67
Chapter 4: Money and Inflation* MACROECONOMICS Seventh Edition N. Gregory Mankiw Chapter 4: Money and Inflation 1/67 *Slides based on Ron Cronovich's slides, adjusted for course in Macroeconomics at the Wang Yanan Institute for Studies in Economics at Xiamen University.

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Page 1: MACROECONOMICS Seventh Edition N. Gregory  · PDF fileChapter 4: Money and Inflation* MACROECONOMICS Seventh Edition N. Gregory Mankiw Chapter 4: Money and Inflation 1/67 *Slides

Chapter 4: Money and Inflation*

MACROECONOMICS

Seventh Edition

N. Gregory Mankiw

Chapter 4: Money and Inflation 1/67*Slides based on Ron Cronovich's slides, adjusted for course in Macroeconomics at the Wang Yanan Institute for Studies in Economics at Xiamen University.

Page 2: MACROECONOMICS Seventh Edition N. Gregory  · PDF fileChapter 4: Money and Inflation* MACROECONOMICS Seventh Edition N. Gregory Mankiw Chapter 4: Money and Inflation 1/67 *Slides

Introduction:U.S. Inflation and Its Trend, 1960-2009

12%

15%

% change in CPI from 12 months earlier

3%

6%

9%

12%

long-run trend

12 months earlier

Chapter 4: Money and Inflation 2/67

-3%

0%

3%

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Page 3: MACROECONOMICS Seventh Edition N. Gregory  · PDF fileChapter 4: Money and Inflation* MACROECONOMICS Seventh Edition N. Gregory Mankiw Chapter 4: Money and Inflation 1/67 *Slides

Introduction:Connection Between Money and Prices

Inflation rate = the percentage increase in the average level of prices. of prices.

Price = amount of money required to buy a good.

Because prices are defined in terms of money, we need to

Chapter 4: Money and Inflation 3/67

Because prices are defined in terms of money, we need to consider the nature of money, the supply of money, and how it is controlled.

Page 4: MACROECONOMICS Seventh Edition N. Gregory  · PDF fileChapter 4: Money and Inflation* MACROECONOMICS Seventh Edition N. Gregory Mankiw Chapter 4: Money and Inflation 1/67 *Slides

Learning Objectives

This chapter introduces you to understanding:

What is moneyWhat is money

The quantity theory of money

Seigniorage: The revenue from printing money

Inflation and interest rates

The nominal interest rate and the demand for money

The social costs of inflation

Chapter 4: Money and Inflation 4/67

The social costs of inflation

Hyperinflation

The classical dichotomy

Page 5: MACROECONOMICS Seventh Edition N. Gregory  · PDF fileChapter 4: Money and Inflation* MACROECONOMICS Seventh Edition N. Gregory Mankiw Chapter 4: Money and Inflation 1/67 *Slides

MoneyMoney is the stock is the stock

→ Definition

4.1) What is Money?

MoneyMoney is the stock is the stock of assets that can be readily of assets that can be readily used to make transactions.used to make transactions.

Chapter 4: Money and Inflation 5/67

Page 6: MACROECONOMICS Seventh Edition N. Gregory  · PDF fileChapter 4: Money and Inflation* MACROECONOMICS Seventh Edition N. Gregory Mankiw Chapter 4: Money and Inflation 1/67 *Slides

Medium of exchangewe use it to buy stuff

→ Functions of Money

4.1) What is Money?

we use it to buy stuff

Store of valuetransfers purchasing power from the present to the future

Unit of account

Chapter 4: Money and Inflation 6/67

Unit of accountthe common unit by which everyone measures prices and values

Page 7: MACROECONOMICS Seventh Edition N. Gregory  · PDF fileChapter 4: Money and Inflation* MACROECONOMICS Seventh Edition N. Gregory Mankiw Chapter 4: Money and Inflation 1/67 *Slides

1. Fiat money

→ Types of Money

4.1) What is Money?

1. Fiat moneyhas no intrinsic valueexample: the paper currency we use

2. Commodity moneyhas intrinsic valueexamples:

Chapter 4: Money and Inflation 7/67

examples: gold coins, cigarettes in P.O.W. camps

Page 8: MACROECONOMICS Seventh Edition N. Gregory  · PDF fileChapter 4: Money and Inflation* MACROECONOMICS Seventh Edition N. Gregory Mankiw Chapter 4: Money and Inflation 1/67 *Slides

The money supply is the quantity of money available in

→ Money Supply and Monetary Policy

4.1) What is Money?

The money supply is the quantity of money available in the economy.

Monetary policy is the control over the money supply.

Chapter 4: Money and Inflation 8/67

Page 9: MACROECONOMICS Seventh Edition N. Gregory  · PDF fileChapter 4: Money and Inflation* MACROECONOMICS Seventh Edition N. Gregory Mankiw Chapter 4: Money and Inflation 1/67 *Slides

Monetary policy is conducted by a country’s central bank .

→ The Central Bank

4.1) What is Money?

Monetary policy is conducted by a country’s central bank .

In China, the central bank is called the People‘s Bank of China .

Chapter 4: Money and Inflation 9/67

Page 10: MACROECONOMICS Seventh Edition N. Gregory  · PDF fileChapter 4: Money and Inflation* MACROECONOMICS Seventh Edition N. Gregory Mankiw Chapter 4: Money and Inflation 1/67 *Slides

Amount ($ billions)

Assets includedSymbol

→ Money Supply Measures, May 2009

4.1) What is Money?

M1 + small time deposits,

$1596C + demand deposits, travelers’ checks, other checkable deposits

M1

$850CurrencyC

($ billions)

Chapter 4: Money and Inflation 10/67

$8328

M1 + small time deposits, savings deposits, money market mutual funds, money market deposit accounts

M2

Page 11: MACROECONOMICS Seventh Edition N. Gregory  · PDF fileChapter 4: Money and Inflation* MACROECONOMICS Seventh Edition N. Gregory Mankiw Chapter 4: Money and Inflation 1/67 *Slides

Learning Objectives

This chapter introduces you to understanding:

what is moneywhat is money

the quantity theory of money

Seigniorage: The revenue from printing money

Inflation and interest rates

The nominal interest rate and the demand for money

The social costs of inflation

Chapter 4: Money and Inflation 11/67

The social costs of inflation

Hyperinflation

The classical dichotomy

Page 12: MACROECONOMICS Seventh Edition N. Gregory  · PDF fileChapter 4: Money and Inflation* MACROECONOMICS Seventh Edition N. Gregory Mankiw Chapter 4: Money and Inflation 1/67 *Slides

Provides the leading explanation of how money affects

4.2) The Quantity Theory of Money

Provides the leading explanation of how money affects the economy in the long run.

A simple theory linking the inflation rate to the growth rate of the money supply.

Chapter 4: Money and Inflation 12/67

Begins with the concept of velocity …

Page 13: MACROECONOMICS Seventh Edition N. Gregory  · PDF fileChapter 4: Money and Inflation* MACROECONOMICS Seventh Edition N. Gregory Mankiw Chapter 4: Money and Inflation 1/67 *Slides

Basic concept: the rate at which money circulates

→ Velocity

4.2) The Quantity Theory of Money

Definition: the number of times the average dollar bill changes hands in a given time period

Example: In 2007, $500 billion in transactions

Chapter 4: Money and Inflation 13/67

$500 billion in transactionsMoney supply = $100 billionThe average dollar is used in five transactions in 2007So, velocity = 5

Page 14: MACROECONOMICS Seventh Edition N. Gregory  · PDF fileChapter 4: Money and Inflation* MACROECONOMICS Seventh Edition N. Gregory Mankiw Chapter 4: Money and Inflation 1/67 *Slides

This suggests the following definition:

→ Velocity

4.2) The Quantity Theory of Money

TV

M=

where

V = velocity

T = value of all transactions

Chapter 4: Money and Inflation 14/67

T = value of all transactions

M = money supply

Page 15: MACROECONOMICS Seventh Edition N. Gregory  · PDF fileChapter 4: Money and Inflation* MACROECONOMICS Seventh Edition N. Gregory Mankiw Chapter 4: Money and Inflation 1/67 *Slides

Use nominal GDP as a proxy for total transactions.

→ Velocity

4.2) The Quantity Theory of Money

Then, P YV

M×=

where

P = price of output (GDP deflator)

Y = quantity of output (real GDP)

Chapter 4: Money and Inflation 15/67

Y = quantity of output (real GDP)

P ××××Y = value of output (nominal GDP)

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The quantity equation

→ The Quantity Equation

4.2) The Quantity Theory of Money

The quantity equationM ××××V = P ××××Y

follows from the preceding definition of velocity.

It is an identity: it holds by definition of the variables.

Chapter 4: Money and Inflation 16/67

Page 17: MACROECONOMICS Seventh Edition N. Gregory  · PDF fileChapter 4: Money and Inflation* MACROECONOMICS Seventh Edition N. Gregory Mankiw Chapter 4: Money and Inflation 1/67 *Slides

When analyzing how money affects the economy, it is useful to express the quantity of money in terms of G & S

→ Money demand and the Quantity Equation

4.2) The Quantity Theory of Money

useful to express the quantity of money in terms of G & S it can buy: M/P = real money balances

Use money demand function to show how much real money balances people wish to hold: (M/P )d = k Y

Chapter 4: Money and Inflation 17/67

where:k = how much money people wish to hold for each dollar of income. (k is exogenous)

Page 18: MACROECONOMICS Seventh Edition N. Gregory  · PDF fileChapter 4: Money and Inflation* MACROECONOMICS Seventh Edition N. Gregory Mankiw Chapter 4: Money and Inflation 1/67 *Slides

Money demand: (M/P )d = k Y

→ Money demand and the Quantity Equation

4.2) The Quantity Theory of Money

Quantity equation: M ××××V = P ××××Y

The connection between them: k = 1/V

Chapter 4: Money and Inflation 18/67

When people hold lots of money relative to their incomes (k is high), money changes hands infrequently (V is low).

Page 19: MACROECONOMICS Seventh Edition N. Gregory  · PDF fileChapter 4: Money and Inflation* MACROECONOMICS Seventh Edition N. Gregory Mankiw Chapter 4: Money and Inflation 1/67 *Slides

If we assume V is constant and exogenous ( ), then the quantity equation becomes a usefull theory about the effects of money.

=V V

→ Deriving the Quantity Theory of Money

4.2) The Quantity Theory of Money

effects of money.

Given the assumption, the quantity equation can be written as

A change in the quantity of money (M) must cause a proportionate change in nominal GDP (PY).

× = ×M V P Y

Chapter 4: Money and Inflation 19/67

proportionate change in nominal GDP (PY).

If velocity is fixed, the quantity of money determines the dollar value of the economy‘s output.

Page 20: MACROECONOMICS Seventh Edition N. Gregory  · PDF fileChapter 4: Money and Inflation* MACROECONOMICS Seventh Edition N. Gregory Mankiw Chapter 4: Money and Inflation 1/67 *Slides

× = ×M V P Y

→Explaining an Economy‘s Overall Level of Prices

4.2) The Quantity Theory of Money

How the price level is determined:

Real GDP is determined by the economy’s supplies of K and L and the production function (Chap 3).

With V constant, the money supply determines nominal GDP (P ×Y ).

Chapter 4: Money and Inflation 20/67

nominal GDP (P ×Y ).

The price level is P = (nominal GDP)/(real GDP).

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The growth rate of a product equals the sum of the growth rates (See Mankiw Ch. 2).

4.2) The Quantity Theory of Money→Explaining an Economy‘s Overall Level of Prices

growth rates (See Mankiw Ch. 2).

The quantity equation in percentage change form:

M V P Y

M V P Y

∆ ∆ ∆ ∆+ = +Exogenous

Inflation

Chapter 4: Money and Inflation 21/67

The quantity theory of money assumes

is constant, so = 0.∆V

VV

Inflation

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4.2) The Quantity Theory of Money→Explaining an Economy‘s Overall Level of Prices

The quantity theory of money states that the central bank, which controls the money supply, has ultimate control over the rate of inflation.

If the central bank keeps the money supply stable (w.r.t. Real GDP growth), the price level will be

Chapter 4: Money and Inflation 22/67

(w.r.t. Real GDP growth), the price level will be stable.

If the central bank increases the money supply rapidly (w.r.t. Real GDP growth), the price level will rise rapidly.

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4.2) The Quantity Theory of Money→U.S. Inflation and Money Supply

Chapter 4: Money and Inflation 23/67

Page 24: MACROECONOMICS Seventh Edition N. Gregory  · PDF fileChapter 4: Money and Inflation* MACROECONOMICS Seventh Edition N. Gregory Mankiw Chapter 4: Money and Inflation 1/67 *Slides

International Data on Inflation and Money Growth

100

Inflation rate (percent,

Indonesia

Turkey

BelarusEcuador

1

10

(percent, logarithmic scale)

Singapore

U.S.

Switzerland

Argentina

Indonesia Belarus

Chapter 4: Money and Inflation 24/67

0,11 10 100

Money Supply Growth (percent, logarithmic scale)

Singapore

Page 25: MACROECONOMICS Seventh Edition N. Gregory  · PDF fileChapter 4: Money and Inflation* MACROECONOMICS Seventh Edition N. Gregory Mankiw Chapter 4: Money and Inflation 1/67 *Slides

U.S. inflation and money growth, 1960-2009

12%

15%

M2 growth

Over the long run, the rates of inflation and money growth

move together,

Over the long run, the rates of inflation and money growth

move together,

3%

6%

9%

12% M2 growth rate

move together, as the Quantity Theory predicts.

move together, as the Quantity Theory predicts.

Chapter 4: Money and Inflation 25/67

-3%

0%

3%

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

inflation rate

Page 26: MACROECONOMICS Seventh Edition N. Gregory  · PDF fileChapter 4: Money and Inflation* MACROECONOMICS Seventh Edition N. Gregory Mankiw Chapter 4: Money and Inflation 1/67 *Slides

Learning Objectives

This chapter introduces you to understanding:

what is moneywhat is money

the quantity theory of money

Seigniorage: The revenue from printing money

Inflation and interest rates

The nominal interest rate and the demand for money

The social costs of inflation

Chapter 4: Money and Inflation 26/67

The social costs of inflation

Hyperinflation

The classical dichotomy

Page 27: MACROECONOMICS Seventh Edition N. Gregory  · PDF fileChapter 4: Money and Inflation* MACROECONOMICS Seventh Edition N. Gregory Mankiw Chapter 4: Money and Inflation 1/67 *Slides

To spend more without raising taxes or selling bonds, the govt can print money.

4.3) Seigniorage

govt can print money.

The “revenue” raised from printing money is called seigniorage .

Chapter 4: Money and Inflation 27/67

The inflation tax : Printing money to raise revenue causes inflation. Inflation is like a tax on people who hold money.

Page 28: MACROECONOMICS Seventh Edition N. Gregory  · PDF fileChapter 4: Money and Inflation* MACROECONOMICS Seventh Edition N. Gregory Mankiw Chapter 4: Money and Inflation 1/67 *Slides

Learning Objectives

This chapter introduces you to understanding:

what is moneywhat is money

the quantity theory of money

Seigniorage: The revenue from printing money

Inflation and interest rates

The nominal interest rate and the demand for money

The social costs of inflation

Chapter 4: Money and Inflation 28/67

The social costs of inflation

Hyperinflation

The classical dichotomy

Page 29: MACROECONOMICS Seventh Edition N. Gregory  · PDF fileChapter 4: Money and Inflation* MACROECONOMICS Seventh Edition N. Gregory Mankiw Chapter 4: Money and Inflation 1/67 *Slides

Interest rates are the market price at which ressources are transferred between the present and the future

4.4) Inflation and Interest Rates

In this subchapter we investigate the relation between interest and inflation

Nominal interest rate, i, not adjusted for inflation

Real interest rate, r, adjusted for inflation:

Chapter 4: Money and Inflation 29/67

Real interest rate, r, adjusted for inflation:r = i − π

Page 30: MACROECONOMICS Seventh Edition N. Gregory  · PDF fileChapter 4: Money and Inflation* MACROECONOMICS Seventh Edition N. Gregory Mankiw Chapter 4: Money and Inflation 1/67 *Slides

The Fisher equation: i = r + ππππ

4.4) Inflation and Interest Rates→The Fisher Effect

Chap 3: S = I determines r .

Hence, an increase in ππππ causes an equal increase in i.

Chapter 4: Money and Inflation 30/67

This one-for-one relationship is called the Fisher effect .

Page 31: MACROECONOMICS Seventh Edition N. Gregory  · PDF fileChapter 4: Money and Inflation* MACROECONOMICS Seventh Edition N. Gregory Mankiw Chapter 4: Money and Inflation 1/67 *Slides

4.4) Inflation and Interest Rates→Inflation and Nominal Interest Rate in the U.S.

Nominal interest rateinterest rate

Chapter 4: Money and Inflation 31/67

Inflation rate

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Nominal interest rate

(percent, RomaniaGeorgia

4.4) Inflation and Interest Rates→Infl. and Nom. Interest Rates Across Countries

(percent, logarithmic

scale)Zimbabwe

Romania

TurkeyBrazil

Israel

U.S.

Kenya

Georgia

Chapter 4: Money and Inflation 32/67

Inflation rate(percent, logarithmic scale)

U.S.

GermanyEthiopia

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ππππ = actual inflation rate (not known until after it has occurred)

4.4) Inflation and Interest Rates→ Two Real Interest Rates

(not known until after it has occurred)

ππππ e = expected inflation rate

i – ππππ e = ex ante real interest rate: the real interest rate people expect at the time they make a loan

Chapter 4: Money and Inflation 33/67

i – ππππ = ex post real interest rate:the real interest rate actually realized

Page 34: MACROECONOMICS Seventh Edition N. Gregory  · PDF fileChapter 4: Money and Inflation* MACROECONOMICS Seventh Edition N. Gregory Mankiw Chapter 4: Money and Inflation 1/67 *Slides

Suppose V is constant, M is growing 5% per year, Y is growing 2% per year, and r = 4.

→ 该你们了

4.4) Inflation and Interest Rates

Y is growing 2% per year, and r = 4.

a. Using the quantity theory of money and the Fisher equation, what is the nominal interest rate, i, given the above values?

b. If the Fed increases the money growth rate by 2 percentage points per year, find ∆∆∆∆i.

Chapter 4: Money and Inflation 34/67

percentage points per year, find ∆∆∆∆i.

c. Suppose the growth rate of Y falls to 1% per year.

What will happen to ππππ ?

What must the Fed do if it wishes to keep ππππ constant?

Page 35: MACROECONOMICS Seventh Edition N. Gregory  · PDF fileChapter 4: Money and Inflation* MACROECONOMICS Seventh Edition N. Gregory Mankiw Chapter 4: Money and Inflation 1/67 *Slides

Learning Objectives

This chapter introduces you to understanding:

what is moneywhat is money

the quantity theory of money

Seigniorage: The revenue from printing money

Inflation and interest rates

The nominal interest rate and the demand for money

The social costs of inflation

Chapter 4: Money and Inflation 35/67

The social costs of inflation

Hyperinflation

The classical dichotomy

Page 36: MACROECONOMICS Seventh Edition N. Gregory  · PDF fileChapter 4: Money and Inflation* MACROECONOMICS Seventh Edition N. Gregory Mankiw Chapter 4: Money and Inflation 1/67 *Slides

In the quantity theory of money, the demand for real money balances depends only on real income Y.

4.5) Money Demand and Nominal Interest

money balances depends only on real income Y.

Another determinant of money demand: the nominal interest rate, i.

It is the opportunity cost of holding money (instead of bonds or other interest-earning assets).

Chapter 4: Money and Inflation 36/67

bonds or other interest-earning assets).

Hence, ↑i ⇒ ↓ in money demand.

Page 37: MACROECONOMICS Seventh Edition N. Gregory  · PDF fileChapter 4: Money and Inflation* MACROECONOMICS Seventh Edition N. Gregory Mankiw Chapter 4: Money and Inflation 1/67 *Slides

( ) ( , )dM P L i Y=

4.5) Money Demand and Nominal Interest

→ The Money Demand Function

(M/P )d = real money demand,

depends negatively on i. i is the opp. cost of holding money

depends positively on Y higher Y ⇒ more spending

Chapter 4: Money and Inflation 37/67

higher Y ⇒ more spending ⇒ so, need more money

(“L” is used for the money demand function because money is the most liquid asset.)

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( ) ( , )dM P L i Y=

4.5) Money Demand and Nominal Interest

→ The Money Demand Function

When people are deciding whether to hold money or bonds, they don’t know what inflation will turn out to be.

( , )e

L r Y+= π

Chapter 4: Money and Inflation 38/67

Hence, the nominal interest rate relevant for money demand is r + ππππ e.

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( , )eM

L r YP

= + π

4.5) Money Demand and Nominal Interest

→ Equilibrium: Money Supply=Money Demand

The supply of real money balances Real money Pmoney balances Real money

demand

�The level of real money balances depends on the expected rate of inflation.

Chapter 4: Money and Inflation 39/67

expected rate of inflation.� Today‘s price level does not only depend on today‘s money supply but also on the money supply expected in the future

Page 40: MACROECONOMICS Seventh Edition N. Gregory  · PDF fileChapter 4: Money and Inflation* MACROECONOMICS Seventh Edition N. Gregory Mankiw Chapter 4: Money and Inflation 1/67 *Slides

Learning Objectives

This chapter introduces you to understanding:

what is moneywhat is money

the quantity theory of money

Seigniorage: The revenue from printing money

Inflation and interest rates

The nominal interest rate and the demand for money

The social costs of inflation

Chapter 4: Money and Inflation 40/67

The social costs of inflation

Hyperinflation

The classical dichotomy

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→ The Economist, Running on M3

Economic Text:

1. Do you know any central banks which give or gave ‘money ’ (that is, the development of monetary aggregates) an (that is, the development of monetary aggregates) an important role in the conduct of monetary policy?

2. What is meant with the statement in the text “We didn’t abandon the monetary aggregates, they abandoned us.”?

3. Which theoretical concept can be used to justify the statement that “Inflation is always and everywhere a monetary phenomenon”?

4. Which are the two pillars of the ECB’s monetary policy

Chapter 4: Money and Inflation 41/67

strategy?5. Which important information -- that might not be contained in

short-term measures of inflation -- can be contained in monetary aggregates?

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Common misperception: Inflation reduces real wages

→ A Common Misperception About Inflation?

4.6) The Social Costs of Inflation

This is true only in the short run, when nominal wages are fixed by contracts.

(Chap. 3) In the long run, the real wage is determined by labor supply and the marginal product of labor, not the price

Chapter 4: Money and Inflation 42/67

level or inflation rate.

Consider the data…

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Hourly w

age in May 2009 dollars

$20800

900

Real average

→ Average Hourly Earnings and the CPI, 1964-2006

4.6) The Social Costs of Inflation19

65 =

100

Hourly w

age in May 2009 dollars

$10

$15

300

400

500

600

700

Nominal average hourly earnings,

(1965 = 100)

Real average hourly earnings in 2009 dollars,

right scale

Chapter 4: Money and Inflation 43/67

Hourly w

age in May 2009 dollars

$0

$5

0

100

200

300

1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

CPI (1965 = 100)

(1965 = 100)

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A change in the price level is merely a change in the units of measurement.

→ The Classical View of Inflation

4.6) The Social Costs of Inflation

of measurement.

� So why, then, is inflation a social problem?

Social costs of inflation fall into two categories:

Chapter 4: Money and Inflation 44/67

1. Costs when inflation is expected

2. Costs when inflation is different than people had expected

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Definition: the costs and inconveniences of reducing money

→ Expected Inflation: Shoeleather Costs

4.6) The Social Costs of Inflation

Definition: the costs and inconveniences of reducing money balances to avoid the inflation tax.

↑ππππ ⇒ ↑i

⇒ ↓ real money balances

Remember: In the long run, inflation does not affect real income or real spending.

Chapter 4: Money and Inflation 45/67

income or real spending.

So, same monthly spending but lower average money holdings means more frequent trips to the bank to withdraw smaller amounts of cash.

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Definition: The costs of changing prices.

→ Expected Inflation: Menue Cost

4.6) The Social Costs of Inflation

Definition: The costs of changing prices.

Examples:cost of printing new menus

cost of printing & mailing new catalogs

The higher is inflation, the more frequently firms must change their prices and incur these costs.

Chapter 4: Money and Inflation 46/67

change their prices and incur these costs.

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Firms facing menu costs change prices infrequently.

→ Expected Inflation: Relative Price Distortions

4.6) The Social Costs of Inflation

Example: A firm issues new catalog each January. As the general price level rises throughout the year, the firm’s relative price will fall.

Different firms change their prices at different times, leading

Chapter 4: Money and Inflation 47/67

Different firms change their prices at different times, leading to relative price distortions…

…causing microeconomic inefficiencies in the allocation of resources.

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Some taxes are not adjusted to account for inflation, such as the capital gains tax.

→ Expected Inflation: Unfair Tax Treatment

4.6) The Social Costs of Inflation

as the capital gains tax.

Example:

Jan 1: you buy $10,000 worth of IBM stock

Dec 31: you sell the stock for $11,000, so your nominal capital gain is $1000 (10%).

Suppose ππππ = 10% during the year.

Chapter 4: Money and Inflation 48/67

Suppose ππππ = 10% during the year. Your real capital gain is $0.

But the govt requires you to pay taxes on your $1000 nominal gain

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Inflation makes it harder to compare nominal values from

→ Expected Inflation: General Inconvenience

4.6) The Social Costs of Inflation

Inflation makes it harder to compare nominal values from different time periods.

This complicates long-range financial planning.

Chapter 4: Money and Inflation 49/67

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Many long-term contracts not indexed, but based on ππππ e.

→ Unexpected Inflation: Arbitrary Redistribution

4.6) The Social Costs of Inflation

If ππππ turns out different from ππππ e, then some gain at others’ expense. Example: borrowers & lenders

If ππππ > ππππ e, then (i −−−− ππππ) < (i −−−− ππππ e) and purchasing power is transferred from lenders to borrowers.

ππππ ππππ

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If ππππ < ππππ e, then purchasing power is transferred from borrowers to lenders.

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When inflation is high, it’s more variable and unpredictable: ππππ ππππ e

→ High Inflation: Increased Uncertainty

4.6) The Social Costs of Inflation

When inflation is high, it’s more variable and unpredictable: ππππ turns out different from ππππ e more often, and the differences tend to be larger (though not systematically positive or negative)

Arbitrary redistributions of wealth become more likely.

This creates higher uncertainty, making risk averse people

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This creates higher uncertainty, making risk averse people worse off.

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Nominal wages are rarely reduced, even when the

→ One Benefit of Inflation

4.6) The Social Costs of Inflation

Nominal wages are rarely reduced, even when the equilibrium real wage falls. This hinders labor market clearing.

Inflation allows the real wages to reach equilibrium levels without nominal wage cuts.

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Therefore, moderate inflation improves the functioning of labor markets.

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Learning Objectives

This chapter introduces you to understanding:

what is moneywhat is money

the quantity theory of money

Seigniorage: The revenue from printing money

Inflation and interest rates

The nominal interest rate and the demand for money

The social costs of inflation

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The social costs of inflation

Hyperinflation

The classical dichotomy

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Definition: ππππ ≥≥≥≥ 50% per month

4.7) Hyperinflation

Definition: ππππ ≥≥≥≥ 50% per month

All the costs of moderate inflation described above become HUGE under hyperinflation.

Money ceases to function as a store of value, and may not serve its other functions (unit of account, medium of

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serve its other functions (unit of account, medium of exchange).

People may conduct transactions with barter or a stable foreign currency.

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Hyperinflation is caused by excessive money supply

→ What Causes Hyperinflation

4.7) Hyperinflation

Hyperinflation is caused by excessive money supply growth:

When the central bank prints money, the price level rises.

If it prints money rapidly enough, the result is hyperinflation.

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hyperinflation.

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Money growth (%) Inflation (%)

→ A Few Examples

4.7) Hyperinflation

Israel, 1983-85 295 275

Poland, 1989-90 344 400

Brazil, 1987-94 1350 1323

Argentina, 1988-90 1264 1912

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1264 1912

Peru, 1988-90 2974 3849

Nicaragua, 1987-91 4991 5261

Bolivia, 1984-85 4208 6515

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→ Why Governments Create Hyperinflation

4.7) Hyperinflation

When a government cannot raise taxes or sell bonds, it must finance spending increases by printing money.

In theory, the solution to hyperinflation is simple: stop printing money.

In the real world, this requires drastic and painful fiscal

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In the real world, this requires drastic and painful fiscal restraint.

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Learning Objectives

This chapter introduces you to understanding:

what is moneywhat is money

the quantity theory of money

Seigniorage: The revenue from printing money

Inflation and interest rates

The nominal interest rate and the demand for money

The social costs of inflation

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The social costs of inflation

Hyperinflation

The classical dichotomy

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Note: Real variables were explained in Chap 3, nominal ones in Chapter 4.

4.8) The Classical Dichotomy

→ The Separation of Real and Nominal Variables

ones in Chapter 4.

Classical dichotomy: the theoretical separation of real and nominal variables in the classical model, which implies nominal variables do not affect real variables.

Neutrality of money: Changes in the money supply do

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Neutrality of money: Changes in the money supply do not affect real variables. �In the real world, money is approximately neutral in the long run.

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Real variables (Chap 3): Measured in physical units –

4.8) The Classical Dichotomy

→ The Separation of Real and Nominal Variables

Real variables (Chap 3): Measured in physical units –quantities and relative prices, for example:

quantity of output produced

real wage: output earned per hour of work

real interest rate: output earned in the future

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real interest rate: output earned in the future by lending one unit of output today

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4.8) The Classical Dichotomy

→ The Separation of Real and Nominal Variables

Nominal variables (Chap 4): Measured in money units, e.g.,

nominal wage: Dollars per hour of work.

nominal interest rate: Dollars earned in future by lending one dollar today.

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by lending one dollar today.

the price level: The amount of dollars needed to buy a representative basket of goods.

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Chapter Summary

Money:

the stock of assets used for transactions the stock of assets used for transactions

serves as a medium of exchange, store of value, and unit of account.

Commodity money has intrinsic value, fiat money does not.

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Central bank controls the money supply.

Quantity theory of money assumes velocity is stable, concludes that the money growth rate determines the inflation rate.

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Chapter Summary (ctd.)

Nominal interest rate

equals real interest rate + inflation rateequals real interest rate + inflation rate

the opp. cost of holding money

Fisher effect: Nominal interest rate moves one-for-one w/ expected inflation.

Money demand

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depends only on income in the Quantity Theory

also depends on the nominal interest rate

if so, then changes in expected inflation affect the current price level.

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Chapter Summary (ctd.)

Costs of inflation

Expected inflationExpected inflationshoeleather costs, menu costs, tax & relative price distortions, inconvenience of correcting figures for inflation

Unexpected inflationall of the above plus arbitrary redistributions of wealth between debtors and creditors

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between debtors and creditors

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Chapter Summary (ctd.)

HyperinflationHyperinflation

caused by rapid money supply growth when money printed to finance govt budget deficits

stopping it requires fiscal reforms to eliminate govt’s need for printing money

Chapter 4: Money and Inflation 65/67

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Chapter Summary (ctd.)

Classical dichotomyIn classical theory, money is neutral--does not affect In classical theory, money is neutral--does not affect real variables.

So, we can study how real variables are determined without reference to nominal ones.

Then, money market equilibrium determines price level and all nominal variables.

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and all nominal variables.

Most economists believe the economy works this way in the long run.

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→ The Economist, Running on M3

Economic Text:

1. Do you know any central banks which give or gave ‘money ’ (that is, the development of monetary aggregates) an (that is, the development of monetary aggregates) an important role in the conduct of monetary policy?

2. What is meant with the statement in the text “We didn’t abandon the monetary aggregates, they abandoned us.”?

3. Which theoretical concept can be used to justify the statement that “Inflation is always and everywhere a monetary phenomenon”?

4. Which are the two pillars of the ECB’s monetary policy

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strategy?5. Which important information -- that might not be contained in

short-term measures of inflation -- can be contained in monetary aggregates?