Inflation: Its Causes and Costs Chapter 17 Inflation: Its Causes and Costs

Outline What is inflation? Causes of inflation Arriving at the monetary equilibrium Quantity theory of money The classical dichotomy- Real versus nominal Velocity of money The Fisher effect Costs of inflation

Inflation Inflation is the overall increase in price level. Inflation rate can be measured as the percent change in CPI, GDP deflator, or any overall price index. Recall that prices rise when the government prints too much money (chap 1).

Causes of Inflation Level of prices and the value of money: P= Price level = # $ required to buy a basket of goods and services 1/P= quantity of goods that can be bought with $1 = value of money Therefore, price level and value of money are inversely related

Monetary Equilibrium Determinants of money supply: The banking system along with the Bank of Canada can influence the supply of money Money supply is determined by the Bank of Canada and is treated as a policy variable Determinants of money demand: Quantity of money held by public (demand) is determined by interest rate on bonds Demand for money also depends on the average price level in the economy

Monetary Equilibrium Determinants of money demand: Higher the price level (lower value of money), more money people choose to hold, and demand for money increases Equilibrium In the LR, the overall level of prices adjusts to the level where demand equals supply of money At the point of equilibrium, price level and value of money have adjusted to balance supply and demand for money

Quantity Theory of Money The theory states that the quantity of money available determines the price level and that the growth rate in the quantity of money available determines the inflation rate.

The Classical dichotomy and Monetary Neutrality Classical dichotomy is the theoretical separation of nominal and real variables Nominal variables are measured in monetary units Real variables are measured in physical units Relative prices are real variables Monetary neutrality states that changes in the money supply affect nominal variables and do not affect real variables

Velocity and the quantity equation Velocity of money is the rate at which money changes hands or the speed at which the $ travels around the economy MV=PY is the quantity equation and relates the quantity of money and its velocity to the nominal value of output Velocity of money is relatively stable over time in Canada Therefore, when Bank of Canada increases money supply rapidly, it results in inflation.

Velocity of money

Inflation tax Hyperinflation is defined as inflation that exceeds 50% per month. Inflation tax is the revenue the government raises by creating money supply When the government prints money in order to fund its expenditure, it increases the price level and thereby reduces the value of money.

Fisher Effect Money neutrality means that an increase in the growth of money supply raises inflation rate but does not affect any real variables. However, increase in money supply does affect (increase) nominal interest rate. Recall real interest rate= nominal interest rate-inflation rate. The one-for-one adjustment between the nominal interest rate to the inflation rate is the Fisher effect.

The Costs of Inflation Inflation fallacy Shoeleather costs Menu costs Relative price variability and misallocation of resources Inflation-induced tax distortions Confusion and inconvenience Arbitrary redistribution of wealth

Inflation does not in itself reduce Inflation fallacy Inflation leads to fall in purchasing power of money and hurts consumers. Suppliers on the other hand receive a higher price for the same quantity sold. Factors of production receive higher incomes Inflation does not in itself reduce real purchasing power Neutrality of money

Shoeleather costs Inflation is like a tax and creates deadweight loss for the society. To reduce the burden of inflation tax, people hold less money in hand and hold in interest bearing savings instead. The resources wasted (time and inconvenience) in reducing money holdings is termed as shoeleather costs. During hyperinflation, local currency’s store of value is vastly reduced.

Menu costs Menu costs are incurred when prices change frequently and frequent changing of prices increases the costs of firms.

Relative-price variability and the misallocation of resources With no inflation, a firm’s relative prices would be constant over a period of time ( a year). With inflation, the relative prices of a firm will be high in the early months of the year and low in later months. As market economies allocate resources based on relative prices, inflation distorts prices resulting in misallocation of resources by markets.

Inflation-induced tax distortions Inflation tends to raise the tax burden on income from savings Tax treatment of capital gains discourages savings All of the nominal interest earned on savings is treated as income for purpose of taxation

Save? Tax rate= 50% Economy 1 Economy 2 Real interest rate 6% Inflation rate 10% Nominal interest rate 16% After-tax nominal interest rate 3% 4% After-tax real interest rate -6% Save?

Confusion and Inconvenience Inflation erodes the real value of money as a unit of account.

Cost of unexpected inflation: Arbitrary redistribution of wealth Hyperinflation enriches the borrower by diminishing the real value of the debt. Deflation enriches the lender by increasing the real value of the debt. Unexpected inflation prevents the Fisher effect from taking place imposing a risk on the borrower and lender. Inflation indexed bonds are a solution to protect long term savings.