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Copyright © 2004 South-Western
3030Money Growth and
Inflation
Copyright © 2004 South-Western
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.
Copyright © 2004 South-Western
THE CLASSICAL THEORY OF
INFLATION
• Inflation is an increase in the overall level of
prices.
• Hyperinflation is an extraordinarily high rate of
inflation.
Copyright © 2004 South-Western
THE CLASSICAL THEORY OF
INFLATION
• Inflation: Historical Aspects
• Over the past 60 years, prices have risen on average
about 5 percent per year.
• Deflation, meaning decreasing average prices,
occurred in the U.S. in the nineteenth century.
• Hyperinflation refers to high rates of inflation such
as Germany experienced in the 1920s.
Copyright © 2004 South-Western
THE CLASSICAL THEORY OF
INFLATION
• Inflation: Historical Aspects
• In the 1970s prices rose by 7 percent per year.
• During the 1990s, prices rose at an average rate of 2
percent per year.
Copyright © 2004 South-Western
THE CLASSICAL THEORY OF
INFLATION
• The quantity theory of money is used to explain
the long-run determinants of the price level and
the inflation rate.
• 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.
Copyright © 2004 South-Western
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.
Copyright © 2004 South-Western
Money Supply, Money Demand, and
Monetary Equilibrium
• Money demand has several determinants,
including interest rates and the average level of
prices in the economy.
Copyright © 2004 South-Western
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.
Copyright © 2004 South-Western
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.
Figure 1 Money Supply, Money Demand, and the
Equilibrium Price Level
Copyright © 2004 South-Western
Quantity of
Money
Value of
Money,1/P
Price
Level, P
Quantity fixed
by the Fed
Money supply
0
1
(Low)
(High)
(High)
(Low)
1
/2
1
/4
3
/4
1
1.33
2
4
Equilibrium
value of
money
Equilibrium
price level
Money
demand
A
Figure 2 The Effects of Monetary Injection
Copyright © 2004 South-Western
Quantity of
Money
Value of
Money,1/P
Price
Level, P
Money
demand
0
1
(Low)
(High)
(High)
(Low)
1
/2
1
/4
3
/4
1
1.33
2
4
M1
MS1
M2
MS2
2. . . . decreases
the value of
money . . .
3. . . . and
increases
the price
level.
1. An increase
in the money
supply . . .
A
B
Copyright © 2004 South-Western
THE CLASSICAL THEORY OF
INFLATION
• The Quantity Theory of Money
• How the price level is determined and why it might
change over time 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.
Copyright © 2004 South-Western
The Classical Dichotomy and Monetary
Neutrality
• Nominal variables are variables measured in
monetary units.
• Real variables are variables measured in
physical units.
Copyright © 2004 South-Western
The Classical Dichotomy and Monetary
Neutrality
• 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.
Copyright © 2004 South-Western
The Classical Dichotomy and Monetary
Neutrality
• The irrelevance of monetary changes for real
variables is called monetary neutrality.
Copyright © 2004 South-Western
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.
Copyright © 2004 South-Western
Velocity and the Quantity Equation
V = (P × Y)/M
• Where: V = velocity
P = the price level
Y = the quantity of output
M = the quantity of money
Copyright © 2004 South-Western
Velocity and the Quantity Equation
• Rewriting the equation gives the quantity
equation:
M × V = P × Y
Copyright © 2004 South-Western
Velocity and the Quantity Equation
• The quantity equation relates the quantity of
money (M) to the nominal value of output
(P × Y).
Copyright © 2004 South-Western
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.
Figure 3 Nominal GDP, the Quantity of Money,
and the Velocity of Money
Copyright © 2004 South-Western
Indexes
(1960 = 100)
2,000
1,000
500
0
1,500
1960 1965 1970 1975 1980 1985 1990 1995 2000
Nominal GDP
Velocity
M2
Copyright © 2004 South-Western
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.
Copyright © 2004 South-Western
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.
Figure 4 Money and Prices During Four
Hyperinflations
Copyright © 2004 South-Western
(a) Austria (b) Hungary
Money supply
Price level
Index
(Jan. 1921 = 100)
Index
(July 1921 = 100)
Price level
100,000
10,000
1,000
100
19251924192319221921
Money supply
100,000
10,000
1,000
100
19251924192319221921
Figure 4 Money and Prices During Four
Hyperinflations
Copyright © 2004 South-Western
(c) Germany
1
Index
(Jan. 1921 = 100)
(d) Poland
100,000,000,000,000
1,000,000
10,000,000,000
1,000,000,000,000
100,000,000
10,000
100
Money
supply
Price level
19251924192319221921
Price level
Money
supply
Index
(Jan. 1921 = 100)
100
10,000,000
100,000
1,000,000
10,000
1,000
19251924192319221921
Copyright © 2004 South-Western
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.
Copyright © 2004 South-Western
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 effect, when the rate of
inflation rises, the nominal interest rate rises by
the same amount.
• The real interest rate stays the same.
Figure 5 The Nominal Interest Rate and the
Inflation Rate
Copyright © 2004 South-Western
Percent
(per year)
1960 1965 1970 1975 1980 1985 1990 1995 2000
0
3
6
9
12
15
Inflation
Nominal interest rate
Copyright © 2004 South-Western
THE COSTS OF INFLATION
• A Fall in Purchasing Power?
• Inflation does not in itself reduce people’s real
purchasing power.
Copyright © 2004 South-Western
THE COSTS OF INFLATION
• Shoeleather costs
• Menu costs
• Relative price variability
• Tax distortions
• Confusion and inconvenience
• Arbitrary redistribution of wealth
Copyright © 2004 South-Western
Shoeleather 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.
Copyright © 2004 South-Western
Shoeleather 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.
Copyright © 2004 South-Western
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.
Copyright © 2004 South-Western
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.
Copyright © 2004 South-Western
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.
Copyright © 2004 South-Western
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.
Table 1 How Inflation Raises the Tax Burden on
Saving
Copyright©2004 South-Western
Copyright © 2004 South-Western
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.
Copyright © 2004 South-Western
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.
Copyright © 2004 South-Western
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.
Copyright © 2004 South-Western
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.
Copyright © 2004 South-Western
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.
Copyright © 2004 South-Western
Summary
• Economists have identified six costs of
inflation:
• Shoeleather costs
• Menu costs
• Increased variability of relative prices
• Unintended tax liability changes
• Confusion and inconvenience
• Arbitrary redistributions of wealth
Copyright © 2004 South-Western
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.

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Money Growth and Inflation

  • 1. Copyright © 2004 South-Western 3030Money Growth and Inflation
  • 2. Copyright © 2004 South-Western 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.
  • 3. Copyright © 2004 South-Western THE CLASSICAL THEORY OF INFLATION • Inflation is an increase in the overall level of prices. • Hyperinflation is an extraordinarily high rate of inflation.
  • 4. Copyright © 2004 South-Western THE CLASSICAL THEORY OF INFLATION • Inflation: Historical Aspects • Over the past 60 years, prices have risen on average about 5 percent per year. • Deflation, meaning decreasing average prices, occurred in the U.S. in the nineteenth century. • Hyperinflation refers to high rates of inflation such as Germany experienced in the 1920s.
  • 5. Copyright © 2004 South-Western THE CLASSICAL THEORY OF INFLATION • Inflation: Historical Aspects • In the 1970s prices rose by 7 percent per year. • During the 1990s, prices rose at an average rate of 2 percent per year.
  • 6. Copyright © 2004 South-Western THE CLASSICAL THEORY OF INFLATION • The quantity theory of money is used to explain the long-run determinants of the price level and the inflation rate. • 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.
  • 7. Copyright © 2004 South-Western 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.
  • 8. Copyright © 2004 South-Western Money Supply, Money Demand, and Monetary Equilibrium • Money demand has several determinants, including interest rates and the average level of prices in the economy.
  • 9. Copyright © 2004 South-Western 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.
  • 10. Copyright © 2004 South-Western 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.
  • 11. Figure 1 Money Supply, Money Demand, and the Equilibrium Price Level Copyright © 2004 South-Western Quantity of Money Value of Money,1/P Price Level, P Quantity fixed by the Fed Money supply 0 1 (Low) (High) (High) (Low) 1 /2 1 /4 3 /4 1 1.33 2 4 Equilibrium value of money Equilibrium price level Money demand A
  • 12. Figure 2 The Effects of Monetary Injection Copyright © 2004 South-Western Quantity of Money Value of Money,1/P Price Level, P Money demand 0 1 (Low) (High) (High) (Low) 1 /2 1 /4 3 /4 1 1.33 2 4 M1 MS1 M2 MS2 2. . . . decreases the value of money . . . 3. . . . and increases the price level. 1. An increase in the money supply . . . A B
  • 13. Copyright © 2004 South-Western THE CLASSICAL THEORY OF INFLATION • The Quantity Theory of Money • How the price level is determined and why it might change over time 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.
  • 14. Copyright © 2004 South-Western The Classical Dichotomy and Monetary Neutrality • Nominal variables are variables measured in monetary units. • Real variables are variables measured in physical units.
  • 15. Copyright © 2004 South-Western The Classical Dichotomy and Monetary Neutrality • 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.
  • 16. Copyright © 2004 South-Western The Classical Dichotomy and Monetary Neutrality • The irrelevance of monetary changes for real variables is called monetary neutrality.
  • 17. Copyright © 2004 South-Western 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.
  • 18. Copyright © 2004 South-Western Velocity and the Quantity Equation V = (P × Y)/M • Where: V = velocity P = the price level Y = the quantity of output M = the quantity of money
  • 19. Copyright © 2004 South-Western Velocity and the Quantity Equation • Rewriting the equation gives the quantity equation: M × V = P × Y
  • 20. Copyright © 2004 South-Western Velocity and the Quantity Equation • The quantity equation relates the quantity of money (M) to the nominal value of output (P × Y).
  • 21. Copyright © 2004 South-Western 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.
  • 22. Figure 3 Nominal GDP, the Quantity of Money, and the Velocity of Money Copyright © 2004 South-Western Indexes (1960 = 100) 2,000 1,000 500 0 1,500 1960 1965 1970 1975 1980 1985 1990 1995 2000 Nominal GDP Velocity M2
  • 23. Copyright © 2004 South-Western 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.
  • 24. Copyright © 2004 South-Western 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.
  • 25. Figure 4 Money and Prices During Four Hyperinflations Copyright © 2004 South-Western (a) Austria (b) Hungary Money supply Price level Index (Jan. 1921 = 100) Index (July 1921 = 100) Price level 100,000 10,000 1,000 100 19251924192319221921 Money supply 100,000 10,000 1,000 100 19251924192319221921
  • 26. Figure 4 Money and Prices During Four Hyperinflations Copyright © 2004 South-Western (c) Germany 1 Index (Jan. 1921 = 100) (d) Poland 100,000,000,000,000 1,000,000 10,000,000,000 1,000,000,000,000 100,000,000 10,000 100 Money supply Price level 19251924192319221921 Price level Money supply Index (Jan. 1921 = 100) 100 10,000,000 100,000 1,000,000 10,000 1,000 19251924192319221921
  • 27. Copyright © 2004 South-Western 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.
  • 28. Copyright © 2004 South-Western 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 effect, when the rate of inflation rises, the nominal interest rate rises by the same amount. • The real interest rate stays the same.
  • 29. Figure 5 The Nominal Interest Rate and the Inflation Rate Copyright © 2004 South-Western Percent (per year) 1960 1965 1970 1975 1980 1985 1990 1995 2000 0 3 6 9 12 15 Inflation Nominal interest rate
  • 30. Copyright © 2004 South-Western THE COSTS OF INFLATION • A Fall in Purchasing Power? • Inflation does not in itself reduce people’s real purchasing power.
  • 31. Copyright © 2004 South-Western THE COSTS OF INFLATION • Shoeleather costs • Menu costs • Relative price variability • Tax distortions • Confusion and inconvenience • Arbitrary redistribution of wealth
  • 32. Copyright © 2004 South-Western Shoeleather 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.
  • 33. Copyright © 2004 South-Western Shoeleather 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.
  • 34. Copyright © 2004 South-Western 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.
  • 35. Copyright © 2004 South-Western 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.
  • 36. Copyright © 2004 South-Western 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.
  • 37. Copyright © 2004 South-Western 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.
  • 38. Table 1 How Inflation Raises the Tax Burden on Saving Copyright©2004 South-Western
  • 39. Copyright © 2004 South-Western 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.
  • 40. Copyright © 2004 South-Western 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.
  • 41. Copyright © 2004 South-Western 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.
  • 42. Copyright © 2004 South-Western 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.
  • 43. Copyright © 2004 South-Western 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.
  • 44. Copyright © 2004 South-Western Summary • Economists have identified six costs of inflation: • Shoeleather costs • Menu costs • Increased variability of relative prices • Unintended tax liability changes • Confusion and inconvenience • Arbitrary redistributions of wealth
  • 45. Copyright © 2004 South-Western 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.

Notas del editor

  1. Bullet 2: Mankiw has removed the word, “directly”
  2. Velocity shouldn’t be in bold. Maybe move V down and align equal signs--it’s not..
  3. Align text for second bullet.
  4. The equation of the fisher effect must appear here or on a new next slide: “Nominal interest rate = real interest rate + inflation rate”
  5. I believe this slide is out of place. It belongs in the previous chapter. Delete it here.