20120527 mankiw economics chapter30

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1

Principles of Economics

Chapter30

Monetary Growth and

Inflation

2

Relative Chapter

PattThe data of macroeconomics 24 Measuring the cost of living

PartThe real economy in the long run 26 Saving,Investment,and the financial sytem

Part Money and prices in the long run 29 The monetary system 30 Money growth and inflation

3

What is inflation?

4

Much Money?

5

Grapha?

6

7

Today's Theme

What determines whether an economy experiences inflation and ,if so, how much?

Why is inflation a problem?

What are the costs of that inflationimposes on a socety?

8

What is inflation?

9

Index

The classic theory of inflation

The costs of inflation

10

Index

The classic thory of inflation

The costs of inflation

11

The classic theory of Inflation

Supply simply the quantity of money supplied as a policy

variables that Fed controls.

Demand how much wealth people want to hold in liquid form. the average levels of prices (a higher price level increases the quantity of money

demand)

Supply and Demand detemines the value of money

12

Figure 1 Money Supply, Money Demand, and the Equilibrium Price Level

Quantity of Money

Value of Money, 1 / P

Price Level, P

Quantity fixed by the Fed

Money supply

0

1

(Low)

(High)

(High)

(Low)

1 / 2

1 / 4

3 / 4

1

1.33

2

4 Equilibrium value of money

Equilibrium price level

Money demand

A

In the long run, the overall level of prices adjusts to the level at which the demand for money equals the supply.

13

Figure 1 Money Supply, Money Demand, and the Equilibrium Price Level

Quantity of Money

Value of Money, 1 / P

Price Level, P

Quantity fixed by the Fed

Money supply

0

1

(Low)

(High)

(High)

(Low)

1 / 2

1 / 4

3 / 4

1

1.33

2

4 Equilibrium value of money

Equilibrium price level

Money demand

A

In the long run, the overall level of prices adjusts to the level at which the demand for money equals the supply.

14

The quantity theory of money

Quantity theory of money a theory asseting that the quantity of money available

determines the price level and that the growth rate in the quantity of money available determines the inflation rate.

"Inflation is always and everywhere a monetary phoenomenon"

15

Figure 2 The Effects of Monetary Injection

Quantity of Money

Value of Money, 1 / P

Price Level, P

Money demand

0

1

(Low)

(High)

(High)

(Low)

1 / 2

1 / 4

3 / 4

1

1.33

2

4

M1

MS1

M2

MS2

2. . . . decreases the value of mone y . . . 3. . . . and increases

the price level.

1. An increase in the money supply . . .

A

B

16

Caution!regarding money supply

When the Fed buys government bonds,it pays out dollars and expands the money supply.

If any of these dollars are deposited inbanks which hold some as reserves and loan out the rest,the money multiplier swings into action.

In this chapter, we ignore the complications introduced by the banking system.

17

Transmission mechanism of monetary policy

18

A brief look at the adjustment process

The economy's output of goods and services is determined by the available labor,physical capital,human capital,natural resources and technological knowledge.

The injection of money alter none of these.

19

The classis dichotomy and monetary neutrality

Classical dichotomy the theoretical separation of nominal and real

variables

Monetary neutrality the proposition that changes in the money

supply do not affect real variables.

20

Velocity and the quantity eqation

YPM =V

V= velocityP= the price levelY= the quantity of outputM= the quantity of money

21

Figure 3 Nominal GDP, the Quantity of Money, and the Velocity of Money

Indexes (1960 = 100)

2,000

1,000

500

0

1,500 Nominal GDP

Velocity

M2

The velocity of money has not changed dramatically.

22

the Equilibrium Price Level, Inflation Rate, and

the Quantity Theory of Money 1. The velocity of money is relatively stable over time.

2. When the Fed changes the quantity of money, it causes proportionate changes in the nominal value of output (P Y).

3. Money is neutral, money does not affect output.

4. With Y determined by factor supplied and technology,when the central bank alters M and induces proportional changes in the nominal value of output(PY),these are reflected in changes in P

5. When the central bank increase the money supply rapidly,the result is a high rate of inflation.

23

the inflation tax

Inflation tax the government raises revenue by printing money

The massive increases in the quantity of money lead to massive inflation.

The inflation ends when the government institutes fiscal reforms that eliminate the need for the inflation tax.

24

Fisher effect

Fisher effect the one-for-one adjustment of the nominal interest rate

to the inflation rate.

The Fisher effect has maintained a long-run perspective and need not hold in the short run because inflation may be unanticipated.

Nominal interest rate

=Real interest rate + Inflation rate

25

Figure 5 The Nominal Interest Rate and the Inflation Rate

Percent (per year)

1960 1965 1970 1975 1980 1985 1990 1995 2000 0

3

6

9

12

15

Inflation

Nominal interest rate

26

Index

The classic thory of inflation

The costs of inflation

27

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

28

The costs of inflation

Shoeleather Costs the resources wasted when inflation encourages people

to reduce their money holdings

Menu Cost the cost of changing prices

Relative-price variability and the misallocation of resources When inflation distorts relative prices,consumer decisions

are distorted, and markets are less able to allocate resources to their best use.

29

Inflation-induced tax distortionsEconomyA

(Price stability)EconomyB(Inflation)

Real interest rate 4% 4%

Inflation rate 0 8%

Nominal interest rate(real interest rate+ inflation rate)

4 12

Reduced interest due to 25% tax(0.25 nominal interest rate)

1 3

After-tax nominal interest rate(0.75 nominal interest rate)

3 9

After-tax real interest rate(after-tax nominal interest rate-inflation rate)

3 1

More complete indexation would be desirable,but it would further complicate a tax code that many people already consider too complex.

30

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.

31

A special cost of unexpected inflationArbitrary redsistributions of wealth

Unexpected inflation redistributes wealth among the population in a way that has nothing to do with either merit or need.

There are no known examples of economies with high,stable inflation.

If a country pursue a high-inflation monetary policy the costs of high expected inflation the arbitary redistributions of wealth associated with unexpected

inflation

32

Deflation may be worse

Friedman rule Some economists have suggested that a small and

predictable amount of deflation may be desirable.

The costs of deflation Some of these mirror the costs of inflation Delfation often arises because of broader macro

economic difficulties.