TOPIC III: Money and Inflation

TOPIC III: MONEY AND INFLATION

Learning Objectives
• Define Inflation, Deflation, and Customer Price Index
• Analyze the effect of the demand and supply of money in the inflation
• Compute for the Price Index and Inflation Rate

Have you ever wondered, before you can buy so many things with 500 pesos, but now your 500
pesos can buy few items only? Before the cost of 1 tricycle ride is 8 pesos only, but now it is 10
pesos. The milk tea before can be bought at 60 to 80 pesos, now the same type and quantity of milk
tea can be bought at the price of 90pesos to 120 pesos. Or the famous C1 of Jollibee, before you
can buy it at 75 pesos only, now it is 90 pesos. Although the type, quality, and quantity of the product
or services doesn’t change, but the value of your money changed (devalued = decrease in its value),
and that is caused by Inflation.

INFLATION is a sustained, generalized increase in the prices of goods and services in an economy.
Every increase in price is not inflation, though. When the prices of produce rise in the winter, we
don’t call this inflation, because prices will come back down in the spring. The price increase is not a
sustained (or permanent) increase. Similarly, if prices increase one time, but don’t continue
increasing, we don’t call it inflation. Inflation must be a sustained increase in prices. When the price
of gasoline increases at the pump, we don’t call this inflation either, since gasoline is only one good
that we consume. Rather, we call this a change in relative prices, since gasoline has become more
expensive relative to other goods and services. A generalized increase in prices means the prices of
all, or at least most, goods and services go up. Deflation is the reverse of Inflation; it is a sustained
generalized decrease in prices of goods and services in an economy.

Undesirability of Inflation
Economic plans and policies are intended to improve the standards of living of people. Inflation,
however, negates the economic objective of improving the quality of life of people. These are some
of the affected by inflation: First, people who have fixed income are severely affected by the inflation.
With increased prices, people who belong to this group would lose out because the income they
receive now would be able to buy less than before. Thus, their income welfare is diminished.
Secondly, because of increased prices, benefits of pensioners from the SSS or the GSIS would
result in net loss to the pensioner. Unless the benefits received by the pensioners are adjusted to the
inflation rate, the pensioners would suffer a net loss. Creditors also lose out during inflation. The
reason they lose out is because the fixed amount of principal and interest they lent out would now be
valued less. If the percent rate charged by the creditor is 12% but the inflation rate is 20% the net
loss of the creditor would be 8%.
Gainers during the Inflation
The first group of gainers are people who have flexible income. For example, business would gain
more if the prices of commodities they produce and sell increase. So long as there is a demand for
their product, these would be sold. At higher prices, their income would obviously register a bigger
gain. The second group of gainers during inflation are the speculators. These are the perceptive and
lucky individuals who are able to buy goods at a cheaper price and then sell later at higher prices
because of inflation. Among the goods that are traded in this category would be groceries,
appliances, jewelry, and the like. The third group of inflation gainers are debtors. Unless there is an
automatic adjustment for inflation, debtors usually gain because the value of the money they
borrowed before would now have more value.

DEMAND-PULL INFLATION
Inflation is said to be demand-pull inflation if those who buy goods and services desire to purchase
greater than what economy can produce. In other words, excess demands for commodities tend to
push prices. As shown in the graph:

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 TOPIC III: Money and Inflation

GRAPH 1: https://tinyurl.com/y32vzr4j
The graph shows that increase (shown
through the shift of the demand curve D1
rightward to D2) in the quantity demanded
from Q1 to Q2, ceterus paribus (all things
being equal), with same supply of goods
and services will result in increase of prices
from P1 to P2.
Example, hypothetically there are 40 Million
Blinks (Blackpink fans) who wants to buy
the new Black pink album (physical copy)
which has only 1.5 Million physical copy.
Then the prices will go up since the demand
is high.
Another example, during pandemic times,
the amount of face masks and alcohols
have increased due to the high demand and
the low supply of it. (This graph and example only show the relationships of an increase in demand
to the prices but not the inflation. But we can see here if the graph shows the general prices then
generally increase in demand for all the services and goods will result to increase in prices.

QUANTITY THEORY OF MONEY

Monetary economics is a branch of economics that studies different theories of money. One of the
primary research areas for this branch of economics is the quantity theory of money. According to
the quantity theory of money, the general price level of goods and services is proportional to the
money supply in an economy. While this theory was originally formulated by Polish mathematician
Nicolaus Copernicus in 1517, it was popularized later by economists Milton Friedman and Anna
Schwartz after the publication of their book, "A Monetary History of the United States, 1867-1960," in
1963.

According to the quantity theory of money, if the amount of money in an economy doubles, price
levels will also double. This means that the consumer will pay twice as much for the same amount of
goods and services. This increase in price levels will eventually result in a rising inflation level;
inflation is a measure of the rate of rising prices of goods and services in an economy.

MV = PQ
Where M = the supply of money, V = the velocity of money, i.e. the number of times an average
peso is spent on final goods and services, P is the general price level, or the average price at which
each unit of physical output is sold, and Q is the physical volume of goods and services produced
The quantity theory of money also assumes that the quantity of money in an economy has a large
influence on its level of economic activity. So, a change in the money supply results in either a
change in the price levels or a change in the supply of goods and services, or both. In addition, the
theory assumes that changes in the money supply are the primary reason for changes in spending.
One implication of these assumptions is that the value of money is determined by the amount of
money available in an economy. An increase in the money supply results in a decrease in the value
of money because an increase in the money supply also causes the rate of inflation to increase. As
inflation rises, purchasing power decreases. Purchasing power is the value of a currency expressed
in terms of the amount of goods or services that one unit of currency can buy. When the purchasing
power of a unit of currency decreases, it requires more units of currency to buy the same quantity of
goods or services.

Hyperinflation – or rapid inflation, is the rapid, excessive, and out of control general price increases
in an economy.

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https://slideplayer.com/slide/8727786/

MONETARIST – QUANTITY THEORY OF MONEY

Monetarists believe that in the short-term velocity (V) is fixed This is because the rate at which
money circulates is determined by institutional factors, e.g. how often workers are paid does not
change very much. Milton Friedman admitted it might vary a little but not very much so it can be
treated as fixed. Monetarists also believe output Q is fixed. They state it may vary in the short run but
not in the long run (because LRAS – Long-run Aggregate Supply is inelastic and determined by
supply-side factors.) Therefore, an increase in the Money Supply will lead to an increase in inflation:

Example 1
 If the total money supply is initially P1000 and the velocity of circulation is 5.
 The level of output (Q) is 5000 units.
 1000×5 = P (5000)
 Therefore P = 1
 If the money supply now doubles the equation if money supply doubles: 2000×5 =P×5000
 Therefore P = 2

Example 2

 If the output is 1,000 units, and there is a money supply of P10,000. The average price of
good will be P10.
 In year 2, if the output stays at 1,000 units, but money supply increases to 15,000.
Consumers have more money to buy the same amount of goods. Therefore, firms put up
prices to reflect this increase in money supply. Ceteris paribus, average prices will rise from
P10 to P15.

Other points
 Milton Friedman predicted an increase in the money supply would take about 9-12 months to
lead to higher output.
 Friedman placed great emphasis on the role of price expectations. If there are expectations of
higher inflation, it becomes self-fulfilling – workers demand higher wages to meet rising living
costs. Firms put up prices to meet rising costs. Strict monetarist policies would help reduce
expectations.
 After another year output will return to its initial equilibrium causing prices to rise to
accommodate the rise in money supply
 Cambridge Version of quantity theory states P= f(M)

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 Monetarism became more popular in the 1970s due to rising inflation. (partly caused by rising
oil prices).
 In the early 1980s, the UK and US adopted monetarist policies with mixed results.

Friedman’s k-percent rule

 Milton Friedman argued that the money supply should rise by a fixed k-percent each year.
This rate of increase should depend on institutional factors and be determined independently
of policymakers.
 Friedman believed this rule would avoid the extremes of deflation (Falling money supply, e.g.
Great Depression) and inflation due to rising money supply.
 It would give business strong expectations of what would happen to money supply and
inflation.
 Monetarist inflation in the AD (Aggregate Demand) and AS (Aggregate Supply) model.

 Following a rise in the Money Supply, consumers have more money and therefore spend
more money on goods; this shifts AD to the right. AD1 to AD 2.
 Firms respond by increasing output along SRAS (Short-run aggregate supply). Real output
increases from Y1 to Y2.
 National output now exceeds the equilibrium level of output. Therefore, there is an inflationary
gap.
 Firms need to hire more workers, so wages rise leading to an increase in costs and hence
prices. Initially, workers agree to work more hours because they see an increase in nominal
wages.
 As prices rise money can buy less, therefore, there is a movement to the left along the new
AD
 Also, workers realize the increase in nominal wage is not a real wage increase. Therefore,
workers also demand higher nominal wages to produce more output and to compensate them
for rising prices, therefore SRAS shifts to the left.
 The economy has returned to the equilibrium level of output (Y1), but at a higher price level
(P3).
 Therefore, the rise in the Money Supply cause a rise in AD, but because the LRAS (Long-run
Aggregate Supply) is inelastic there is no increase in real output, but inflation rises. It is a form
of demand-pull inflation.

Criticisms of monetarism
 The link between the money supply and inflation is often very weak in practice.
 The velocity of circulation (V) is not stable but can vary significantly due to confidence,
changes in the use of credit cards, decline in use of cash. Etc.
 Targeting arbitrary money supply targets can cause a severe recession and high
unemployment. For example, UK targeted money supply growth in the early 1980s, but this
caused the recession of 1981 with many economists arguing it was deeper than necessary.
 The large increase in the monetary base following the 2009 recession did not cause any
inflationary pressures.
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 Why not target inflation directly? If you want to control inflation, it makes more sense to target
inflation directly rather than through the intermediary of the money supply.
  Monetarists say that income can vary in the short run, but the short run could be a long time
and therefore make monetary policy ineffective, Keynesians argue that the LRAS is not
necessarily inelastic they argue that the economy can be below full capacity for a long time.

COST-PUSH INFLATION
A different kind of inflation occurs from shifts in the supply curve. It is believed that such a shift
usually results from increases in the cost of production of inputs and raw materials, and increase in
wage costs. Cost-push inflation is the type of inflation where increases in the costs of production
push prices up.
GRAPH 1: https://tinyurl.com/y32vzr4j

The graph shows that when Supply decreases

from S1 to S2 (due to cost of production). The
quantity supplied decreases from Q1 to Q2 that
results to increase in price from P1 to P2.
Example, due to the increase of price of oil
which results in increase of the cost of
production for most companies, this will result to
increase of prices. Since oil is very important
specially in transportation, increase in its price
will increase transportation cost for distributing
materials, therefore the companies will add the
increase in the cost of transporting raw
materials to the prices of the output goods
causing inflation.

BSP Responsibility in Relation to Inflation

Section 3 of R.A. 7653 or the new Central Bank Act states that the primary objective of the BSP is to
maintain price stability conducive to a balanced and sustainable growth of the economy. As such,
the BSP monitors the movements of prices, analyzes their causes and undertakes necessary
measures to ensure money supply is managed in a manner that does not contribute to inflation.
(Philippines Inflation Rate of September 2020 is 2.3% which is within the BSP’s forecast range of
1.8-2.6%) This photo is posted in the BSP official FB Page.

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The Development Budget and Coordination Committee (DBCC), an inter-agency economic planning
body together with the BSP sets the annual inflation targets. The government's inflation target is
defined in terms of the average year-on-year change in the consumer price index (CPI) over the
calendar year. The BSP makes the announcement of the inflation target two years in advance. In
line with the inflation targeting approach to the conduct of monetary policy, the Development Budget
Coordination Committee (DBCC), during its meeting on 11 December 2019, decided to keep the
current inflation target at 3.0 percent ± 1.0 percentage point for 2020 – 2022.

Inflation targeting is an approach to monetary policy that involves the use of a publicly announced
inflation target set by the Government, which the BSP commits to achieve over a two-year horizon.
Promoting price stability is the BSP's main priority, and the target serves as a guide for the public's
expectations about future inflation, allowing them to plan ahead with greater certainty.

MEASURING INFLATION
The government tracks the prices of specific “market baskets” that included the same goods and
services.
There are two ways to look at inflation:
The Inflation Rate = the percent change in prices over a specific time period. For example, the
inflation rate of the Philippines in 2019 was 2.5%.
Price Indices – Index numbers assigned to each year that show how prices have changed relative
to a specific base year. For example, the Consumer Price Index in the Philippines 2019 was 120.2
(compared to base year 2012 = 100)

Measure of Price Increases

There are at least four commonly use measures of price increases. These are the Consumer Price
Index (CPI), the Retail Price Index (RPI), the Wholesale Price Index (WPI), and the Stock Price
Index (SPI).
Price Index
The Consumer Price Index is the most popular and the most used measures as it reflects what
happens to the living standards of the most of us, the consumers. The Retail Price Index is designed
to measure monthly changes of the prices at which retailers dispose of their goods to consumers
and end-users. The Wholesale Price Index measures monthly changes in the general price level of
commodities that flow into the wholesale trade intermediaries in Metro Manila, hence, it measures
changes during trade turnover. The Stock Price Index serves as the measure of the changes in, and
to trace the movement of the average prices of company shares of stocks traded in the Makati and
Manila Stock Exchanges.

CONSUMER PRICE INDEX

In this topic we will focus on CPI since it is the most commonly used measurement of inflation. The
base year us given an index of 100. Each year is given an index # as well.

What are the uses of CPI?

The CPI is most widely used in the calculation of the inflation rate and purchasing power of the peso.
It is a major statistical series used for economic analysis and as a monitoring indicator of
government economic policy. The CPI is also used to adjust other economic series for price
changes. For example, CPI components are used as deflators for most personal consumption
expenditures (PCE) in the calculation of the gross national product (GNP). Another major importance
of the CPI is its use as basis to adjust wages in labor management contracts as well as pensions
and retirement benefits. Increases in wages through collective bargaining agreements use the CPI
as one of their bases.

How is the CPI computed?

The CPI is computed using the weighted arithmetic mean of price relatives, a variant of Laspeyres
formula with fixed base year period weights.

a. Base Period. This is a reference date or simply a convenient benchmark to which a continuous
series of index numbers can be related, (and has no numerical significance). Since the CPI
measures the average changes in the retail prices of a fixed basket of goods, it is necessary to
compare the movement in prices in the current year to movements in previous years back to a

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reference date at which the index is taken as equal to 100. The base period is a year. A month is
deemed unwise to use as a base period because it often reflects accidental or seasonal influences.
The present series uses 2012 as the base year. The year 200 was chosen as the base year because
it is the year when the Family Income and Expenditure Survey (FIES) was conducted. The FIES is
the basis of the CPI weights. Philippines changes base rates every 6 years (1994, 2000, 2006, and
now 2012) but it doesn’t mean that is will use every 6 years as a base year. In choosing a base year,
it should be a normal year or a typical year, that is, no economic phenomenon that is of an
extraordinary nature happened during that year.

b. Market Basket. Since it is virtually impossible to have periodic measures on the changes in the
prices of all the thousands of varieties of goods purchased for consumption and services availed of
by households in the country, a sample of these items, known as the `CPI market basket’, was
selected to represent the composite price behavior of all goods and services purchased by
consumers.

c. Weighting System. A desirable system that considers the relevance of the components of the
index. For the consumer items purchased by households as a proportion to total expenditure.

In Philippines, the most important categories in the Consumer Price Index and its weight are:

Division Percent
0 ALL ITEMS 100
0
0 Food and Non-Alcoholic 38.98
1 Beverages
0 Alcoholic Beverages and 2.00
2 Tabacco
0 Clothing and Footwear 2.95
3
0 Housing, Water, Electricity, 22.47
4 Gas and other Fuels
0 Furnishing, Household 3.22
5 Equipment and Routine
Maintenance of the House
0 Health 2.99
6
0 Transport 7.81
7
0 Communication 2.26
8
0 Recreation and Culture 1.93
9
1 Education 3.36
0
1 Restaurant and 12.03
1 Miscellaneous Goods and
Services

The value of a Market Basket contains the 11 categories shown in the table. Its price is computed by
their percent get the weighted price index.

THE CPI FORMULA

https://cdn.educba.com/academy/wp-
content/uploads/2019/07/Consumer-
Price-Index-Formula.jpg
Year Market CPI
Basket
2010 P 2400 80
2011 P 2550 85
7 2012* P 3000 100
FM 102 – Monetary Policy and Central Banking
2013 P 3500 116.7
2014 P 3600 120
2015 P 3750 125
 TOPIC III: Money and Inflation

For example, the base year is 2012. The 2010 CPI was calculated by P2,400/ P3000 x 100 = 80.
And the 2015 CPI was P3750/3000 x 100 = 125.

HOW TO CALCULATE INFLATION RATE:

https://www.wallstreetmojo.com/wp-content/uploads/2019/11/Inflation-Formula.jpg

For example:

Year Market CPI Inflation

Basket Rate
2010 P 2400 80 ?
2011 P 2550 85 6.25
2012* P 3000 100 17.65
2013 P 3500 116. 16.7
7
2014 P 3600 120 2.83
2015 P 3750 125 4.17
The CPIx = the previous year CPI, while the CPIx+1
is the current year CPI. In the table we did not calculate the Inflation rate of year 2010 since there
is no CPI data for the previous year (2009). We got the inflation rate of year 2011 by computing this:
85 – 80 / 80 x 100 = 6.25%, and the year 2015 was calculated using 125 – 120 / 120 x 100 = 4.17%.

Actual data of the Philippines CPI and Inflation Rate (2017-2019)

http://www.bsp.gov.ph/statistics/spei_new/tab33_cpi.htm

You will see in this data that the Headline Inflation Rate was computed like this:
2019 CPI – 2018 CPI / 2018 CPI x 100 or 120.2 – 117.3 / 117.3 x 100 = 2.5% inflation rate of 2019.

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References:
Pagoso, C.M. (2010) Money, Credit and Banking.
Aquino et Al (2015) Money, Banking and Financial Market 4/E
Stephen G. Cechetti (2015) Money, Banking and Financial Market
Roberto Medina (2014) Money, Credit and Banking
Croushore, Dean (2012) Money and Banking
https://www.investopedia.com/insights/what-is-the-quantity-theory-of-money/
https://courses.lumenlearning.com/wm-macroeconomics/chapter/introduction-to-inflation/
https://www.economicshelp.org/macroeconomics/inflation/monetarist-theory-inflation/
http://www.bsp.gov.ph/monetary/targeting_inflation.asp
https://psa.gov.ph/sites/default/files/Primer%20on%20Consumer%20Price%20Index2_1_0.pdf
http://www.bsp.gov.ph/statistics/efs_prices.asp

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FM 102 – Monetary Policy and Central Banking