Professional Documents
Culture Documents
Inflation and The Quantity Theory of Money
Inflation and The Quantity Theory of Money
Theory of Money
Introduction
• Zimbabwe President Robert Mugabe’s policy of seizing commercial
farms drove away entrepreneurs and investors.
• To bribe his enemies and pay the army, he simply printed more
money.
• The economy was flooded with money but could not produce more
goods.
• Prices went up: The inflation rate increased from 50% per year to 50%
per month to more than 50% per day.
Inflation
• An increase in the average level of prices.
• Inflation is measured by changes in a price index.
• The inflation rate is the percentage change in a price index from one
year to the next.
• , where P2 is the index value in year 2 and P1 is the index value in year
1.
Price Indexes
• Consumer price index (CPI): Measures the average price for a basket
of goods and services bought by a typical American consumer; covers
80,000 goods and services and is weighted so major items count
more.
• GDP deflator: The ratio of nominal to real GDP multiplied by 100;
covers finished goods and services.
• Producer price indexes (PPI): Measure the average price received by
producers; includes intermediate and finished goods and services.
Relevance of CPI as a Price Index
• For Americans, CPI is the measure of inflation that corresponds most
directly to their daily economic activity.
• The Bureau of Labor Statistics (BLS) computes the CPI.
• It tries to take both new goods and higher-quality goods into account
when computing the CPI.
Inflation in the United States
Real Price
• A price that has been corrected for
1982 2006
inflation. Real prices are used to
compare the prices of goods over time. Gallon of gasoline $1.25 $2.50
• The quantity theory of money also says that the growth rate of the money supply
will be approximately equal to the inflation rate.
The Cause of Inflation: Application
• Nations with rapidly (slowly)
growing money supplies had
high (low) inflation rates.
• As indicated by the red line, on
average the relationship is
almost perfectly linear, with a
10% increase in the money
growth rate leading to a 10%
increase in the inflation rate.
The Cause of Inflation Continued
• An unexpected increase in the money supply can boost the economy
in the short run.
• As firms and workers come to expect and adjust to the new influx of
money, output will not grow any faster than normal.
• In the long run, money is neutral.
An Inflation Parable
• Butcher, brewer, and baker in a small economy in Zimbabwe
• Zimbabwe pays soldiers by printing more money
• The economy responded by producing more goods initially but later
realized the price has gone up.
• The economy then stopped producing more goods because of
expected inflation.
The Costs of Inflation
• Four problems associated with inflation:
• There is price confusion and money illusion.
• Inflation redistributes wealth.
• Inflation interacts with other taxes.
• Inflation is painful to stop.
Price Confusion and Money Illusion
• Money illusion: when people mistake changes in nominal prices for
changes in real prices.
• Inflation makes price signals more difficult to interpret.
• It is not always clear whether prices are rising because of increased
demand or because of an increase in the money supply.
• We sometimes mistake inflation for higher wages and prices in real
terms.
• Resources are wasted in activities that appear profitable but are not,
and resources flow more slowly to profitable uses.
Inflation Redistributes Wealth
• Inflation is a type of tax that transfers real resources from citizens to
the government.
• Inflation reduces the real return that lenders receive on loans,
transferring wealth from lenders to borrowers.
• When inflation and interest rates fall unexpectedly, wealth is
redistributed from borrowers (who are paying higher rates) to
lenders.
Inflation Redistributes Wealth: Rate of Return
• Real rate of return: the nominal rate of return minus the inflation rate.
• Nominal rate of return: the rate of return that does not account for inflation.
• The relationship between the lender’s real rate of return, the nominal rate of
return, and the inflation rate, is
• The real rate of return is equal to the nominal rate of return minus the
inflation rate.
Inflation Redistributes Wealth: Fisher Effect
• The tendency of nominal interest rates to rise with
expected inflation rates.
• When lenders expect inflation to increase, they will
demand a higher nominal interest rate.
• The Fisher effect says that the nominal interest
rate is equal to the expected inflation rate plus the
equilibrium real interest rate.
• It also says the nominal rate will rise with expected
inflation.
Inflation Redistributes Wealth: Monetizing
the Debt
• When the government pays off its debts by printing money.
• A government with massive debts has an incentive to increase the
money supply, since it benefits from unexpected inflation.
• The government doesn’t always inflate its debt away for two reasons:
• If lenders expect inflation, they will increase nominal rates.
• Buyers of bonds are often also voters, who would be upset if real returns
were shrunk.
Inflation Interacts with Other Taxes
• Most tax systems define incomes, profits, and capital gains in nominal
terms.
• Inflation will produce some tax burdens and liabilities that do not
make economic sense.
• If asset prices rise due to inflation, people pay capital gains taxes
when they should not.
• Inflation can push people into higher tax brackets.
• Corporations pay taxes on phantom profits.
Inflation Is Painful to Stop
• The government can reduce inflation by reducing the growth in the
money supply.
• When inflation is expected, lower inflation may be misinterpreted as a
reduction in demand.
• Firms reduce output and employment.
• Workers may become unemployed as the unexpected increase in
their real wage makes them unaffordable.
• Expectations will eventually adjust in the long run.
Takeaway
• Inflation is an increase in the average level of prices as measured by a price index.
• Sustained inflation is always and everywhere a monetary phenomenon.
• Although money is neutral in the long run, changes in the money supply can
influence real GDP in the short run.
• Inflation makes price signals more difficult to interpret.
• The tendency of the nominal interest rate to increase with expected inflation is
called the Fisher effect.
• Arbitrary redistributions of wealth make lending and borrowing riskier and thus
break down financial intermediation.
• Anything above a mild rate of inflation is generally bad for an economy.