Macroeconomics

Topic 3C
Money and Inflation

Relationship between money and prices

 Inflation is an increase in the overall level

of prices.
 Inflation rate is the percentage increase
in the average of price level.
 It is one of the major concerns of the
public.
 Milton Friedman
– “Inflation is always and everywhere a
monetary phenomenon”.
 U.S. inflation and its trend,
1960-2006
15% % change in CPI
from 12 months
12%
earlier
9%
long-run trend
6%

3%

0%
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

© 2007 Worth Publishers, all rights reserved

Money and Inflation

 In particular, we are concerned with the
long-term trend of inflation. This can be
understood by:
– the changing money supply (act by the
central bank), or;
– The changing money demand (desire to
hold asset in form of money by the general
public).
 Money and Inflation
 One of the leading economic theories in
explaining how money affects the economy
in the long run is the quantity theory of
money.

 This theory starts with the quantity

equation and income velocity of money.

Income velocity of money

 People hold money to buy goods and services.

Each banknote will change hands many times
in transactions.

 Suppose, in an economy,
• the nominal GDP is $500 billion, and
• the money supply is $100 billion.
• On average, it looks like each dollar would
be used __ times in transactions.
 Income velocity of money
 The above rate at which money circulating in
the economy is called the income velocity of
money.

V = (P × Y) / M

The Quantity Equation

• From the definition of the income
velocity of money, we can derive the
quantity equation:

M ×V = P ×Y
where
M = money supply
V = income velocity of money
P = price of output (GDP deflator or CPI)
Y = quantity of output (real GDP)
 Income velocity of money

 The income velocity of money is in fact

related to the demand for money.
– k = how much money people would like to hold for every
dollar of income.

 When people want to hold less money

relative to their incomes, money changes
hands more frequently(V is larger)
 The smaller demand for money, the
_______the value of (k).

Income velocity of money

 The value of V (and thus money demand) is
affected by many factors, including:
– change in regulations of the financial system,
– major financial innovation and payment technology,
– The permanent income of households, etc.

 All these are institutional factors which would not

change suddenly.
 Therefore, some economists looked at the past
data and they believed that V was quite stable.
 Hence, income velocity of money is ____ in the long
run.
 The Quantity Theory of Money

 A simple theory linking the inflation

rate to the growth rate of the money
supply.
 Assumes V is constant & exogenous
V= V
 Under the assumption of a constant and
exogenous V, the quantity equation can
be rewritten as:

M ×V = P ×Y

The Quantity Theory of Money

M ×V = P ×Y
 With V constant, the money supply determines
nominal income (P x Y)
 Since, in the long run, real GDP is determined by
the economy’s supplies of K and L and the
production function.
 Any change in M will lead to a proportionate
change in nominal GDP and thus, this represents a
change in the price level.
 In the LR, price level is proportional to ___.
The Quantity Theory of Money
 In fact, real output grows over a long time horizon.
 It is more practical to interpret the quantity
equation in terms of growth rates format:

∆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

∆M ∆Y
π = −
M Y

 π is inflation rate.
 A certain amount of money supply
growth is required to facilitate real
economic growth,
 When money supply grows in ______ of
real economic growth, inflation arises.
 Example 1
 Suppose the real economic growth of a
country is 2% while the money supply
grows at 5%. Find the inflation rate
using QTM.

International data on inflation and money growth

(2007 – 2019)
 U.S. inflation and money growth,
1960-2006
15%

12% M2 growth rate

9%

6%

3%
inflation
rate
0%
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
slide 16
© 2007 Worth Publishers, all rights reserved

U.S. inflation and money growth,

1960–2019
 Fed, money supply and
macroeconomic stability
 By setting up long-term policy on the
growth in the money supply, central banks
may facilitate a smooth economic growth
without inducing a higher inflation.

 However, if we have an inaccurate estimate

of the long-term economic growth rate,
improper monetary policy may ignite an
undesirable level of inflation.

Example 2
 From Example 1, if the real economy
actually grows by 1%, and the money
supply still grows at 5%, what will
happen?
 Difficulties of conducting
monetary policy
 It is difficult to set up a long-term
monetary policy because:
– It is difficult to estimate the growth of
production capacity. (Topic 01A)
– Many unexpected shocks may happen in
short run (Topic 05-06)
– It is difficult to estimate the time lag of
monetary policy. (Topic 08A)
– The economic goal of the government and
the central bank may not always be the
same. (Topic 5C &Topic 08A)

Why excessive
money supply growth?

 It is well-known that excessive money

supply growth will lead to inflation. What
induce governments to increase money
supply excessively?
– ________: Increase Government revenue
– Reduce the real value of government debts
– Other political benefits
 Government and inflation

 When a government cannot raise taxes

or sell bonds to finance its spending, it
will print money.
 Printing money to raise revenue causes
inflation. Such inflation “tax away”
the purchasing power of people who
hold money. It is called __________.

Government and inflation

 Many governments own large debts.
Inflation would reduce the real value of
their debts and therefore a government
may gain short term benefit from
inflation.

 Moreover, at the beginning of an inflation,

people may have the wrong impression
that the economy is booming. This
provides an incentive for government
officials to use increase money supply
before an election.
 Money supply and inflation
- a brief summary
 So far, we learn that changing money
supply explains changing general price
level.
 Money supply is ultimately controlled by
the central bank.
 However, the demand for money – the
desire to hold money by the general
public – can also influence the general
price level.

Constant velocity?
 The QTM assumes a constant velocity
of money.
 In other words, it assumes a stable
money demand.
 Empirically, there are no conclusive
evidence to show that velocity is stable.
This means that money demand may
fluctuate.
Money demand and price level
 There is no definite conclusion concerning
the stability of velocity due to
differences in the definitions of money,
and the problem of time lag.
 Studies show that velocity of M2 is quite
stable, but velocity of M1 is not.
 If velocity is not stable, then money
demand may also affect the price level of
the economy.

Velocity – M1 vs. M2

http://cw.routledge.com/textbooks/rossana/links7.asp
 Money market equilibrium
and price level
 When the velocity is not stable, money
demand is not stable.

 Thus, a change in money demand may

result in a change in general price level.

 We can understand this relationship by

going through the mechanism of the
money market.

Money demand
 Money demand is the desire to hold
money as an asset for transactions.

 Money demand depends on both income

level and the nominal interest rate.
Money demand and income level
 Money is the asset used in transaction.
 When people have higher income level,
they buy more goods and services, and
they demand more money.

Nominal interest rate

 Interest is the compensation for deferred
consumption. In a society with fiat money,
it compensates for two things:
– the loss of real return from an investment
opportunity, r, and;
– the loss of purchasing power due to inflation, π.
 Thus, nominal interest rate, i is the
interest rate not adjusted for inflation:
i = r +π
 This is called the Fisher equation.
 Money demand and
the nominal interest rate
 Nominal interest rate, i, is the interest
rate not adjusted for inflation. Examples
include the interest rates that a bank
pays, or the interest rates earned by
holding bonds.

 Real interest rate, r , is determined in

the loanable fund market. It is the
interest rate adjusted for inflation. Thus,
r=i -π

Money demand and

the nominal interest rate
 By holding money, it is convenient for
transaction. But you have to give up the
returns from bank deposits, bonds or
other interest-earning assets, i.e.,
nominal interest rate i .

 Thus, i is the opportunity cost of holding

money, and,
 ↑i  ↓ in money demand.
 The money demand function
 Real money demand = L(i, Y)
 It depends:
– negatively on i
• i is the opportunity cost of holding
money
– positively on Y
• higher Y
 more spending
 so, need more money for transaction
purpose

Money market equilibrium

 For money demand, economists usually look
at the real money demand, L(i,Y), which is
measured in terms of the units of goods
purchased.

 The real money supply (real money balances)

is M/P, , the purchasing power of the money
stock, i.e., the quantity of goods it can buy.
 Money market equilibrium
 In equilibrium, the real money balance should
equal to the money demand.

M/P = L(i,Y)

 M is controlled by the central bank.

 L(i,Y) is determined by the public.
 When money demand and real money balance
are not equal, the price level (P) will adjust.

Example 3
 Suppose L (i,Y) = 5 + 6Y – 5i , M = 50.
 Find P1 if Y = 5 and i = 2.

 Suppose i increases to 3. Find P2.

 Example 4
Given the rising trend towards a cashless
society, how would this affect the money
demand and hence price level?
Explain the concept of money market
equilibrium.

The money demand function

and expectation
 From previous discussion, i = r + π
 But the determination of nominal
interest rate is forward looking. People
do not know the future inflation with
certainty. They have expectation only.
 So, we can rewrite the Fisher equation:
i = r + πe
 i is indeed affected by both r and πe .
 The money demand function
and expectation
 Real money demand
= L (i, Y)
= L (r + pe, Y)

 As nominal interest rate depends on

expected inflation rate, the money
demand also depends on πe.

Change in inflationary expectation

 Suppose Fed announces it will increase
the growth in money supply next year.
People will expect a higher inflation in
the next year.
 By Fisher equation, this increase in πe
will increase the nominal interest rate.
 Thus, the demand for real money
balance thus reduces.
 How P responds to ∆πe
 From the money market equilibrium:
M/P = L (r+pe ,Y)
 For r, Y, and M remain unchanged,
A ↑ in pe
 ↑ in i
 ↓ in real money demand
 To maintain the money market equilibrium,
M/P has to ↓. The current P has to ↑.

Inflation expectation
 This example demonstrates that
despite the change in monetary policy
(money supply growth) should happen
only in the future, as long as this is an
expected change, the current price
level will adjust.
 Discussion
 Read “U.S. consumer inflation expectations decline
to a new low: NY Fed survey”
(Reuters, 9 Sept 2019):
a. Why would “U.S. consumer inflation expectations
decline to a new low”?
b. How would this affect the decision of the Fed?
c. “ …consumers feel more confident … finding new
jobs if they were to become unemployed”.
What does it imply on the actual inflation
outlook?

https://www.reuters.com/article/us-usa-fed-survey/u-s-consumer-
inflation-expectations- decline-to-a-new-low-ny-fed-survey-
idUSKCN1VU1O5

The Classical Dichotomy

 Real variables are measured in physical
units: quantities and relative prices, e.g.
– quantity of output produced (Y)
– real wage: output earned per hour of
work (w)
– real interest rate: output earned in the
future by lending one unit of output
today (r)
 The Classical Dichotomy
 Nominal variables: measured in money
units, e.g.
– nominal wage: dollars per hour of work
(W)
– nominal interest rate: dollars earned in
future by lending one dollar today (i)
– the price level: the amount of dollars
needed to buy a representative basket
of goods (P)

The Classical Dichotomy

 Real variables were explained in Topic 1,
without considering the nominal variables.

 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.

 What really hurts the economy is not

higher prices as such, but the fact that
prices are constantly changing, which
distort decisions and reduce the
economy’s efficiency.

"Monetary policy has its limits

- it is not a panacea"
 But monetary policy doesn't make an
ageing economy young, it doesn't make an
economy which is having little innovation
suddenly innovate, it doesn't make an
economy with a Zombie banking sector
somehow miraculously healthy.” - Ken
Rogoff (former chief economist, IMF), 26
Sept 2016

http://www.bbc.com/news/business-37468566
 “Real” costs of inflation
 Confusion and Inconvenience
– Shoeleather Costs
– Menu Costs
– Business planning, etc
 Distorted relative prices, which
affects resources allocation
 Arbitrary Redistribution of Wealth
– Expected vs. unexpected inflation

One benefit of inflation

 A moderate inflation will better
facilitate the adjustment of real wages,
i.e., it makes the labour market works
better.
 It is because workers in general do not
accept a cut in nominal wage. A mild
inflation will help to reduce the real
wage of workers to the equilibrium
level.
 Deflation
 Deflation is even worse than inflation. It
makes people stop their spending and the
economy falls into a recession.
 “Prices are falling because the economy is
depressed; now we’ve just learned that
the economy is depressed because prices
are falling. That sets the stage for … a
‘deflationary spiral’ in which falling prices
and a slumping economy feed on each
other, plunging the economy into the
abyss.”
– Paul Krugman, “Fear itself,” New York Times Magazine,
September 30, 2001.

Key concepts of this topic

 Quantity Theory of Money
 Money Demand and the Money Market
Equilibrium
 Fisher Effect
– Nominal vs. Real interest rate
 The Classical Dichotomy
 Social cost of inflation
 Reading
 Mankiw
– p.110 - 115

 Wheelan, Charles
– “Naked Economics – undressing the
dismal science”, Chapter 10.

Self-study

Hyperinflation
 Hyperinflation
 In the long run, the primary cause of
inflation is the growth in money supply.

 The central bank, which controls the

money supply, has the ultimate control
over the rate of inflation.

 If the central bank increases the money

supply rapidly, the price level will rise
rapidly, i.e. inflation, or even
hyperinflation.

A few examples of hyperinflation

Country Period CPI M2 growth

inflation % % per year
per year
Israel 1983-85 338% 305%
Brazil 1987-94 1,256 1,451
Bolivia 1983-86 1,818 1,727
Ukraine 1992-94 2,089 1,029
Argentina 1988-90 2,671 1,583
Dem. 1990-96 3,039 2,373
Republic of
Congo/Zaire
Angola 1995-96 4,145 4,106
Peru 1988-90 5,050 3,517
Zimbabwe 2005-07 5,316 9,914
 Country with the highest inflation
rate in the world(2017)
Venezuela's inflation rate— 254.9% is in excess of 250%, more
than 10 times that of any other country.

(10 million% in 2019)

“Bags of Bricks” - The Economist,

August 26, 2006

 Discussions:
– This article is called “Bags of Bricks”.
What do “bricks” mean in Zimbabwe?
– How did the central bank of Zimbabwe
deal with the inflation?
– Do you think these methods are
effective?
– What would you suggest to the central
bank for combating inflation in
Zimbabwe?
 Reading
 Mankiw
– p.115 - 117