Money Growth and inflation

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 Outline
• The classical theory of inflation
– Level of prices; value of money
– Money demand, money supply and monetary
equilibrium
– Effects of a monetary injection
– Adjustment process
– Classical dichotomy and monetary neutrality
– Velocity and the quantity equation
• The inflation tax
• The Fisher effect
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 The Classical Theory of Inflation, Part 1

• Classical theory of money

– Quantity theory of money
– Explain the long-run
determinants of the price level
– Explain the inflation rate

“So what’s it going to

be? The same size as
last year or the same
price as last year?”

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 Level of Prices; Value of Money
• Inflation
– Economy-wide phenomenon
– Concerns the value of economy’s medium
of exchange
• Inflation: rise in the price level
– Lower value of money
– Each dollar buys a smaller quantity of
goods and services

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 The Classical Theory of Inflation, Part 2

• Money demand
– Reflects how much wealth people want to
hold in liquid form
– Depends on
• Credit cards
• Availability of ATM machines
• Interest rate
• Average level of prices in economy
– Demand curve – downward sloping

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 The Classical Theory of Inflation, Part 3

• Money supply
– Determined by the RBI and the banking
system
– Supply curve is vertical
• In the long run
– Money supply and money demand are
brought into equilibrium by the overall
level of prices

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 Figure 1 How the Supply and Demand for Money
Determine the Equilibrium Price Level

The horizontal axis shows the quantity of money. The left vertical axis shows the value of money,
and the right vertical axis shows the price level. The supply curve for money is vertical because the
quantity of money supplied is fixed by the Fed. The demand curve for money is downward sloping
because people want to hold a larger quantity of money when each dollar buys less. At the
equilibrium, point A, the value of money (on the left axis) and the price level (on the right axis) have
adjusted to bring the quantity of money supplied and the quantity of money demanded into balance.

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 Effects of a Monetary Injection, Part 1

• Economy is in equilibrium
– If the RBI doubles the supply of money
• Prints money
– Or the RBI undertakes: open-market
purchase
– New equilibrium
• Supply curve shifts right
• Value of money decreases
• Price level increases

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Figure 2 An Increase in the Money Supply

When the Fed increases the supply of money, the money supply curve shifts from MS 1 to MS2.
The value of money (on the left axis) and the price level (on the right axis) adjust to bring supply
and demand back into balance. The equilibrium moves from point A to point B. Thus, when an
increase in the money supply makes dollars more plentiful, the price level increases, making
each dollar less valuable.

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 Effects of a Monetary Injection, Part 2

• Quantity theory of money

– The quantity of money available in the
economy determines (the value of money)
the price level
– Growth rate in quantity of money available
determines the inflation rate

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 Effects of a Monetary Injection, Part 3

• Adjustment process (from old to new

equilibrium)
– Excess supply of money
– Increase in demand of goods and services
– Price of goods and services increases
– Increase in price level
– Increase in quantity of money demanded
– New equilibrium

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 Classical Dichotomy, Part 1
• Nominal variables
– Variables measured in monetary units
• Dollar prices
• Real variables
– Variables measured in physical units
• Relative prices, real wages, real interest rate
• Classical dichotomy
– Theoretical separation of nominal and real
variables
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 Classical Dichotomy, Part 2
• Developments in the monetary system
– Influence nominal variables
– Irrelevant for explaining real variables
• Monetary neutrality
– Changes in money supply don’t affect real
variables
– Not completely realistic in short-run
– Correct in the long run

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 Velocity and the Quantity Equation, Part 1

• Velocity of money (V)

– Rate at which money changes hands
• V = (P × Y) / M
P = price level (GDP deflator)
Y = real GDP
M = quantity of money

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 Velocity and the Quantity Equation, Part 2

• Quantity equation: M × V = P × Y
• Quantity of money (M)
• Velocity of money (V)
• Dollar value of the economy’s output of goods
and services (P × Y )
– Shows: an increase in quantity of money
• Must be reflected in:
– Price level must rise
– Quantity of output must rise
– Velocity of money must fall

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 Figure 3 Nominal GDP, the Quantity of Money, and
the Velocity of Money

This figure shows the nominal value of output as measured by nominal GDP, the quantity of
money as measured by M2, and the velocity of money as measured by their ratio. For
comparability, all three series have been scaled to equal 100 in 1960. Notice that nominal GDP
and the quantity of money have grown dramatically over this period, while velocity has been
relatively stable.
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 Quantity Theory of Money, Part 1
1. Velocity of money
– Relatively stable over time
2. Changes in quantity of money, M
– Proportionate changes in nominal value of
output (P × Y)
3. Economy’s output of goods & services, Y
– Primarily determined by factor supplies
– And available production technology
– Money does not affect output
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 Quantity Theory of Money, Part 2
4. Change in money supply, M
– Induces proportional changes in the
nominal value of output (P × Y)
• Reflected in changes in the price level (P)
5. When the central bank increases the
money supply rapidly
– High rate of inflation

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 The Inflation Tax
• The inflation tax
– Revenue the government raises by
creating (printing) money
– Like a tax on everyone who holds money
• When the government prints money
• The price level rises
• And the dollars in your wallet are less
valuable

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 The Fisher Effect, Part 1
• Principle of monetary neutrality
– An increase in the rate of money growth
– Raises the rate of inflation
– But does not affect any real variable
• Real interest rate = Nominal interest rate
– Inflation rate
• Nominal interest rate = Real interest rate
+ Inflation rate

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 The Fisher Effect, Part 2
• Fisher effect
– One-for-one adjustment of nominal
interest rate to inflation rate
– When the central bank increases the rate
of money growth
– Long-run result
• Higher inflation rate
• Higher nominal interest rate

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Figure 5 The Nominal Interest Rate and the
Inflation Rate

This figure uses annual data since 1960 to show the nominal interest rate on three-month
Treasury bills and the inflation rate as measured by the consumer price index. The close
association between these two variables is evidence for the Fisher effect: When the inflation rate
rises, so does the nominal interest rate.

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