Chapter 5IN THIS CHAPTER, YOU WILL LEARN:U.S. inflation and its trend, 1960–2012U.S. inflation and its trend, 1960–2012The quantity theory of moneyVelocityVelocity, cont.Velocity, cont.The quantity equationMoney demand and the quantity equationMoney demand and the quantity equationBack to the quantity theory of moneyThe quantity theory of money, cont.The quantity theory of money, cont.The quantity theory of money, cont.The quantity theory of money, cont.The quantity theory of money, cont.Confronting the quantity theory with dataInternational data on inflation and money growthU.S. inflation and money growth, 1960–2012U.S. inflation and money growth, 1960–2012SeigniorageInflation and interest ratesThe Fisher effectU.S. inflation and nominal interest rates, 1960–2012Inflation and nominal interest rates in 96 countriesNOW YOU TRY Applying the theoryANSWERS Applying the theoryTwo real interest ratesThe Fisher effectMoney demand and the nominal interest rateThe money demand functionThe money demand functionEquilibriumWhat determines whatHow P responds to MWhat about expected inflation?How P responds to ENOW YOU TRY Discussion questionA common misperceptionThe CPI and Average Hourly Earnings, 1965–2012The classical view of inflationThe social costs of inflationThe costs of expected inflation: 1. Shoeleather costThe costs of expected inflation: 2. Menu costsSlide 46The costs of expected inflation: 4. Unfair tax treatmentThe costs of expected inflation: 5. General inconvenienceSlide 49Additional cost of high inflation: Increased uncertaintyOne benefit of inflationHyperinflationWhat causes hyperinflation?A few examples of hyperinflationWhy governments create hyperinflationThe Classical DichotomyThe Classical DichotomyCHAPTER SUMMARYCHAPTER SUMMARYCHAPTER SUMMARYCHAPTER SUMMARYCHAPTER SUMMARY1CHAPTER 5 InflationChapter 5Inflation: Its Causes, Effects, and Social Costs2CHAPTER 5 InflationIN 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 23CHAPTER 5 Inflation0%2%4%6%8%10%12%% c h a n g e f r o m 1 2 m o s . e a r l i e rU.S. inflation and its trend, 1960–2012% change in GDP deflator4CHAPTER 5 Inflation0%2%4%6%8%10%12%% c h a n g e f r o m 1 2 m o s . e a r l i e rU.S. inflation and its trend, 1960–2012long-run trend5CHAPTER 5 InflationThe 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…6CHAPTER 5 InflationVelocity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 = 57CHAPTER 5 InflationVelocity, cont.This suggests the following definition:where V = velocityT = value of all transactionsM = money supplyTVM=8CHAPTER 5 InflationVelocity, cont.Use nominal GDP as a proxy for total transactions. Then, where P = price of output (GDP deflator) Y = quantity of output (real GDP)P  Y = value of output (nominal GDP)P YVM�=9CHAPTER 5 InflationThe quantity equationThe quantity equationM  V = P  Yfollows from the preceding definition of velocity.It is an identity: it holds by definition of the variables.10CHAPTER 5 InflationMoney 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 Ywherek = how much money people wish to hold for each dollar of income. (k is exogenous)11CHAPTER 5 InflationMoney 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).12CHAPTER 5 InflationBack to the quantity theory of moneystarts with quantity equationassumes V is constant & exogenous:Then, quantity equation becomes:=V V� = �M V P Y13CHAPTER 5 InflationThe quantity theory of money, cont.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).� = �M V P Y14CHAPTER 5 InflationThe 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:M V P YM V P YD D D D+ = +The quantity theory of money assumes is constant, so = 0.DVVV15CHAPTER 5 InflationThe quantity theory of money, cont. (Greek letter pi ) denotes the inflation rate:The result from the preceding slide:Solve this result for :M P YM P YD D D= +PPD=p  M YM Y16CHAPTER 5 InflationThe quantity theory of money, cont.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.   M YM Y17CHAPTER 5 InflationThe quantity theory of money, cont.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. Hence, the quantity theory predicts a one-for-one relation between changes in the money growth rate and changes in the inflation rate.   M YM Y18CHAPTER 5 InflationConfronting the quantity theory with dataThe 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?19CHAPTER 5 InflationInternational data on inflation and money growthInflation rate (percent)Money supply growth(percent)-10 0 10 20 30 40 50-50510152025303540ChinaIraqTurkeyBelarusZambiaU.S.MexicoMaltaCyprusSerbiaSurinameRussia20CHAPTER 5 Inflation0%2%4%6%8%10%12%14%% c h a n g e f r o m 1 2 m o