BUI DUY HUNG

MACROECONOMICS

TOPIC

Money Growth and Inflation

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Interactive PowerPoint Slides by:
V. Andreea Chiritescu
Eastern Illinois University

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IN THIS CHAPTER
• How does the money supply affect inflation and nominal interest
rates?
• Does the money supply affect real variables like real GDP or the
real interest rate?
• How is inflation like a tax?
• What are the costs of inflation? How serious are they?

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IN THIS CHAPTER

1.The Classical Theory of Inflation

2.The Costs of Inflation

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 I INFLATION

• Inflation
– Increase in the overall level of prices
– Substantial variation over time:
• 2008 – 2018: average rate of 1.5% per year
• 1970s: average rate of 7.8% per year.
• Deflation
– Decrease in the overall level of prices
– Average level of prices in the U.S. economy was 23% lower in 1896 than in
1880

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 I INFLATION

• 2018, inflation rates:

– 2.4 percent in the United States
– 1.2 percent in Japan
– 4.8 percent in Mexico
– 12 percent in Nigeria
– 15 percent in Turkey
– 32 percent in Argentina
– 1.4 million percent per year in Venezuela
• Hyperinflation
– An extraordinarily high rate of inflation

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 I INFLATION: THE CLASSICAL THEORY OF INFLATION

Prices rise when the government prints too much money.

– Most economists rely on the quantity theory of money to explain long-run
determinants of the price level and the inflation rate
• Asserts that the quantity of money determines the value of money
• We study this theory using two approaches:
1. A supply-demand diagram
2. An equation

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 I INFLATION: THE CLASSICAL THEORY OF INFLATION

The Level of Prices and the Value of Money

• Price level, P: Number of dollars needed to buy a basket of goods and

services
– When the price level rises, people have to pay more for the goods and
services they buy.
• Value of money, 1/P: The quantity of goods and services that can be bought
with $1
– A rise in the price level: lower value of money because each dollar in your
wallet now buys a smaller quantity of goods and services.
Inflation drives up prices and drives down the value of money.

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 I INFLATION: THE CLASSICAL THEORY OF INFLATION

Money Supply (MS)

• Money supply in the real world
– Determined by central bank, the banking system, and consumers.
• Money supply in this model
– We assume central bank precisely controls MS and sets it at some fixed
amount.

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 I INFLATION: THE CLASSICAL THEORY OF INFLATION

Money Demand (MD)

• Money demand
– How much wealth people want to hold in liquid form
– Depends on P: an increase in P reduces the value of money, so more money
is required to buy goods and services.
• Quantity of money demanded
– Is negatively related to the value of money
– And positively related to P, other things equal.

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 The money supply-demand diagram – 1
Value of Price
Money, 1/P Level, P
(High) As the value of money (Low)
rises, the price level falls.
1 1

¾ 1.33

½ 2

¼ 4
(Low) (High)
Quantity
of Money
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 The money supply-demand diagram – 2
Value of Price
Money
Money, 1/P Level, P
Supply
(High) (Low)
MS1
1 1

¾ 1.33
The central bank
½ sets MS 2
at some fixed value,
¼ regardless of P. 4
(Low) (High)
$1,000 Quantity
of Money
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 The money supply-demand diagram – 3
Value of Price
Money, 1/P A fall in value of money (or Level, P
(High)
increase in P) increases the (Low)
quantity of money demanded:
1 1

¾ 1.33

½ 2
Money
demand
¼ 4
MD1
(Low) (High)
Quantity
of Money
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 The equilibrium price level
Value of Price
Money, 1/P Level, P
MS1 P adjusts to equate
(High) quantity of money (Low)
demanded with
1 1
money supply.
¾ 1.33
eq’m
value A eq’m
½ 2 price
of
money level
¼ 4
MD1
(Low) (High)
$1,000 Quantity
of Money
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 The effects of a monetary injection
Value of If the CB Price
Money, 1/P Level, P
MS1 MS2 increases
(High) the money (Low)
supply.
1 1
Then the
¾
value of 1.33
money falls,
A and P rises.
New ½ 2
eq’m New
B eq’m
value ¼ 4
of MD1 price
money level
$1,000 $2,000 Quantity of Money

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 A brief look at the adjustment process

Increasing money supply causes P to rise.

• At the initial P, an increase in MS causes an excess supply of money.
• People get rid of their excess money: spend it on goods and services or by loan
it to others, who spend it.
• Result: increased demand for goods and services.
• But supply of goods does not increase, so prices must rise, so the quantity of
money demanded increases because people are using more dollars for every
transaction.

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 I INFLATION: THE CLASSICAL THEORY OF INFLATION

The Classical Dichotomy – 1

• Classical dichotomy
– The theoretical separation of nominal variables and real variables
• Nominal variables: measured in monetary units.
– Nominal GDP, nominal interest rate (rate of return measured in $), nominal
wage ($ per hour worked)
• Real variables: measured in physical units.
– Real GDP, real interest rate (measured in output), real wage (measured in
output)

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EXAMPLE 1: The relative price of a good

The relative price of a good is the price of one good in terms of another.
• The price of a smartphone is $450 and the price of a pepperoni pizza is $10.
• What is the relative price of a smartphone?

The relative price of a smartphone is:

= P smartphone / P pizza
= ($450/smartphone ) / ($10/pizza)
= 45 pizzas per smartphone

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EXAMPLE 2: Real vs. nominal wage

The real wage is the price of labor relative to the price of output.
• The nominal wage, W = $15/hour (the price of labor), and the price level, P =
5 (the price of goods and services, so it’s $5/unit of output).
• Calculate the real wage.

• Real wage = W / P
= ($15/hour) / ($5/unit of output)
= 3 units of output per hour

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 I INFLATION: THE CLASSICAL THEORY OF INFLATION

The Classical Dichotomy – 2

• Classical dichotomy:
– Theoretical separation of nominal and real variables
– Monetary developments affect nominal variables but not real variables:
• If central bank doubles the money supply:
• Then all nominal variables—including prices—will double
• But all real variables—including relative prices—will remain unchanged.

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 I INFLATION: THE CLASSICAL THEORY OF INFLATION

The Neutrality of Money – 1

• Monetary neutrality:
– The proposition that changes in the money supply do not affect real variables
• Doubling money supply
– Causes all nominal prices to double
– What happens to relative prices?

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EXAMPLE 3: The neutrality of money

• Initially, relative price of smartphones in terms of pizza is

$ /
= =
$ /
= 45 pizzas per smartphone
• If all prices double:
$ /
= =
$ /
= 45 pizzas per smartphone
• The relative price is unchanged.
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Active Learning 1: The neutrality of money

If the central bank doubles the money supply, what happens with the real wage
and total employment?

• Doubling the money supply:

– Nominal wages double
– Price level doubles
– Real wage is W/P remains unchanged
– Quantity of labor supplied does not change
– Quantity of labor demanded does not change
– Total employment of labor does not change

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 I INFLATION: THE CLASSICAL THEORY OF INFLATION

The Neutrality of Money – 2

• Most economists believe

– The classical dichotomy and neutrality of money describe the economy in the
long run.
• In later chapters
– We will see that monetary changes can have important short-run effects on
real variables.

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 I INFLATION: THE CLASSICAL THEORY OF INFLATION

The Quantity Theory of Money

• Quantity theory of money

– A theory asserting that the quantity of money available determines the price
level and that the growth rate in the quantity of money available determines
the inflation rate

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 I INFLATION: THE CLASSICAL THEORY OF INFLATION

The Velocity of Money and the quantity equation

How many times per year is the typical VND bill used to pay for a newly produced
good or service?

• Velocity of money: The rate at which money changes hands

• Notation:
P x Y = nominal GDP = (price level) x (real GDP)
M = money supply
V = velocity
PxY
• Velocity formula: V =
M

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EXAMPLE 4: The velocity of money

Assume there is only one good in the economy, pizza. In 2019, money supply is
$10,000, real GDP is 3,000 pizzas and the price of pizza is $10. What was the
velocity of money?

• Y = real GDP = 3,000 pizzas

• P = price level = price of pizza = $10
• P x Y= nominal GDP = value of pizzas = $30,000
• Velocity, V = P × Y / M = nominal GDP / money supply = $30,000/$10,000 = 3
The average dollar was used in 3 transactions.

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Active Learning 2: Velocity of money

Assume there is only one good in the economy, corn. The economy has enough
labor, capital, and land to produce 1,800 bushels of corn.
V is constant. In 2019, money supply was $3,600 and the price of corn was
$8/bushel.
• Compute nominal GDP and velocity in 2019.

• Nominal GDP = P x Y = $8 x 1,800 = $14,400

• Velocity V = P x Y / M = $14,400 / $3,600 = 4

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 U.S. nominal GDP, M2, and velocity 1960–2019
Velocity is fairly stable over the long run

M2
1960=100

Nominal GDP

Velocity

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 I INFLATION: THE CLASSICAL THEORY OF INFLATION

The Quantity Equation

• The quantity equation: M x V = P x Y

– Relates the quantity of money (M) to the nominal value of output (P × Y)
– Shows that an increase in the quantity of money in an economy must be
reflected in one of the other three variables:
• The price level must rise
• The quantity of output must rise
• Or the velocity of money must fall

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 I INFLATION: THE CLASSICAL THEORY OF INFLATION

The Quantity Theory of Money

1. V is relatively stable over time.

2. A change in M causes nominal GDP (P x Y) to change by the same
percentage.
3. A change in M does not affect Y: money is neutral, Y is determined by
technology & resources
4. So, P changes by same percentage as
P x Y and M.
5. Rapid money supply growth causes rapid inflation.

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Active Learning 3: Quantity theory of money

Assume there is only one good in the economy, corn. The economy has enough
labor, capital, and land to produce 1,800 bushels of corn.
V is constant. In 2019, money supply was $3,600 and the price of corn was
$8/bushel. For 2020, the Fed increases MS by 10%.
A. Compute the 2020 values of nominal GDP and P. Compute the inflation rate
for 2019–2020.
B. Suppose tech. progress causes Y to increase to 1,950 in 2020. Compute the
2019–2020 inflation rate.

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Active Learning 3: Answers, A

• First, calculate velocity because it is constant from 2019 to 2020. For 2019: P x
Y = M x V, so 8 × 1,800 = 3,600 × V, therefore V= 4
• Calculate nominal GDP for 2020, knowing the money supply increased by 10%
to $3,960.
• Nominal GDP in 2020 = P x Y = M x V = 3,960 x 4 = $15,840
• To calculate inflation rate we need the price of corn in 2019 ($8) and in 2020: P
= M x V / Y = 15,840/1,800 = $8.80
• Inflation rate 2019-2020 = (8.80 – 8.00)/8.00 = 10% (same as money supply)

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Active Learning 3: Answers, B
2019: Y = 1,800 bushels; P = $8 per bushel, MS = $3,600.
In 2020, MS increases by 10%. V = 4 (constant)
B. Suppose tech. progress causes Y to increase to 1,950 in 2020.
Compute the 2019–2020 inflation rate.

• 2020 prices: P = M x V / Y = 15,840/1,950 = $8.12

• Inflation rate 2019-2020 = (8.12 – 8.00)/8.00 = 1.5%

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 I INFLATION: THE CLASSICAL THEORY OF INFLATION

The Inflation Tax

• The inflation tax
– Revenue the government raises by creating (printing) money
– Like a tax on everyone who holds money
• When the government prints money
• The price level rises
• The VND in your wallet are less valuable
– In the U.S., the inflation tax today accounts for less than 3% of total revenue

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 I INFLATION: THE CLASSICAL THEORY OF INFLATION

The Fisher Effect – 1

• Principle of monetary neutrality
– An increase in the rate of money growth raises the rate of inflation but does
not affect any real variable
• Because
Real interest rate = Nominal interest rate – Inflation rate
• We get
Nominal interest rate = Real interest rate + Inflation rate

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 I INFLATION: THE CLASSICAL THEORY OF INFLATION

The Fisher Effect – 1

• Principle of monetary neutrality

– An increase in the rate of money growth raises the rate of inflation but does
not affect any real variable
• Because
Real interest rate = Nominal interest rate – Inflation rate
• We get
Nominal interest rate = Real interest rate + Inflation rate

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 I INFLATION: THE CLASSICAL THEORY OF INFLATION

The Fisher Effect – 2

• Fisher effect
– One-for-one adjustment of nominal interest rate to inflation rate
– When the Fed increases the rate of money growth, the long-run result is:
• Higher inflation rate
• Higher nominal interest rate

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U.S. nominal interest & inflation rates, 1960–2019

The close relation

between these
Nominal variables is evidence
interest rate for the Fisher effect.

Inflation rate

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 II THE COST OF INFLATION: THE INFLATION FALLACY

• Inflation fallacy
– “Inflation robs people of the purchasing power of his hard-earned dollars”
• When prices rise
– Buyers pay more
– Sellers get more
• Inflation does not in itself reduce people’s real purchasing power

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U.S. average hourly earnings & the CPI 1965 - 2019

Inflation causes the

Nominal wage
CPI and nominal
wages to rise
together over the CPI
long run.

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 II THE COST OF INFLATION

Shoeleather Costs
• Inflation
– Is like a tax on the holders of money
• Avoid the inflation tax
– By holding less money (and go to the bank more often)
• Shoeleather costs
– Resources wasted when inflation encourages people to reduce their money
holdings
– Can be substantial

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 II THE COST OF INFLATION

Menu Costs
• Menu costs
– Costs of changing prices
– Inflation increases menu costs firms must bear
– Deciding on new prices
– Printing new price lists and catalogs
– Sending the new price lists and catalogs to dealers and customers
– Advertising the new prices
– Dealing with customer annoyance over price changes

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 II THE COST OF INFLATION

Inflation-Induced Tax Distortions

• Inflation-induced tax distortions:

– Inflation makes nominal income grow faster than real income.
– Taxes are based on nominal income, and some are not adjusted for inflation.
– So, inflation causes people to pay more taxes even when their real incomes
don’t increase.

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Active Learning 4: Tax distortions
You deposit $1,000 in the bank for one year.
CASE 1: inflation = 0%, nom. interest rate = 10%
CASE 2: inflation = 10%, nom. interest rate = 20%
A. In which case does the real value of your deposit grow the most?
Assume the tax rate is 25%.
B. In which case do you pay the most taxes?
C. Compute the after-tax nominal interest rate,
then subtract inflation to get the after-tax real interest rate for both
cases.

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Active Learning 4: Answers, A
Deposit $1,000.
CASE 1: inflation = 0%, nom. interest rate = 10%
CASE 2: inflation = 10%, nom. interest rate = 20%
A. In which case does the real value of your deposit
grow the most?
• Real interest rate = Nominal interest rate –
Inflation rate
• In both cases, the real interest rate is 10%, so the
real value of the deposit grows 10% (before
taxes).

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Active Learning 4: Answers, B
Deposit $1,000. Tax rate =25%.
CASE 1: inflation = 0%, nom. interest rate = 10%
CASE 2: inflation = 10%, nom. interest rate = 20%

B. In which case do you pay the most taxes?

• CASE 1: interest income = $100, so you pay $25 in

taxes.
• CASE 2: interest income = $200, so you pay $50 in
taxes.

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Active Learning 4: Answers, C
Deposit $1,000. Tax rate =25%.
CASE 1: inflation = 0%, nom. interest rate = 10%
CASE 2: inflation = 10%, nom. interest rate = 20%
C. Compute the after-tax nominal interest rate,
then subtract inflation to get the after-tax real
interest rate for both cases.
CASE 1: nominal = 0.75 x 10% = 7.5%
real = 7.5% – 0% = 7.5%
CASE 2: nominal = 0.75 x 20% = 15%
real =15% – 10% = 5%

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Active Learning 4: Summary and lessons
Deposit $1,000. Tax rate =25%.
CASE 1: inflation = 0%, nom. interest rate = 10%
CASE 2: inflation = 10%, nom. interest rate = 20%

Inflation…
• raises nominal interest rates (Fisher effect)
but not real interest rates
• increases savers’ tax burdens
• lowers the after-tax real interest rate

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 II THE COST OF INFLATION

Confusion and Inconvenience

• Confusion and inconvenience:

– Inflation changes the yardstick we use to measure transactions
• Complicates long-range planning and the comparison of dollar amounts
over time
– Difficult to judge the costs of the confusion and inconvenience that arise from
inflation

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 II THE COST OF INFLATION

Arbitrary Redistributions of Wealth

• Unexpected inflation
– Redistributes wealth among the population
• Not by merit
• Not by need
– Redistribute wealth among debtors and creditors
• Inflation: volatile and uncertain
– When the average rate of inflation is high

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 II THE COST OF INFLATION

Deflation May Be Worse

• Friedman rule
– Prescription for moderate inflation
– Small and predictable amount of deflation may be desirable
• In practice, deflation is rarely steady and predictable
– Redistribution of wealth away from debtors (who are often poorer)
• Deflation often arises from broader macroeconomic difficulties

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 THINK-PAIR-SHARE
Suppose you explain the concept of an “inflation tax” to a
friend. You correctly tell them, “When a government prints money
to cover its expenditures instead of taxing or borrowing, it causes
inflation. An inflation tax is simply the erosion of the value of
money from this inflation. Therefore, the burden of the tax lands
on those who hold money.” Your friend responds, “What’s so bad
about that? Rich people have all the money, so an inflation tax
seems fair to me. Maybe the government should finance all of its
expenditures by printing money.”

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 THINK-PAIR-SHARE

A. Is it true that rich people hold more money than poor people do?
B. Do rich people hold a higher percent of their income as money
than poor people?
C. Compared to an income tax, does an inflation tax place a
greater or lesser burden on the poor? Explain.
D. Are there any other reasons why engaging in an inflation tax is
not good policy?

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 CHAPTER IN A NUTSHELL
• The overall level of prices in an economy adjusts to bring money
supply and money demand into balance. When the central bank
increases the supply of money, it causes the price level to rise.
Persistent growth in the quantity of money supplied leads to
continuing inflation.
• The principle of monetary neutrality asserts that changes in the
quantity of money influence nominal variables but not real variables.
Most economists believe that monetary neutrality approximately
describes the behavior of the economy in the long run.

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 CHAPTER IN A NUTSHELL
• A government can pay for some of its spending simply by printing
money. When countries rely heavily on this “inflation tax,” the result is
hyperinflation.
• One application of the principle of monetary neutrality is the Fisher
effect. According to the Fisher effect, when the inflation rate rises, the
nominal interest rate rises by the same amount so that the real interest
rate remains the same.
• Many people think that inflation makes them poorer because it raises
the cost of what they buy. This view is a fallacy, however, because
inflation also raises nominal incomes.

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 CHAPTER IN A NUTSHELL
• Economists have identified six costs of inflation: shoeleather costs
associated with reduced money holdings, menu costs associated
with more frequent adjustment of prices, increased variability of
relative prices, unintended changes in tax liabilities due to
nonindexation of the tax code, confusion and inconvenience
resulting from a changing unit of account, and arbitrary
redistributions of wealth between debtors and creditors.
• Many of these costs are large during hyperinflation, but the size of
these costs for moderate inflation is less clear.

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