomy is the division of variables
into real and nominal. The neutrality of money is the
idea that changes in the money supply affect nominal
variables but not real ones. Most economists believe
these ideas describe the economy in the long run.
Summary
• The inflation tax is the loss in the real value of
people’s money holdings when the government
causes inflation by printing money.
• The Fisher effect is the one-for-one relation
between changes in the inflation rate and
changes in the nominal interest rate.
• The costs of inflation include menu costs,
shoeleather costs, confusion and inconvenience,
distortions in relative prices and the allocation of
resources, tax distortions, and arbitrary
redistributions of wealth.
Question 1
Using separate graphs, demonstrate what
happens to the money supply, money demand, the
value of money, and the price level if:
(a) the Fed increases the money supply.
(b) people decide to demand less money at each
value of money.
49
Question 2
Identify each of the following as nominal or real variables.
a. the physical output of goods and services
b. the overall price level
c. the dollar price of apples
d. the price of apples relative to the price of oranges
e. the unemployment rate
f. the amount that shows up on your paycheck after taxes
g. the amount of goods you can purchase with the wage
you get each hour
h. the taxes that you pay the government
50

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Principles of

Wojciech Gerson (1831-1901)

CHAPTER Money Growth

• How does the money supply affect inflation and

The Fed sets MS

Value of A fall in value of money Price

Value of P adjusts to equate Price

One good: corn.

Given: Y = 800, V is constant,

Nominal GDP = P x Y = $5 x 800 = $4000

One good: corn. The economy has enough labor,

Given: Y = 800, V is constant,

Given: Y = 800, V is constant,

 The real interest rate is determined by saving &

 In the long run, money is neutral:

 The inflation tax applies to people’s holdings of

800 Inflation causes

over the long run.

You deposit $1000 in the bank for one year.

Deposit = $1000. Tax rate = 25%.

Deposit = $1000. Tax rate = 25%.

Deposit = $1000. Tax rate = 25%.

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