Lecture Note Chapter 4 Money and Inflation

Econ 202 Macroeconomic Theory 1Lecture Note Chapter 4Money and InflationUniversity of WaterlooDepartment of EconomicsSpring 2015IntroductionInflation is always and everywhere a monetary phenomenon. .. Milton FriedmanInflation is always and everywhere a fiscal phenomenon. .. Thomas Sargent

CHAPTER 4 Money and Inflation2IntroductionThis chapter explains the classical theory of money and inflation. The chapter has three main goals:(1). To explain the economic meaning of money and introduce money supply and money demand.(2). To examine the effects of monetary policy when prices are flexible.(3). To discuss the costs of inflation.CHAPTER 4 Money and Inflation3In this chapter, you will learnThe classical theory of inflationcauseseffectssocial costsClassical assumes prices are flexible & markets clear.Applies to the long run.4CHAPTER 4 Money and Inflation4U.S. inflation and its trend, 19602014% change in GDP deflatorOver the short run, the inflation rate can be volatile. In later chapters, we will learn about the forces that affect inflation in the short run. In this chapter, we focus on

Source: Federal Reserve Bank of St. Louishttp://research.stlouisfed.org/fred2/GDPDEF (percent change from year ago)

5U.S. inflation and its trend, 19602014the long-run trend behavior of inflation. We will learn a simple theory of inflation over the long run and see that its predictions are very consistent with U.S. and international data.

Note about the graph: The long-run trend line was produced in Excel, type polynomial order 3.

6The connection between money and pricesInflation rate = the percentage increase in the average level of prices. 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.7CHAPTER 4 Money and Inflation7What is inflation?Here is a great illustration of the power of inflation:In 1970, the New York Times cost 15 cents, the median price of a single-family home was $23,400, and the average wage in manufacturing was $3.36 per hour.In 2008, the Times cost $1.50, the price of a home was $183,300, and the average wage was $19.85 per hour.

19701950

2008Money: DefinitionMoney is the stock of assets that can be readily used to make transactions.

9CHAPTER 4 Money and Inflation9Money: Functionsmedium of exchangewe use it to buy stuff.store of valuetransfers purchasing power from the present to the future.unit of accountthe common unit by which everyone measures prices and values.The ease with which money is converted into other things such as goods and services--is sometimes called moneys liquidity.10CHAPTER 4 Money and Inflation10The definition of store of value (an item that transfers purchasing power from the present to the future) simply means that money retains its value over time, so you need not spend all your money as soon as you receive it. The idea should be familiar, even though Mankiws wording is a bit more sophisticated than most other texts.

Monetization increases efficiency!!!

Money is the yardstick with which we measure economic transactions. Without it, we would be forced to barter. However, barter requires the double coincidence of wantsthe unlikelysituation of two people, each having a good that the other wants at the right time and place to make an exchange.Money: Types1.fiat money is money by declaration.has no intrinsic valueexample: the paper currency we use2.commodity moneyhas intrinsic valueexamples: gold coins, cigarettes in P.O.W. camps3. When people use gold as money, the economy is said to be on a gold standard.

12CHAPTER 4 Money and Inflation

12Note: Many students have seen the film The Shawshank Redemption starring Tim Robbins and Morgan Freeman. Most of this film takes place in a prison. The prisoners have an informal underground economy in which cigarettes are used as money, even by prisoners who dont smoke. Students who have seen the film will better understand commodity money if you mention this example. Also, the textbook (p.79) has a case study on cigarettes being used as money in POW camps during WWII.

Discussion QuestionWhich of these are money? a.Currencyb.Checksc.Deposits in checking accounts (demand deposits)d.Credit cardse.Certificates of deposit (time deposits)13CHAPTER 4 Money and Inflation13Answers:a - yesb - no, not the checks themselves, but the funds in checking accounts are money.c - yes (see b)d - no, credit cards are a means of deferring payment. e - CDs are a store of value, and they are measured in money units. They are not readily spendable, though. The money supply and monetary policy definitionsThe money supply is the quantity of money available in the economy. Monetary policy is the control over the money supply. 14CHAPTER 4 Money and Inflation14 This is mostly review. The central bankMonetary policy is conducted by a countrys central bank. In Canada, the central bank is called the The Bank of Canada.

The official website : www.bankofcanada.ca

15CHAPTER 4 Money and Inflation15Again, this is mostly review.

To expand the money supply: BOC buys Canadian Government Bonds and pays for them with new money.

To reduce the money supply: BOC sells Canadian Government Bonds and receives the existing dollars and then destroys them.Open-Market Operations The purchase and sale of U.S. Treasury BondsThe Federal Reserve controls the money supply in 3 ways:Conducting Open Market Operations (buying and selling Treasury bonds).Changing the Reserve requirements (never really used).Changing the Discount rate which member banks (not meeting the reserve requirements) pay to borrow from BOC.Money Supply Measures in Canada, December 2005

18CHAPTER 4 Money and InflationMoney supply measures, June 2014 (US)9,952M1 + small time deposits, savings deposits, money market mutual funds, money market deposit accountsM22,270C + demand deposits, travelers checks, other checkable depositsM11,214CurrencyCamount ($ billions)assets includedsymbol19The most important thing that students should get from this slide is the following:Each successive measure of the money supply is BIGGER and LESS LIQUID than the one it follows. I.e., checking account deposits (in M1 but not C) are less liquid than currency. Money market deposit account and savings account balances (in M2 but not M1) are less liquid than demand deposits. Whether you require your students to learn the definitions of every component of each monetary aggregate is up to you. Most professors agree that students should learn the definitions of M1, M2, demand deposits, and time deposits. Some professors feel that, since the quantity of information students can learn in a semester is finite, it is not worthwhile to require students to learn such terms as repurchase agreements. However, you might orally state the definitions of such terms to help students better understand the nature of the monetary aggregates.

Source: Federal Reserve Board, H.6 release. http://www.federalreserve.gov/releases/h6/current/h6.htmFigures are seasonally adjusted. The Quantity Theory of MoneyA simple theory linking the inflation rate to the growth rate of the money supply.Begins with the concept of velocity20CHAPTER 4 Money and Inflation20Velocitybasic concept: the rate at which money circulates.definition: the number of times the average dollar bill changes hands in a given time period.example: In 2009, $500 billion in transactionsmoney supply = $100 billionThe average dollar is used in five transactions in 2009So, velocity = 521CHAPTER 4 Money and Inflation21In 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. Velocity, cont.This suggests the following definition:

where V = velocityT = value of all transactionsM = money supply

22CHAPTER 4 Money and Inflation22Velocity, cont.Use nominal GDP as a proxy for total transactions. Then,

where P = price of output (GDP deflator) Y = quantity of output (real GDP)P Y = value of output (nominal GDP)23CHAPTER 4 Money and Inflation23Think about 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 theres lots of great data on GDP. So from this point on, well use the income version of velocity.

The quantity equationThe quantity equationM V = P Yfollows from the preceding definition of velocity.It is an identity: it holds by definition of the variables.24CHAPTER 4 Money and Inflation24The quantity equationTransactions and output are related, because the more the economy produces, the more goods are bought and sold.If Y denotes the amount of output and P denotes the price of one unit of output, then the dollar value of output is PY. We encountered measures for these variables when we discussed the national income accounts.

CHAPTER 4 Money and Inflation25The quantity equationThis version of the quantity equation is called the income velocity of money, which tells us the number of times a dollar bill enters someones income in a given time.

CHAPTER 4 Money and Inflation26Money demand and the quantity equationWhen we analyze how money affects the real economy, it is often useful to express the quantity of money in terms of the goods and services it can buy. This amount M/P, is called the real money balances.Real money balances measure the purchasing power of the stock of money.M/P = real money balances, the purchasing power of the money supply.

CHAPTER 4 Money and Inflation27Money demand and the quantity equationA money demand function an equation that shows the determinants of the quantity of real balances people wish to hold. A simple money demand function: (M/P )d = k Ywhere, k = how much money people wish to hold for each dollar of income. (k is exogenous)28CHAPTER 4 Money and Inflation28Money demand and the quantity equationmoney demand: (M/P )d = k Y quantity equation: M V = P YThe connection between them: k = 1/VWhen people hold lots of money relative to their incomes (k is high), money changes hands infrequently (V is low) and vice versa.29CHAPTER 4 Money and Inflation29Back to the quantity theory of moneystarts with quantity equationassumes V is constant & exogenous:With this assumption, the quantity equation can be written as

30CHAPTER 4 Money and Inflation30The quantity theory of money, cont.How the price level is determined:With V constant, the money supply determines nominal GDP (P Y ).Real GDP is determined by the economys supplies of K and L and the production function (Chap 3).The price level is P = (nominal GDP)/(real GDP).

31CHAPTER 4 Money and Inflation31Its worthwhile to underscore the order (logical order, though not necessarily chronological order) in which variables are determined in this model (as well as the other models students will learn in this course).

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).

If, on an exam or homework problem, students forget the logical order in which endogenous variables are determined --- or on a more fundamental level, forget which variables are endogenous and which are exogenous --- then they are much less likely to earn the high grades that most of them desire.

[Note the similarity between the way P is determined and the definition of the GDP deflator from chapter 2.]

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

32CHAPTER 4 Money and Inflation32The quantity theory of money, cont. (Greek letter pi) denotes the inflation rate:

The result from the preceding slide was:Solve this result for to get33CHAPTER 4 Money and Inflation33The quantity theory of money, cont.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.

34CHAPTER 4 Money and Inflation34The 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.

The quantity theory of money, cont.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. 35CHAPTER 4 Money and Inflation35Note: the theory doesnt 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.

The quantity theory of money, cont.Note: the theory doesnt 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.

CHAPTER 4 Money and Inflation36Confronting the quantity theory with dataThe quantity theory of money implies1.countries with higher money growth rates should have higher inflation rates.2.the long-run trend behavior of a countrys inflation should be similar to the long-run trend in the countrys money growth rate.Are the data consistent with these implications?37CHAPTER 4 Money and Inflation37International data on inflation and money growthInflation rate (percent, logarithmic scale)Money supply growth(percent, logarithmic scale)SingaporeEcuadorTurkeyBelarusArgentinaIndonesia38CHAPTER 4 Money and InflationFigure 4-2, p.92

Each variable is measured as an annual average over the period 1999-2007.

The strong positive correlation is evidence for the Quantity Theory of Money.

Source: International Financial Statistics.

38Historical data on U.S. Inflation and money growth

39CHAPTER 4 Money and InflationFigure 4.1 pg 9239Confronting the quantity theory with dataData for the U.S. economy since 1870 provide broad support for the link between money growth and inflation implied by the quantity theory. Decadal averages over this period reveal a positive relationship between the GDP deflator and the growth of M2. International data show the correlation even more clearly.CHAPTER 4 Money and Inflation40U.S. inflation and money growth, 19602014M2 growth rateinflation ratesource: Federal Reserve Bank of St. Louishttp://research.stlouisfed.org/fred2/M2SL (percent change from year ago, quarterly aggregation method average)GDPDEF (percent change from year ago)

41U.S. inflation and money growth, 19602014Inflation 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. Louishttp://research.stlouisfed.org/fred2/M2SL (percent change from year ago, quarterly aggregation method average)GDPDEF (percent change from year ago)

42SeigniorageTo spend more without raising taxes or selling bonds, the govt 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.43CHAPTER 4 Money and Inflation43Introduction of abbreviation govt for governmentIts quicker and easier for students to write govt in their notes.

In the U.S., seigniorage accounts for only about 3% of total government revenue. In Italy and Greece, seigniorage has often been more than 10% of total revenue. In countries experiencing hyperinflation, seigniorage is often the governments main source of revenue, and the need to print money to finance government expenditure is a primary cause of hyperinflation.

See Case Study on p.90 Paying for the American Revolution.

SeigniorageWhile the government can print money and use that money to purchase goods and services, it obviously does not get these goods and services for free. Someone is paying for them. In effect, when the government prints new money, it levies an inflation tax. As more money is introduced into the economy, we now know that there will be inflation.

CHAPTER 4 Money and Inflation44SeigniorageAn increase in the money supply increases the general price level. This makes existing money in the economy worth less; existing money holdings decline in real value. Inflation serves as a tax on real balances.CHAPTER 4 Money and Inflation45SeigniorageSeigniorage is not an important source of revenue in North America, but it has been used to finance a significant fraction of government spending in some other countries.

CHAPTER 4 Money and Inflation46Inflation and interest ratesWe now turn to the distinction between nominal and real interest rates. The interest rate quoted in the newspapers is a nominal interest rate. It gives the number of dollars that will be paid next year for a dollar deposited today.CHAPTER 4 Money and Inflation47Inflation and interest ratesFor example, a 10 percent interest rate implies that $100 deposited today earns $110 next year. But suppose that prices also rise at 10 percent per year. Then, $100 deposited in the bank has exactly the same purchasing power in terms of real goods next year as this year.

CHAPTER 4 Money and Inflation48Inflation and interest ratesThe dollar price of goods is not ultimately important to people making economic decisions; rather, they care about real tradeoffs. An individual deciding whether to consume today or to save for consumption next year needs to know how much she can get in terms of goods next year if she gives up goods today. CHAPTER 4 Money and Inflation49Inflation and interest ratesIn other words, she cares about the real interest rate. The real interest rate corrects for inflation. In the preceding example, the real interest rate was zero, even though the nominal rate was 10 percent.

CHAPTER 4 Money and Inflation50Inflation and interest ratesNominal interest rate, inot adjusted for inflationReal interest rate, radjusted for inflation:r = i Remember that the real interest rate is the interest rate that matters for investment.51CHAPTER 4 Money and Inflation51The Fisher effectThe Fisher equation: i = r + Chap 3: S = I determines r . Hence, an increase in causes an equal increase in i.This one-for-one relationship is called the Fisher effect. 52CHAPTER 4 Money and Inflation52The Fisher effectNote that S and I are real variables. In chapter 3, we learned about the factors that determine S and I. These factors did not include the money supply, velocity, inflation, or other nominal variables.

CHAPTER 4 Money and Inflation53The Fisher effectHence, in the classical (long-run) theory we are learning, changes in money growth or inflation do not affect the real interest rate. This is why theres a one-for-one relationship between changes in the inflation rate and changes in the nominal interest rate.

CHAPTER 4 Money and Inflation54Deriving the Fisher EquationCHAPTER 4 Money and Inflation55

The Fisher effectAgain, the Fisher effect does not imply that the nominal interest rate EQUALS the inflation rate. It implies that CHANGES in the nominal interest rate equal CHANGES in the inflation rate, given a constant value of the real interest rate.

CHAPTER 4 Money and Inflation56The Fisher effectNotice that we now have two implications of an increase in the money growth rate.First, our theory predicts that an increase in the money growth rate of, say, 1 percent should increase the inflation rate by 1 percent. In turn, this should imply a 1 percent increase in the nominal interest rate. This link between the inflation rate and the nominal interest rate is known as the Fisher effect.CHAPTER 4 Money and Inflation57Inflation and nominal interest rate over time in Canada

58CHAPTER 4 Money and InflationU.S. inflation and nominal interest rates, 1960-2009inflation ratenominal interest rate59CHAPTER 4 Money and InflationA replica of Fig 4-3, p.95

The data are consistent with the Fisher effect: inflation and the nominal interest rate are very highly correlated. However, they are not perfectly correlated, which absolutely does not invalidate the Fisher effect. Over time, the saving and investment curves move around, causing the real interest rate to move, 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 (not seasonally adjusted) CPI from 12 months earlier. The nominal interest rate is the (not seasonally adjusted) 3-month Treasury bill rate in the secondary market. Data obtained from http://research.stlouisfed.org/fred2/

59Inflation and nominal interest rates across countriesNominal interest rate(percent, logarithmic scale)Inflation rate(percent, logarithmic scale)ZimbabweRomaniaTurkeyBrazilIsraelU.S.GermanyEthiopiaKenyaGeorgia60CHAPTER 4 Money and InflationSource: same as textbookEach variable is measured as an annual average over 1999-2007. The nominal interest rate is the rate on short-term government debt.

60The Fisher EffectThe data for the U.S. and other economies clearly reveal the connection between the inflation rate and the nominal interest rate suggested by the Fisher effect. They also reveal that the real interest rate changes over time.CHAPTER 4 Money and Inflation61NOW YOU TRY: Applying the theorySuppose 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?

62CHAPTER 4 Money and InflationThis exercise gives students an immediate application of the Quantity Theory of Money and the Fisher effect. The math is not difficult. NOW YOU TRY: Answersa.First, find = 5 2 = 3. Then, find i = r + = 4 + 3 = 7. b. i = 2, same as the increase in the money growth rate. c.If the Fed does nothing, = 1. To prevent inflation from rising, Fed must reduce the money growth rate by 1 percentage point per year. V is constant, M grows 5% per year, Y grows 2% per year, r = 4.63CHAPTER 4 Money and InflationAnswers---the details:a. First, we need to find . Constant velocity implies = (M/M) - (Y/Y) = 5 - 2 = 3. Then, i = r + = 4 + 3 = 7.

b. Changes in the money growth rate do not affect real GDP or its growth rate. So, a two-point increase in money growth causes a two-point increase in inflation. According to the Fisher effect, the nominal interest rate should rise by the increase in inflation: two points (from i=7 to i=9).

c. = (M/M) - (Y/Y). If (Y/Y) falls by 1 point, then will increase by 1 point; the Fed can prevent this by reducing (M/M) by 1 point. Intuition: With slower growth in the economy, the volume of transactions will be growing more slowly, which means that the need for new money will grow more slowly. Two real interest rates = actual inflation rate (not known until after it has occurred) e = expected inflation ratei 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.64CHAPTER 4 Money and Inflation64Two real interest ratesWhen people make inter-temporal economic decisions, they dont know for sure what the inflation rate will be. This means that, rather than the actual inflation rate, we should use the expected inflation rate. CHAPTER 4 Money and Inflation65Two real interest ratesThe relevant real interest rate for, say, investors decisions is defined as r = i e.The Fisher effect is modified: i = r + e.

CHAPTER 4 Money and Inflation66Money demand and the nominal interest rateIn 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. 67CHAPTER 4 Money and Inflation67The 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 consumers 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).

The money demand function(M/P )d = real money demand, dependsnegatively on i i is the opp. cost of holding moneypositively 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.)

68CHAPTER 4 Money and Inflation68An 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 consumers 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.

The money demand functionWhen people are deciding whether to hold money or bonds, they dont know what inflation will turn out to be. Hence, the nominal interest rate relevant for money demand is r + e.

69CHAPTER 4 Money and Inflation69Equilibrium

The supply of real money balancesReal money demand70CHAPTER 4 Money and Inflation70What determines whatvariablehow determined (in the long run)Mexogenous (the Bank of Canada)radjusts to make S = IY P adjusts to make

71CHAPTER 4 Money and Inflation71Again, 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.

How P responds to MFor 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.

72CHAPTER 4 Money and Inflation72This slide shows the connection between the money market equilibrium condition and the (simpler) Quantity Theory of Money, presented earlier in this chapter.

What about expected inflation?Over the long run, people dont consistently over- or under-forecast inflation, so e = on average. In the short run, e may change when people get new information. EX: Fed announces it will increase M next year. People will expect next years P to be higher, so e rises. This affects P now, even though M hasnt changed yet. 73CHAPTER 4 Money and Inflation73This slide and the next correspond to the subsection of Chapter 4 entitled Future Money and Current Prices, appearing on pp.96-97.

How P responds to e

For given values of r, Y, and M ,74CHAPTER 4 Money and Inflation74The linkages among money, prices and interest rates

75CHAPTER 4 Money and InflationDiscussion 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.76CHAPTER 4 Money and Inflation76 A common misperceptionCommon misperception: inflation reduces real wagesThis 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 data77CHAPTER 4 Money and Inflation77The CPI and Average Hourly Earnings, 196520141965 = 100Hourly wage in 2014 dollarsReal average hourly earnings in 2014 dollars, right scaleNominal average hourly earnings, (1965 = 100)CPI (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 doesnt. While the real wage is not constant, it exhibits no downward long-term trend.

(We wouldnt 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: BLSObtained from: http://research.stlouisfed.org/fred2/AHETPI = average hourly earnings: total private industries monthlyCPIAUCSL = CPI, all urban consumers, seasonally adjusted

78The classical view of inflationThe 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?79CHAPTER 4 Money and Inflation79The social costs of inflationfall into two categories:1. costs when inflation is expected.2. costs when inflation is different than people had expected. 80CHAPTER 4 Money and Inflation80The costs of expected inflation: 1. Shoe leather costdef: the costs and inconveniences of reducing money balances to avoid the inflation tax. i real money balancesRemember: 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. 81CHAPTER 4 Money and Inflation

81The costs of expected inflation: 2. Menu costsdef: The costs of changing prices.Examples:cost of printing new menuscost of printing & mailing new catalogsThe higher is inflation, the more frequently firms must change their prices and incur these costs.

82CHAPTER 4 Money and Inflation

82The costs of expected inflation: 3. Relative price distortionsFirms facing menu costs change prices infrequently.Example: A firm issues new catalog each January. As the general price level rises throughout the year, the firms relative price will fall. Different firms change their prices at different times, leading to relative price distortionscausing microeconomic inefficiencies in the allocation of resources. 83CHAPTER 4 Money and Inflation83The costs of expected inflation: 4. Unfair tax treatmentSome taxes are not adjusted to account for inflation, such as the capital gains tax. Example:Jan 1: you buy $10,000 worth of IBM stockDec 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!!84CHAPTER 4 Money and Inflation

84In 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 1995-2000, when lots of people were earning high capital gains, then there might have been more political pressure to index the capital gains tax.

The costs of expected inflation: 5. General inconvenienceInflation makes it harder to compare nominal values from different time periods.This complicates long-range financial planning.

85CHAPTER 4 Money and Inflation85Examples: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 isnt 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 doesnt accept the offer. :)

Additional cost of unexpected inflation: Arbitrary redistribution of purchasing powerMany long-term contracts not indexed, but based on 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 purchasing power is transferred from borrowers to lenders.86CHAPTER 4 Money and Inflation86Would it upset you off if somebody arbitrarily took wealth away from some people and gave it to others? Well, this in effect is whats happening when inflation turns out different than expected. Furthermore, its 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.)Additional cost of high inflation: Increased uncertaintyWhen inflation is high, its more variable and unpredictable: turns out different from 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. 87CHAPTER 4 Money and Inflation87One benefit of inflationNominal wages are rarely reduced, even when the equilibrium real wage falls. This hinders labor market clearing. Inflation allows the real wages to reach equilibrium levels without nominal wage cuts.Therefore, moderate inflation improves the functioning of labor markets. 88CHAPTER 4 Money and Inflation

88Students will better appreciate this point when they learn chapter 6 (the natural rate of unemployment). In this chapter, we will see how the failure of wages to adjust contributes to a long-term unemployment problem.

Hyperinflationdef: 50% per monthAll 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. 89CHAPTER 4 Money and Inflation

89What 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. 90CHAPTER 4 Money and Inflation90Why governments create hyperinflationWhen 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. 91CHAPTER 4 Money and Inflation91Solving the problem of hyperinflation is easy. Why, then, do governments allow hyperinflation to occur?

A few examples of hyperinflationcountryperiodCPI Inflation % per yearM2 Growth % per yearIsrael1983-85338%305%Brazil1987-941256%1451%Bolivia1983-861818%1727%Ukraine1992-942089%1029%Argentina1988-902671%1583%Dem. Republic of Congo / Zaire1990-963039%2373%Angola1995-964145%4106%Peru1988-905050%3517%Zimbabwe2005-075316%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 2007-2008 (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, Zimbabwes hyperinflation continued and became spectacular. The table on this slide excludes 2008 data because it is missing from the WDI database. Its easy to find estimates of Zimbabwes 2008 inflation, for example here: http://www.cato.org/zimbabwe. However, I cannot verify their reliability or find good data on Zimbabwes money supply in 2008. If you taught with a previous edition of my PowerPoints for Mankiws 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. 92The Classical DichotomyNote: 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. 93CHAPTER 4 Money and Inflation93Useful websiteshttp://minneapolisfed.org/pubs/region/int.cfmhttp://www.dictionaryofeconomics.com/dictionarywww.federalreserve.govwww.bankofcanada.caTextbooks on Monetary economics (Monetary economics is a sub discipline of economics that is very closely related to macroeconomics but that pays particular attention to financial institutions): -Gary Smith, Money, Banking, and Financial Intermediation (Lexington, Mass.: D.C. Heath, 1991) -Laurence Ball, Money, Banking, and Financial Markets (New York: Worth Publishers, 2008)

CHAPTER 4 Money and Inflation94AssignmentQuestions 3, 4 & 8 from the textbook.CHAPTER 4 Money and Inflation95Chapter SummaryCosts of inflationExpected inflationshoe leather costs, menu costs, tax & relative price distortions, inconvenience of correcting figures for inflationUnexpected inflationall of the above plus arbitrary redistributions of wealth between debtors and creditors

96CHAPTER 4 Money and Inflation96Chapter SummaryHyperinflationcaused by rapid money supply growth when money printed to finance govt budget deficitsstopping it requires fiscal reforms to eliminate govts need for printing money

97CHAPTER 4 Money and Inflation97Chapter SummaryClassical dichotomyIn 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 equilibrium determines price level and all nominal variables. Most economists believe the economy works this way in the long run.

98CHAPTER 4 Money and Inflation98