Chapter Money Growth and Inflation 17

Inflation – Increase in the overall level of prices Deflation – Decrease in the overall level of prices Hyperinflation – Extraordinarily high rate of inflation 2

The Classical Theory of Inflation The level of prices and the value of money Inflation – Economy-wide phenomenon Concerns the value of economy’s medium of exchange Inflation - rise in the price level – Lower value of money – Each dollar - buys a smaller quantity of goods and services 3

The Classical Theory of Inflation Classical Theory (Says, Hayek) – Where Monetarists came from (Friedman and Univ. of Chicago School) Money Supply – Determined by the Fed and banking system – Supply curve – vertical – fixed in the short-run Monetary equilibrium – In the long-run overall level of prices adjusts such that Demand for money equals the supply 4

Figure How the supply and demand for money determine the equilibrium price level 1 5 Quantity of Money 0 (high) (low) Value of Money, 1/P 1 ¾ ½ ¼ Price Level, P (high) (low) Money Demand Quantity fixed by the Fed Money Supply A Equilibrium value of money Equilibrium price level The horizontal axis shows the quantity of money. The left vertical axis shows the value of money, and the right vertical axis shows the price level. The supply curve for money is vertical because the quantity of money supplied is fixed by the Fed. The demand curve for money is downward sloping because people want to hold a larger quantity of money when each dollar buys less. At the equilibrium, point A, the value of money (on the left axis) and the price level (on the right axis) have adjusted to bring the quantity of money supplied and the quantity of money demanded into balance.

The Classical Theory of Inflation The effects of a monetary injection Economy – in equilibrium – The Fed doubles the supply of money Prints bills; Drops them on market – Or: The Fed – open-market purchase – New equilibrium Supply curve shifts right Value of money decreases Price level increases 6

Figure An increase in the money supply 2 7 Quantity of Money 0 (high) (low) Value of Money, 1/P 1 ¾ ½ ¼ Price Level, P (high) (low) Money Demand M1M1 MS 1 A When the Fed increases the supply of money, the money supply curve shifts from MS 1 to MS 2. The value of money (on the left axis) and the price level (on the right axis) adjust to bring supply and demand back into balance. The equilibrium moves from point A to point B. Thus, when an increase in the money supply makes dollars more plentiful, the price level increases, making each dollar less valuable. M2M2 MS 2 B 1. An increase in the money supply decreases the value of money and increases the price level.

The Classical Theory of Inflation Quantity theory of money (J S Mills, I Fischer, von Mises) – Quantity of money available Ultimately determines the price level P = (M x V) / Y = M * constant – Growth rate in quantity of money available Determines the inflation rate Δ M = Δ P * constant 8

Real GDP in the United States 2 9 This figure shows quarterly data on real GDP for the U.S. economy since Recessions—periods of falling real GDP—are marked with the shaded vertical bars.

The Classical Theory of Inflation Velocity and the quantity equation Velocity of money (V) – Rate at which money changes hands V = (P × Y) / M – P = price level (GDP deflator) – Y = real GDP – M = quantity of money 10

The Classical Theory of Inflation Velocity and the quantity equation Quantity equation: M × V = P × Y Quantity of money (M) Velocity of money (V) Dollar value of the economy’s output of goods and services (P × Y ) – Shows: an increase in quantity of money Must be reflected in: – Price level must rise – Quantity of output must rise – Velocity of money must fall 11

The Classical Theory of Inflation The classical dichotomy & monetary neutrality Nominal variables (e.g., P, nominal interest) Variables measured in monetary units Real variables (e.g., Real GNP, Unemployment) Variables measured in physical units Classical dichotomy Theoretical separation of nominal & real variables Monetary neutrality Changes in money supply don’t affect real variables 12

Figure Nominal GDP, quantity of money, & velocity of money 3 13 This figure shows the nominal value of output as measured by nominal GDP, the quantity of money as measured by M2, and the velocity of money as measured by their ratio. For comparability, all three series have been scaled to equal 100 in Notice that nominal GDP and the quantity of money have grown dramatically over this period, while velocity has been relatively stable.

GDP Deflator and Real GDP Growth 14 GDP Deflator - Inflation Real GDP (Economic) Growth

The Classical Theory of Inflation Five steps - essence of quantity theory of money 1.Velocity of money Relatively stable over time 2.Changes in quantity of money (M) Proportionate changes in nominal value of output (P × Y) 15

The Classical Theory of Inflation Five steps - quantity theory of money 3.Economy’s output of goods and services (Y) Primarily determined by factor supplies – Kapital, Human K, Nat Resources And available production technology (Tech) Because money is neutral – Money does not affect output » Sargent – “Rational Expectations” » May be fooled in the short-run and therefore have short- run effect 16

The Classical Theory of Inflation Five steps - quantity theory of money 4.Change in money supply (M) Induces proportional changes in the nominal value of output (P × Y) – Reflected in changes in the price level (P) 5.Central bank - increases the money supply rapidly High rate of inflation. 17

Hyperinflation – Inflation that exceeds 50% per month – Price level - increases more than a hundredfold over the course of a year Data on hyperinflation – Clear link between Quantity of money And the price level Money and prices during four hyperinflations 18

Four classic hyperinflation, 1920s – Austria, Hungary, Germany, and Poland – Slope of the money line Rate at which the quantity of money was growing – Slope of the price line Inflation rate – The steeper the lines The higher the rates of money growth or inflation Prices rise when the government prints too much money Money and prices during four hyperinflations 19

Figure Money and prices during four hyperinflations (a, b) 4 20 This figure shows the quantity of money and the price level during four hyperinflations. (Note that these variables are graphed on logarithmic scales. This means that equal vertical distances on the graph represent equal percentage changes in the variable.) In each case, the quantity of money and the price level move closely together. The strong association between these two variables is consistent with the quantity theory of money, which states that growth in the money supply is the primary cause of inflation

Figure Money and prices during four hyperinflations (c, d) 4 21 This figure shows the quantity of money and the price level during four hyperinflations. (Note that these variables are graphed on logarithmic scales. This means that equal vertical distances on the graph represent equal percentage changes in the variable.) In each case, the quantity of money and the price level move closely together. The strong association between these two variables is consistent with the quantity theory of money, which states that growth in the money supply is the primary cause of inflation

German Hyperinflation (post WW I) Wholesale Price Index July Jan July Jan Jan July Jan July Jan ,785.0 July ,000.0 Nov ,000,000,

German Weimar Hyperinflation September 1922, a loaf of bread cost 163 marks. September of ,500,000 marks. At the peak of hyperinflation, November 1923, 200,000,000,000 marks! People were paid by the hour and rushed to buy whatever they could before the paper notes lost their purchasing power. People had to shop with wheel barrows full of money. 23

It takes wheelbarrows full of money to buy …..things 24

The Classical Theory of Inflation The Fisher effect – Real interest rate = Nominal interest rate – Inflation rate – Nominal interest rate = Real interest rate + Inflation rate Fisher effect: one-for-one adjustment of nominal interest rate to inflation rate When the Fed increases the rate of money growth Long-run result – Higher inflation rate – Higher nominal interest rate 25

Expectations and Neutrality Keynesians – Increase in Money Supply (Ms) -> lower real interest rates (r) -> increase investment (I) and expand production (Y) -> lower unemployment (U) Except during a “liquidity trap” Monetarists – Increase in Ms -> only leads to an increase in inflation – If Fed increases Ms -> ΔM -> ΔP 26

Expectations and Neutrality 27

Figure The nominal interest rate and the inflation rate 5 28 This figure uses annual data since 1960 to show the nominal interest rate on 3- month Treasury bills and the inflation rate as measured by the consumer price index. The close association between these two variables is evidence for the Fisher effect: When the inflation rate rises, so does the nominal interest rate

Figure The Aggregate Supply Curve Long run – Aggregate-supply curve is vertical Short run – Aggregate-supply curve is upward sloping Why the aggregate-supply curve (LRAS) is vertical in the long run – Price level does not affect the long-run determinants of GDP: Supplies of labor, capital, and natural resources Available technology 29

Figure The long-run aggregate-supply curve 4 30 Price Level Quantity of Output In the long run, the quantity of output supplied depends on the economy’s quantities of labor, capital, and natural resources and on the technology for turning these inputs into output. Because the quantity supplied does not depend on the overall price level, the long-run aggregate-supply curve is vertical at the natural rate of output. 1. A change in the price level does not affect the quantity of goods and services supplied in the long run Long-run aggregate supply Natural rate of output P1P1 P2P2

Counter Cyclical Monetary Policy 31 Cooling the booms – reduce money supply (tight) Heating up the recessions – increase money supply (loose) Problem is getting the timing right – otherwise overheat/cool

The Costs of Inflation A special cost of unexpected inflation: arbitrary redistributions of wealth Unexpected inflation – Redistributes wealth among the population Not by merit Not by need – Redistribute wealth among debtors and creditors Inflation - volatile & uncertain – When the average rate of inflation is high 32