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Chapter 8
Inflation
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8.1 Introduction
In this chapter, we learn: What inflation is, and how costly it can be.
How the quantity theory of money and the
classical dichotomy help us understand
inflation.
The relationship of interest rates and inflation
through the Fisher equation.
The important link between fiscal policy andhigh inflation.
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Inflation
The percentage change in the overall price level
Hyperinflation
an episode of extremely high inflation
Greater than 500 percent per year (Mankiw: 50
percent per month) Example: Post World War I Germany
The inflation rate is computed as the annual percentage
change in the price level in period t(Pt):
The Consumer Price Index (CPI)
Price index for a bundle of consumer goods
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Case Study: How Much Is That?
We can use the CPI to evaluate the value of a
good in 1950 in todays dollars.
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Multiply the price of the good in 1950 times
the ratio of the CPI in todays dollars to the
CPI in 1950 dollars.
Its not as large of a difference as the raw
numbers may lead you to believe.
Other price indexes
The CPI excluding food and energy prices
The GDP deflator
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8.2 The Quantity Theory of Money
We often think of money as paper currency.
Historically
Money was backed by gold or silver
Today
Currency is fiat money.
Currency is paper that the government simplydeclares is worth a certain price.
Money has value because we expect others will
value it.
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Measures of the Money Supply
The monetary base includes currency and
accounts, called reserves.
Private banks hold accounts with the economys
central bank, which pay no interest. These banks ensure that they have sufficient cash
on hand in case of money withdrawals.
Other measures of currency: M1: adds demand deposits to the money base
M2: adds savings accounts and money market
account balances to M1
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Case Study: Digital Cash
Electronic forms of currency
Debit cards, PayPal, travelers checks
Makes up most money in advanced economies
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The Quantity Equation
The quantity theory of money allows us to
make the connection between money andinflation.
Price
level
Real
GDP
Money
supply
Velocity
of money
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Velocity of money
The average number of times per year that
each piece of paper currency is used in a
transaction
The equation implies that the amount of money
used in purchases is equal to nominal GDP.
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The Classical Dichotomy, Constant
Velocity, and the Central Bank
The classical dichotomy
States that, in the long run, the real and nominal
sides of the economy are completely separate.
In the quantity theory of money
Real GDP is assumed as exogenously given
Determined by real forces.
In other words:
Bar over the Y
means exogenous.
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The velocity of money
Exogenously given constant
Assumed to be constant over time
In other words:
The money supply
Determined by the central bank
Monetary policy is exogenously given
In other words:
No timesubscript
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The Quantity Theory for the Price Level
To solve the model Plug all the exogenous variables
Solve for the price level
Prices will rise as a result of
Increases in the money supply
Decreases in real GDP
In the long run, the key determinant of the price
level is the money supply.
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The Quantity Theory for Inflation
We can express the quantity equation interms of growth rates.
Using gas growth rate
Constant = 0 Rate of inflation,
represented as
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Rate of
inflation
Growth
rate in
money
supply
Growth
rate in
GDP
Thus:
Quantity Theory of Money
Changes in the growth rate of money lead one-for-
one to changes in the inflation rate.
Empirically, this holds up both in U.S. and worldwidedata.
Deflation
Occurs when inflation rates are negative
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Revisiting the Classical
Dichotomy
When allprices in the economy double,
relative prices are unchanged.
When the relative prices of goods are
unchanged, nothing real is affected.
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The neutrality of moneysays that changes in the
money supply
Have no real effects on the economy Only affect prices
Empirically
Holds in the long run
Does not hold in the short run:
nominal prices do not respond immediately to
changes in the money supply
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8.3 Real and Nominal Interest Rates
The real interest rate
Is equal to the marginal product of capital
Is paid in goods
The nominal interest rate
Is the interest rate on a savings account
Is paid in dollars
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The Fisher equation
The nominal interest rate is generally high when
inflation is high.
Empirically The real interest rate has been negative
This implies that in the short run the real
interest rate need not equal the MPK.
Nominal
interest
rate
Real
interest
rate
Rate of
inflation
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8.4 Costs of Inflation
Individuals who are hurt during inflation:An individual who has a pension that is not
indexed to inflation
A bank that issues loans at fixed rates but
that pays interest rates that move with the
market
An individual with a variable rate mortgage
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Large surprise inflations can lead to largedistributions in wealth.
People with debts can pay back their loans with
new cheaper dollars.
Creditors wind up losers.
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Taxes Based on nominal incomes
Economic decisions
Based on real variables
Tax distortions are more severe when inflation is
high.
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Inflation also distorts relative prices.
Some prices are faster at adjusting to inflationthan other prices are.
Shoe leather costs of inflation
People want to hold less money when inflation
is high.
Menu costs
The costs to firms of changing prices frequently.
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Case Study: The Wage-Price Spiral
and President Nixons Price Controls
At the time, the view was: Strong unions pushed for high wages
Strong corporations translated rising costs to
rising prices
Strong unions demanded even higher wages.
Wage-price spiral, resulting in inflation
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Nixon froze wages and prices for 90 days to
break the spiral.
High unemployment resulted from an
expansionary policy that brought the return of
inflation.
Price controls also distort economic decisions.
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8.5 The Fiscal Causes of High Inflation
The government budget constraint
Government
funds
Tax revenue
Borrowing
Changes in
the stock of
money
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The Inflation Tax
Seignorage and the inflation tax
Names for the revenue that the government
obtains from printing more money (M) The inflation tax
Shows up as a rise in the price level
Is paid by people holding currency
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If a government runs large budget deficits, as debt
rises
Lenders may worry the government will havetrouble paying back loans
They may stop lending to the government
altogether.
Debt solution: Raising taxes?
May not be politically feasible
The government may resort to printing currency tofinance its budget.
Lenders to the government will be paid back in
currency that is worth less than the dollars lent.
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Central Bank Independence
Monetary Policy
Conducted by Federal Reserve
Fiscal Policy
President and Congress
Central Bank Independence
An attempt to prevent fiscal considerations
from leading to excessive inflation
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Case Study: Episodes of High Inflation
Episodes of high inflation tend to recur.
Hyperinflations can stop just as quickly as they
start. Countries experiencing hyperinflation typically
raise about 5 percent of GDP from the inflationtax.
Argentina raised 10 percent of GDP this way.
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Hyperinflation
Ends when the rate of money growth falls
rapidly
The government gets its finances in order
through lower spending, higher taxes, and new
loans The coordination problem
People build their expectations into the prices
they set.
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8.6 The Great Inflation of the 1970s
During the Great Inflation,
The rate peaked below 15 percent
Yet the inflation tax was a small fraction of
government spending
Inflation rose in the 1970s for the following reasons:
OPEC coordinated increases in oil prices that
spurred inflation.
The Federal Reserve grew the money supply toorapidly.
Policymakers pursued such a policy because of the
productivity slowdown.
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Summary
Inflation The annual percentage change in the overall
price level in an economy
A dollar today is worth much less than it was a
decade ago.
Th tit th f i b i d l
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The quantity theory of money is our basic model
for understanding the long-run determinants of
the price level and therefore of inflation. There
are two ways to express the solution.
For the price level
For the rate of inflation
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The classical dichotomy
The real and nominal sides of the economy are
largely separate. Real economic variables, like real GDP, are
determined only by real forceslike the
investment rate and TFP.
They are not influenced by nominal changes,
such as a change in the money supply.
Classical dichotomy holds in the long run but
not necessarily in the short run.
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The nominal interest rate
Paid in units of currency
Real interest rate
Paid in goods
Related by the Fisher equation
Nominal
interest
rate
Real
interest
rate
Rate of
inflation
I fl ti
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Inflation
Can be very costly to an economy
Generally transfers resources from lenders and
savers to borrowers
Can cause
high effective tax rates
distortions to relative prices
shoe-leather costs
menu costs
Th t b d t t i t th t th
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The government budget constraint says that the
government has three basic ways to finance its
spending.
Taxes
Borrowing
Printing money
If none of those methods work, the government
may be forced to print money to satisfy the
budget constraint.
Hyperinflations are generally a reflection of such
fiscal problems.