Macroeconomics 1BB3 - Chapter 12 - Money Growth and Inflation

quantity theory of money

a theory asserting that the quantity of money available determinesthe price level and that the growth rate in the quantity of money available determines the inflation rate

nominal variables

variables measured in monetary units

real variables

variables measured in physical units

classical dichotomy

the theoretical seperation of nominal and real variables

monetary neutrality

the proposition that changes in the money supplydo not affect real variables

quantity equation

the equation M x V = P x Y which relates the quantityof money, the velocity of money, and the dollar valueof the economy's output of goods and services

inflation tax

the revenue the government raises by creating money

Fisher effect

the one-for-one adjustment of the nominal interestrate to the inflation rate

shoeleather costs

the resources wasted when inflation encouragespeople to reduce their money holdings

menu costs

the costs of changing prices

See why inflation results from rapid growth inthe money supply

Learn the meaning of the classical dichotomyand monetary neutrality

See why some countries print so much moneythat they experience hyperinflation

Examine how the nominal interest rate respondsto the inflation rate

Consider the various costs that inflation imposeson society

inflation

deflation

hyperinflation

quantity theory of money

THE LEVEL OF PRICES AND THE VALUE OF MONEY

MONEY SUPPLY, MONEY DEMAND, AND MONETARY EQUILIBRIUM

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

THE EFFECTS OF MONETARY INJECTION

A BRIEF LOOK AT THE ADJUSTMENT PROCESS

THE CLASSICAL DICHOTOMY AND MONETARY NETRALITY

dichotomy

classical

relative

measured

actual

VELOCITY AND THE QUANITY EQUATION

Velocity of Money Equation

nominal value of output ( nominal GDP)divided by the quantity of money

V = ( P x Y ) / M

Where:V - velocity of moneyP - price level ( GDP deflator )Y - the quanitity of output ( real GDP )M - the quantity of money

Quantity Equation

relates the quantity of money to thenominal value of output

M x V = P x Y

Where:M - quantity of moneyV - velocity of money( P x Y ) - nominal value of output)if:P - priceY - quantity of output

Quantity theory of Money

5 Steps for the essense of the

1. The velocity of money is relatively stable over time.

2. Because velocity is stable, when the central bank changesthe quantity of money ( M ), it causes proportionate changesin the nominal value of output ( P x Y )

3. The economy's output of goods and services ( Y ) isprimarily determined by factor supplies (labour, phyisicalcapital, human capital, and natural resources) and theavailable production technology. In particular becausemoney 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 inducespropotional changes in the nominal value of output ( P x Y ), thesechanges are reflected in changes in the price level ( P ).

5. Therefore, when the central bank increases the money supplyrapidly, the result is a high rate of inflation

THE INFLATION TAX

the inflation tax is like a tax on everyone who holds money

THE FISHER EFFECT

nominal interest rate

real interest rate

when the Bank of Canada increases the rate of moneygrowth, the result is both a higher inflation rate and ahigher nominal interest rate

FIGURE 12.1

How the Supply and Demand for Money Determinethe Equilibrium Price Level

FIGURE 12.2

An increase in the Money Supply

FIGURE 12.3

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

FIGURE 12.4

Money and Prices during FourHyperinflations

FIGURE 12.5

The Nominal Interest Rate and theInflation Rate

TABLE 12.1

How Inflation Raises the Tax Burdenon Savings

A FALL IN PURCHASING POWER? THE INFLATION FALLACY

inflation does not itself reduce people's realpurchasing power

SHOELEATHER COSTS

MENU COSTS

RELATIVE-PRICE VARIABILITY AND THE MISALLOCATIONOF RESOURCES

INFLATION-INDUCED TAX DISTORTIONS

capital gains

CONFUSION AND INCONVENIENCE

A SPECIAL COST OF UNEXPTECTED INFLATION:ARBITRARY REDISTRIBUTIONS OF WEALTH

Point 1

The overall level of prices in an economy adjusts to bringmoney supply and money demand into balance.

When the central bank increases teh supply of money, it caussthe price level to rise.

Persistant growth in the quantity of money supplied leadsto continuing inflation.

Point 2

The principle of monetary neutrality asserts that changes in thequantity of money influence nominal variables but not real variables

Most economists beleive that monetary neutrality approximatelydescribes the behaviour of the economy in the long run.

Point 3

The government can pay for some it its spending by printing money.

When countries rely heavily on this "inflation tax," the result is hyperinflation

Point 4

One application of the principle of monetary neutrality is the Fishereffect.

According to the Fisher effect, when inflation rises, the nominal interest raterises by teh same amount, so that the real interest rate remains the same.

Point 5

Many people think that inflation makes them poorer because it raises the cost of what they buy.

This view is a fallacy, however, because inflation also raises nominal incomes.

Point 6

Economists have indentified six costs of inflation:

shoeleather costs associated with reduced money holdings

menu costs associated with more frequent adjustment of prices

increased variability of relative prices

unintended changes in tax liabilities due to nonindexation of the tax code

confusion and inconvenience resulting from a changing unit of account

and arbitrary redistributions of wealth betwen debtros and creditors

Many of these costs are large during hyperinflation,but the size of these costs for modeterate inflationis less clear.

INTRODUCTION

inflation

deflation

Velocity of money equation

V = ( P x Y ) / M

Quantity equation

M x V = P x Y

Interst Rates

Real Interest rate = Nominal interest rate - Inflation rate

Nominal interest rate = Real interest rate + Inflation rate

CASE STUDY

Money and Prices During Four Hyperinflations

Money Growth, Inflation, and the Bank of Canada

IN THE NEWS

Russia Turns to the Inflation Tax

Russia's New Leaders Plan to Pay Debtsby Printing Money

The Hyperinflation in Serbia

Special, Today Only: 6 Million Dinarsfor a Snickers Bar

How to Protect Your Savings From Inflation

Inflation Fighters for the Long Term

QUICK QUIZ

Question 1

The government of a country increases the growth rate of the moneysupply from 5% per year to 50% per year.

What happens to prices?

What happens to nominal interest rates?

Why might the government be doing this?

Question 2

List and describe six costs of inflation

QUESTIONS FOR REVIEW

Question 1

Explain how an increase in the price level affectsthe real value of money

Question 2

According to the quantity theory of money,what is the effect of an increase in the quantityof money?

Question 3

Explain the difference between nominal and realvariables, and give two examples of each

According to the principles of monetery neutrality,which variables are affected by the changes in thequantity of money?

Question 4

In what sense is inflation like a tax?

How does thinking about inflation help explainhyperinflation?

Question 5

According to the Fisher effect, how does an increasein the inflation rate affect the real interest rate andthe nominal interest rate?

Question 6

What are the costs of inflation?

Which of these costs do you think are most important forthe Canadian economy?

Question 7

If the inflation is less than expected, who benefits - debtors or creditors? Explain.