Inflation and the Quantity Theory of Money Outline Defining and Measuring Inflation The Quantity Theory of Money The Costs of Inflation Defining Inflation Inflation an increase in the average level of prices Inflation rate the percentage change in the average level of prices as measured by a price index over a period of time Measured using the following formula Pt Pt 1 Inflation rate 100 Pt 1 Defining Inflation A change in the average price level Some prices go up and some go down relative to each other Think of an elevator containing many prices As the elevator rises all of the prices rise The following figure may help Defining Inflation Price Indices Price Indexes are used to measure inflation An index is a number that compares the price level in one period relative to the prices in some base year There are several price indexes including Consumer price index CPI Producer price index PPI GDP deflator Let s take a closer look at each of these Price Indices Consumer price index CPI measures the average price of goods bought by a typical American consumer Often referred to as the cost of living index Covers 80 000 goods Higher priced items count more Data can be found at the following link Consumer Price Indexes BLS gov Price Indices GDP deflator measures the average price of all final goods and services Nominal GDPt GDP Deflator t 100 Real GDPt Nominal and real GDP data can be found at following link http www bea gov national income data Price Indices PPI measures the average price received by producers Includes intermediate goods as well as final goods Often used to calculate changes in the cost of inputs Data can be found at the following link PPI bls gov Inflation in the U S Calculating Real Prices Using the CPI to calculate real prices Real price is the price of a good that has been corrected for inflation Example 1982 price gasoline was 1 25 gal 2006 it was double that at 2 50 gal Calculating Real Prices CPI was 100 in 1982 and 202 in 2006 so that 202 1 25 2 53 100 Conclusion The real price of gasoline was slightly lower in 2006 than it was in 1982 Inflation Around the World Inflation Around the World Hyperinflation extremely high rates of inflation that make inflation in the U S look pretty tame by comparison A lot of governments have fell into the trap of inflating their currency in order to pay debts The next table shows some pretty dramatic examples Hyperinflation Quantity Theory of Money The quantity theory of money does two things Sets out the general relationship between inflation money real output and prices Presents the critical role of the money supply in regulating the level of prices M n PYR M money supply n velocity P average price level YR real GDP Quantity Theory of Money Velocity the average number of times a dollar is spent on final goods and services in a year Quantity theory of money depends on two assumptions Real GDP is stable compared to the money supply The velocity of money v is stable compared to the money supply The Cause of Inflation The quantity theory is a theory of inflation If YR is fixed by real factors of production and v is stable then it follows that inflation is caused by an increase in the supply of money The quantity theory of money can also be written in terms of growth rates M v P YR Growth rate of money growth rate of v is identically equal to the rate of inflation growth rate of real GDP Quantity Theory of Money Important implication If the growth rates of n and YR are small compared to the growth rate of M The rate of inflation will be approximately equal to the inflation rate P M Or more generally P M YR The Cause of Inflation The Cause of Inflation One of the most important truths of economics Inflation is always and everywhere a monetary phenomenon Milton Friedman Nobel Prize Winner Milton Friedman 1912 2008 The Cause of Inflation The Cause of Inflation Deflation a decrease in the average level of prices a negative inflation rate If M and grow more slowly than YR prices will fall If M and are fixed and there is an increase in YR prices will fall The Cause of Inflation Example Gold standard 1834 1933 Dollar was fixed at 1 20th of an ounce of gold Supply of gold increases slowly Prices typically decrease a bit each year The Cause of Inflation Changes in velocity will affect prices Hyperinflation People will spend their money faster increase n even faster increase in prices Great Depression Fear spending decreased n deflation worse depression In the long run money is neutral The Costs of Inflation If all prices including wages are going up then what is the problem with inflation We will look at four problems with inflation 1 Price confusion and money illusion 2 Inflation redistributes wealth 3 Inflation Interacts with other taxes 4 Inflation is painful to stop Price Confusion and Money Illusion Price confusion inflation makes price signals more difficult to interpret A decision maker does not always know if the price of a product is increasing because of increased demand or simply as a result of all prices going up with inflation Money Illusion people mistake changes in nominal prices for changes in real prices Results of both resources are wasted Inflation Redistributes Wealth Inflation is type of tax It transfers wealth to the government Even tax cheats can t avoid this tax Governments that print money to pay their bills are using this type of tax Inflation redistributes wealth among the public Especially from lenders to borrowers Inflation Redistributes Wealth Nominal rate of return the rate of return that does not account for inflation Real rate of return the nominal rate of return minus the inflation rate rreal i p Where rreal real rate of return i nominal rate of interest p rate of inflation Inflation Redistributes Wealth Suppose a bank makes a 30 year home loan at an interest rate of 7 If the rate of inflation is 3 over that period bank s actual rate of return 7 3 4 If inflation rises unexpectedly to 13 as it did in late 1970s Now the actual rate of return 7 13 6 The lender is now losing money on the loan The borrow gains Inflation Redistributes Wealth What happens if people expect inflation to go up Lenders will increase nominal rates of interest Fisher effect the tendency for nominal interest rates to rise with expected inflation E i requilibriu m Fisher Effect Inflation Redistributes Wealth The actual rate of return determined in large part by the difference between expected inflation and actual inflation From earlier
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