Lecture 7 money growth and inflation

 The causes of inflation and the quantity theory of money.. Cost-push Inflation Occurs when there is a rise in production costs wage and salary, raw material and components, government

Lecture 7

Macroeconomics

Money Growth &

Inflation

Chapter 28

In this chapter, you will study:

 The definition and measures of inflation

 Two types of inflation.

 The causes of inflation and the quantity theory of money.

 The relationship between inflation and interest rates.

 The costs of inflation.

Inflation & Its Historical Aspects

Hyperinflation in Venezuela

cash would seem an

extremely affluent action in

most countries But in

Venezuela, it's now the

financially prudent thing to

do.

Types of Inflation

 Demand-pull inflation

 Cost-push inflation

Demand-Pull Inflation

 Occurs when Aggregate Demand grows up quickly and runs ahead of Aggregate Supply for goods and services

 Supply cannot increase accordingly because

it is constrained by factor supplies (labor,

technology, natural resources and capital)

 Excess demand enables suppliers to increase the prices of their limited products

Demand-Pull Inflation

Cost-push Inflation

 Occurs when there is a rise in production costs (wage and salary, raw material and components, government taxes, ect)

 Profit margin decrease: a rationale for

reducing supply (the law of diminishing

marginal returns)

 Suppliers increase prices to compensate

partly for deacrease in profit margin,

passing a part of their loss on to consumers

Cost-push 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

 Value of money (1/P): number of goods and services bought by each dollar

=> P  => 1/P 

=> When the price level rises, the value of money falls.

Money Supply, Money Demand,

and Monetary Equilibrium

 Money Supply (MS)

• Determined by the Central Bank and the banking system

• Assumptions: The quantity of money

supplied is a policy variable that the

Central Bank controls directly and

completely

Money Supply, Money Demand,

and Monetary Equilibrium

 In the long-run, the overall price level

turns out to be the most important

determinants

Money Supply, Money Demand,

and Monetary Equilibrium

 Monetary Equilibrium : The point at

which the quantity of money demanded

balances the quantity of money supplied

Value of

Money (1/P) Level (P) Price

A Money supply

demand

Money Supply, Money Demand, and

the Equilibrium Price Level

Value of

Money (1/P) Level (P) Price

A

MS 1 1

The Effects of Monetary Injection

MS

2

1 An increase

in the money supply

The Quantity Theory of Money

 Quantity theory of money : explains how the price level is determined and why it might change over time

 The quantity of money available in the

economy determines the price level.

 The primary cause of inflation is the growth

in the quantity of money.

Classical Dichotomy and

Monetary Neutrality

 Classical Dichotomy: the separation of

economic variables into two groups:

• Nominal variables: variables measured in monetary units

• Real variables: measured in physical units

 Monetary neutrality: changes in the

money supply affect nominal variables but

Velocity and the Quantity Equation

 Velocity of money: the speed at which the typical

dollar bill travels around the economy from wallet

to wallet.

M x V = P x Y

Where: V = velocity

P = the price level

Y = the quantity of output

M = the quantity of money

· P x Y = nominal value of output

The Quantity Theory of Money

M = (P x Y)/V

 An increase in the quantity of money (M)

 Changes in other three variables

The Quantity Theory of Money

Case Study: Money and prices

during four hyperinflations

(a) Austria Index

1923 1922

1921

Money supply

(b) Hungary

Money supply Price level

Index (July 1921 = 100)

100,000 10,000 1,000

100

1925 1924

1923 1922

1921

Case Study: Money and prices

during four hyperinflations

(c) Germany

1

Index (Jan 1921 = 100)

Money supply Price level

1925 1924

1923 1922

1921

Price level

Money supply

Index (Jan 1921 = 100)

100

10,000,000 100,000 1,000,000

10,000 1,000

1925 1924

1923 1922

1921

The inflation tax

 Inflation tax: The revenue the

government raises by printing money

 An inflation tax is like a tax on everyone who holds money.

 Most hyperinflations originated from

government’s high spending

 Inflation ends when the government

institutes fiscal reforms such as cuts in government spending.

The Fisher Effect

 Fisher effect: when the rate of inflation rises, the nominal interest rate rises by the same amount and the real interest rate stays the same.

Nominal Interest Rate = Real Interest Rate + Inflation

 Techcombank doubles the deposit

interest rate from 7% to 14% per year

 Meanwhile, the inflation rate rockets

from 3% to 20%

 Should you put your money at the bank?

If not, what would you do instead?

The nominal interest rate

and the inflation rate

The Costs of Inflation:

A Fall in Purchasing Power?

 Increasing overall price level erodes the

value of money

 People earn income by selling their services

• Pay more for what they buy.

• Get more for what they sell.

=> Nominal income tends to keep pace

with rising prices.

=> Inflation does not itself reduce people’s

The Costs of Inflation

misallocation of resources

special cost of unexpected inflation

Shoeleather Costs

 Inflation erodes the real value of money People try to minimize their cash

holdings More frequent trips to the

bank to withdraw money from bearing accounts.

interest- Costs of reducing money holdings:

 time and convenience sacrificed to keep less money on hand.

 less productive activities.

Menu Costs

 Menu costs: costs of price adjustment

(Eg: the cost of deciding on and printing new price lists and catalogs)

 Inflation increases menu costs as firms must change their price more frequently

to keep up with other prices in the

economy => a resource-consuming

process that takes away from other

productive activities.

Relative-Price Variability and the Misallocation of Resources

 Relative price: the price of one good compared to the price of others in the economy

 Inflation distorts relative prices

 Distort consumer decisions

 less able for markets to allocate

resources to their best use.

Inflation-Induced Tax Distortion

 Inflation blows up the size of capital

gains

 Tax law does not take account of

inflation and compute income tax

based on nominal income

=> Increase the tax burden on capital

gains

Inflation-Induced Tax Distortion

 The income tax treats the nominal

interest earned on savings as income.

 Part of the nominal interest rate merely compensates for inflation

=>The after-tax real interest rate is

reduced, making saving less attractive,

depressing economic growth in the

long-How Inflation Raises the Tax

Nominal interest rate

(Real interest rate + inflation rate)

Reduced interest due to 25 percent tax

(.25 x nominal interest rate)

After-tax nominal interest rate

(.75 x nominal interest rate)

Confusion and Inconvenience

 Money is used to measure economic

transactions, to quote prices and record debts.

 Inflation causes dollars to have different real values at different times

 Difficult to compare real revenues, costs, and profits over time

Arbitrary Redistribution of Wealth

 Unexpected changes in prices redistributes

wealth among debtors and creditors

 Inflation is taken into account when setting

nominal interest rate for loans

 If inflation is not up to expectation:

• Unexpected hyperinflation enriches at the

expense of creditors

• Unexpected deflation enriches creditors at the

expense of debtors