ECON 3010

Intermediate Macroeconomics

Chapter 5
Inflation:
Its Causes, Effects, and Social Costs
 U.S. inflation 1960–2012
12%

% change in
% change from 12 mos. earlier

10%
GDP deflator
8%

6%

4%

2%

0%
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
The quantity theory of money

 A simple theory linking the inflation rate to

the growth rate of the money supply.

 Begins with the concept of velocity…

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: In 2012,
◦ $500 billion in transactions
◦ money supply = $100 billion
◦ The average dollar is used in five transactions
◦ So, velocity = 5
Velocity, cont.
 This suggests the following definition:
T
V=
M
where
V = velocity
T = value of all transactions
M = money supply
Velocity, cont.
 Use nominal GDP as a proxy for total
transactions.

P ×Y
Then, V=
M

where
P = price of output (GDP deflator)
Y = quantity of output (real GDP)
P × Y = value of output (nominal GDP)
The quantity equation
 The quantity equation

M×V = P×Y

follows from the preceding definition of

velocity.
 It is an identity:
it holds by definition of the variables.
More on the quantity theory of money…

 starts with quantity equation

 assumes V is constant & exogenous:
V =V

Then, quantity equation becomes:

M ×V =P ×Y
The quantity theory of money, cont.
M ×V =P ×Y
How the price level is determined:
◦ With V constant, the money supply determines
nominal GDP (P × Y ).
◦ Real GDP is determined by the economy’s supplies
of K and L and the production function (Chap. 3).
◦ The price level is
P = (nominal GDP)/(real GDP).
The quantity theory of money, cont.
 Math Fact: The growth rate of a product equals
the sum of the growth rates.

 The quantity equation in growth rates:

∆M ∆V ∆P ∆Y
+ = +
M V P Y

The quantity theory of money assumes

∆V
V is constant, so = 0.
V
The quantity theory of money, cont.
π (Greek letter pi ) ∆P
denotes the inflation rate: π =
P
The result from the ∆M ∆P ∆Y
= +
preceding slide: M P Y

Solve this result ∆M ∆Y

for π: π
= −
M Y
The quantity theory of money, cont.
∆M ∆Y
π
= −
M Y

 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.
Confronting the quantity theory with data

The quantity theory of money implies:

1. Countries with higher money growth rates
should have higher inflation rates.
2. The long-run trend in a country’s inflation rate
should be similar to the long-run trend in the
country’s money growth rate.

Are the data consistent with these implications?

 International data on inflation and
money growth
40
Belarus
35
30
Zambia
Inflation rate

25 Iraq
Turkey
(percent)

Serbia
20 Suriname
Mexico
15
U.S. Russia
10 Malta
5
0
Cyprus China
-5
-10 0 10 20 30 40 50
Money supply growth
(percent)
 U.S. inflation and money growth,
1960–2012
14%

M2 growth rate
12%
% change from 12 mos. earlier

10%

8%

6%

4%

2%
inflation
rate
0%
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
 U.S. inflation and money growth,
1960–2012
Inflation and money growth
14%
have the same long-run trends,
12%
as the quantity theory predicts.
% change from 12 mos. earlier

10%

8%

6%

4%

2%

0%
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Inflation and interest rates

 Nominal interest rate, i

not adjusted for inflation

 Real interest rate, r

adjusted for inflation: r = i − π
The Fisher effect

 The Fisher equation: i = r + π

 Chap. 3: S = I determines r.

 Hence, an increase in π
causes an equal increase in i.
U.S. inflation and nominal interest rates,
1960–2012
18%

14% nominal
interest rate
10%

6%

2%

inflation rate
-2%
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
 Inflation and nominal interest rates
in 96 countries
40
Nominal Turkey
interest rate 35
(percent) 30
Georgia Malawi
25
Ghana
Mexico
20
Brazil
15
Poland
10 Iraq
U.S.
5
Japan Kazakhstan
0
-5 0 5 10 15 20 25
Inflation rate
(percent)
NOW YOU TRY
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 π ?
 What must the Fed do if it wishes to
keep π constant?
20
ANSWERS
Applying the theory
V is constant, M grows 5% per year,
Y grows 2% per year, r = 4.
a. First, find π = 5 − 2 = 3.
Then, find i = r + π = 4 + 3 = 7.
b. ∆i = 2, same as the increase in the money growth
rate.
c. If the Fed does nothing, ∆π = 1.
To prevent inflation from rising,
Fed must reduce the money growth rate by
1 percentage point per year. 21
Two real interest rates
Notation:
 π = actual inflation rate
(not known until after it has occurred)
 Eπ = expected inflation rate

Two real interest rates:

 i – Eπ = ex ante real interest rate:
the real interest rate people expect
at the time they buy a bond or take out a loan
 i – π = ex post real interest rate:
the real interest rate actually realized
Why is inflation bad?
 Common misperception:
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…
 The CPI and Average Hourly Earnings,
1965–2012
900
Real average hourly earnings

Hourly wage in May 2012 dollars

800 in 2012 dollars, right scale $20

700

600 $15
1965 = 100

500

400 $10
Nominal average
300 hourly earnings,
(1965 = 100)
200 $5

100 CPI (1965 = 100)

0 $0
1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
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?
The social costs of inflation
…fall into two categories:

1. costs when inflation is expected

2. costs when inflation is different than
people had expected
The costs of expected inflation:
Shoeleather cost
 def: the costs and inconveniences of reducing money
balances to avoid the inflation tax.

 ↑π ⇒ ↑i
⇒ ↓ real money balances

 So, same monthly spending but lower average money

holdings means more frequent trips to the bank to
withdraw smaller amounts of cash.
The costs of expected inflation:
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.
The costs of expected inflation:
Relative price distortions

 Firms facing menu costs change prices infrequently.

 Different firms change their prices at different times,

leading to relative price distortions…
…causing microeconomic inefficiencies
in the allocation of resources.
The costs of expected inflation:
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 $1,000 (10%).
◦ Suppose π = 10% during the year.
Your real capital gain is $0.
◦ But the govt requires you to pay taxes on your
$1,000 nominal gain!!
The costs of expected inflation:
General inconvenience
 Inflation makes it harder to compare
nominal values from different time
periods.

 This complicates long-range financial

planning.
Additional cost of unexpected inflation:
Arbitrary redistribution of purchasing power

 Many long-term contracts not indexed,

but based on Eπ .
 If π turns out different from Eπ ,
then some gain at others’ expense.

 Example: borrowers & lenders

◦ If π > Eπ , then purchasing power is transferred
from lenders to borrowers.
◦ If π < Eπ , then purchasing power is transferred
from borrowers to lenders.
Additional cost of high inflation:
Increased uncertainty
 When inflation is high, it’s more variable and
unpredictable: π is different from Eπ more
often, and the differences tend to be larger
 So, arbitrary redistributions of wealth more
likely.
 This creates higher uncertainty,
making risk-averse people worse off.
One benefit of inflation

 Nominal wages are rarely reduced. 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.
The Classical Dichotomy
 Classical dichotomy:
the 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.