0. In Chapter 5 (8th) and Chapter 4 (7th) we cover:
The classical theory of inflation
causes
effects
social costs
“Classical” – assumes prices are flexible & markets clear
Applies to the long run

1. Average Inflation Rate Versus Average Rate of Money Growth for Selected Countries, 1997–2007
Source: International Financial Statistics. 1

2. The connection between money and prices
Inflation rate = the percentage increase in the average level of prices = ∆P/P
Price = amount of money required to buy a good.
Because prices are defined in terms of money, we need to consider the nature of money, the supply of money, and how it is controlled.

3. Money: Definition
Money is the stock of assets that can be readily used to make transactions.

4. Money: Functions medium of exchange we use it to buy stuff
store of value transfers purchasing power from the present to the future
unit of account the common unit by which everyone measures prices and values

5. Money: Types has no intrinsic value example: the paper currency we use
1. Fiat money
has no intrinsic value
example: the paper currency we use
2. Commodity money
has intrinsic value
example: gold coins,
Again, this material should be review for most students.

6. The money supply and monetary policy definitions
The money supply is the quantity of money available in the economy.
Monetary policy is the control over the money supply.
Again, this is mostly review.

7. The central bank
Monetary policy is conducted by a country’s central bank.
In the U.S., the central bank is called the Federal Reserve (“the Fed”).
Again, this is mostly review.

8. The Quantity Theory of Money
A simple theory linking the inflation rate to the growth rate of the money supply.
Irving Fisher
Begins with the concept of velocity…

9. Velocity basic concept: the rate at which money circulates
definition: the number of times the average dollar bill changes hands in a given time period
example:
$500 billion in transactions
money supply = $100 billion
Each dollar is used on average in five transactions.
So, velocity = 5
In order for $500 billion in transactions to occur when the money supply is only $100b, each dollar must be used, on average, in five transactions.

10. Velocity, cont. This suggests the following definition: where
V = velocity
T = value of all transactions
M = money supply

11. Velocity, cont.
Use nominal GDP (P x Y) as a proxy for total transactions (T):
Then,
NGDP =17.7 trillion, M1 = $2.9 trillion, V = 6.1
where
P = price of output (GDP deflator)
Y = quantity of output (real GDP)
P Y = value of output (nominal GDP)
You might ask students if they know the difference between nominal GDP and the value of transactions.
Answer: nominal GDP includes the value of purchases of final goods; total transactions also includes the value of intermediate goods.
Even though they are different, they are highly correlated. Also, our models focus on GDP, and there’s lots of great data on GDP. So from this point on, we’ll use the income version of velocity.

12. The quantity equation (equation of exchange)
M V = P Y
follows from the preceding definition of velocity.
It is an identity: It holds by definition of the variables.

13. Money demand and the quantity equation
Cambridge Approach – Marshall, Pigou
M/P = real money balances, the purchasing power of the money supply.
A simple money demand function: (M )d = k PY
(M/P )d = k Y where k = how much money people wish to hold for each dollar of income (k is exogenous)

14. Money demand and the quantity equation
money demand: (M/P )d = k Y
quantity equation: M V = P Y
The connection between them: k = 1/V
When people hold lots of money relative to their incomes (k is large), money changes hands infrequently (V is small).

15. The quantity theory of money
starts with quantity equation (equation of exchange
assumes V is constant & exogenous:
Then, quantity equation becomes:
This is the Quantity Theory of Money

16. The quantity theory of money
How the price level is determined:
With V constant, the money supply determines nominal GDP (P Y ).
Real GDP (Y) is determined by the economy’s supplies of K and L and the production function (Chap 3).
It’s worthwhile to underscore the order (logical order, though not necessarily chronological order) in which variables are determined in this model.
First, real GDP is already determined outside this model (real GDP is determined by the model from chapter 3, which was completely independent of the money supply or velocity or other nominal variables).
Second, the Quantity Theory of money determines nominal GDP.
Third, the values of nominal GDP (PY) and real GDP (Y) together determine P
(as a ratio of PY to Y).

17. The quantity theory of money
Recall from Chapter 2: The growth rate of a product equals the sum of the growth rates.
The quantity equation in growth rates:

18. The quantity theory of money
 (Greek letter “pi”) denotes the inflation rate:
The result from the preceding slide:
Solve this result for :

19. The quantity theory of money
What this says is:
Normal economic growth requires a certain amount of money supply growth to facilitate the growth in transactions.
Money growth in excess of this amount leads to inflation.
The text on this slide is an intuitive way to understand the equation.
For students that are more comfortable with concrete numerical examples, you could offer the following:
Suppose real GDP is growing by 3% per year over the long run. Thus, production, income, and spending are all growing by 3%. This means that the volume of transactions will be growing as well.
The central bank can achieve zero inflation (on average over the long run) simply by setting the growth rate of the money supply at 3%, in which case exactly enough new money is being supplied to facilitate the growth in transactions.

20. The quantity theory of money
Y/Y depends on growth in the factors of production and on technological progress (all of which we take as given, for now).
Hence, the Quantity Theory predicts a one-for-one relation between changes in the money growth rate and changes in the inflation rate.
Note: the theory doesn’t predict that the inflation rate will equal the money growth rate. It *does* predict that a change in the money growth rate will cause an equal change in the inflation rate.

21. The Quantity Theory and the data
The quantity theory of money implies:
1. Countries with higher money growth rates should have higher inflation rates.
2. The long-run trend behavior of a country’s inflation should be similar to the long-run trend in the country’s money growth rate.
Are the data consistent with these implications?

22. International data on inflation and money growth (1999 – 2007)
Belarus
Indonesia
Inflation rate (percent, logarithmic scale)
Turkey
Ecuador
Argentina
Singapore
Figure 4-2, p.92
Each variable is measured as an annual average over the period
The strong positive correlation is evidence for the Quantity Theory of Money.
Source: International Financial Statistics.
Money supply growth (percent, logarithmic scale)

23. U.S. inflation and money growth, 1960–2013
M2 growth rate
source:
Federal Reserve Bank of St. Louis
M2SL (percent change from year ago, quarterly aggregation method average)
GDPDEF (percent change from year ago)
inflation rate

24. U.S. inflation and money growth, 1960–2013
Inflation and money growth have the same long-run trends, as the quantity theory predicts.
The quantity theory of money is intended to explain the long-run relation of inflation and money growth, not the short-run relation. In the long run, inflation and money growth are positively related, as the theory predicts.
(In the short run, however, inflation and money growth appear highly negatively correlated! One possible reason is that the causality is reversed in the short run: when inflation rises – or is expected to rise – the Fed cuts back on money growth. If the economy slumps and inflation falls, the Fed increases money growth. It might be appropriate to discuss this when covering the chapters on short-run fluctuations.)
source:
Federal Reserve Bank of St. Louis
M2SL (percent change from year ago, quarterly aggregation method average)
GDPDEF (percent change from year ago)

25. Seigniorage
To spend more without raising taxes or selling bonds, the gov’t can print money.
The “revenue” raised from printing money is called seigniorage (pronounced SEEN-your-idge).
The inflation tax: Printing money to raise revenue causes inflation. Inflation is like a tax on people who hold money.

26. Inflation and interest rates
Nominal interest rate, i not adjusted for inflation
Real interest rate, r adjusted for inflation: r = i  
The Fisher equation: i = r + 
Actually, i = (1+r)(1+)
i = (1.05)(1.03) = => 8.15%
i = = .08 => 8.00%

27. The Fisher effect The Fisher equation: i = r + 
Chap 3: S = I determines r (S, I and r are real variables)
Hence, an increase in  causes an equal increase in i.
This one-for-one relationship is called the Fisher effect.

28. U.S. inflation and nominal interest rates, 1960–2013
The data are consistent with the Fisher effect: inflation and the nominal interest rate are very highly correlated.
That they are not perfectly correlated does not contradict the Fisher effect. Over time, the saving and investment curves (see Chapter 3) move around, changing the real interest rate, which, in turn, causes the nominal interest rate to change for a given value of inflation.
About the data:
The inflation rate is the percentage change in the CPI from 12 months earlier.
(CPIAUCSL, monthly, percent change from year ago)
The nominal interest rate is the 3-month Treasury bill rate in the secondary market (TB3MS, monthly)
Data obtained from
inflation rate

29. Inflation and nominal interest rates in 96 countries (2000 – 2010)
Nominal interest rate (percent)
Turkey
Georgia
Malawi
Ghana
Mexico
Brazil
Poland
Sources:
Interest Rate Data - > Data > International Financial Statistics (IFS)
Inflation Data - > Data > World Economic Outlook
Each variable is measured as an annual average over
The nominal interest rate is the rate on short-term government debt.
Iraq
U.S.
Kazakhstan
Japan
Inflation rate (percent)

30. Applying the theory
Suppose V is constant, M is growing 5% per year, Y is growing 2% per year, and r = 4.
a. Solve for i.
b. If the Fed increases the money growth rate by 2 percentage points per year, find i.
c. Suppose the growth rate of Y falls to 1% per year.
What will happen to  ?
What must the Fed do if it wishes to keep  constant? .

31. Two real interest rates
FIRST - Notation (7th and 8th Editions):
 = actual inflation rate (not known until after it has occurred)
E = expected inflation rate
Two real interest rates:
i – E = ex ante real interest rate: the real interest rate people expect at the time they buy a bond or take out a loan
i –  = ex post real interest rate: the real interest rate actually realized
*** ATTENTION ***
Mankiw has changed the notation for the expected inflation rate. He is now using the expectation operator E.
Old notation from previous edition:  e
New notation starting in 7th edition: E
When he wrote the new chapter on dynamic aggregate demand and dynamic aggregate supply, he used the expectation operator rather than the “e” superscript. He then decided to go back throughout the whole book and use the expectation operator consistently in all chapters.

32. Two real interest rates
Notation (earlier Editions):
 = actual inflation rate (not known until after it has occurred)
e = expected inflation rate
Two real interest rates:
i – e = ex ante real interest rate: the real interest rate people expect at the time they buy a bond or take out a loan
i –  = ex post real interest rate: the real interest rate actually realized
*** ATTENTION ***
Mankiw has changed the notation for the expected inflation rate. He is now using the expectation operator E.
Old notation from previous edition:  e
New notation starting in 7th edition: E
When he wrote the new chapter on dynamic aggregate demand and dynamic aggregate supply, he used the expectation operator rather than the “e” superscript. He then decided to go back throughout the whole book and use the expectation operator consistently in all chapters. 32

33. 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, i   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).

34. The money demand function
(M/P )d = real money demand, depends:
negatively on i
i is the opportunity 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.

35. 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 + E.

36. The supply of real money balances
Equilibrium
The supply of real money balances
Real money demand

37. What determines what variable how determined (in the long run)
M exogenous (the Fed)
r adjusts to ensure S = I (Chap. 3)
Y (Chap. 3)
P adjusts to ensure
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.

38. For given values of r, Y, and E ,
How P responds to M
For given values of r, Y, and E ,
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.

39. What about expected inflation?
Over the long run, people don’t consistently over- or under-forecast inflation,
so on average, E =  (e =  ).
In the short run, e may change when people get new information.
For example: The Fed announces it will increase M next year. People will expect next year’s P to be higher, so E rises.
Interestingly, 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

40. How P responds to E For given values of r, Y, and M ,
Remember: M x V = P x Y

41. A common misperception about inflation
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…

42. The CPI and Average Hourly Earnings, 1965-2009
900
$20
800
Real average hourly earnings in 2009 dollars, right scale
700
$15
600
1965 = 100
500
Hourly wage in May 2009 dollars
$10
400
Nominal average hourly earnings, (1965 = 100)
The CPI has risen tremendously over the past 45 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. While the real wage is not constant - it varies within the range of $15 to $20 – it exhibits no downward long-term trend.
(We, of course, 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:
(AHETPI = average hourly earnings: total private industries)
300 $5
200
CPI (1965 = 100)
100 $0
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010

43. Labor productivity and wages
Theory: Real wages depend on labor productivity
U.S. data:
period
productivity growth
real wage growth
2.1%
2.0%
2.8%
1.4%
1.2%
2.5%
2.4%
The table shows the average annual rates of productivity and real wage growth in each time period.
Source: Economic Report of the President 2008
and US Department of Commerce 43

44. The classical view of inflation
The classical view: A change in the price level is merely a change in the units of measurement.
Then, why is inflation a social problem?

45. The social costs of inflation
…fall into two categories:
1. costs when inflation is expected (anticipated)
2. costs when inflation is different than people had expected (unanticipated)

46. The costs of expected (anticipated) inflation: 1. Shoeleather cost
def: the costs and inconveniences of reducing money balances to avoid the inflation tax.
  i
  real money balances
Remember: In 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.
Thanks to ATMs and internet banking, the shoeleather cost is likely to be very small.

47. 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.

48. 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.

49. 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  = 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.

50. 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 used to have conversations like this with me, concluding that the dollar just isn’t worth what it was when she was young. I asked her “well, how much is a dollar worth today?”. She considered the question, and then offered her estimate: “About 60 cents.” I then offered her 60 cents for every dollar she has. She didn’t accept the offer. :)

51. Additional cost of unexpected inflation: Arbitrary redistribution of purchasing power
Many long-term contracts not indexed, but based on E (e )
If  turns out different from e , then some gain at others’ expense.
Example: borrowers & lenders
If  > e , then (i  ) < (i  e ) and purchasing power is transferred from lenders to borrowers.
If  < e , then (i  ) > (i  e )
and purchasing power is transferred from
borrowers to lenders.
Ask students this rhetorical question: Would it upset you 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 on p.103.
(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.)

52. Additional cost of high inflation: Increased uncertainty
When inflation is high, it’s more variable and unpredictable:  turns out different from E more often, and the differences tend to be larger (though not systematically positive or negative)
Investors require additional risk premium.

53. Hyperinflation Common definition:   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.
The bottom of p. 106 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

54. 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.

55. A few examples of hyperinflation
country
period
CPI Inflation % per year
M2 Growth % per year
Israel
338%
305%
Brazil
1256%
1451%
Bolivia
1818%
1727%
Ukraine
2089%
1029%
Argentina
2671%
1583%
Dem. Republic of Congo / Zaire
3039%
2373%
Angola
4145%
4106%
Peru
5050%
3517%
Zimbabwe
5316%
9914%
source: World Development Indicators, World Bank.
The textbook discusses a few examples of hyperinflation, including:
1. interwar Germany (data and discussion)
Bolivia in 1985 (case study)
Zimbabwe in (case study)
This table provides data on the hyperinflations in Bolivia and Zimbabwe, and some additional examples.
Notes:
The inflation and money growth figures are computed from the end of the first year to the end of the last year shown in each “period.”
During 2008, Zimbabwe’s hyperinflation continued and became spectacular. The table on this slide excludes 2008 data because it is missing from the WDI database. It’s easy to find estimates of Zimbabwe’s 2008 inflation, for example here: However, I cannot verify their reliability or find good data on Zimbabwe’s money supply in 2008.
If you taught with a previous edition of my PowerPoints for Mankiw’s Macroeconomics, the slide like this one gave inflation and money growth as cumulative figures (over the period shown) rather than annual averages. Thus, it was a bit harder to compare, say, the two-year hyperinflation of Argentina with the six-year hyperinflation of Zaire. This slide, however, shows all inflation and money growth figures as annual averages over the period shown, which makes comparisons easier and just seems to make more sense.
Also, compared to the corresponding slide in the previous edition of my PowerPoint slides for Mankiw, the set of countries included here is slightly different.

56. Why governments create hyperinflation
When a government cannot raise taxes or sell bonds, it must finance spending increases by printing money.
In theory, the solution to hyperinflation is simple: stop printing money.
In the real world, this requires drastic and painful fiscal restraint.
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?”

57. 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
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.

58. The Classical Dichotomy
Note: Real variables were explained in Chap 3, nominal ones in Chapter 4.
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.

59. Chapter Summary Money def: the stock of assets used for transactions
functions: medium of exchange, store of value, unit of account
types: commodity money (has intrinsic value), fiat money (no intrinsic value)
money supply controlled by central bank
Quantity theory of money assumes velocity is stable, concludes that the money growth rate determines the inflation rate. 59

60. Chapter Summary Nominal interest rate
equals real interest rate + inflation rate
the opp. cost of holding money
Fisher effect: Nominal interest rate moves one-for-one w/ expected inflation.
Money demand
depends only on income in the Quantity Theory
also depends on the nominal interest rate
if so, then changes in expected inflation affect the current price level. 60

61. Chapter Summary Costs of inflation
Expected inflation shoeleather costs, menu costs, tax & relative price distortions, inconvenience of correcting figures for inflation
Unexpected inflation all of the above plus arbitrary redistributions of wealth between debtors and creditors 61

62. Chapter Summary Hyperinflation
caused by rapid money supply growth when money printed to finance govt budget deficits
stopping it requires fiscal reforms to eliminate govt’s need for printing money 62

63. Chapter Summary Classical dichotomy
In classical theory, money is neutral--does not affect real variables.
So, we can study how real variables are determined w/o reference to nominal ones.
Then, money market eq’m determines price level and all nominal variables.
Most economists believe the economy works this way in the long run. 63