Chapter 5 Inflation Its Causes Effects and Social Costs CHAPTER 5 Inflation 1 IN THIS CHAPTER YOU WILL LEARN The classical theory of inflation causes effects social costs Classical assumes prices are flexible markets clear Applies to the long run CHAPTER 5 Inflation 2 c h a n g e fr o m 1 2 m o s e a r l U S inflation and its trend 1960 2012 change in GDP deflator 12 10 8 6 4 2 0 CHAPTER 5 Inflation 3 c h a n g e fr o m 1 2 m o s e a r l U S inflation and its trend 1960 2012 12 long run trend 10 8 6 4 2 0 CHAPTER 5 Inflation 4 The quantity theory of money A simple theory linking the inflation rate to the growth rate of the money supply Begins with the concept of velocity CHAPTER 5 Inflation 5 Velocity basic concept the rate at which money circulates definition the number of times the average dollar bill changes hands in a given time period example In 2012 500 billion in transactions money supply 100 billion The average dollar is used in five transactions in 2012 So velocity 5 CHAPTER 5 Inflation 6 Velocity cont This suggests the following definition T V M where V velocity T value of all transactions M money supply CHAPTER 5 Inflation 7 Velocity cont Use nominal GDP as a proxy for total transactions Then P Y V M where P price of output CHAPTER 5 GDP deflator Y quantity of output real GDP P Y value of output nominal GDP Inflation 8 The quantity equation The quantity equation M V P Y follows from the preceding definition of velocity It is an identity it holds by definition of the variables CHAPTER 5 Inflation 9 Money demand and the quantity equation M P real money balances the purchasing power of the money supply A simple money demand function M P d k Y where k how much money people wish to hold for each dollar of income k is exogenous CHAPTER 5 Inflation 10 Money demand and the quantity equation money demand M P d k Y quantity equation M V P Y M P 1 V Y The connection between them k 1 V When people hold lots of money relative to their incomes k is large money changes hands infrequently V is small CHAPTER 5 Inflation 11 Back to the quantity theory of money starts with quantity equation assumes V is constant exogenous V V Then quantity equation becomes M V P Y CHAPTER 5 Inflation 12 The quantity theory of money cont M V P Y How the price level is determined With V constant the money supply determines nominal GDP P Y Real GDP is determined by the economy s supplies of K and L and the production function Chap 3 The price level is P nominal GDP real GDP CHAPTER 5 Inflation 13 The quantity theory of money cont Recall from Chapter 2 The growth rate of a product equals the sum of the growth rates The quantity equation in growth rates DM DV DP DY M V P Y The quantity theory of money assumes DV V is constant so 0 V CHAPTER 5 Inflation 14 The quantity theory of money cont Greek letter pi denotes the inflation rate The result from the preceding slide Solve this result for CHAPTER 5 Inflation DP p P DM DP DY M P Y M Y M Y 15 The quantity theory of money cont M Y M Y Normal economic growth requires a certain amount of money supply growth to facilitate the growth in transactions Money growth in excess of this amount leads to inflation CHAPTER 5 Inflation 16 The quantity theory of money cont M Y M Y Y Y depends on growth in the factors of production and on technological progress all of which we take as given for now Hence the quantity theory predicts a one for one relation between changes in the money growth rate and changes in the inflation rate CHAPTER 5 Inflation 17 Confronting the quantity theory with data The quantity theory of money implies 1 Countries with higher money growth rates should have higher inflation rates 2 The long run trend in a country s inflation rate should be similar to the long run trend in the country s money growth rate Are the data consistent with these implications CHAPTER 5 Inflation 18 International data on inflation and money growth 40 Belarus 35 percent Inflation rate 30 Zambia 25 Serbia Iraq Turkey 20 Suriname Mexico 15 U S Russia 10 Malta 5 0 5 10 CHAPTER 5 China Cyprus Inflation 0 10 20 30 40 50 Money supply growth percent 19 c h a n g e fr o m 1 2 m o s e a r l U S inflation and money growth 1960 2012 M2 growth rate 14 12 10 8 6 4 inflation rate 2 0 CHAPTER 5 Inflation 20 c h a n g e fr o m 1 2 m o s e a r l U S inflation and money growth 1960 2012 Inflation and money growth have the same long run trends as the quantity theory predicts 14 12 10 8 6 4 2 0 CHAPTER 5 Inflation 21 Seigniorage To spend more without raising taxes or selling bonds the govt can print money The revenue raised from printing money is called seigniorage pronounced SEEN your idge The inflation tax Printing money to raise revenue causes inflation Inflation is like a tax on people who hold money CHAPTER 5 Inflation 22 Inflation and interest rates Nominal interest rate i not adjusted for inflation Real interest rate r adjusted for inflation r i CHAPTER 5 Inflation 23 The Fisher effect The Fisher equation i r Chap 3 S I determines r Hence an increase in causes an equal increase in i This one for one relationship is called the Fisher effect CHAPTER 5 Inflation 24 U S inflation and nominal interest rates 1960 2012 18 14 nominal interest rate 10 6 2 inflation rate 2 CHAPTER 5 Inflation 25 Inflation and nominal interest rates in 96 countries 40 Turkey Nominal interest rate 35 percent 30 Georgia Malawi 25 20 Brazil 15 Poland 10 5 Iraq U S Kazakhstan Japan 0 5 CHAPTER 5 Ghana Mexico Inflation 0 5 10 Inflation rate percent 15 20 25 26 NOW YOU TRY Applying the theory Suppose V is constant M is growing 5 per year Y is growing 2 per year and r 4 a Solve for i b If the Fed increases the money growth rate by 2 percentage points per year find i c Suppose the growth rate of Y falls to 1 per year What will happen to What must the Fed do if it wishes to keep constant CHAPTER 5 Inflation 27 ANSWERS Applying the theory V is constant M grows 5 per year Y grows 2 per year r 4 a First find 5 2 3 Then find i r 4 3 7 b i 2 same as the increase …