Money Growth

and
Inflation

David Chow
Mar 2020
Learning Objectives
1. Understand the value of money
2. Explain what determine money demand
and money supply
3. Define velocity and the quantity equation
4. Analyze various costs of inflation

We will talk about long run a lot 

Introduction (1 of 3)
 Let’s begin with a common belief, that:
 Inflation occurs when the government prints too
much money
(OR: when there is too much $$ flowing around)

“Inflation is ____ and ____

a monetary phenomenon”
Milton Friedman, 1976 Nobel Laureate
Introduction (2 of 3)
 Inflation is an increase in the overall level of prices
 Other things unchanged, the value of money falls

 Caution:
◦ Value of money =
◦ Cost of holding money =
◦ Analogy: Price & rent of an apartment
Introduction (3 of 3)

The Classical Theory of Inflation

 Money demand – downward sloping
◦ how much wealth people want to hold in cash form
◦ depends mainly on the need for transactions

 MS – vertical
◦ controlled by the
central bank

 Eg: An increase in MS
◦ What is on the y-axis?
 Classical Dichotomy
 According to the classical dichotomy
◦ Nominal and real variables are separated so that
◦ monetary factors affect nominal variables only

 In other words, money is neutral

◦ In particular, changes in MS don’t affect real variables
◦ True in the ____ run

Two Common Beliefs Regarding M↑

1. M↑ leads to inflation (P↑)
2. M↑ leads to output growth (Y↑)
Which one is true?
Quantity Equation (1 of 3)
Velocity of Money
 Define velocity as the speed money changes hands in
transaction for final goods and services:

 Nominal GDP is the price level (P) times real GDP (Y), M is the
money supply:
PY = Nominal
GDP
 Rearranging terms:
Quantity Equation (2 of 3)

 MV = PY is called the quantity equation

◦ A mere restatement of the velocity definition

 Eg1: If M=100, V=1, nominal GDP = ___

 Eg2: M1 and M2 velocities in the US

◦ M1 = $2,440.1 billion (seasonally adjusted, Dec 2012)
◦ M2 = $10,402.4 billion (seasonally adjusted, Dec 2012)
◦ Nominal GDP = $15,681.5 billion
◦ Find M1-velocity and M2-velocity
Quantity Equation (3 of 3)

Another Version of Quantity Equation

 Let gX denotes growth rate (% change) of variable X

 If MV = PY, then gMV = gPY

 The quantity equation becomes:

gM + g V ≈ g P + gY

 Suppose M grows 4%, and V grows 1% per year,

◦ Eg1: If Y grows 3% per year, then the inflation rate is ____
◦ Eg2: What do we know about GDP growth?
Quantity Theory of Money (1 of 3)

 We want to know the relationship between M and P

◦ Can’t conclude from MV=PY

 When M rises, is it true that both V and Y remain constant?

 IF classical dichotomy holds (money printing doesn’t affect
V and Y), then
Money growth rate = Inflation
 This is the quantity theory of money (QTM), which holds in
the long run
Quantity Theory of Money (2 of 3)

• Also, it turns out that velocity is largely constant

• So QTM does make some sense even without classical dichotomy

Velocity of money in the US

(quarterly
(quarterly values,
values, 1960-2009)
1960-2009)
• M1 velocity shows more fluctuation
• M2 velocity is more stable
Quantity Theory of Money (3 of 3)
 Quick Recap
◦ Quantity equation: gM + gV ≈ gP + gY
◦ QTM holds (gM ≈ gP) in the LR

 QTM also holds in times

of high inflation
 Hyperinflations in the 1920s (1 of 3)

(a) Austria (b) Hungary

Index Index
(Jan. 1921 = 100) (July 1921 = 100)
100,000 100,000
Price level
Price level
10,000 10,000
Money supply
Money supply
1,000 1,000

100 100
1921 1922 1923 1924 1925 1921 1922 1923 1924 1925
 Hyperinflations in the 1920s (2 of 3)

(c) Germany (d) Poland

Index Index
(Jan. 1921 = 100) (Jan. 1921 = 100)
100,000,000,000,000 10,000,000
Price level
1,000,000,000,000 Price level
Money 1,000,000
10,000,000,000
100,000,000 supply 100,000 Money
1,000,000 supply
10,000
10,000
100 1,000
1 100
1921 1922 1923 1924 1925 1921 1922 1923 1924 1925
Hyperinflations in the 1920s (3 of 3)

The German
Hyperinflation

 Left: 30,000 marks, issued in Aug/Sept 1923

 This stamp is an overprint of a 10-mark "Farmers" of 1922
 Right: 500 million marks, issued in Oct/Nov 1923
 By Nov first class letter rates would hit 800 billion marks!
 800 billion = __ x 500 million
The Fisher Effect (1 of 2)

 Recall the definition of real interest rate

 Nominal interest rate
= Real interest rate + Inflation rate

 Fisher effect: IF money is neutral, then there will be a

one-for-one adjustment of nominal interest rate to
inflation rate
◦ True in the long run
◦ Useful in understanding movements in nominal interest rate
The Fisher Effect (2 of 2)

Fig: US Nominal Interest Rate & Inflation Rate, 1960-2012

Hyperinflation
 Hyperinflation is a situation when inflation is more than
50% per month
 Typically occurs when the government over-spends and
resort to money-printing
 The revenue from printing
money is called inflation tax
 An inflation tax is like a tax
on every money holder
Anticipated (Expected) Inflation
 People hate inflation because money loses its value
 If inflation is perfectly anticipated, people can change
prices and incomes accordingly
 The effect of inflation disappears, right?

• Not exactly ...

• While Inflation is “adapted” by the
society, prices keep rising. It may
cause some problems later
• Eg: Lost in international competitiveness
 Costs of Inflation
Even when Inflation is Perfectly Anticipated

E. Confusion and inconvenience

A. Shoe-leather costs F. For unexpected inflation, there exists an
B. Menu costs arbitrary redistribution of wealth among
borrowers and lenders

C. Relative price variability

• Inflation distorts relative price. Markets are less
able to allocate resources efficiently
D. Tax distortions
• With progressive taxation, capital gains are
taxed more heavily, thus discouraging S and I

Last words …
Inflation is volatile (more so when inflation is high)
Inflation is bad, but deflation may be worse
 Case Study: Quantitative Easing
 The Fed has created an amazing amount of money
 Three rounds of QE (Quantitative Easing) since Sep 2008, when the financial
tsunami broke out (QE1-3 Timeline)
 Any implications? The Inconvenient Debt
Fox News, 2009-01-29
Case Study: The German Hyperinflation (1 of 2)

 Hyperinflation in Germany (2:02-4:40)

 Between Jun 1921 and Jan 1924,

Germany had one of the worst
hyperinflations in history
 Many of the dramatic and unusual
incidences in hyperinflation are no
longer strange to us now
 For instance,
◦ huge increases in prices and interest
rates,
◦ consumer flight from cash to real assets,
◦ redenomination of the currency, etc
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Case Study: The German Hyperinflation (2 of 2)

Discussion Questions
1. Which one is to blame for
hyperinflation?
◦ War?
◦ Budget deficit, or
◦ Money-printing?

2. What is your policy suggestion

to stop inflation in a high-
inflation economy?

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