Lecture 8Money Growth & Inflation

(Ch:17; P.O.M.E)ECO 104

Faculty: Asif Chowdhury

• Inflation: Increase in the overall level of prices. Measured by CPI, GDP Deflators & other indexes.

• Deflation: Decrease in the overall level of prices.• Hyperinflation: an extraordinarily high rate of

inflation. Through the “Quantity Theory of Money” we can

see how increase in money supply can lead to inflation.

• Recalling that people hold money to conduct transactions, price level of goods & services can be interpreted in terms of value of money held by somebody. If price level is represented by the GDP Deflator & denoted as P then the quantity of goods & services that can be bought with $1 will be expressed as 1/P. This relationship shows that as price level increases the value of money, in terms of purchasing of goods & services decreases.

Money Supply, Money Demand & Monetary Equilibrium:

• Money Supply is controlled by the CB & in this analysis we shall take the money supply as given. Money demand depend on a number of factors, one of the most important determinant of money demand is the overall price level. As price level rises people will want to hold more money since the value of money decreases in terms of purchasing of goods & services. In the long run, the overall price level adjust to bring the money demand & money supply to equilibrium.

The Money Demand curve is downward sloping because value of money & price level are inversely related, higher the price level, lower the value of money, hence quantity demand for money will go up.

The Money Supply Curve is vertical because in this analysis the money supply is taken as fixed by the CB.

Effects of changing the Money Supply:

• Any change in the money supply will affect the price level. This linking between money supply & price level is illustrated through the “ Quantity Theory of Money”

Quantity Theory of Money: The theory asserting that the quantity of money available determines the price level & that the growth rate in the quantity of money available determines the inflation rate.

If the CB increases the Money Supply:

• An increase in money supply will shift the money supply curve to the right. At current price level people will have more money at hand than before, they will want to buy more goods & services in order to get rid of the extra money stock. Since production of goods & services doesn’t change ( Y depends on other factors) these leads to situation of excess demand for goods & services over supply of goods & services & so price level rise. The rise in price level raises the QD for money stock since money has lower value now & eventually the money demand & money supply move to equilibrium at the new price level.(QD of money equals QS of money.)

Classical Dichotomy & Monetary Neutrality:

Nominal Variables: Variables measured in money terms/monetary units ( e.g.. Nominal GDP)

Real Variable: Variables measured in Physical units ( e.g. Real GDP)

Classical Dichotomy: the theoretical separation of nominal & real variable.

o The fact that changes in money supply ( nominal variable) leads to change in another nominal variable ( price level) but doesn’t affect output ( real variable) is what Classical Dichotomy implies.

• Another concept that's linked to the Classical Dichotomy is known as the Monetary Neutrality.

Monetary Neutrality: holds that changes in money supply do not affect real variables.

Velocity & The Quantity Equation:

• Another concept linked to the “ Quantity Theory of Money” is known as the Velocity of Money.

Velocity of Money: the rate at which money changes hands.

Velocity of Money is expressed as: V = (P X Y)/ MV= Velocity of Money, P= GDP Deflator, Y= Real GDP, M

=Quantity of Money. In short Velocity of Money equals Nominal GDP over money stock.

• Rewriting the Velocity of Money equation: MV = PY This equation is known as the Quantity Equation since it

relates quantity of money to a nominal variable like Nominal GDP.

V has seen to exhibit constant trend over time Y ( Real GDP) is a function of other variables ( labor, capital,

human capital etc.) Thus holding “V” & “Y” constant we can see that an

increase in money stock “M” will lead o increase in price level “P”

• In other words the “Quantity Equation” implies that if the CB keeps on raising the level of money stock ( growth in money stock) will lead to raise in the price level ( Inflation). Thus Quantity Equation ties up money stock with inflation.

Fisher Effect:

• An application of “Monetary Neutrality” is the impact of money on interest rate.

• RIR = NIR- Inflation Rate• Rearranging the terms: NIR = RIR + Inflation Rate NIR = Nominal Interest Rate RIR= Real interest Rateo RIR is determined in the market for loanable funds,

where demand for loanable funds adjust with supply of loanable funds at an equilibrium real interest rate.

• Thus holding RIR constant in the previous equation we can see that rate of inflation has a direct one to one effect on nominal interest rate. If inflation rate is on the high NIR is also on the high & vice versa. This is known as the “Fisher Effect”

Fisher Effect: the one for one adjustment of the nominal interest rate to the inflation rate.

Fisher Effect is based on the long run time frame since in the short run inflation rate is unknown so while negotiating the nominal interest rate, the inflation rate can’t be predicted accurately & thus won’t have the same effect on NIR as laid down by the Fisher Effect.

Cost of Inflation:

o Shoe leather Cost: the resources wasted when inflation causes people to reduce their money holdings.

o Menu Cost: The cost of changing priceo Relative Price Variability & Misallocation of

Resources: If one product price is adjusted at a different time compared to another product/s then there will be variation in the relative price & cause misallocation of resources.

o Inflation Induced Tax Distortions: has implication for savings; in terms of savings in the form of financial assets ( corporate stock) & savings in the form of bank deposits. Tax are based on nominal capital gains or nominal interest income & this tends to discourage savings. This has farther implication for the economy’s productivity since lower savings eventually leads to lower investment.

• Confusion & Inconvenience: With prevailing inflation money loses its value in terms of purchasing power & people tend to lose confidence on money as an Unit of Account. Also, while computing corporate profits, accountants focus on nominal profit rather than real profit, this cause confusion among investors to differentiate properly between successful & unsuccessful firms.

Arbitrary Redistribution of Wealth:

• Unexpected inflation makes borrowers well off at the expense of the lenders since the returned amount is lesser in terms of real value. The opposite happens in case of disinflation.