Money Growth and Inflation: Chapter 30 P.

1. Brief Review on Inflation

A. The inflation rate can be measured as the percentage change in:

 Consumer Price Index ,
 GDP deflator , or
 some other index of the overall price level.

B. Over the past 80 years, prices have risen an average of about 3.6% per year in the United
States.
 But there has been substantial variation in the rate of price changes over time.
 In the last ten years (2010-2019), inflation rates averaged 1.6% per year,
while prices rose by 7.8% per year during the 1970s. And prior to World War II,
the U.S. had experienced several periods of deflation.
 International data shows an even broader range of inflation experiences. In 2019, inflation
was 2.9% in China, 7.7% in India, 0.4% in South Korea and ~ 20,000% in Venezuela.

C. Principle #9 of the Ten Principles of Economics

 Prices rise when the government prints ( creates ) too much money.
 Most economists believe that the “ quantity theory of money ”
is a good explanation of the long run behavior of inflation.

D. Some remarks on inflation:

 Inflation represents a continuous increase in the price level .
 Price level represents the average level of prices . So it’s the average that
is rising, but not the prices of all goods.

2. The Classical Theory of Inflation

A. The Level of Prices and the Value of Money

 When the price level rises, people have to pay more for the goods and services that
they purchase. This also means that the value of money is now [ higher / lower ]
because each dollar now buys a smaller quantity of goods and services.

 If P is the price level, then the quantity of goods and services that can be purchased
with $1 is equal to 1/P .

 For example, you live in a country with one good (ice cream cones).
- When the price of an ice cream cone is $2, the value of money (a dollar) is
1/2 cone .
- When the price of an ice cream cone rises to $4, the value of money (a dollar) is
1/4 cone .

B. Money Supply, Money Demand, and Monetary Equilibrium

 The value of money is determined by the supply and demand for money, and also
partly by the general price level.

 The supply of money is primarily controlled by the Fed’s policy .

- This implies that the quantity of money supplied is fixed (until the
© 2020 by Sunny HA
Money Growth and Inflation: Chapter 30 P. 2

Fed decides to change it).

- Thus, the supply of money will be vertical (perfectly inelastic).

 The demand of money reflects how much wealth people want to hold in liquid form.
- One important variable in determining the demand for money is the price level .
- The higher the prices, the more is the money needed to perform
transactions.
- Therefore, an increase in price level  a fall in value of money
 higher Qd for money  demand for money is downward sloping

Value of Money (1/P) Price Level (P)

(high) MS1 MS2 (low)

1 1

¾ 1.33

½ 2

¼ Demand 4

(low) (high)
$1000 $2000
Quantity of Money

 The demand for and supply of money establish the monetary equilibrium, which
also determine the value of money and price level at the same time.

C. The Effects of a Monetary Injection

 Assume that the Fed suddenly increases the supply of money.

 From graph, the supply curve of money shifts to the [ left / right ]. With more money
in circulation, the value of money [ rises / falls ].

 On the other hand, the general price level [ rises / falls ]. Reasons behind:
- With excess money in the economy, people must spend it on goods & services
(of course, some people may save the money in banks; but banks would lend out
the money; so finally, money is still spent for goods & services).
- The result is an increase in total demand for goods & services.
- But supply of goods does not increase. Therefore, prices rise.

D. The Quantity Theory of Money

 asserts that the quantity of money available determines the value of money
and price level, and

 that the growth rate in quantity of money available determines the

inflation rate.

© 2020 by Sunny HA
Money Growth and Inflation: Chapter 30 P. 3

3. The Classical Dichotomy and Monetary Neutrality

A. In the 18th century, David Hume and other economists wrote about the relationship
between monetary changes and important macroeconomic variables such as
production, employment, real wages, and real interest rates.

B. They suggested that economic variables should be divided into two groups:
nominal variables and real variables.

 Definition of nominal variables: variables measured in monetary units .

 Definition of real variables: variables measured in physical units .

C. The theoretical separation of nominal and real variables is called classical dichotomy .

D. For instance, the average CUHK graduate earned $13,000 per month in the year 2008
and $16,000 per month in the year 2018. Is the average CUHK graduate earning more in
real term?
 [ Yes / Not sure ] The wage you earn per month is a [ nominal / real ] variable as this
involves money.

 When measured in term of money or dollars , all “prices” (whether

it’s for labor, capital, goods or services) are nominal variable.

E. Then, what is real variable?

 In semester 1, your GPA is 3.40; in semester 2, this is 3.80 .

 In 2010, Thailand produced 2,500 million tons of wheat; but due to the adverse
weather in 2011, it produced only 2,100 million tons of wheat.

 In 2008, the monthly income of CUHK graduate can buy 400 lunch boxes; in 2018, the
average CUHK graduate can buy 360 lunch boxes with their monthly income.

 Measured in 2000 constant dollar, the real GDP per person in HK was
$24,435 in 1996, and was $37,958 in 2011.

F. Real variable is “real” in the sense that it is measured in physical unit or in a way that
has eliminated the effect of inflation .

 Real variable is important because it has real effect on people’s satisfaction

& decisions . For example, we are uncertain whether people will be
better off with an increase in salary for $3,000 (a nominal variable) as the value of
money changes over time. However, we know that people are worse off with 360
lunch boxes in 2018 (a real variable) than 400 lunch boxes in 2008.

 Similarly, your decision to save would depend on the real interest rate (i.e. nominal
interest rate minus inflation rate). Over time, an increase in real interest rate will
encourage you to save more . But an increase in nominal interest rate
[ may / may not ] due to the inflation.

© 2020 by Sunny HA
Money Growth and Inflation: Chapter 30 P. 4

G. Classical analysis suggested that changes in the money supply do not affect
[ real / nominal ] variables but affect [ real / nominal ] variables only. This proposition is
known as the monetary neutrality .

H. If central bank doubles the money supply, Hume & classical thinkers contend that:

You may think of the case of doubling the MS as follows:

- The Central Bank announces that, starting from midnight, all bank deposits and all
paper money notes and coins could have its value (face value) doubled. For example,
you can cross out the value of $100 on the paper money and change it to $200; and
for $500 note, you can also double its value and use it as $1000 note. That will be the
“perfect way” to double the total value of money (Money Supply) in the economy!

- So what happen afterwards?

 All nominal variables will be doubled : you will earn doubled the “nominal
income”, pay doubled for the “nominal spending”; effectively, all prices and
nominal GDP are doubled. However,

 All real variables will be unchanged : the quantity of goods

you buy, the number of hours you work, the amount of output
firms produce are unchanged; effectively, the economy’s real income, real GDP, real
prices remain the same.

- Real prices can be thought as relative prices . For example, if a

hamburger was sold at $10 and a can of coke was $5, the relative price of a
hamburger is 2 cans of coke .

- Now, if the money supply is doubled, the nominal price of hamburger will be
$20 and coke $10 . But the real price will remain unchanged (still
2 cans of coke ).

- As a result, the quantity of hamburger and coke you buy is likely to [ be doubled /
remain the same ] given there is no change to the real price and your real wage.
(The real variable – quantity – would not be affected by the change in MS).

I. Therefore, money is said to be neutral as it won’t change any real variables.

 So, whether there is a 100% or 10% increase in MS, it will just proportionately change
all nominal prices and people’s nominal income (the nominal GDP). The real GDP is
not changed or improved by a change of MS in any way.

 (But) If this is true, then there is no need for any government to pursue the
monetary policy (as this results in inflation only, but not economic growth).

 (Reminder) The monetary neutrality is a theory about the long-run. The monetary
policy (changing MS/interest rate) is still useful in short-run (to be discussed in
Chapter 33).

© 2020 by Sunny HA
Money Growth and Inflation: Chapter 30 P. 5

4. Velocity and the Quantity Equation

A. The velocity of money (V) refers to the rate at which money changes hands .

B. Theoretically, this can be calculated by dividing the nominal GDP by the quantity of
money (the Money Supply).

Nominal GDP
V=
Quantity of money

P*Y
V=
M

C. Data revealed that the velocity of money

(V) has been relatively stable
over the past fifty years. Therefore, it
would be fair to treat V as a constant
in our economic studies.

D. Rearranging the calculation of velocity, we get the following quantity equation:

 M*V=P*Y
where M is the quantity of money,
V is the velocity of money,
P is the price level (GDP deflator), and
Y is the quantity of output (Real GDP)

E. Now, using the quantity equation (M * V = P * Y), we can try to explain how an increase
in M affects the economic variables.

 Firstly, we have assumed that V is a constant.

 So, when the central bank changes the quantity of money (M), it will
proportionately change the nominal value of output (P * Y) .

 When we believe that money is neutral, changes in M do not affect real output (Y)

 This means that, only P changes proportionately with the change in M

 Policy implication: When the central bank increases the money supply rapidly, the
result is a high level of inflation .

F. If Y does nothing with the change in M, then what changes Y?

 Classical thinkers suggest that Y (the economy’s output of goods & services) is
determined primarily by available resources and technology .

© 2020 by Sunny HA
Money Growth and Inflation: Chapter 30 P. 6

5. Hyperinflation and The Inflation Tax

A. Case Study: Money and Prices during Four Hyperinflations

 Hyperinflation is generally defined as inflation that exceeds 50% per month .

 Figure 4 shows data from four classic periods of hyperinflation during the 1920s in
Austria, Hungary, Germany, and Poland.

 We can see that, in each graph, the quantity of money and the price level are almost
parallel showing the strong correlation between M and P.

B. Almost all hyperinflations follow the same pattern:

 The government has a high level of spending and inadequate
tax revenue to pay for its spending.
 The government’s ability to borrow funds is limited.
 As a result, it turns to printing money to pay for its spending.
 The large increases in the money supply lead to large amounts of inflation.
 The hyperinflation ends when the government cuts its spending and eliminates
the need to create new money.

C. In some way, inflation is like a tax, chargable on people who are holding money. The so-
called inflation tax can be illustrated using a simple example below:
 Suppose that the public holds $10 billion but the government owns no money at all.
 Instead of taking cash directly from the public, the government could increase MS by
printing notes of $10 billion.
 As the quantity equation predicts, doubling MS would also double the price level.
 Therefore, the purchasing power of $10 billion held by the public will be cut by half .
 That 50% decrease in purchasing power can be thought of being transferred to the
hand of government now holds the newly created $10 billion.
 So, the inflation (as a result of increase in MS by government) is similar to a
tax instrument, executed by government to steal purchasing power from the public.
© 2020 by Sunny HA
Money Growth and Inflation: Chapter 30 P. 7

6. The Fisher Effect

A. Recall that the real interest rate is equal to the nominal interest rate minus the
inflation rate.

B. This, of course, means that:

Nominal interest rate = Real interest rate + inflation rate

 Note: it’s the demand and supply for loanable funds determines the real interest rate.

 And the growth in money supply determines the inflation rate.

C. Irving Fisher, an American economist, argued that there is one-for-one

adjustment of the nominal interest rate to the inflation rate. Specifically, should there
be an increase in MS that causes the price level (or inflation rate) to increase by 1%,
the nominal interest rate must also increase by 1% as the real interest
rate remains unchanged (the monetary neutrality suggests).

D. This figure uses annual data since 1960 to

show the trends on nominal interest rate
(on three-month Treasury bills) and the
inflation rate (measured by the CPI).

 The close association between these

two variables is evidence for the Fisher
effect: When the inflation rate rises, so
does the nominal interest rate.

7. The Cost of Inflation

A. The Inflation Fallacy: a fall in purchasing power?

 Most people believe that inflation erodes the purchasing power of a person’s
income. You pay more for your housing, clothing, travel and food; therefore, higher
cost of living.

 However, always remember this is a study on macroeconomics.

- As prices rise, so do incomes .
- The higher prices paid by consumers are offset exactly by the higher incomes
received by the sellers.
- In other words, inflation does not reduce (pose no harm to) the economy’s
real income when seeing it as a whole.

 But inflation may still pose some costs to the society. Included are:

© 2020 by Sunny HA
Money Growth and Inflation: Chapter 30 P. 8

B. Menu costs
 Menu costs represent the costs of changing prices .

 During periods of inflation, firms must change their prices more often.

 The related costs include printing new menus, mailing new catalogs , etc.

C. Shoeleather Costs
 In general, during inflation, you will be better off by placing your money at bank
(rather than keeping it on hand) as this gives you higher nominal interest income.

 Therefore, inflation induces people to keep less currency and go

more often to banks .

 Shoeleather costs are the resources wasted when inflation encourages

people to reduce their money holding. These include the time and the transaction
costs of more frequent visits to banks.

D. Misallocation of resources from relative-price variability

 Firms don’t raise their prices all at the same time, so inflation causes relative prices
to vary more than they would otherwise.

 When inflation distorts relative prices, consumer decisions are

distorted and markets are less able to allocate resources to their best use.

E. Inflation-induced tax distortions

 Lawmakers fail to take inflation into account when they write tax laws.

 Very often, taxes are levied on the nominal values of income (such as
interest incomes and capital gains), but not the real values.

 Example: Hannah and Miley each earn a real interest rate on their savings account
of 3%. However, Hannah lives in a country with a 1% inflation rate, while Miley lives in
a country with a 10% inflation rate. Both countries have a 20% tax on income.
Hannah Miley
Real interest rate 3% 3%
Inflation rate 1% 10%
Nominal interest rate 4% 13%
Tax (20%) charged on interest income 0.8% 2.6%
After-tax nominal interest rate 3.2% 10.4%
After-tax real interest rate 2.2% 0.4%

 As you will find, people living in a country with higher inflation pay more in tax ,
resulting in lower real income after tax .

 The consequence is: higher inflation will tend to discourage saving and
probably other economic activities.

 A possible solution to this problem would be to index the tax system

(however it is always imperfect).
© 2020 by Sunny HA
Money Growth and Inflation: Chapter 30 P. 9

F. Confusion and Inconvenience

 One of the important functions of money is to serve as a unit of account
(the yardstick that people use to post prices and record debts).

 When inflation occurs, the value of money falls. This complicates the long-range
planning and comparison of dollar amounts over time .

G. A special cost of unexpected inflation: Arbitrary Redistributions of Wealth

 Example: Sam takes out a $20,000 loan at 7% interest per annum. After his debt has
compounded for 10 years at 7%, Sam will owe the bank $39,434.

- Of course, the “nominal” interest rate of 7% would have included the

expected inflation rate in the coming 10 years (i.e. the higher the
the expected inflation, the more the borrower/debtor will be charged).

- Therefore, if the actual inflation turns to be higher than expected, debtor (Sam)
will be better off (because of having paid less in real term).

- Conversely, if the actual inflation is lower than expected, creditor (bank)

will be better off (because of having received more in real term).

 In general, high inflation (e.g. 9% to 15% ) is more volatile ( less predictable )

than low inflation (e.g. 1.5% to 3% ). So, these arbitrary redistributions of wealth are
even more frequent when inflation is high.

 Because inflation is often hard to predict, it imposes risk on both lenders

and investors. In an extreme case, people may fail to reach a loan agreement due to
uncertainty on inflation. The society may be worse off if firms cancel the
investment project .

H. A final remark: Inflation Is Bad, but Deflation May Be Worse

 As regards the above costs of inflation, deflation results in saving of

shoeleather costs , but other costs such as menu costs, relative-price variability,
tax distortions, creation of confusion and uncertainties still exist.

 Besides, unexpected deflation also results in the redistribution of

wealth towards creditors (and away from debtors). This is
more undesirable than the other way, because debtors are usually poorer.

 Perhaps most important, deflation often arises because of broader macroeconomic

difficulties. This may be a symptom of deeper economic problem –
for example, falling prices because of a decrease in overall demand
for goods and services.

© 2020 by Sunny HA