Chapter 17 Money Growth and Inflation 1 Increase in overall level of prices Inflation Decrease in the overall level of prices Inflation Deflation Hyperinflation Extraordinary high rate of inflation exceeds 50 per month Price level increases more than a hundredfold over the course of a yr Clear link between quantity of money price level U S Inflation 2002 2012 1970s o Prices rose at avg rate of 2 5 per yr o prices rose by 7 8 per yr o price level more than doubled over decade International data 2012 inflation rate o 2 1 U S o 0 1 Japan o 5 1 Russia o 9 3 India o 21 1 Venezuela February 2008 Zimbabwe o 24 000 The Classical Theory of Inflation Classical Theory of Money o quantity theory of money o explains long run determinants of the price level o explains the inflation rate Money Demand o reflects how much wealth people want to hold in liquid form o depends on o credit cards o availability of ATM machines o interest rate o average level of prices in economy o downward sloping demand curve Chapter 17 Money Growth and Inflation 2 Money Supply o determined by Fed and banking system o vertical supply curve In the Long Run o overall level of prices adjust to the level at which demand supply Level of Prices Value of Money Inflation o economy wide phenomenon o concerns value of economy s medium of exchange o rise in price level o lower value of money each buys less G S Effects of a Monetary Injection Economy is in Equilibrium o if Fed doubles money supply o printing bills drops them on market o if the Fed uses open market purchase o New E Supply shifts right money value decreases price level Chapter 17 Money Growth and Inflation 3 Quantity Theory of Money value of money o quantity of money available in economy determines the price level the o growth rate in quantity of money available determines the inflation rate Adjustment process o excess money supply o increase in demand of G S inc price of G S o inc price level o inc in quantity of money demanded new E Classical Dichotomy Nominal variables o variables measured in monetary units dollar prices Real variables o variables measure in physical unites o relative prices e g 1 apple 2 bananas real wages real interest rate Classical Dichotomy o theoretical separation of nominal and real variables Developments in the Monetary System o influence nominal variables Chapter 17 Money Growth and Inflation 4 o irrelevant for explaining real variables in the long run Monetary Neutrality o changes in money supply don t affect real variables o realistic in long run not short run Velocity and the Quantity Equation Velocity of Money V o rate of which money changes hands V P Y M o P price level GDP deflator o Y real GDP o M quantity of money Quantity equation M V P Y o P Y dollar value of the economy s output of G S o shows an increase in quantity of money o price level Q output Velocity of Money will fall 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 All three Chapter 17 Money Growth and Inflation 5 series have been scaled to equal 100 in 1960 Nominal GDP and the quantity of money inc dramatically relatively stable velocity Quantity Theory of Money 1 Velocity of Money o Relatively stable over time 2 Changes in Quantity of Money M o Proportionate changes in nominal value of output P Y 3 Economy s output of G S Y o Primarily determined by factor supplies avail Production tech o Money does not effect output 4 Change in money Supply M o Induces proportional changes in the nominal value of output P Y o Reflected in changes in the price level P 5 When the central bank increases the money supply rapidly o Higher rate of inflation Money and Prices During Four Hyperinflations Four Classic Hyperinflations 1920s o Austria Hungary Germany Poland o Slope of the Money line o Rate at which quantity of money was growing o slope of the price line inflation rate o steeper lines higher rates of money growth or inflation Prices when govt prints too much money Chapter 17 Money Growth and Inflation 6 The strong association between these two variables is consistent with the quantity theory of money which states that growth in the money supply is the primary cause of inflation Chapter 17 Money Growth and Inflation 7 The Inflation Tax The Inflation Tax o Revenue the government raises by printing money o Tax on everyone who holds money o When the government prints money o The price level rises paper less valuable The Fisher Effect Principle of Monetary Neutrality o Increase in the rate of money growth o Raises the rate of inflation o Does not affect any real variable Real interest rate nominal interest rate inflation rate Chapter 17 Money Growth and Inflation 8 Nominal interest rate Real Interest rate Inflation Fisher Effect o 1 for 1 adjustment of nominal interest rate to inflation rate o when the Fed increases the rate of money growth o long run result o higher inflation rate o higher nominal interest rate THE COSTS OF INFLATION o inflation robs people of the purchasing power of his hard earned dollars Inflation does not in itself reduce people s real purchasing power o resources wasted when inflation encourages people to reduce their money Inflation Fallacy When prices rise o buyers pay more o sellers get more Shoe Leather costs holdings o can be substantial Menu Costs o costs of changing prices o inflation increases menu costs that firm must bear Relative Price Variability Market economies o relative prices allocate scarce resources o consumers compare quality and prices of various G S o determine allocation of scarce factors of production o inflation distorts relative prices o consumer decisions distorted o markets less able to allocate resources to best use Inflation Induced Tax Distortions Taxes distort incentives o many taxes more problematic in the presence of inflation Tax treatment of capital gains o capital gains profits o sell an asset for more than its purchase price Chapter 17 Money Growth and Inflation 9 o inflation discourages saving o exaggerates size of capital gains o increases tax burden Tax treatment of interest income o nominal interest earned on savings o treated as income o even though part of the nominal interest rate compensates for inflation Higher inflation discourages people from saving How Inflation Raises the Tax Burden on Saving Money o measures economic transactions stored value Confusion Inconvenience The Fed s Job o to ensure the reliability of