Money Growth &

Inflation

Chapter 28

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In this chapter, you will study:
 The definition and measures of inflation
 Two types of inflation.
 The causes of inflation and the quantity
theory of money.
 The relationship between inflation and
interest rates.
 The costs of inflation.

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 Inflation
 Inflation
An increase in the overall level of prices in
the economy
 Inflation rate
The percentage change in the price level
from the previous period

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 Inflation & Its Historical Aspects
 Inflation
 Deflation

A decrease in the overall level of prices in the

economy (the U.S. 1818-1821)
 Disinflation

A reduction in the rate of inflation (Vietnam

2011-2013)
 Hyperinflation

An extraordinary high rate of inflation

(Germany after World War I)
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 Hyperinflation in Venezuela

 Replacing toilet paper with

cash would seem an
extremely affluent action in
most countries. But in
Venezuela, it's now the
financially prudent thing to
do.

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 Types of Inflation

 Demand-pull inflation
 Cost-push inflation

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Demand-Pull Inflation

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Cost-push Inflation

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 The level of prices and the
value of money
 Price level (P): number of dollars needed
to buy a basket of goods and services
 Value of money (1/P): number of goods
and services bought by each dollar
=> P  => 1/P 
=> When the price level rises, the value of
money falls.

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Money Supply, Money Demand,
and Monetary Equilibrium
 Money Supply (MS)
• Determined by the Central Bank and the
banking system
• Assumptions: The quantity of money
supplied is a policy variable that the
Central Bank controls directly and
completely

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Money Supply, Money Demand,
and Monetary Equilibrium
 Money Demand (MD)
 Determined by many factors: the level of
reliability on credit cards, whether an
ATM is easy to find, the interest rate, the
overall price level in the economy
 In the long-run, the overall price level
turns out to be the most important
determinants

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Money Supply, Money Demand,
and Monetary Equilibrium
 Monetary Equilibrium: The point at
which the quantity of money demanded
balances the quantity of money supplied

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 Money Supply, Money Demand, and
the Equilibrium Price Level
Value of Price
Money (1/P) Money supply
Level (P)
(High) 1 1 (Low)

3/4 1.33
value of money

price level
Equilibrium
1/2 2
Equilibrium

1/4 4
Money
demand
(Low) 0 (High)
Quantity fixed Quantity of
by the Central Bank Money
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 The Effects of Monetary Injection
Value of Price
Money (1/P) MS1 MS2
Level (P)
(High) 1 1. An increase 1 (Low)
in the money
supply...
3/4 1.33
2. ...decreases the
value of money ...

3. …and
increases the
price level
A
1/2 2

B
1/4 4
Money
demand
(Low) 0 (High)
M1 M2 Quantity of
Money
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The Quantity Theory of Money
 Quantity theory of money: explains how
the price level is determined and why it
might change over time
 The quantity of money available in the
economy determines the price level.
 The primary cause of inflation is the growth
in the quantity of money.

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 Classical Dichotomy and
Monetary Neutrality
 Classical Dichotomy: the separation of
economic variables into two groups:
• Nominal variables: variables measured in
monetary units
• Real variables: measured in physical units

 Monetary neutrality: changes in the

money supply affect nominal variables but
not real variables.
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Velocity and the Quantity Equation
 Velocity of money: the speed at which the typical
dollar bill travels around the economy from wallet
to wallet.

MxV=PxY
Where: V = velocity
P = the price level
Y = the quantity of output
M = the quantity of money
·
P x Y = nominal value of output
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 The Quantity Theory of Money

M = (P x Y)/V
 Anincrease in the quantity of money (M)
 Changes in other three variables

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 Quantity of Money and the
Indexes
(1960 = 100)
Velocity of Money in USA
1,500
Nominal GDP

M2
1,000

500

Velocity

0
1960 1965 1970 1975 1980 1985 1990 1995 2000
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 The Quantity Theory of Money
• V: relatively stable.
• M  (P x Y).
• Money is neutral  does not affect Y
• M  P
=> Rapid increase in money supply causes
high inflation rate

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 The inflation tax
 Inflation tax: The revenue the
government raises by printing money
 An inflation tax is like a tax on everyone
who holds money.
 Most hyperinflations originated from
government’s high spending
 Inflation ends when the government
institutes fiscal reforms such as cuts in
government spending.
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 The Fisher Effect
 Fisher effect: when the rate of inflation
rises, the nominal interest rate rises by
the same amount and the real interest
rate stays the same.
Nominal Interest Rate = Real
Interest Rate + Inflation

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 Discussion

 Techcombank doubles the deposit

interest rate from 7% to 14% per year
 Meanwhile, the inflation rate rockets
from 3% to 20%
 Should you put your money at the bank?
If not, what would you do instead?

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 The Costs of Inflation:
A Fall in Purchasing Power?
 Increasing overall price level erodes the
value of money.
 People earn income by selling their services
• Pay more for what they buy.
• Get more for what they sell.
=> Nominal income tends to keep pace
with rising prices.
=> Inflation does not itself reduce people’s
real purchasing power.
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 The Costs of Inflation
 Shoeleather costs
 Menu costs
 Relative price variability and the
misallocation of resources
 Inflation-induced tax distortions
 Confusion and inconvenience
 Arbitrary redistribution of wealth – a
special cost of unexpected inflation
Self-study

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 Shoeleather Costs

The resources wasted when

inflation encourages people
to reduce their money holdings.

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 Shoeleather Costs
 Inflation erodes the real value of money
People try to minimize their cash
holdings More frequent trips to the
bank to withdraw money from interest-
bearing accounts.
 Costs of reducing money holdings:
 time and convenience sacrificed to keep less
money on hand.
 less productive activities.

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 Menu Costs
 Menu costs: costs of price adjustment
(Eg: the cost of deciding on and printing
new price lists and catalogs)
 Inflation increases menu costs as firms
must change their price more frequently
to keep up with other prices in the
economy => a resource-consuming
process that takes away from other
productive activities.
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 Relative-Price Variability and
the Misallocation of Resources
 Relative price: the price of one good
compared to the price of others in the
economy
 Inflation distorts relative prices

 Distort consumer decisions

 less able for markets to allocate

resources to their best use.

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Inflation-Induced Tax Distortion

 Inflation blows up the size of capital

gains
 Tax law does not take account of
inflation and compute income tax
based on nominal income
=> Increase the tax burden on capital
gains

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Inflation-Induced Tax Distortion

 The income tax treats the nominal

interest earned on savings as income.
 Part of the nominal interest rate merely
compensates for inflation.
=>The after-tax real interest rate is
reduced, making saving less attractive,
depressing economic growth in the long-
run
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 How Inflation Raises the Tax
Burden On Saving
Economy 1 Economy 2
(price stability) (inflation)

Real interest rate 4% 4%

Inflation rate 0 8

Nominal interest rate 4 12

(Real interest rate + inflation rate)
Reduced interest due to 25 percent tax 1 3
(.25 x nominal interest rate)
After-tax nominal interest rate 3 9
(.75 x nominal interest rate)
After-tax real interest rate 3 1
(after-tax nominal interest rate - inflation rate)

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Confusion and Inconvenience
 Money is used to measure economic
transactions, to quote prices and record
debts.
 Inflation causes dollars to have different
real values at different times
 Difficult to compare real revenues, costs,
and profits over time
 Impede investors’ making right decisions

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Arbitrary Redistribution of Wealth
 Unexpected changes in prices redistributes
wealth among debtors and creditors
 Inflation is taken into account when setting
nominal interest rate for loans
 If inflation is not up to expectation:
• Unexpected hyperinflation enriches at the
expense of creditors
• Unexpected deflation enriches creditors at the
expense of debtors

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 Lecture Review
 Definition and measures of inflation
 Types of inflation

 Causes of inflation and the quantity

theory of money
 Inflation and interest rates

 Costs of inflation