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

2. Money demand and the nominal interest rate
In the quantity theory of money, the demand for real money balances depends only on real income Y.
Another determinant of money demand: the nominal interest rate, i.
the opportunity cost of holding money (instead of bonds or other interest-earning assets).
Hence, Δi  Δ in money demand.
The concept of “money demand” can be a bit awkward for students the first time they learn it. A good way to explain it is to imagine that a consumer has a certain amount of wealth, which is divided between money and other assets. The other assets typically generate some type of income (e.g. interest income in the case of bonds), but are much less liquid than money. There is therefore a trade-off: the more money the consumer holds in his portfolio, the more interest income he foregoes; the less money he holds, the more interest income he makes, but the less liquid is his portfolio.
With this for background, a consumer’s “money demand” refers to the fraction of his wealth he would like to hold in the form of money (as opposed to less-liquid income-generating assets like bonds).
CHAPTER 4 Money and Inflation

3. The money demand function
(M/P )d = real money demand, depends
negatively on i
i is the opp. cost of holding money
positively on Y
higher Y  more spending
so, need more money
(“L” is used for the money demand function because money is the most liquid asset.)
An increase in the nominal interest rate represents the increase in the opportunity cost of holding money rather than bonds, and would motivate the typical consumer to hold less of his wealth in the form of money, and more in the form of bonds (or other interest-earning assets).
An increase in real income (other things equal) causes an increase in the consumer’s consumption and therefore spending. To facilitate this extra spending, the consumer will require more money. Thus, the consumer would like a larger fraction of his wealth to be in the form of money (rather than bonds, etc). This might involve redeeming some of his bonds. Or it might simply involve holding the additional income in the form of money rather than putting it into bonds.
CHAPTER 4 Money and Inflation

4. The money demand function
When people are deciding whether to hold money or bonds, they don’t know what inflation will turn out to be.
Hence, the nominal interest rate relevant for money demand is r + π e.
CHAPTER 4 Money and Inflation

5. The supply of real money balances
Equilibrium
The supply of real money balances
Real money demand
CHAPTER 4 Money and Inflation

6. What determines what variable how determined (in the long run)
M exogenous (the Fed)
r adjusts to make S = I Y
P adjusts to make
Again, it is very important for students to learn the logical order in which variables are determined. I.e., you do NOT need to know P in order to determine Y. You DO need to know Y in order to determine L, and you need to know L and M in order to determine P.
CHAPTER 4 Money and Inflation

7. How P responds to ΔM For given values of r, Y, and πe,
a change in M causes P to change by the same percentage – just like in the quantity theory of money.
This slide shows the connection between the money market equilibrium condition and the (simpler) Quantity Theory of Money, presented earlier in this chapter.
CHAPTER 4 Money and Inflation

8. What about expected inflation?
Over the long run, people don’t consistently over- or under-forecast inflation,
so π e =π on average.
In the short run, πe may change when people get new information.
EX: Fed announces it will increase M next year. People will expect next year’s P to be higher, so πe rises.
This affects P now, even though M hasn’t changed yet….
This slide and the next correspond to the subsection of Chapter 4 entitled “Future Money and Current Prices,” appearing on pp
CHAPTER 4 Money and Inflation

9. How P responds to Δπ e For given values of r, Y, and M ,
CHAPTER 4 Money and Inflation

10. Discussion question Why is inflation bad?
What costs does inflation impose on society? List all the ones you can think of.
Focus on the long run.
Think like an economist.
Many of the social costs of inflation are not hard to figure out, if students “think like an economist.”
Suggestion: After you pose the question, don’t immediately ask for students to volunteer their answers. Instead, tell them to think about the question for a moment, jot down their answers, and THEN ask for volunteers. You will get more participation (quantity & quality) this way, especially from students who don’t consider themselves fast thinkers.
After presenting the following slides (which describe the costs), see how many of the costs presented here were anticipated by the students’ responses to the question on this slide.
CHAPTER 4 Money and Inflation

11. A common misperception
Common misperception: inflation reduces real wages
This is true only in the short run, when nominal wages are fixed by contracts.
(Chap. 3) In the long run, the real wage is determined by labor supply and the marginal product of labor, not the price level or inflation rate.
Consider the data…
CHAPTER 4 Money and Inflation

12. Average hourly earnings and the CPI, 1964-2006
$20
250
$18
$16
200
$14
$12
150
hourly wage
$10
CPI ( = 100) $8
100
First, note that the CPI has risen tremendously over the past 40 years.
However, nominal wages have risen by a roughly similar magnitude.
If the common misperception were true, then the real wage should show exactly the opposite behavior as the CPI. It doesn’t. The real wage is not constant - it varies within the range of $15 to $19 - but there is no downward trend in the real wage over the long term.
Note: We wouldn’t expect the real wage to be constant over the long run – we would expect it to change in response to shifts in the labor supply and MPL curves.
source: BLS
Obtained from: $6
CPI (right scale) $4 50
wage in current dollars $2
wage in 2006 dollars $0
CHAPTER 4 Money and Inflation
1964
1970
1976
1982
1988
1994
2000
2006

13. The classical view of inflation
The classical view: A change in the price level is merely a change in the units of measurement.
So why, then, is inflation a social problem?
CHAPTER 4 Money and Inflation

14. The social costs of inflation
…fall into two categories:
1. costs when inflation is expected
2. costs when inflation is different than people had expected
CHAPTER 4 Money and Inflation

15. The Costs of Expected Inflation
If we live in an economy where all prices are indexed to inflation, then the social cost of inflation would be minimal.
The Costs of Expected Inflation
Suppose there is a monthly inflation rate of 1% (= 12% annual) and everybody in the economy expects this monthly inflation rate throughout the year.
CHAPTER 4 Money and Inflation

16. The costs of expected inflation: 1. Shoe-leather cost
def: the costs and inconveniences of reducing money balances to avoid the costs of inflation.
↑ πe  ↑ i
 ↓ real money balances
Remember: In the long run, inflation does not affect real income or real spending.
So, same monthly spending but lower average money holdings means more frequent trips to the bank to withdraw smaller amounts of cash.
CHAPTER 4 Money and Inflation

17. The costs of expected inflation: 2. Menu costs
def: The costs of changing prices.
Examples:
cost of printing new menus
cost of printing & mailing new catalogs
The higher is inflation, the more frequently firms must change their prices and incur these costs.
CHAPTER 4 Money and Inflation

18. The costs of expected inflation: 3. Relative price distortions
Firms facing menu costs change prices infrequently.
Example: A firm issues new catalog each January. As the general price level rises throughout the year, the firm’s relative price will fall.
Different firms change their prices at different times, leading to relative price distortions…
…causing microeconomic inefficiencies in the allocation of resources.
CHAPTER 4 Money and Inflation

19. The costs of expected inflation: 4. Unfair tax treatment
Some taxes are not adjusted to account for inflation, such as the capital gains tax.
Example:
Jan 1: you buy $10,000 worth of IBM stock
Dec 31: you sell the stock for $11,000, so your nominal capital gain is $1000 (10%).
Suppose π = 10% during the year. Your real capital gain is $0.
But the govt requires you to pay taxes on your $1000 nominal gain!!
In the 1970s, the income tax was not adjusted for inflation. There were a lot of people who received nominal salary increases large enough to push them into a higher tax bracket, but not large enough to prevent their real salaries from falling in the face of high inflation. This led to political pressure to index the income tax brackets.
If inflation had been higher during , when lots of people were earning high capital gains, then there might have been more political pressure to index the capital gains tax.
CHAPTER 4 Money and Inflation

20. The costs of expected inflation: 5. General inconvenience
Inflation makes it harder to compare nominal values from different time periods.
This complicates long-range financial planning.
Examples:
Parents trying to decide how much to save for the future college expenses of their (now) young child.
Thirty-somethings trying to decide how much to save for retirement.
The CEO of a big corporation trying to decide whether to build a new factory, which will yield a revenue stream for 20 years or more.
Your grandmother claiming that things were so much cheaper when she was your age.
A silly digression: My grandmother often has these conversations with me, concluding that the dollar just isn’t worth what it was when she was young. I ask her “well, how much is a dollar worth today?”. She considers the question, and then offers her estimate: “About 60 cents.” I then offer her 60 cents for every dollar she has. She doesn’t accept the offer. :)
CHAPTER 4 Money and Inflation

21. Many long-term contracts not indexed, but based on π e.
Additional cost of unexpected inflation: Arbitrary redistribution of purchasing power
Many long-term contracts not indexed, but based on π e.
If π turns out different from π e, then some gain at others’ expense.
Example: borrowers & lenders
If π > πe, then (i - π) < (I - π e) and purchasing power is transferred from lenders to borrowers.
If π < π e, then purchasing power is transferred from borrowers to lenders.
Ask students this rhetorical question: Would it upset you off if somebody arbitrarily took wealth away from some people and gave it to others?
Well, this in effect is what’s happening when inflation turns out different than expected.
Furthermore, it’s impossible to predict when inflation will turn out higher than expected, when it will be lower, and how big the difference will be. So, these redistributions of purchasing power are arbitrary and random.
The text gives a simple numerical example starting on the bottom of p.100.
(In the short run, when many nominal wages are fixed by contracts, there are transfers of purchasing power between firms and their employees whenever inflation is different than expected when the contract was written and signed.)
CHAPTER 4 Money and Inflation

22. Example You borrow $100. π e = 5%, you agree to pay $108 Next year:
(rEA =i- πe =3%)
Next year:
π = 10%  you are better off. Your payment doesn’t even pay for inflation rate.
(rEP=i- π =8-10=-2%)
π = 2%  you are worse off. Real interest rate is higher than 3%.
(rEP=i- π =8-2=6%)
One way to protect the borrowers and the lenders from inflation would be to index the debt contracts to inflation or to write contracts in a foreign currency (e.g. salary fixed to $)
CHAPTER 4 Money and Inflation

23. Additional cost of unexpected inflation: Arbitrary redistribution of purchasing power
Fixed pension (retirement salary): If you are on a fixed pension (adjusted for π e ), the real purchasing power of your income
↓ when π > π e
↑ when π < π e
CHAPTER 4 Money and Inflation

24. Additional cost of high inflation: Increased uncertainty
When inflation is high, it’s more variable and unpredictable: π turns out different from π e more often, and the differences tend to be larger (though not systematically positive or negative)
Arbitrary redistributions of wealth become more likely.
This creates higher uncertainty, making risk averse people worse off.
CHAPTER 4 Money and Inflation