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Chapter 30Money Growth
and Inflation
The Meaning of Money
• Money is the set of assets in an economy that people regularly use to buy goods and services from other people.
30.1 The Classical Theory of Inflation
• Inflation is an increase in the overall level of prices.
• Hyperinflation is an extraordinarily high rate of inflation.
30.1 The Classical Theory of Inflation
• Inflation: Historical Aspects
– Over the past 60 years, prices have risen on average about 5 percent per year.
– Deflation, meaning decreasing average prices, occurred in the U.S. in the nineteenth century.
– Hyperinflation refers to high rates of inflation such as Germany experienced in the 1920s.
30.1 The Classical Theory of Inflation
• Inflation: Historical Aspects
– In the 1970s prices rose by 7 percent per year.
– During the 1990s, prices rose at an average rate of 2 percent per year.
30.1.1 The Level of Prices and the Value of Money
• It may help to express these ideas mathematically. Suppose P is the price level as measured by the consumer price index or the GDP deflator. Then P measures the number of dollars needed to buy a basket of goods and services. Now turn this idea around: The quantity of goods and services that can be bought with $1 equals 1/P. In other words, if P is the price of goods and services measured in terms of money, 1/P is the value of money measured in terms of goods and services. Thus, when the overall price level rises, the value of money falls.
30.1.1 The Level of Prices and the Value of Money
• The quantity theory of money is used to explain the long-run determinants of the price level and the inflation rate.
• Inflation is an economy-wide phenomenon that concerns the value of the economy’s medium of exchange.
• When the overall price level rises, the value of money falls.
30.1.2 Money Supply, Money Demand, and Monetary Equilibrium
• The money supply is a policy variable that is controlled by the Fed.
– Through instruments such as open-market operations, the Fed directly controls the quantity of money supplied.
30.1.2 Money Supply, Money Demand, and Monetary Equilibrium
• Money demand has several determinants, including interest rates and the average level of prices in the economy.
30.1.2 Money Supply, Money Demand, and Monetary Equilibrium
• People hold money because it is the medium of exchange.
– The amount of money people choose to hold depends on the prices of goods and services.
30.1.2 Money Supply, Money Demand, and Monetary Equilibrium
• In the long run, the overall level of prices adjusts to the level at which the demand for money equals the supply.
Figure 1 Money Supply, Money Demand, and the Equilibrium Price Level
Quantity ofMoney
Value ofMoney, 1/P
Price Level, P
Quantity fixedby the Fed
Money supply
0
1
(Low)
(High)
(High)
(Low)
1/2
1/4
3/4
1
1.33
2
4
Equilibriumvalue ofmoney
Equilibriumprice level
Moneydemand
A
Figure 2 The Effects of Monetary Injection
Quantity ofMoney
Value ofMoney, 1/P
Price Level, P
Moneydemand
0
1
(Low)
(High)
(High)
(Low)
1/2
1/4
3/4
1
1.33
2
4
M1
MS1
M2
MS2
2. . . . decreasesthe value ofmoney . . .
3. . . . andincreasesthe pricelevel.
1. An increasein the moneysupply . . .
A
B
30.1.4 The Effects of a Monetary Injection• The Quantity Theory of Money
– How the price level is determined and why it might change over time is called the quantity theory of money.
– The Quantity Theory of Money is a theory asserting that the quantity of money available in the economy determines the price level (or the value of money) and that the growth in the quantity of money available determines the inflation rate.
30.1.5 The Classical Dichotomy and Monetary Neutrality
• Nominal variables are variables measured in monetary units.
• Real variables are variables measured in physical units.
• the classical dichotomy is the theoretical separation of nominal and real variables.
30.1.5 The Classical Dichotomy and Monetary Neutrality
• According to Hume and others, real economic variables do not change with changes in the money supply.
– According to the classical dichotomy, different forces influence real and nominal variables.
• Changes in the money supply affect nominal variables but not real variables.
30.1.5 The Classical Dichotomy and Monetary Neutrality
• The irrelevance of monetary changes for real variables is called monetary neutrality 货币中性 .
30.1.6 Velocity and the Quantity Equation
• The velocity of money refers to the speed at which the typical dollar bill travels around the economy from wallet to wallet.
30.1.6 Velocity and the Quantity Equation
V = (P Y)/M
– Where: V = velocity
P = the price level
Y = the quantity of output
M = the quantity of money
30.1.6 Velocity and the Quantity Equation• Rewriting the equation gives the quantity
equation:
M V = P Y
30.1.6 Velocity and the Quantity Equation
• The quantity equation relates the quantity of money (M) to the nominal value of output (P Y).
30.1.6 Velocity and the Quantity Equation
• The quantity equation shows that an increase in the quantity of money in an economy must be reflected in one of three other variables:
– the price level must rise,
– the quantity of output must rise, or
– the velocity of money must fall.
Figure 3 Nominal GDP, the Quantity of Money, and the Velocity of Money
Indexes(1960 = 100)
2,000
1,000
500
0
1,500
1960 1965 1970 1975 1980 1985 1990 1995 2000
Nominal GDP
Velocity
M2
30.1.6 Velocity and the Quantity Equation
Explain the Equilibrium Price Level and Inflation Rate? (What is the essence of the Quantity Theory of Money? )
1. The velocity of money is relatively stable over time.
2. Because velocity is stable, when the central bank changes the quantity of money (M), it causes proportional changes in the nominal value of output (P Y).
3. The economy’s output of goods and services(Y) is primarily determined by factor supplies (labor, physical capital, human capital, and natural resources) and the available production technology. In particular, because money is neutral, money does not affect output.
4. With output(Y) determined by factor supplies and technology, when the central bank alters the money supply (M) and induces proportional changes in the nominal value of output (P Y), these changes are reflected in changes in the price level (P).
5. Therefore, when the central bank increases the money supply rapidly, the result is a high rate of inflation.
CASE STUDY: Money and Prices during Four Hyperinflations
• Hyperinflation is inflation that exceeds 50 percent per month.
• Hyperinflation occurs in some countries because the government prints too much money to pay for its spending.
Figure 4 Money and Prices During Four Hyperinflations
(a) Austria (b) Hungary
Money supply
Price level
Index(Jan. 1921 = 100)
Index(July 1921 = 100)
Price level
100,000
10,000
1,000
10019251924192319221921
Money supply
100,000
10,000
1,000
10019251924192319221921
Figure 4 Money and Prices During Four Hyperinflations
(c) Germany
1
Index(Jan. 1921 = 100)
(d) Poland
100,000,000,000,000
1,000,000
10,000,000,0001,000,000,000,000
100,000,000
10,000100
Moneysupply
Price level
19251924192319221921
Price levelMoneysupply
Index(Jan. 1921 = 100)
100
10,000,000
100,000
1,000,000
10,000
1,000
19251924192319221921
30.1.7 The Inflation Tax• When the government raises revenue by printing
money, it is said to levy an inflation tax.
• When the government prints money, the price level rises, and the dollars in your wallet are less valuable. Thus, an inflation tax is like a tax on everyone who holds money.
• The inflation ends when the government institutes fiscal reforms such as cuts in government spending.
30.1.8 The Fisher Effect
• Real interest rate = Nominal interest rate – Inflation rate.
• Nominal interest rate = Real interest rate + Inflation rate.
30.1.8 The Fisher Effect• The Fisher effect 费雪效应 refers to a one-to-one
adjustment of the nominal interest rate to the inflation rate.
• According to the Fisher effect, when the rate of inflation rises, the nominal interest rate rises by the same amount. The real interest rate stays the same.
• Keep in mind that our analysis of the Fisher effect has maintained a long-run perspective. The Fisher effect does not hold in the short run to the extent that inflation is unanticipated.
Figure 5 The Nominal Interest Rate and the Inflation Rate
Percent(per year)
1960 1965 1970 1975 1980 1985 1990 1995 20000
3
6
9
12
15
Inflation
Nominal interest rate
30.2 The Costs of Inflation
30.2.1 A Fall in Purchasing Power? The Inflation Fallacy• If you ask the typical person why inflation is
bad, he will tell you that the answer is obvious: Inflation robs him of the purchasing power of his hard-earned dollars. When prices rise, each dollar of income buys fewer goods and services. Thus, it might seem that inflation directly lowers living standards.
30.2.1 A Fall in Purchasing Power? The Inflation Fallacy
• Yet further thought reveals a fallacy in this answer. When prices rise, buyers of goods and services pay more for what they buy. At the same time, however, sellers of goods and services get more for what they sell. Because most people earn their incomes by selling their services, such as their labor, inflation in incomes goes hand in hand with inflation in prices. Thus, Inflation does not in itself reduce people’s real purchasing power.
• People believe the inflation fallacy because they do not appreciate the principle of monetary neutrality.
30.2 The Costs of Inflation If nominal incomes tend to keep pace with rising
prices, why then is inflation a problem?….. Instead, economists have identified several costs of inflation.
• Shoeleather costs• Menu costs• Relative price variability• Tax distortions• Confusion and inconvenience• Arbitrary redistribution of wealth
30.2.2 Shoeleather Costs
• Shoeleather costs are the resources wasted when inflation encourages people to reduce their money holdings.
• Inflation reduces the real value of money, so people have an incentive to minimize their cash holdings.
30.2.2 Shoeleather Costs
• Less cash requires more frequent trips to the bank to withdraw money from interest-bearing accounts.
• The actual cost of reducing your money holdings is the time and convenience you must sacrifice to keep less money on hand.
• Also, extra trips to the bank take time away from productive activities.
30.2.3 Menu Costs
• Menu costs are the costs of adjusting prices.
• During inflationary times, it is necessary to update price lists and other posted prices.
• This is a resource-consuming process that takes away from other productive activities.
30.2.4 Relative-Price Variability and the Misallocation of Resources
• Market economies rely on relative prices to allocate scarce resources. Consumers decide what to buy by comparing the quality and prices of various goods and services. Through these decisions, they determine how the scarce factors of production are allocated among industries and firms.
• When inflation distorts relative prices. Consumer decisions are distorted, and markets are less able to allocate resources to their best use.
30.2.5 Inflation-Induced Tax Distortion• Almost all taxes distort incentives, cause people to alter
their behavior, and lead to a less efficient allocation of the economy’s resources.
• One example of how inflation discourages saving is the tax treatment of capital gains----the profits made by selling an asset for more than its purchase price. Suppose that in 1980 you used some of your savings to buy stock in Microsoft Corporation for $10 and that in 2006 you sold the stock for $50. According to the tax law, you have earned a capital gain of $40, which you must include in your income when computing how much income tax you owe. But suppose the overall price level doubled from 1980 to 2006. In this case, the $10 you invested in 1980 is equivalent to $20 in 2006. When you sell your stock for $50, you have a real gain of only $30. The tax code, however, does not take account for inflation and assesses you a tax on a gain of $40.
30.2.5 Inflation-Induced Tax Distortion
• Inflation exaggerates the size of capital gains and increases the tax burden on this type of income.
• With progressive taxation, capital gains are taxed more heavily.
30.2.5 Inflation-Induced Tax Distortion
• The income tax treats the nominal interest earned on savings as income, even though part of the nominal interest rate merely compensates for inflation.
• The after-tax real interest rate falls, making saving less attractive.
Table 1 How Inflation Raises the Tax Burden on Saving
30.2.6 Confusion and Inconvenience
• When the Fed increases the money supply and creates inflation, it erodes the real value of the unit of account.
• Inflation causes dollars at different times to have different real values.
• Therefore, with rising prices, it is more difficult to compare real revenues, costs, and profits over time.
30.2.7 A Special Cost of Unexpected Inflation: Arbitrary Redistribution of Wealth
• Unexpected inflation redistributes wealth among the population in a way that has nothing to do with either merit or need.
• These redistributions occur because many loans in the economy are specified in terms of the unit of account—money.
• Unexpected changes in prices redistribute wealth among debtors and creditors.
30.2.7 A Special Cost of Unexpected Inflation: Arbitrary Redistribution of Wealth• Consider an example. Suppose that Sam student takes
out a $20,000 loan at a 7 percent interest rate from Bigbank to attend college. In ten years, the loan will come due. After his debt has compounded for ten years at 7 percent, Sam will owe Bigbank $40,000. The real value of this debt will depend on inflation over the decade. If Sam is lucky, the economy will have a hyperinflation. In this case, wages and prices will rise so high that Sam will be able to pay the $40,000 debt out of pocket change. By contrast, if the economy goes through a major deflation, the wages and prices will fall, and Sam will find the $40,000 debt a greater burden than he anticipated.
Summary
• 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.
Summary
• The principle of money neutrality asserts that changes in the quantity of money influence nominal variables but not real variables.
• A government can pay for its spending simply by printing more money.
• This can result in an “inflation tax” and hyperinflation.
Summary
• According to the Fisher effect, when the inflation rate rises, the nominal interest rate rises by the same amount, and the real interest rate stays the same.
• Many people think that inflation makes them poorer because it raises the cost of what they buy.
• This view is a fallacy because inflation also raises nominal incomes.
Summary
• Economists have identified six costs of inflation:
– Shoeleather costs
– Menu costs
– Increased variability of relative prices
– Unintended tax liability changes
– Confusion and inconvenience
– Arbitrary redistributions of wealth
Summary
• When banks loan out their deposits, they increase the quantity of money in the economy.
• Because the Fed cannot control the amount bankers choose to lend or the amount households choose to deposit in banks, the Fed’s control of the money supply is imperfect.
1. What is the classical Dichotomy and Monetary neutrality?
2. What is the essence of the quantity theory of money? (Mankiw,3rd edition,p654.)
3. What is inflation tax? (the revenue the government raises by creating money)
4.What is the Fisher effect? (the one-for-one adjustment of the nominal interest rate to the inflation rate.)
5. List and describe six costs of inflation?
1 ．解释物价水平上升如何影响货币的实际价值。2 ．根据货币数量论，货币量增加的影响是什么？3 ．解释名义变量与实际变量之间的差别，并各举出两个例子。根据货币中性原理，哪一个变量受货币量变动的影响？
4 ．从什么意义上说，通货膨胀像一种税？把通货膨胀作为一种税如何有助于解释超速通货膨胀？
5 ．根据费雪效应，通货膨胀率的上升如何影响实际利率与名义利率？
6 ．通货膨胀的成本是什么？你认为这些成本中的哪一种对美国经济最重要？
7 ．如果通货膨胀比预期的低，谁会受益－－债务人还是债权人？试解释之。
