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Money Growth and Inflation

chap 17

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35 views

Money Growth and Inflation

chap 17

Uploaded by

yurai.kaze
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Money Growth and

Inflation

17

THE CLASSICAL THEORY OF


INFLATION
Inflation: Historical Aspects
Over the past 60 years, prices have risen on average
about 4 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.

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 controls the quantity of money
supplied.

Money Supply, Money Demand, and


Monetary Equilibrium
Money demand has several determinants,
including interest rates and the average level of
prices in the economy.
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.

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
Value of
Money, 1/P
(High)

Price
Level, P

Money supply

1.33

/4

12

Equilibrium
value of
money

(Low)

(Low)

2
Equilibrium
price level
4

14

Money
demand
0

Quantity fixed
by the Fed

Quantity of
Money

(High)

Figure 2 The Effects of Monetary Injection

Value of
Money, 1/P
(High)

MS1

MS2

1
1. An increase
in the money
supply . . .

2. . . . decreases
the value of
money . . .

Price
Level, P

/4

12

1.33

2
B

14

(Low)

3. . . . and
increases
the price
level.

4
Money
demand
(High)

(Low)
0

M1

M2

Quantity of
Money

THE CLASSICAL THEORY OF


INFLATION
The Quantity Theory of Money
Implications:
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.

The Classical Dichotomy and Monetary


Neutrality
Nominal variables are variables measured in
monetary units.
Real variables are variables measured in
physical units.
Changes in the money supply affect nominal
variables in long term but not real variables.
The irrelevance of monetary changes for real
variables is called monetary neutrality.

Velocity and the Quantity Equation


The velocity of money refers to the speed at
which the typical dollar bill travels through the
economy.
V = (P Y)/M
Where: V = velocity
P = the price level
Y = the quantity of output
M = the quantity of money

Velocity and the Quantity Equation


Rewriting the equation gives the quantity
equation:
MV=PY
The quantity equation relates the quantity of
money (M) to the nominal value of output
(P Y).

Figure 3 Nominal GDP, the Quantity of Money, and


the Velocity of Money
Indexes
(1960 = 100)
2,000
Nominal GDP
1,500
M2

1,000

500
Velocity
0

1960

1965

1970

1975

1980

1985

1990

1995

2000

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).

Figure 4 Money and Prices During Four


Hyperinflations

(a) Austria

(b) Hungary

Index
(Jan. 1921 = 100)

Index
(July 1921 = 100)

100,000

100,000
Price level

Price level

10,000

10,000

Money supply

1,000
100

Money supply

1,000

1921

1922

1923

1924

1925

100

1921

1922

1923

1924

1925

Figure 4 Money and Prices During Four


Hyperinflations

(c) Germany

(d) Poland

Index
(Jan. 1921 = 100)
100,000,000,000,000
1,000,000,000,000
10,000,000,000
100,000,000
1,000,000
10,000
100
1

Index
(Jan. 1921 = 100)
10,000,000

Price level
Money
supply

Price level

1,000,000

Money
supply

100,000
10,000
1,000

1921

1922

1923

1924

1925

100

1921

1922

1923

1924

1925

THE COSTS OF INFLATION


A Fall in Purchasing Power?
Inflation does not in itself reduce peoples real
purchasing power.

THE COSTS OF INFLATION

Shoeleather costs
Menu costs
Relative price variability
Tax distortions
Confusion and inconvenience
Arbitrary redistribution of wealth

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.

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.

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.
The after-tax real interest rate falls, making
saving less attractive.

Table 1 How Inflation Raises the Tax Burden on


Saving

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.

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