topic 3: Money Growth and Inflation

How do we ensure hyperinflation does not reach such catastrophic levels?

Creation of stronger independent central banks, money growth follows inflation.

Inefficiencies and uncertainty with inflation

Firms do not feel the need to be disciplined and keep costs down if they can raise prices because of prevailing inflation. A volatile and unpredictable inflationary environment makes it harder for everyone to plan for the future.

Let's consider the effects of inflation in an economy composed of only two people: Bob, a bean farmer, and Rita, a rice farmer. Bob and Rita both always consume equal amounts of rice and beans. In 2019, the price of beans was $1 and the price of rice was $3. c. Finally suppose in 2020 the price of beans was $2 and the price of rice was $1.50. What was inflation? Did the price change leave Bob better off worse off, or unaffected? Rita?

If the price of beans rises to $2 and the price of rice falls to $1.50, then the cost of the market basket in the second year is $3.50. This means that the inflation rate is ($3.5 - $4)/$4 × 100 = -12.5%. Bob is better off because his dollar revenues doubled (increased 100%) while prices overall fell 12.5%. Rita is worse off because inflation was -12.5%, so the price of the good she buys didn't fall as fast as the price of the good (rice) she sells, which fell 50%.

Let's consider the effects of inflation in an economy composed of only two people: Bob, a bean farmer, and Rita, a rice farmer. Bob and Rita both always consume equal amounts of rice and beans. In 2019, the price of beans was $1 and the price of rice was $3. b Now suppose in 2020 the price of beans was $2 and the price of rice was $4. What was inflation? Did the price change leave Bob better off worse off, or unaffected? Rita?

If the price of beans rises to $2 and the price of rice rises to $4, then the cost of the market basket in the second year is $6. This means that the inflation rate is ($6 - $4)/$4 × 100 = 50%. Bob is better off because his dollar revenues doubled (increased 100%) while inflation was only 50%. Rita is worse off because inflation was 50% percent, so the price of the good she buys rose faster than the price of the good (rice) she sells, which rose only 33%.

Quantity equation

M x V = P x Y

Is this tax distributed proportionally across the population?

No. Taxes do not affect certain people, for example, a tax on cigarettes would not affect a nonsmoker. Since inflation is a tax on money/the purchasing power of money, those who hold a lot of their wealth on money are affected more. Rich people tend to store their wealth in assets, such as real estate, stocks, gold, etc. Poor people face the burden of inflation (regressive tax)

Distortion of Price Signals

The actions of government which distort the operation of the price mechanism and so misallocates resources. in market economics, the most important signal of a market sends is price, prices induce behavior and inflation distorts this signal People wonder: are goods more expensive because better quality or is it inflation?

Inflation Tax

When the government uses money creation to finance its spending, it is said to be imposing this - government prints money, price level rises, money becomes less valuable = inflation= tax on money

Suppose that people expect inflation to equal 3 percent, but in fact, prices rise by 5 percent. Describe how this unexpectedly high inflation rate would help/hurt the following a. the government

help because it provides a higher tax revenue and reduces the real value of outstanding government debt

Suppose that people expect inflation to equal 3 percent, but in fact, prices rise by 5 percent. Describe how this unexpectedly high inflation rate would help/hurt the following b. a homeowner with a fixed-rate mortgage

help because the mortgage is fixed rated and the homeowner pays that rate which was based on expected inflation. Therefore, they are paying a lower real interest rate

Suppose that people expect inflation to equal 3 percent, but in fact, prices rise by 5 percent. Describe how this unexpectedly high inflation rate would help/hurt the following c. a union worker in the second year of labor contract

hurts because the contract probably based the workers nominal wage on the expected inflation rate, and he will receive a lower-than-expected real wage

Suppose that people expect inflation to equal 3 percent, but in fact, prices rise by 5 percent. Describe how this unexpectedly high inflation rate would help/hurt the following d. college that has invested some of its endowment in government bonds

hurts; because a higher inflation rate means the college is receiving a lower real interest rate than it palnned. ( assuming not inflation-indexed treasury bonds)

What happens when governments who are unable- or unwilling- to use traditional sources to finance their spending (taxes, debt) turn to the inflation tax and heavily rely on it?

hyperinflation.

Inflation is a regressive tax

inflation takes a larger percentage of income from low-income earners than from high-income earners.

Alternative of the government either levies taxes or borrows (right-hand side) to pay for its obligations (left-hand side).

simply printing (issuing) money:

Money velocity is relatively:

stable, determined by current payment technologies

Menu costs:

the costs of updating prices to keep up with inflation. in market economics, the most important signal of a market sends is price, prices induce behavior and inflation distorts this signal

money velocity

the rate at which money changes hands - Nominal GDP/money stock -PxY = MxV

Shoe-leather costs:

the resources wasted when high inflation encourages people to reduce their money holdings. - trying to identify the cheapest shoe

What are your shoe leather costs of going to the banks? How might you measure these costs in dollars? How do you think the shoe leather costs of your college president differ from your own?

- shoe-leather costs: the resources wasted when high inflation encourages people to reduce their money holdings. The cost to individuals who have to take frequent visits to the bank to take out more money for goods and services. periods of high inflation, the name comes from the fact that walking to the bank more regularly will wear down your shoes. My shoe leather costs of going to the bank can be measured by the time and convenience sacrificed going to the bank and can be measured by the opportunity costs of traveling to the bank and how much money has been removed from the bank alomg with how . College Presidnet would have to pay remove more money from the bank if they held more wealth there.

What factors can account for the surge in prices/high inflation?

- supply chain bottle necks aborad and domestic - Labor Makrt shortages - risong energy prices Magnitude of stimukus packages -Russian invasion of Ukraine

Example of Hyperinflation in Germany between WW1-WW2

-money was basically worthless in Germany during this time. - Germany lost the war (WW1), the treaty that finalizes the war says that since they lost they have to pay other countries' respirations, had to pay with resources like gold leading to this resource being exhausted, Government prints more money in response, hyperinflation RESULT= conditions allow for Nazi Party to rise to power

Suppose there is a large monetary expansion. For example, suppose the Fed increases M by 50%. What are the consequences of this?

The monetary expansion does not change the productive capacity of the economy fundamentally. Thus, output Y remains basically unchanged. Since V is constant, Y does change substantially, the increase in M is reflected in changes in price level P When there is a rapid increase in money supply, the result is a high rate of inflation

d. What matters more to Bob and Rita- overall inflation rate or relative price of rice and beans

The relative price of rice and beans matters more to Bob and Rita than the overall inflation rate. If the price of the good that a person produces rises more than inflation, he will be better off. If the price of the good a person produces rises less than inflation, he will be worse off.

Suppose that this year's money supply is $500 billion, nominal GDP is $10 TRILLION, AND REAL GDP IS $5 TRILLION, D. What money supply should the Fed set next year if it wants an inflation of 10 percent?

They should increase the money supply by 15% Thus, M × V will rise 15%, causing P × Y to rise 15%, with a 10% increase in prices and a 5% rise in real GDP.

Suppose that this year's money supply is $500 billion, nominal GDP is $10 TRILLION, AND REAL GDP IS $5 TRILLION. c. What money supply should the Fed set next year if it wants to keep the price levels stable?

To keep the price level stable, the fed must increase the money supply by 5%, matching the increase in real GDP. Thid will cause velocity to remain unchanged=stable price level

Let's consider the effects of inflation in an economy composed of only two people: Bob, a bean farmer, and Rita, a rice farmer. Bob and Rita both always consume equal amounts of rice and beans. In 2019, the price of beans was $1 and the price of rice was $3. Suppose in 2020 the price of beans was $2 and the price of rice was $6. What was inflation? Did the price change leave Bob better off worse off, or unaffected? Rita?

When the price of both goods doubles in a year, inflation is 100%. Suppose the market basket is equal to one unit of each good. The cost of the market basket is initially $4 and becomes $8 in the second year. Thus, the rate of inflation is ($8 - $4)/$4 × 100 = 100%. Because the prices of all goods rise by 100%, the farmers get a 100% increase in their incomes to go along with the 100% increase in prices, so neither is affected by the change in prices.

Suppose that this year's money supply is $500 billion, nominal GDP is $10 TRILLION, AND REAL GDP IS $5 TRILLION. a. What is the price level? What is the velocity of money

a. Price level nominal GDP= P x Y= P X Y= 10 trillion Y (real GDP)= 5 trillion P=PxY/Y 10,000/5000= 2 trillion velocity of money = Nominal GDP/ M 10 trillion/ 500 BILLION = 20

Suppose that this year's money supply is $500 billion, nominal GDP is $10 TRILLION, AND REAL GDP IS $5 TRILLION. B. Suppose that the velocity is constant and the economy's output of goods and services rises by 5 percent each year. What will happen to nominal GDP and the price level next year if the Fed keeps the money supply constant?

when output rises (Y), then Price must fall by apporximatley 5% Nominal GDP will be unchanged MxV=YxP