Topic 6: Money Growth and Inflation

Learning Outcomes
At the end of this topic you are able to
 demonstrate the link between money and prices with the quantity equation.
 explain the factors influencing the money demand and money supply.
 describe the money market equilibrium and factors causing the changes to the money
market equilibrium.
 analyze the effects of money injection to the interest rate, price level, and real GDP in the
short run and long run.
 explain classical dichotomy and monetary neutrality.
 explain why money has no impact on real variables in the long run.
 explain Fisher effect.
 explain the concept of an inflation tax.
 show the relationship between the nominal interest rate, the real interest rate, and the
inflation rate.
 explain who gains and who loses on a loan contract when inflation rises unexpectedly

Introduction

Inflation has always been the concern of the central bank. The main function of a central bank is
to control the growth of money in order to achieve price stability. Inflation rate in measured
using the consumer price index or GDP deflator. The consumer price index reflects changes in
the cost to the average consumer of acquiring a basket of goods and services that may be fixed or
changed at specified intervals, such as yearly.The value of the consumer price index (2010 =
100) in Malaysia was 112.81 as of 2015. As the graph below shows, over the past 10 years, this
indicator reached a maximum value of 112.81 in 2015 and a minimum value of 100 in 2010.

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 Malaysia CPI 2010 - 2015( 2010 =
100)
115

110

CPI 105

100

95
2009 2010 2011 2012 2013 2014 2015 2016
Year

Source: International Monetary Fund, International Financial Statistics and data

The Classical Theory of Inflation

The classical theory of inflation relates a sustained increase in the price causing inflation due to
excessive growth in the quantity of money in circulation. For this reason, the classical theory is
sometimes called the “quantity theory of money,” even though it is a theory of inflation, not a
theory of money.

The continuous and persistent rise in the overall price level will have an adverse impact on the
value of money. The price level and the value of money are inversely related. When the price
level rises money can buy less goods and services. So we say that its purchasing power has
fallen. Conversely, when the price level falls, money can buy more and we can say its purchasing
power has gone up. Thus, the value of money changes inversely with the price level.

What gives money value? We know that intrinsically, a dollar bill is just worthless paper and ink.
However, the purchasing power of a dollar bill is much greater than that of another piece of
paper of similar size. From where does this power originate?

Like most things in economics, there is a market for money. The supply of money in the money
market comes from the Fed. The Fed has the power to adjust the money supply by increasing or

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decreasing the number of bills in circulation. Nobody else can make this policy decision. The
demand for money in the money market comes from consumers.

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Value of money(VM) = Price(P)

The value of money, as revealed by the money market, is variable. A change in the money
demand or a change in the money supply will yield a change in the value of money and in the
price level. Notice that the change in the value of money and the change in the price level are of
the same magnitude but in opposite directions.

Income (Y) Price of Bread Quantity of bread Value of money

$100 $2/unit 50 units ½
$100 $4/unit 25 units ¼

If P is the price, then the goods and services that can be bought with $1 is 1/P . As the price
increase from $2 per unit to 4 per unit, the value of money diminishes from ½ to ¼..

Determinants of the Price Level

Changes in the price level are caused by two factors:
(a) Changes money market, and
(b) Changes in the goods and services.

Changes in the Money Market : Changes to the Money Supply

For example, when the quantity of money in circulation in a country is increased (e.g., by
printing new notes) more money is available to the people for making purchases, the demand for
goods and services goes up and the price level tends to rise.
Conversely, if the supply of money decreases people can buy less and the price level tends to go
down. Again, if there is an increase in the supply of goods and services, the price level tends to
fall and, in the converse case, it tends to rise.

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Money Market Equilibrium
The money market equilibrium is determined by the demand for money and the supply of
money. The demand for money is the desired holding of financial assets in the form of money.
The demand for money is affected by several factors, including the level of income, interest
rates, and inflation as well as uncertainty about the future. The way in which these factors affect
money demand is usually explained in terms of the three motives for demanding money: the
transactions, the precautionary, and the speculative motives.

Supply of Money
The supply of money refers to the total quantity of money in the country. Though the supply of
money is a function of the rate of interest to a certain degree, yet it is considered to be fixed by
the monetary authorities. Hence the supply curve of money is taken as perfectly inelastic
represented by a vertical straight line.

Determination of the Rate of Interest

Like the price of any product, the rate of interest is determined at the level where the demand for
money equals the supply of money. In the following figure, the vertical line QM represents the
supply of money and L the total demand for money curve. Both the curve intersect at E2 where
the equilibrium rate of interest OR is established.

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If there is any deviation from this equilibrium position an adjustment will take place through the
rate of interest, and equilibrium E2 will be re-established.
At the point E1 the supply of money OM is greater than the demand for money OM1.
Consequently, the rate of interest will start declining from OR1 till the equilibrium rate of interest
OR is reached. Similarly, at OR2 level of interest rate, the demand for money OM2 is greater than
the supply of money OM. As a result, the rate of interest OR2 will start rising till it reaches the
equilibrium rate OR.

Change in the Money Market Equilibrium: Monetary Injection

The changes to the money market equilibrium is caused by the change in the demand for money,
or change in the supply of money or both a change in the demand and supply of money.

Q1

It may be noted that, if the supply of money is increased by the central bank, but the liquidity
preference curve L remains the same, the rate of interest will fall.Referring to the above figure,
the supply of money increases, shifting the supply of money curve to the right from Q to Q1. The
new money market equilibrium is at point E3, giving a new equilibrium interest rate of OR2 and
the equilibrium of money of OM2. A declined in the interest rate would induce domestic
investment, causing the total spending in the economy to increase. An increase in the total
spending would then a have a direct impact on the price of goods and services. Monetary
injection is one of the causes of inflation.

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Classical Dichotomy and Monetary Neutrality
In macroeconomics, the classical dichotomy refers to an idea attributed to classical and pre-
Keynesian economics that real and nominal variables can be analyzed separately.

In the classical model based on flexibility of prices and wages, changes in the money supply in
the long run only affect the price level and nominal magnitudes (i.e. money wages, nominal
interest rate, while the real variables such as levels of labor, employment and output, saving and
investment, real wages, real rate of interest remain unaffected in the long run.. This
independence of real variables from changes in money supply and nominal variables is called
classical dichotomy.

The neutrality of money, also called neutral money, says changes in the money supply only
affect nominal variables and not real variables. In other words, an increase or decrease in the
money supply can change the price level, but not the output or structure of the economy. In
modern versions of money neutrality theory, changes in the money supply might affect output or
unemployment levels in the short run only, but neutrality is still assumed in the long run after
money circulates throughout the economy.

Quantity of Money Theory

The quantity theory of money is based directly on the changes brought about by an increase in
the money supply. The quantity theory of money states that the value of money is based on the
amount of money in the economy. Thus, according to the quantity theory of money, when the
Fed increases the money supply, the value of money falls and the price level increases. We
learned that inflation is defined as an increase in the price level. Based on this definition, the
quantity theory of money also states that growth in the money supply is the primary cause of
inflation.

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Velocity
The most important variable that mediates the effects of changes in the money supply is the
velocity of money.
Velocity of money is defined simply as the rate at which money changes hands. If velocity is
high, money is changing hands quickly, and a relatively small monetary supply can fund a
relatively large amount of purchases. On the other hand, if velocity is low, then money is
changing hands slowly, and it takes a much larger money supply to fund the same number of
purchases.

As you might expect, the velocity of money is not constant. Instead, velocity changes as
consumers' preferences change. It also changes as the value of money and the price level change.
If the value of money is low, then the price level is high, and a large number of bills must be
used to fund purchases. Given a constant money supply, the velocity of money must increase
funding all of these purchases. Similarly, when the money supply shifts due to Fed policy,
velocity can change. This change makes the value of money and the price level remain constant.

The relationship between velocity, the money supply, the price level, and output is represented
by the equation:

MxV=PxY

Where M is the money supply, V is the velocity, P is the price level, and Y is the quantity of
output. P x Y, the price level multiplied by the quantity of output, gives the nominal GDP.

This equation can thus be rearranged as V = (nominal GDP) / M. Conceptually, this equation
means that for a given level of nominal GDP, a smaller money supply will result in money
needing to change hands more quickly to facilitate the total purchases, which causes increased
velocity.

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The equation for the velocity of money, while useful in its original form, can be converted to a
percentage change formula for easier calculations. In this case, the equation becomes:

Percent change in the money supply + Percent change in velocity = Percent change in the
price level + Percent change in output.

The percentage change formula aids calculations that involve this equation by ensuring that all
variables are in common units.

Example
What is the effect of a 3% increase in the money supply on the price level, given that output and
velocity remain relatively constant?

The equation used to solve this problem is :

(Percent change in the money supply) + (Percent change in velocity) = (Percent change in the
price level) + (Percent change in output).

3% + 0% = x% + 0%.

In this case, a 3% increase in the money supple results in a 3% increase in the price level.
Remember that a 3% increase in the price level means that inflation was 3%.

The Effect of Monetary Expansion in The long-run

In the long run, the equation for velocity becomes even more useful. In fact, the equation shows
that increases in the money supply by the Fed tend to cause increases in the price level and
therefore inflation, even though the effects of the Fed's policy is slightly dampened by changes in
velocity. This results a number of factors. First, in the long run, velocity, V, is relatively constant
because people's spending habits are not quick to change. Similarly, the quantity of output, Y, is
not affected by the actions of the Fed since it is based on the amount of production, not the value
of the stuff produced. This means that the percent change in the money supply equals the percent

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change in the price level since the percent change in velocity and percent change in output are
both equal to zero. Thus, we see how an increase in the money supply by the Fed causes
inflation.

Example
What is the effect of a 5% increase in the money supply on inflation?

(Percent change in the money supply) + (Percent change in velocity) = (Percent change in the
price level) + (Percent change in output).

Remember that in the long run, output not affected by the Fed's actions (monetary neutrality) and
velocity remains relatively constant. Thus, the equation becomes :

5% + 0% = x% + 0%.

In this case, a 5% increase in the money supply results in a 5% increase in inflation.

The Inflation Tax

Inflation tax is not an actual legal tax paid to a government; instead "inflation tax" refers to the
penalty for holding cash at a time of high inflation. When the government prints more money or
reduces interest rates, it floods the market with cash, which raises inflation in the long run. As a
government prints more money, the value of that money goes down--just like the value of any
commodity decreases as supply increases If an investor is holding securities, real estate or other
assets, the effect of inflation may be negligible. If a person is holding cash, though, this cash is
worth less after inflation has risen. The degree of decrease in the value of cash is termed the
inflation tax for the way it punishes people who hold assets in cash, which tend to be lower- and
middle-class wage earners.

Fisher Effect
The Fisher effect is an economic theory proposed by economist Irving Fisher that describes the
relationship between inflation and both real and nominal interest rates. The Fisher effect states

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that, in response to a change in the money supply, the nominal interest rate changes in tandem
with changes in the inflation rate in the long run. The Fisher effect states that the real interest rate
equals to the nominal interest rate minus the expected inflation rate.
Fisher mathematically expressed this theory in the following way:

Nominal interest rate = Real interest rate + Inflation rate

The equation states that a country's current (nominal) interest rate is equal to a real interest rate
adjusted for the rate of inflation.
For example, if monetary policy were to cause inflation to increase by 5 percentage points, the
nominal interest rate in the economy would eventually also increase by 5 percentage points.

The Cost of Inflation

In general, people seem to know that inflation is often not a good thing in an economy. This
makes sense, to some degree- inflation refers to rising prices, and rising prices are typically
viewed as a bad thing. Technically speaking, however, increases in the aggregate price level
need not be particularly problematic if prices of different goods and services rise uniformly, if
wages rise in tandem with the price increases, and if nominal interest rates adjust in response to
changes in inflation. (In other words, inflation need not reduce real purchasing power of
consumers.)

There are, however, costs of inflation that are relevant from an economic perspective and cannot
be easily avoided.

Menu Costs

When prices are constant over long periods of time, firms benefit in that they don't need to worry
about changing the prices for their output. When prices change over time, on the other hand,
firms would ideally like to change their prices in order to keep pace with the general trends in
prices, since this would be the profit-maximizing strategy.

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Unfortunately, changing prices is generally not costless, since changing prices require printing,
new menus, relabeling items, and so on. These costs are referred to as menu costs, and firms
have to decide whether to operate at a price that is not profit-maximizing or incur the menu costs
involved in changing prices. Either way, firms bear a very real cost of inflation.

Shoe leather Costs

Whereas firms are the ones who directly incur menu costs, shoe leather costs directly impact all
holders of the currency. When inflation is present, there is a real cost to holding cash (or holding
assets in non-interest bearing deposit accounts), since the cash won't buy as much tomorrow as it
could today. Therefore, citizens have an incentive to keep as little cash on hand as possible,
which means that they have to go to the bank or otherwise transfer money on a very frequent
basis. The term shoe leather costs refer to the increase in the number of trips to the bank, but
shoe leather costs are a very real phenomenon.

Shoe leather costs are not a serious issue in economies with relatively low inflation, but they
become very relevant in economies that experience hyperinflation. In these situations, citizens
generally prefer to keep their assets as foreign rather than the local currency, which also
consumes unnecessary time and effort.

Misallocation of Resources

When inflation occurs and prices of different goods and services rise at different rates, some
goods and services become cheaper or more expensive in a relative sense. These relative price
distortions, in turn, affect the allocation of resources toward different goods and services in a
way that would not happen if relative prices remained stable.

Wealth Redistribution

Unexpected inflation can serve to redistribute wealth in an economy because not all investments
and debt are indexed to inflation. Higher than expected inflation lower the value of debt in real
terms, but it also makes the real returns on assets lower. Therefore, unexpected inflation serves to

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hurt investors and benefit those who have a lot of debt. This is likely not an incentive that
policymakers want to create in an economy, so it can be viewed as another cost of inflation.

Tax Distortions

In the United States, there are many taxes that do not automatically adjust for inflation. For
example, capital gains taxes are calculated based on the absolute increase in value of an asset,
not on the inflation-adjusted value increase. Therefore, the effective tax rate on capital gains
when inflation is present may be much higher than the stated nominal rate. Similarly, inflation
increases the effective tax rate paid on interest income.

General Inconvenience

Even if prices and wages are flexible enough to adjust well for inflation, inflation still makes
comparisons of monetary quantities across years more difficult than they could be. Given that
people and companies would like to fully understand how their wages, assets, and debt evolve
over time, the fact that inflation makes it more difficult to do so can be viewed as yet another
cost of inflation.

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