Study with the several resources on Docsity
Earn points by helping other students or get them with a premium plan
Prepare for your exams
Study with the several resources on Docsity
Earn points to download
Earn points by helping other students or get them with a premium plan
Community
Ask the community for help and clear up your study doubts
Discover the best universities in your country according to Docsity users
Free resources
Download our free guides on studying techniques, anxiety management strategies, and thesis advice from Docsity tutors
Material Type: Notes; Class: Principles of Economics II/Macroeconomics; Subject: economics; University: Boston College; Term: Fall 2009;
Typology: Study notes
1 / 10
This page cannot be seen from the preview
Don't miss anything!
Copyright (c) 2009 by Peter N. Ireland. Redistribution is permitted for educational and research
purposes, so long as no changes are made. All copies much be provided free of charge and must include
this copyright notice.
Remember our previous example from Chapter 23, “Measuring the Cost of Living.” In 1931, the Yankees
paid Babe Ruth an annual salary of $80,000. But then again, in 1931, an ice cream cone cost a nickel and
a movie ticket cost a quarter.
The overall increase in the level of prices, as measured by the CPI or the GDP deflator, is called inflation.
Although at least some inflation seems inevitable today, in the 19
th century many economies
experienced long periods of falling prices, or deflation.
And even in the more recent past, there have been wide variations in the inflation rate: from rates
exceeding 7 percent per year in the 1970s to the current rate of about 2 percent per year.
Also, in some countries during some periods, extremely high rates of inflation have been experienced. In
Germany after World War I, for instance, the price of a newspaper rose from 0.3 marks in January 1921
to 70,000,000 marks less than two years later. These episodes of extremely high inflation are called
hyperinflations.
But exactly what economic forces produce inflation, and lead to variations in the rate of inflation?
An economic theory called the quantity theory of money indicates that excess money creation is the
underlying cause of inflation. Interestingly, the 18
th century Scottish philosopher David Hume was one of
the first to formulate a version of the quantity theory of money. A more recent proponent was Milton
Friedman.
After developing the quantity theory of money to explain inflation, this chapter goes on to identify the
costs that inflation, particularly very high rates of inflation, impose on the economy.
A. The Level of Prices and the Value of Money
B. Money Supply, Money Demand, and Monetary Equilibrium
C. The Effects of a Monetary Injection
D. A Brief Look at the Adjustment Process
E. The Classical Dichotomy and Monetary Neutrality
F. Velocity and the Quantity Equation
G. The Inflation Tax
H. The Fisher Effect
Let’s build on this idea that 1/ P measures the goods price of a dollar.
Figure 1 applies standard microeconomic supply‐and‐demand theory to money:
‐ The quantity of the good – in this case money – appears on the horizontal axis.
‐ The price of the good – in this case 1/ P – appears on the vertical axis.
‐ The money demand curve slopes downward. There are two ways to think about this:
o When the price of money rises, the demand for money falls.
o When the goods price of money 1/ P rises, the dollar price of goods P falls. Since fewer
dollars are needed to buy the same number of goods, the demand for money falls.
‐ The money supply curve is vertical, as the money stock is determined by Federal Reserve policy
(and by the response of banks to that policy).
‐ The goods price of money 1/ P is determined by the intersection between demand and supply.
‐ When the goods price of money is below its equilibrium value, there is excess demand for
money, putting upward pressure on the goods price of money until equilibrium is restored.
‐ When the goods price of money is above its equilibrium value, there is excess supply of money,
putting downward pressure on the goods price of money until equilibrium is restored.
‐ Translate the goods price of money 1/ P back into the money price of goods P , and the same
theory determines the price level.
Figure 2 illustrates what happens when the Fed acts to increase the money supply, either by
‐ Using open market operations to increase the supply of reserves to the banking system, which
then increases the money supply working through the money multiplier, or
‐ Lowering its target for the federal funds rate, which requires it to use open market operations to
increase the supply of reserves to the banking system.
When the supply curve shifts, a new equilibrium occurs at a lower goods price of money 1/ P and hence a
higher price level P.
The upshot is that inflation, a rising price level, is associated with a policy of money creation.
This theory is called the quantity theory of money , as it asserts that the quantity of money available
determines the price level and the growth rate of money available determines the inflation rate.
Figure 2 can also be used to think about the process through which money creation leads to a higher
level of prices.
Suppose again that the money supply curve shifts, reflecting an increase in the money supply.
‐ If 1/ P does not change, there is an excess supply of money. In other words, people find
themselves with more money than they need.
‐ Some people will use the extra money to buy more goods and services. This causes the money
price of goods P to increase, and the goods price of money 1/ P to fall.
‐ Other people will deposit the extra money in the bank. But then the bank will lend the money to
a borrower who wants to buy more goods and services. Again, P will rise and 1/ P will fall.
‐ This process will continue until monetary equilibrium is restored at a higher price level.
The quantity theory of money describes how changes in the money supply affect the price level. But
how do those changes affect other economic variables, like GDP, unemployment, and interest rates?
David Hume and his contemporaries suggested that economic variables be divided into two groups.
According to this classification, for example:
‐ Nominal GDP is a nominal variable because it measures the dollar value of an economy’s output
of goods and services.
‐ Real GDP is a real variable because it measures the value of an economy’s output of goods and
services correcting for inflation, that is, eliminating the effects of changes in the value of money.
‐ The CPI is a nominal variable because it measures the number of dollars that are required to
purchase a basket of goods and services.
‐ The unemployment rate is a real variable because it measures the percentage of the labor force
that is unemployed.
This theoretical separation of nominal and real variables is called the classical dichotomy.
The quantity theory of money implies that changes in the money supply affect nominal variables.
The theory of monetary neutrality goes a step further, and says that changes in the money supply do
not affect real variables.
Hume’s thought experiment:
‐ Suppose that the money supply doubles from $100 million to $200 million.
‐ Everybody has twice as much money, but the ability to produce goods and services has not
changed.
‐ Introspection suggests that the overall price level P should double, leaving output and all other
real variables unchanged.
‐ An analogy: suppose that the definition of a foot was changed from 12 inches to 6 inches. Would
this make everyone twice as tall? No! Everyone would physically be the same height as before,
but their height when measured in feet would be twice as big.
‐ Similarly, when the government doubles the money supply, the physical quantity of goods
produced would be the same as before, but prices measured in dollars would all be twice as big.
quantity of money is reflected in the price level P rather than real output Y.
Figure 4 shows the behavior of money supplies and inflation rates during four periods of hyperinflation.
‐ In all four cases, price levels rose dramatically in tandem with money supplies.
‐ And in all four cases, when the extreme growth in the money supply ended, so did the
hyperinflation.
‐ Analysis of these extreme historical cases bolstered economists’ confidence in the quantity
theory of money.
Why do some economies experience hyperinflation?
Almost always, it is because the government needs to raise revenue to finance spending, but for political
reasons cannot obtain that revenue through standard income taxation. Hence, it must pay for the goods
and services it purchases not with existing money collected through taxes, but instead using newly‐
created money.
Since money creation leads to inflation, the inflation tax refers to the revenue that the government
raises through money creation.
Historically, many cases of hyperinflation occur during or after a war, when the government is in need of
large amounts of revenue to finance high levels of spending, and may not have the ability to raise this
revenue through standard income taxation. All of the hyperinflations shown in Figure 4, for example,
occurred in the aftermath of World War I.
Another application of the classical dichotomy is to interest rates:
‐ The nominal interest rate is the interest rate measured without correcting for inflation.
‐ The real interest rate is the interest rate measured after correction for inflation.
Recall from Chapter 24 that mathematically,
Real Interest Rate = Nominal Interest rate – Inflation Rate
Example:
‐ A bank pays interest at the rate of 7 percent per year.
‐ You deposit $100 today, and have $107 at the end of one year.
‐ But the inflation rate is 3 percent, so your money next year buys 3 percent less.
‐ Your real, or inflation‐adjusted, return, is 7 percent – 3 percent = 4 percent.
We can rearrange this equation to read
Nominal Interest Rate = Real Interest Rate + Inflation Rate
Under monetary neutrality, an increase in the rate of money growth will increase the rate of inflation,
but leave the real interest rate unchanged.
Hence, under monetary neutrality, an increase in the rate of money growth will lead to a higher nominal
interest rate as well as a higher rate of inflation.
This application of monetary neutrality to interest rates is associated with the economist Irving Fisher,
and the predicted association of the nominal interest rate and the inflation rate is called the Fisher
effect.
Figure 5 plots the inflation rate and the nominal interest rate in the US economy since 1960. Note that
these two variables move together, providing evidence for the Fisher effect.
Generally, economists and non‐economists alike believe that inflation is costly for the economy. But
why?
Many people dislike inflation because they believe it erodes the purchasing power of their income.
What this argument fails to recognize is that while inflation leads to an increase in the dollar prices of
goods and services, it also leads to an increase in nominal (dollar‐denominated) wages and incomes.
Real (inflation‐adjusted) wages and incomes should, according to the principle of monetary neutrality,
remain unaffected.
This argument would appear to be a fallacy, so long as monetary neutrality holds.
But inflation does erode the value of money that each person holds in his or her wallet.
Thus, when inflation rises, people make greater efforts to reduce the amounts of money that they hold,
for example, by going to the bank or the ATM more often, but withdrawing smaller amounts each time.
The costs that are associated with these efforts are called shoeleather costs , based on the imagery of
someone wearing out his or her shoes walking to the bank more often.
Generally, under moderate rates of inflation like those currently prevailing in the US, shoeleather costs
appear small – maybe even trivial.
But these costs can be substantial during episodes of hyperinflation.
‐ During the Bolivian hyperinflation of 1985, prices rose at an annual rate of 38,000 percent.
Recall the analogy used earlier in our discussion of monetary neutrality: in a sense, a doubling of the
money supply and a corresponding doubling of the price level is like changing the definition of a foot
from 12 inches to 6 inches.
If the definition of a foot, or a pound, or a mile were continually changed, it would be confusing and
inconvenient to make comparisons over time.
Extending the analogy, the same might be said about the effects of inflation.
Suppose that you take out a 30 ‐year mortgage at 7 percent interest, expecting the inflation rate to be 3
percent.
The real interest rate that you are paying is 4 percent.
But now suppose that unexpectedly, inflation turns out to be 1 percent.
Now the real interest rate that you are paying is 6 percent – considerably higher. The bank wins, but
you lose.
On the other hand, if inflation turns out to be 5 percent, the real interest rate you pay is only 2 percent.
You win, but the bank loses.
Unexpected changes in inflation lead to redistributions of wealth across borrowers and lenders. On net
the effects cancel out, but before knowing who wins and who loses, everyone might object to the
arbitrariness of these potential redistributions.
Both theory and evidence points to excessive money growth as the principal cause of inflation.
Many sources of the costs of inflation appear trivial when inflation is low, but become much more
significant when inflation is much higher.
However, even at modest rates of inflation, interactions between inflation and the tax code can have
negative effects of saving. And even small changes in inflation, if unexpected, can lead to large and
arbitrary redistributions of wealth across borrowers and lenders.
