Ch 30 Money Growth and Inflation

N.
GREGORY MANKIW NINTH EDITION
PRINCIPLES OF
ECONOMICS
CHAPTER
Money Growth and
30 Inflation
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?
2
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Inflation – 1
• 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
• 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.
3
Inflation – 2
• 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
4
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
5
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
6
Money Supply (MS)
• Money supply in the real world
– Determined by the Fed, the banking
system, and consumers.
• Money supply in this model
– We assume the Fed precisely controls MS
and sets it at some fixed amount.
7
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.
8
The money supply-demand diagram – 1
Value of Price
Money, 1/P Level, P
(Hig As the value of money (Low)
h) rises, the price level falls.
1 1
¾ 1.33
½ 2
¼ 4
(Low) (High)
Quantity
of Money
9
Value of Price
Money
Money, 1/P Level, P
Supply
(Hig (Low)
MS1
h)
1 1
¾ 1.33
The Fed sets MS
½ 2
at some fixed value,
regardless of P.
¼ 4
(Low) (High)
$1,000 Quantity
of Money
10
Value of Price
Money, 1/P A fall in value of money (or Level, P
(Hig
increase in P) increases the (Low)
h) quantity of money demanded:
1 1
¾ 1.33
½ 2
Money
demand
¼ 4
MD1
(Low)
(High)
Quantity
11
The equilibrium price level
Value of Price
Money, 1/P Level, P
MS P adjusts to equate
(Hig quantity of money (Low)
h) 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
12
The effects of a monetary injection
Value of If the Fed Price
Money, 1/P Level, P
MS1 MS2 increases
(Hig the (Low)
h) money
1 supply. 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
13
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.
14
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
15
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)
16
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
17
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
18
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.
19
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?
20
EXAMPLE 3: The neutrality of money
• Initially, relative price of smartphones in
terms of pizza is
𝑃 𝑜𝑓
$123/𝑠𝑚𝑎𝑟𝑡𝑝ℎ𝑜𝑛𝑒
𝑠𝑚𝑎𝑟𝑡𝑝ℎ𝑜𝑛𝑒
𝑃 𝑜𝑓𝑝𝑖𝑧𝑧𝑎 = $13/𝑝𝑖𝑧𝑧𝑎 =
= 45 pizzas per
smartphone
• If all prices double:
𝑃 𝑜 𝑓 𝑠𝑚𝑎𝑟𝑡𝑝ℎ𝑜𝑛𝑒
$633/𝑠𝑚𝑎𝑟𝑡𝑝ℎ𝑜𝑛𝑒
𝑃 𝑜𝑓𝑝𝑖𝑧𝑧𝑎 = $23/𝑝𝑖𝑧𝑧𝑎 =
= 45 pizzas per
smartphone
• The relative price is unchanged.
21
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
22
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.
23
The Velocity of Money
• 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
• Velocity formula:
=
© 2021 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a
24
®
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.
25
Active Learning 2: Velocity of money
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
26
U.S. nominal GDP, M2, and velocity 1960–2019
Velocity is fairly stable over the long run
M2
1960=100
Nominal GDP
Velocity
27
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
28
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
PxY and M.
5. Rapid money supply growth causes rapid
inflation.
29
Active Learning 3: Quantity theory of money
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.
30
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)
31
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%
32
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 dollars in your wallet are less
valuable
– In the U.S., the inflation tax today
accounts for less than 3% of total revenue
33
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
34
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
35
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
36
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
37
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.
38
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
39
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
40
Relative-Price Variability
• Misallocation of resources from relative-
price variability:
– Firms don’t all raise prices at the same
time, so relative prices can vary
– Consumer decisions are distorted and
markets are less able to allocate
resources to their best use
41
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.
42
Active Learning 4: Tax distortions
You deposit $1,000 in the bank for one year.
CASE 1: inflation = 0%, nom. interest rate = 10%
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.
43
Active Learning 4: Answers, A
Deposit $1,000.
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).
44
Active Learning 4: Answers, B
Deposit $1,000. Tax rate =25%.
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.
45
Active Learning 4: Answers, C
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%
46
Active Learning 4: Summary and lessons
Inflation…
• raises nominal interest rates (Fisher effect)
but not real interest rates
• increases savers’ tax burdens
• lowers the after-tax real interest rate
47
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
48
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
49
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
50
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.”
51
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?
52
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.
53
• 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.
54
• 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.
55

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N.

GREGORY MANKIW NINTH EDITION

• Nominal GDP = P x Y = $8 x 1,800 =

The close relation

Inflation causes the

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

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

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