Chapter 4: Money and Inflation Continued CHAPTER 4 Money and Inflation

One benefit of inflation Nominal wages are rarely reduced, even when the equilibrium real wage falls. This hinders labor market clearing. Sometimes the equilibrium real wage for an industry may change Now, the firm needs to take the nominal wage as given and hire workers to a point where MPL= W/P Students will better appreciate this point when they learn chapter 6 (the natural rate of unemployment). In this chapter, we will see how the failure of wages to adjust contributes to a long-term unemployment problem. CHAPTER 4 Money and Inflation

CHAPTER 4 Money and Inflation Factor Price L F-demand 2 F-demand 1 (W/P)2 (W/P)1 Factor Supply CHAPTER 4 Money and Inflation

When this happens, the logical thing to do is to cut the real wage from (W /P) 1 to (W /P) 2 If prices are fixed, this implies a reduction in nominal wages However, this is hardly done in practice because workers feel offended. Inflation allows the real wages to reach equilibrium levels without nominal wage cuts. Therefore, moderate inflation improves the functioning of labor markets. CHAPTER 4 Money and Inflation

Hyperinflation def: π = 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. Page 104 has an excellent example of life during a hyperinflation, which involves beer, a commodity with which your students may be somewhat familiar. See also the excellent case study on pp.104-105. Note: On p.103, the text states “Hyperinflation is often defined as inflation that exceeds 50 percent per month.” I’ve included this definition at the top of this slide, to be consistent with the textbook. However, some professors are a bit uncomfortable assigning a specific number (such as 50% per month) to the definition of hyperinflation, because, for example, most would agree that 49% per month inflation is high enough to be considered hyperinflation. The definition I like to use in my own teaching is this: hyperinflation: a really, really, really high rate of inflation Feel free to edit the definition of “hyperinflation” on this slide if you wish. CHAPTER 4 Money and Inflation

Costs of Hyperinflation -1 Shoeleather costs: Business executives spend much more time to manage the firms’ cash that they cannot work on production and investment. Menu costs: Prices change too fast. Ex: German hyperinflation (1920s) waiter announces new prices every ½ hour. Changing relative prices: Almost impossible to do a price search when prices are changing very rapidly. Ex: German bar: order two pitchers of beer because the price of the 2nd one increase before you finish 1st pitcher. CHAPTER 4 Money and Inflation

Costs of Hyperinflation -2 Tax systems: The real value of our tax payment ↓ by the time government receives it. Overall inconvenience: Imagine carrying a bag of money to the grocery store. CHAPTER 4 Money and Inflation

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 4 Money and Inflation

Aside: “Money printing” “Money printing” is a technical term that refers to an increase in money supply Central banks usually increase the money supply through “open market operations” An “open market purchase” is the central banks purchase of bonds from public In exchange for bonds, CB gives money to public and the money supply increases CHAPTER 4 Money and Inflation

Literally printing money through the printing press is also done to replace old currency with new ones. Because the old currency is replaced with new currency, money supply does not change due to “money printing” via the printing press. Printing money via printing press is under the autority of the Government (Treasury department) CHAPTER 4 Money and Inflation

A few examples of hyperinflation money growth (%) inflation (%) Israel, 1983-85 295 275 Poland, 1989-90 344 400 Brazil, 1987-94 1350 1323 Argentina, 1988-90 1264 1912 Peru, 1988-90 2974 3849 Nicaragua, 1987-91 4991 5261 Bolivia, 1984-85 4208 6515 Examples of hyperinflation from the textbook: 1. interwar Germany (data and discussion) 2. Bolivia in 1985 (Case Study) This table provides data on Bolivia’s hyperinflation, and some additional examples. CHAPTER 4 Money and Inflation

Why governments create hyperinflation Hyperinflations are caused by fiscal imbalances. G – T: Budget Deficit: Three ways to finance: 1) ↑ T 2) Issue bonds 3) Print money (via printing press) When a government cannot raise taxes or sell bonds, it must finance spending increases by printing money. Before revealing the contents of this slide, you might consider asking students the following question: “Solving the problem of hyperinflation is easy. Why, then, do governments allow hyperinflation to occur?” CHAPTER 4 Money and Inflation

In the real world, this requires drastic and painful fiscal restraint. If the government cannot get the funds via T or bonds, then it may rely on printing money which is inflationary. This starts a circular act: Printing money → ↑ π → ↓ Real tax revenue → Deficit widens →print more money In theory, the solution to hyperinflation is simple: stop printing money. In the real world, this requires drastic and painful fiscal restraint. Hyperinflations usually end with a fiscal reform. ↑ T, ↓ G CHAPTER 4 Money and Inflation

The Classical Dichotomy Real variables: Measured in physical units – quantities and relative prices, for example: quantity of output produced real wage: output earned per hour of work real interest rate: output earned in the future by lending one unit of output today CHAPTER 4 Money and Inflation

Nominal variables: Measured in money units, e.g., nominal wage: Dollars per hour of work. nominal interest rate: Dollars earned in future by lending one dollar today. the price level: The amount of dollars needed to buy a representative basket of goods. CHAPTER 4 Money and Inflation

In this chapter, we have seen nominal variables: Money and inflation. In chapter 3, we have seen real variables: Real GDP, W/P: all in physical units. In this chapter, we have seen nominal variables: Money and inflation. In chapter 3, we have produced and allocated income without any money. This separation between the real and the nominal side of the economy is called: Classical Dichotomy. CHAPTER 4 Money and Inflation

Neutrality of Money Recall the quantity theory: ∆M has no impact on ∆Y. The irrelevance of money to real variables is called money neutrality. CHAPTER 4 Money and Inflation

Conclusions 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 4 Money and Inflation

End of chapter problem 10 Suppose consumption depends on the level of real money balances. Show that if real money balances depend on the nominal interest rate, an increase in the rate of M growth affects C, I, and r. Does i adjust one for one to expected inflation? CHAPTER 4 Money and Inflation

C=C(M/P) and (M/P)d =L(i) M(up)P (up)Inflation (up)i (up)(M/P)d (down)C (down)S=Y-C-G (up)r (down) i=r + π e (down) (up) CHAPTER 4 Money and Inflation