Macro Lecture ch12 Money Growth and Inflation

8/9/2019 Macro Lecture ch12 Money Growth and Inflation

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Money Growth and Inflation

Dr. Katherine Sauer

Principles of Macroeconomics

ECO 2010

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Overview:

I. Money MarketII. Classical Dichotomy and Money Neutrality

III. Quantity Theory of Money

IV. Fisher Effect

V. Costs of Inflation

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A little history

Inflation originally referred to increases in the amount of money

in circulation.

When gold was used as currency:

- government pulls coins out of circulation

- melts them down- mixes them with other metals

- reissues them at the same nominal value

The government could issue more coins without needing to

increase the amount of gold used to make them.

The money supply would rise, but the value of each coin fell.

Consumers needed more coins to make the same purchases.3


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US:

Currency was printed during the Civil War.

The term inflation referred to the currency depreciation that

happened when the quantity of bank notes exceeded the quantity

of metal available for their redemption.

- did not refer to an increase in prices

In modern times, inflation is an increase in the overall price

level.


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The Classical Theory of Inflation: (long run theory)

The price level is inversely related to the value of money.

- if prices are low, dont need much money to make your

transactions the value of money is high

- if prices are high, need more money to make your

transactions the value of money is low

(Think of the value of money aspurchasing power.)


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value of

money

Quantity of Money

MS

0

low

The Money Supply is

verticalbecause it is set by

the Fed.

It will shift when the Fed

changes monetary policy.

- Fed buys bonds, MS

shifts right

- Fed sells bonds, MS

shifts left

price

level

low

high

high

(P)(1/P)


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value of

money

Quantity of Money

MS

MD

0

low

The Money Demand is

downward sloping.

-As the value of money

falls, the quantity ofmoney needed to make

your purchases rises

-A

s the price level rises,the quantity of money

needed to make your

purchases rises

The Money Demand curvewill shift if income

changes.

- increase in income,

rightward shift

price

level

low

high

high

(P)(1/P)


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In the long run, the overallprice level adjusts to bring money

supply and money demand into equality.- if money supply > money demand, price level rises

- if money supply < money demand, price level falls

(In the short run, interest rates play a key role)


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value of

money

Quantity of Money

MS

MDlow

Ex: The effect of a

monetary injection

1) Fed buys bonds

2) Money Supply increases

(shifts right)

3) value of money falls and

price level rises (inflation)

4) quantity of money rises

price

level

low

high

high

(P)(1/P)

QM1

value1 P1

MS2

value2 P2

QM2


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value of

money

Quantity of Money

MS

MDlow

Ex: The effect of a

decrease in consumer

incomes

1) Lower incomes mean

fewer transactions

2) Money Demanddecreases (shifts left)

3) value of money falls and

price level rises (inflation)

4) quantity of money stays

constant

price

level

low

high

high

(P)(1/P)

QM1

value1 P1

MD2

value2 P2


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value of

money

Quantity of Money

MS

MDlow

To counteract the rising

price level, the Fed may

wish to contract the money

supply and stabilize prices.

1) Fed sells bonds

2) Money Supply decreases

3) Value of money and

price level stabilize at

initial level

price

level

low

high

high

(P)(1/P)

QM1

value1 P1

MD2

value2 P2

MS2

P3value3

QM3


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II. The Classical Dichotomy and Money Neutrality

Divide all economic variables into 2 groups:- nominal (measured in monetary units)

- real (measured in physical units)

This separation of real and nominal variables is called theclassical dichotomy.

Money Neutrality says that changes in the money supply will

affect nominal variables but not real variables.

(true in long run, not in short run)


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III. The Quantity Theory of Money (monetarists)

The quantity of money determines its value and the price level.

Inflation is caused by growth in the money supply.

(How the price level is determined and why it changes over time.)

The Quantity Equation:

M V = P Y

M: money supply (M1 or M2)

P: price level (CPI or GDPdeflator)

Y: real GDP

V: velocity of money: rate at which money circulates


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The term ofP Y is nominal GDP.

The quantity equation shows that when the money supply changes,

the price level, velocity, or real GDP must change.

M V = P Y

M = P Y

V


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For the US, velocity has been fairly stable over time.

M V = P Y

So, an increase in the money supply will increase nominal GDP.

If money neutrality is true, then real variables arent affected by

changes in the money supply.

M V = P Y

So, any increase in the money supply will cause an increase in the

price level.

In other words, an increase in the money supply leads to inflation.


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This is assuming that the change is initiated by a change in the

money supply.

If the change stems from an increase in RGDP, then the money supply

can grow without causing inflation.

Recap: if velocity is constant and money neutrality is true, then any

increase in the money supply will cause aproportional increase in theprice level (inflation)

We will usually assume velocity is constant, but not necessarily that

money neutrality is true.

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Example: In 2002 the Money Supply was $200b and the GDP

deflator was 4. In 2003 the Money Supply was $240b, the GDP

deflator was 4.6, and nominal GDP was $1200b.

Assuming velocity is stable, by how much did real GDP change?

2002

MV = PY

200V = 4Y

200x5=4Y

1000 = 4Y

250 = Y

2003

MV = PY

240V = 1200

V = 5

PY = 12004.6Y=1200

Y = 260.9

Between 2002 and 2003 real GDP increased by $10.9b.


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IV. The Fisher Effect

Recall: i = r +

The Supply and Demand for Loanable funds determine the real

interest rate.

Growth in the money supply determines the inflation rate.

The Fisher Effect is the one for one adjustment of the nominal

interest rate to the rate of inflation.

- long run (in the short run inflation can be unexpected)


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V. The Costs of Inflation

Inflation reduces purchasing powerin many different ways:

1. Shoeleather costs are the resources that are wasted when

inflation encourages people to decrease their money holdings.

- cost, time, inconvenience of physically getting more

cash

2. Menu costs are the costs of physically changing prices.

- reprint menu- new price tags on shelves

- update electronic database


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3. Relative price variability and misallocation of resources

- not all prices can adjust immediatelybecause of contracts

4.Arbitrary redistribution of wealth

- helps borrowers, harms lenders

5. Tax distortions- the nominal value of interest and capital gains are taxed

6. Confusion and inconvenience


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Note on hyperinflation:

Hyperinflation is inflation that exceeds 50% per month.

It usually occurs when the government prints way to much

money to pay for things.

Historical Examples:

In the 1920s, the WeimarRepublic of Germany was issuing

2trillion Mark notes

- postage stamps had a face value of 50 billion Mark- largest note was 100trillion Mark

- exchange rate was 1 US dollar to 4trillion Mark


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In 1946 the Hungarian National Bank issued the largest

denomination banknote ever issued for circulation

100 quintillion pengo 10

hundred million billion pengo

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Hungarys hyperinflation held the record for the highest monthly

inflation rate ever.

41,900,000,000,000,000% (4.19 1016%) in July, 1946

This meant prices doubled every 13.5 hours.

More recently, Zimbabwe has experienced hyperinflation and as of

February 2009 people stopped using the currency all together.


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It is not a secret that increasing the money supply by too much will

cause hyperinflation.

So why do some governments still do it?

Governments may print money topay for purchases or to pay off

debt. (seigniorage revenue)

- TheU

S does not do this!!!!!!

This increases the money supply and results in inflation so

everyones purchasing power falls.

All money becomes less valuable as more is printed and so theprice level rises.

It is as if there is a tax on everyone who holds money.

The Inflation Tax

Macro Lecture ch12 Money Growth and Inflation

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