Chapter 17 Money Growth and InflationEnd-of-Chapter ProblemsThe Meaning of MoneyTHE CLASSICAL THEORY OF INFLATIONSlide 5Slide 6This DecadeSlide 8Aside: TerminologyMoney Supply, Money Demand, and Monetary EquilibriumSlide 11Slide 12Slide 13Figure 1 Money Supply, Money Demand, and the Equilibrium Price LevelFigure 2 The Effects of Monetary InjectionSlide 16The Classical Dichotomy and Monetary NeutralitySlide 18Slide 19Velocity and the Quantity EquationSlide 21Slide 22Slide 23Slide 24Figure 3 Nominal GDP, the Quantity of Money, and the Velocity of MoneySlide 26Slide 27Slide 28CASE STUDY: Money and Prices during Four HyperinflationsFigure 4 Money and Prices During Four HyperinflationsSlide 31Hyperinflation in GermanySlide 33Slide 34Slide 35Slide 36Hyperinflation in YugoslaviaSlide 38Slide 39Slide 40Slide 41Slide 42Money and Inflation in U.S.Slide 44The Inflation TaxThe Fisher EffectFigure 5 The Nominal Interest Rate and the Inflation RateTHE COSTS OF INFLATIONSlide 49Shoeleather CostsSlide 51Menu CostsRelative-Price Variability and the Misallocation of ResourcesInflation-Induced Tax DistortionSlide 55Table 1 How Inflation Raises the Tax Burden on SavingConfusion and InconvenienceA Special Cost of Unexpected Inflation: Arbitrary Redistribution of WealthSummarySlide 60Slide 61Slide 62Slide 63Chapter 17 Money Growth and Inflation23 October 2006Eco 2022End-of-Chapter Problems1, 2, 6, 8, 11, 133The Meaning of MoneyMoney is the set of assets in an economy that people regularly use to buy goods and services from other people.Economists contend that money is productive because it lowers the transaction costs of exchange.If money is a good thing, could it be possible to have too much money?4THE CLASSICAL THEORY OF INFLATIONInflation is an increase in the overall level of prices.Hyperinflation is an extraordinarily high rate of inflation.Inflation: Historical AspectsOver the past 60 years, prices have risen on average about 5 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.56THE CLASSICAL THEORY OF INFLATIONInflation: Historical AspectsIn the 1970s prices rose by 7 percent per year. During the 1990s, prices rose at an average rate of 2 percent per year.7This DecadeYear Inflation Rate (Dec-Dec)2000 3.42001 1.62002 2.42003 1.92004 3.32005 3.48THE CLASSICAL THEORY OF INFLATIONThe quantity theory of money is used to explain the long-run determinants of the price level and the inflation rate.Inflation is an economy-wide phenomenon that concerns the value of the economy’s medium of exchange.When the overall price level rises, the value of money falls.9Aside: TerminologyThe Quantity Equation is not the same as the Quantity Theory of MoneyQuantity Equation is true by definition—it is an identity.Quantity Theory of Money is subject to testing.10Money 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 directly controls the quantity of money supplied.11Money Supply, Money Demand, and Monetary EquilibriumMoney demand has several determinants, including interest rates and the average level of prices in the economy.12Money Supply, Money Demand, and Monetary Equilibrium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.As prices rise, people will want to hold more of their assets in the form of money (liquid asset), and less in the form of assets that are not liquid.13Money 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.This suggests that changes in either the supply of money or the demand for money will cause the price level to change.Figure 1 Money Supply, Money Demand, and the Equilibrium Price LevelCopyright © 2004 South-WesternQuantity ofMoneyValue ofMoney, 1/PPrice Level, PQuantity fixedby the FedMoney supply01(Low)(High)(High)(Low)1/21/43/411.3324Equilibriumvalue ofmoneyEquilibriumprice levelMoneydemandAFigure 2 The Effects of Monetary InjectionCopyright © 2004 South-WesternQuantity ofMoneyValue ofMoney, 1/PPrice Level, PMoneydemand01(Low)(High)(High)(Low)1/21/43/411.3324M1MS1M2MS22. . . . decreasesthe value ofmoney . . .3. . . . andincreasesthe pricelevel.1. An increasein the moneysupply . . .AB16THE CLASSICAL THEORY OF INFLATIONThe Quantity Theory of MoneyHow the price level is determined and why it might change over time is called the quantity theory of money.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.17The Classical Dichotomy and Monetary NeutralityNominal variables are variables measured in monetary units.Real variables are variables measured in physical units.18The Classical Dichotomy and Monetary NeutralityAccording to Hume and others, real economic variables do not change with changes in the money supply.According to the classical dichotomy, different forces influence real and nominal variables.Changes in the money supply affect nominal variables but not real variables.19The Classical Dichotomy and Monetary NeutralityThe irrelevance of monetary changes for real variables is called monetary neutrality.20Velocity and the Quantity EquationThe velocity of money refers to the speed at which the typical dollar bill travels around the economy from wallet to wallet.21Velocity and the Quantity EquationV = (P  Y)/MWhere: V = velocityP = the price levelY = the quantity of output (real GDP)M = the quantity of moneyBecause Velocity is defined from the other three variables, the Quantity Equation is an Identity22Velocity and the Quantity EquationRewriting the equation gives the quantity equation:M  V = P  YM = money supplyV = velocityP = price levelY = real GDP23Velocity and the Quantity EquationThe quantity equation relates the quantity of money (M) to the nominal value of output (P  Y).24Velocity and the Quantity EquationThe quantity equation shows that an increase in the quantity of money in an economy must be reflected in one of three other variables:the price level must