1. Money Growth and Inflation

2. Copyright Notice
This presentation is adapted from content copyright 2004 South-Western College and substantially modified using standard references and original material. It is intended only for classroom use under the fair use exemption of the U.S. Copyright Law. Materials have been prepared with the multimedia fair use guidelines and are restricted from further use.

3. “Inflation is at all times and everywhere a monetary phenomenon…
… in the sense that it cannot occur without a more rapid increase in the quantity of money than in output.”

4. The Meaning of Money
Money is the set of assets in an economy that people regularly use to buy goods and services from other people.

5. Definitions
Inflation is a general increase in the overall level of prices of goods and services over time. Inflation is everywhere, at all times.
Hyperinflation is an extraordinarily high rate of inflation.

6. Measuring It
Inflation is measured in many ways, but the most commonly used measuring tool is the Consumer Price Index, or CPI.
The CPI reveals changes in retail prices of a basket of consumer goods such as food, clothing, and cars. The index compares the value of the same basket each year to calculate the level of inflation for that period.

7. Inflation: Historical Aspects
Over the past 60 years, prices have risen on average about 5 percent per year.
Hyperinflation refers to high rates of inflation such as Germany experienced in the 1920s.
In the 1970s prices rose by 7 percent per year.
During the 1990s, prices rose at an average rate of 2 percent per year.

9. Accounting for Gimmickry

10. THE CLASSICAL THEORY OF INFLATION
Inflation is an economy-wide phenomenon that concerns the value of the economy’s medium of exchange.
When the overall price level rises, the value of money falls.
The quantity theory of money is used to explain the long-run determinants of the price level and the inflation rate.

11. THE CLASSICAL THEORY OF INFLATION
The Quantity Theory of Money
How the price level is determined and why it might change over time (the long term) is called the quantity theory of money:
The quantity of money available in the economy determines the value of money.
The primary cause of inflation is the growth in the quantity of money.

12. Money Supply, Money Demand, and Monetary Equilibrium
The money supply is a policy variable that is controlled by the Fed.
Through instruments such as open-market operations, the Fed directly controls the quantity of money supplied.
Bullet 2: Mankiw has removed the word, “directly”

13. Money Supply, Money Demand, and Monetary Equilibrium
Money demand has several determinants, including interest rates and the average level of prices in the economy.

14. Money Supply, Money Demand, and Monetary Equilibrium
People hold money because it is the medium of exchange.
The amount of money people choose to hold depends on the prices of goods and services.

15. Money Supply, Money Demand, and Monetary Equilibrium
In the long run, the overall level of prices adjusts to the level at which the demand for money equals the supply.

16. Figure 1 Money Supply, Money Demand, and the Equilibrium Price Level
Value of
Price
Money,
Quantity fixed
by the Fed
Money supply 1 / P
Level, P
(High) 1
Money
demand 1
(Low) 3 /
1.33 4 A 1 / 2 2
Equilibrium
value of
money
Equilibrium
price level 1 / 4 4
(Low)
(High)
Quantity of
Money
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17. Figure 2 The Effects of Monetary Injection
Value of
Price
Money, M1
MS1 M2
MS2 1 / P
Level, P
(High) 1
Money
demand 1
(Low)
1. An increase
in the money
supply . . . 3 /
1.33 4
decreases
the value of
mone
y . . . 3.
. . . and
increases
the price
level. A 1 / 2 2 B 1 / 4 4
(Low)
(High)
Quantity of
Money
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18. Variables in Inflation
Nominal variables are variables measured in current monetary units. (nominal GDP, Nominal wages measured in $ earned /hour, rate of return in $, etc.)
Real (or physical) variables are measured in physical units – real GDP, real interest rates (measured in output), real wages (measured in output) – the term can also refer to inflation-adjusted variables.

19. Real vs. Nominal Variables
Prices are normally measured in terms of money.
Price of a school lunch: $2.50/svng
Price of a fast food lunch: $5.00/svng
A relative price is the price of one good relative to (divided by) another:
Relative price of school meal in terms of fast food:
$5.00/svng
$2.50/svng =
price of ff
price of sl
= 2.0 sl per ff
Relative prices are measured in physical units, so they are real variables. 19

20. Real vs. Nominal Wage W P $10/hour $5/unit of output =
An important relative price is the real wage:
W = nominal wage = price of labor, e.g., $10/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 P
$10/hour
$5/unit of output =
= 2 units output per hour 20

21. The Classical Dichotomy
According to Hume and others, real economic variables do not change with changes in the money supply.
According to the classical dichotomy, different forces influence real and nominal variables.
Changes in the money supply affect nominal variables but not real variables.

22. The Classical Dichotomy & Monetary Neutrality
The irrelevance of monetary changes for real variables is called monetary neutrality.

23. The Classical Dichotomy
So, if a central bank doubles the money supply, according to the theory, then
all nominal variables – including prices – will double.
all real variables – including relative prices – will remain unchanged. 23

24. The Neutrality of Money
Monetary neutrality holds that a change in the money supply will not affect real variables
Doubling the money supply causes all nominal prices to double, but what about relative prices?
Initially, relative price of hot dogs in terms of burgers is
price of hd
price of burger
= hd per brgr
$1.00/hd
$2.00/brgr =
Relative price
After nominal prices double,
price of hd
price of burger
= 2 hd per brgr
$2.00/hd
$4.00/brgr = 24

25. Keynsian and Monetarist Argument
Money neutrality may hold true over the long term, but not over the short term…
Prices, including wages, are “sticky”: market forces might reduce the value of wages, but the wages paid will tend to remain at previous levels in the short run
Causes: Menu costs (Can’t easily change prices), money illusion (do not distinguish between real and nominal), imperfect information (people don’t realize they should change prices)

26. Keynsian and Monetarist Argument
Post-Keynsians and Monetarists reject the neutrality of money in favor of the role that credit money plays in the economy. Post-Keynesians also emphasize the role that nominal debt plays: since nominal amounts of debt are not in general linked to inflation, inflation erodes the real value of nominal debt, and deflation increases it, causing real economic effects, as in debt-deflation.

27. Velocity and the Quantity Equation
The velocity of money refers to the speed at which the typical dollar bill travels around the economy from wallet to wallet; in other words, it describes how quickly people spend money.

28. The Velocity of Money V = (P  Y)/M Where: V = velocity
P = the price level
Y = the quantity of output
M = the quantity of money
Velocity shouldn’t be in bold. Maybe move V down and align equal signs--it’s not..

29. An Example Y = Real GDP = 100,000 hot dogs
P = Price level = Price/hotdog = $1.00
P x Y = Nominal GDP = Value of hot dogs = $100,000
M = Money Supply = $50,000
V = $100,000 / $50,000 = 2

30. What It Means
When the economy is doing well, and especially when interest rates are high, this number is higher;
When the economy is recessionary, the number is lower.
The Velocity of Money can be used to predict the threat of inflation – what do you think is the current V?

31. Trends, M1

32. Trends, M2

33. Trends, M2 On 9/21/09, M2 V was 9.11 On 08/31/11, M2 V was 1.85
For a look at M2 V, go here!

34. Velocity and the Quantity Equation
Rewriting the equation gives the quantity equation:
M  V = P  Y

35. Velocity and the Quantity Equation
The quantity equation relates the quantity of money (M) to the nominal value of output (P  Y).

36. Velocity and the Quantity Equation
The quantity equation shows that an increase in the quantity of money in an economy must be reflected in one of three other variables:
the price level must rise,
the quantity of output must rise, or
the velocity of money must fall.

37. Figure 3 Nominal GDP, the Quantity of Money, and the Velocity of Money
Indexes
(1960 = 100)
2,000
Nominal GDP
1,500 M2
1,000
500
Velocity
1960
1965
1970
1975
1980
1985
1990
1995
2000
Copyright © South-Western

38. Velocity and the Quantity Equation
The Equilibrium Price Level, Inflation Rate, and the Quantity Theory of Money
The velocity of money is relatively stable over time.
When the Fed changes the quantity of money, it causes proportionate changes in the nominal value of output (P  Y).
Because money is neutral, money does not affect output.

39. The Fisher Effect
The Fisher effect refers to a one-to-one adjustment of the nominal interest rate to the inflation rate.
According to the Fisher hypothesis, when the rate of inflation rises, the nominal interest rate rises by the same amount.
The real interest rate stays the same:
(n = i + r where i = Rate of Inflation, n = nominal interest rate, and r = the real interest rate)

40. Figure 5 The Nominal Interest Rate and the Inflation Rate
Percent
(per year) 15 12
Nominal interest rate 9 6
Inflation 3
1960
1965
1970
1975
1980
1985
1990
1995
2000
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41. THE COSTS OF INFLATION A Fall in Purchasing Power?
Inflation does not in itself reduce people’s real purchasing power.

42. The Costs of Inflation: The Inflation Tax
When the government raises revenue by printing money, it is said to levy an inflation tax.
An inflation tax is like a tax on everyone who holds money.
The inflation ends when the government institutes fiscal reforms such as cuts in government spending.

43. THE COSTS OF INFLATION Shoeleather costs Menu costs
Relative price variability
Tax distortions
Confusion and inconvenience
Arbitrary redistribution of wealth

44. Shoe leather Costs
Shoeleather costs are the resources wasted when inflation encourages people to reduce their money holdings.
Inflation reduces the real value of money, so people have an incentive to minimize their cash holdings.

45. Shoe leather Costs
Less cash requires more frequent trips to the bank to withdraw money from interest-bearing accounts.
The actual cost of reducing your money holdings is the time and convenience you must sacrifice to keep less money on hand.
Also, extra trips to the bank take time away from productive activities.

46. Menu Costs
Menu costs are the costs of adjusting prices.
During inflationary times, it is necessary to update price lists and other posted prices.
This is a resource-consuming process that takes away from other productive activities.

47. Relative-Price Variability and the Misallocation of Resources
Inflation distorts relative prices.
Consumer decisions are distorted, and markets are less able to allocate resources to their best use.

48. Inflation-Induced Tax Distortion
Inflation exaggerates the size of capital gains and increases the tax burden on this type of income.
With progressive taxation, capital gains are taxed more heavily.

49. Inflation-Induced Tax Distortion
The income tax treats the nominal interest earned on savings as income, even though part of the nominal interest rate merely compensates for inflation.
The after-tax real interest rate falls, making saving less attractive.

50. Table 1 How Inflation Raises the Tax Burden on Saving
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51. Confusion and Inconvenience
When the Fed increases the money supply and creates inflation, it erodes the real value of the unit of account.
Inflation causes dollars at different times to have different real values.
Therefore, with rising prices, it is more difficult to compare real revenues, costs, and profits over time.

52. A Special Cost of Unexpected Inflation: Arbitrary Redistribution of Wealth
Unexpected inflation redistributes wealth among the population in a way that has nothing to do with either merit or need.
These redistributions occur because many loans in the economy are specified in terms of the unit of account—money.

53. Summary
The overall level of prices in an economy adjusts to bring money supply and money demand into balance.
When the central bank increases the supply of money, it causes the price level to rise.
Persistent growth in the quantity of money supplied leads to continuing inflation.

54. Summary
The principle of money neutrality asserts that changes in the quantity of money influence nominal variables but not real variables.
A government can pay for its spending simply by printing more money.
This can result in an “inflation tax” and hyperinflation.

55. Summary
According to the Fisher effect, when the inflation rate rises, the nominal interest rate rises by the same amount, and the real interest rate stays the same.
Many people think that inflation makes them poorer because it raises the cost of what they buy.
This view is a fallacy because inflation also raises nominal incomes.

56. Summary Economists have identified six costs of inflation:
Shoe leather costs
Menu costs
Increased variability of relative prices
Unintended tax liability changes
Confusion and inconvenience
Arbitrary redistributions of wealth

57. Summary
When banks loan out their deposits, they increase the quantity of money in the economy.
Because the Fed cannot control the amount bankers choose to lend or the amount households choose to deposit in banks, the Fed’s control of the money supply is imperfect.
I believe this slide is out of place. It belongs in the previous chapter. Delete it here.

58. Looking Back: How to use the CPI
It's fairly easy to use the CPI. Let's measure the rate of inflation (how fast prices rose) from 2001 to The annual CPI for 2001 is 177.1, and the annual CPI for 2002 is Just calculate the percentage change between the two index values (( ) / )*100, and you'll see that prices rose 1.6 percent from 2001 to 2002.
Another way of thinking about the inflation rate is to ask how much will a dollar buy now versus what a dollar would have bought before? In our example, $1.00 in 2001 had the same value as $1.06 in In terms of what you can buy with one dollar, you are worse off in 2002: to buy what cost $1.00 in 2001, you needed $1.06 in 2002.

59. This relationship is easier to see if we use a longer time period
This relationship is easier to see if we use a longer time period. One dollar of goods in 1980 would cost $2.29 in You can calculate this measure for any two years with the BLS Inflation Calculator.

60. CASE STUDY: Money and Prices during Four Hyperinflations
Hyperinflation is inflation that exceeds 50 percent per month.
Hyperinflation occurs in some countries because the government prints too much money to pay for its spending.
Align text for second bullet.

61. Next Topic: Hyperinflation in History

62. Figure 4 Money and Prices During Four Hyperinflations
(a) Austria
(b) Hungary
Index
Index
(Jan = 100)
(July 1921 = 100)
100,000
100,000
Price level
Price level
10,000
10,000
Money supply
Money supply
1,000
1,000
100
100
1921
1922
1923
1924
1925
1921
1922
1923
1924
1925
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63. Figure 4 Money and Prices During Four Hyperinflations
(c) Germany
(d) Poland
Index
Index
(Jan = 100)
(Jan = 100)
100,000,000,000,000
10,000,000
Price level
1,000,000,000,000
1,000,000
Price level
10,000,000,000
Money
supply
100,000
Money
supply
100,000,000
1,000,000
10,000
10,000
1,000
100 1
100
1921
1922
1923
1924
1925
1921
1922
1923
1924
1925
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64. Inflation in the United States

65. Another Look at the Past: The Great Inflation
Oil shocks: 1973 – oil forced from $3 to $11 bbl; 1980, $13 to $28 bbl.
Massive public sector spending of 30% - 50% or more of all public expenditures.
Vietnam war financed by borrowing
Percent
(per year)
Generally rising trend in raw mater1al prices due to global boom. 15
The rise of institutions of private power; less agriculture, more industry.
U.S. forced other nations to accept dollars instead of gold to settle foreign obligations, building up large dollar credits abroad which were used to buy U.S. exports. 12
Inflation indexing (social security, etc.). 9
Many of the causes of the Great Inflation were exogenous – that is, outside the U.S. economy. They tended to be exaggerated by such policies as wage and benefit indexing, and by funding the Vietnam war by borrowing instead of taxing. 6
Inflation 3
Global food shortages
The “Dot.Com Bubble”
1960
1965
1970
1975
1980
1985
1990
1995
2000
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66. Another Look at the Past: Recessionary Disinflation
Oil: Over-pricing leads to lower consumption and a steep price drop to just over $10 bbl.
The global boom slows down, material prices fall (copper falls to levels seen last before the Great Depression
“Tough love” policies of Reagan – a deliberate decision to place the U.S. in a business recession through tight monetary policy.
Percent
(per year) 15
Slowdown in global population growth, increased agricultural production, better weather
Soaring U.S. interest rates lead foreigners to buy high-yield U.S. bonds and choke off access to capital for domestic use. (Three-month T-bill over 14%!) 12 9 6
Inflation 3
End of Vietnam War – steep drop-off in defense spending.
Japanese and Taiwanese markets crash.
1960
1965
1970
1975
1980
1985
1990
1995
2000
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67. What about now? How do we snap the recession?
Government spending and budget deficits, along with such other fiscal tools as credit, can stimulate the economy, resulting in business activity and profitability. A deficit can help to create business and investor optimism along with more employment opportunities. But too much of a good thing can also fuel a rise of inflation. Deficit spending may also create a rise in unemployment, but lower the inflation rate. The object is to maintain a balance.

68. $10,000,000 buys…
In 2008, the annual rate of inflation was close to 90,000,000,000,000,000,000,000 percent. What is in your future?
89.7 sextillion

69. Works Cited
Harford, Tim. The Undercover Economist. New York: 2007, Random House.
Heilbroner, Robert and Lester Thurow. Economics Explained: Everything You Need to Know About How the Economy Works and Where It’s Going. New York; 1999, Touchstone.
McEacherm, William. Economics: A Contemporary Approach, 4th ed. Boston: 1996, South-Western College Pub.
Musgrave, Frank and Elia Kacapyr. Barron’s AP Advanced Placement Exam Micro/Macro Economics Ithaca: 2007, Barron’s.