ECO - Ch.17 - Money Growth and Inflation
quantity equation shows: increase in quantity of money
- price level rise - quantity of output rise - or velocity of money must fall
The nominal interest rate is 4%, the inflation rate is 1% and the tax rate is 20%. Given U.S. tax laws, how is after-tax real return computed?
0.04 (1 - 0.20) - 0.01
Fed sells bonds
receives dollars in exchange and contracts the money supply = reduce the quantity of money = increase in rate of interest (the price of money)
Economists have identified 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 between debtors and creditors. Many of these costs are large during hyperinflation, but the size of these costs for moderate inflation is less clear.
determines the value of money
supply and demand
Most economists believe the classical dichotomy and neutrality of money describe_________
the economy in the long run
The Costs of Inflation
the inflation fallacy, shoe leather costs, menu costs, unit of account costs, Misallocation of resources from relative-price variability, Confusion & inconvenience, Tax distortions
Monetary neutrality
the proposition that changes in the money supply do not affect real variables
Velocity of money
the rate at which money changes hands
nominal variables
variables measured in monetary units, ex. income of corn farmers - DOLLAR PRICE
One application of the principle of monetary neutrality is the Fisher effect. According to the Fisher effect,
when the inflation rate rises, the nominal interest rate rises by the same amount, so that the real interest rate remains the same.
P = the overall price level
(e.g., the CPI or GDP deflator) 1/P is the value of $1 (also called the value of Money), measured in goods. - Example: basket contains one candy bar. + If P = $2, value of $1 is 1/2 candy bar +If P = $3, value of $1 is 1/3 candy bar - Inflation drives up prices and drives down the value of money.
The Money Supply-Demand Diagram
- As the value of money rises, the price level falls. - The Fed sets MS at some fixed value, regardless of P. - P adjusts to equate quantity of money demanded with money supply.
The Quantity Theory of Money
- Developed by 18th century philosopher David Hume and the classical economists. - Advocated more recently by Nobel Prize Laureate Milton Friedman. - Asserts that the quantity of money determines the value of money (price level, quantity of money available and inflation rate) - We study this theory using two approaches: 1.A supply-demand diagram 2.An equation
Misallocation of resources from relative-price variability:
- Firms don't all raise prices at the same time, so relative prices can vary... - Which distorts the allocation of resources
Hyperinflation
- Hyperinflation is generally defined as inflation exceeding 50% per month. - Recall : Prices rise when the government prints too much money. - Excessive growth in the money supply always causes hyperinflation.
Summary and lessons about the quantity theory of money
- If real GDP is constant, then inflation rate = money growth rate. - If real GDP is growing, then inflation rate < money growth rate. - The bottom line: + Economic growth increases # of transactions. + Some money growth is needed for these extra transactions. + Excessive money growth causes inflation.
The Fisher Effect
- In the long run, money is neutral: a change in the money growth rate affects the inflation rate but not the real interest rate. - So, the nominal interest rate adjusts one-for-one with changes in the inflation rate. - This relationship is called the Fisher effect after Irving Fisher, who studied it.
Money Supply (MS)
- In this model, we assume the Fed precisely controls MS and sets it at some fixed amount.
Confusion & inconvenience:
- Inflation changes the yardstick we use to measure transactions. - Complicates long-range planning and the comparison of dollar amounts over time.
Tax distortions:
- Inflation makes nominal income grow faster than real income. - Taxes are based on nominal income, and some are not adjusted for inflation. - So, inflation causes people to pay more taxes even when their real incomes don't increase.
The Value of Money
- P = the overall price level (e.g., the CPI or GDP deflator) 1/P is the value of $1 (also called the value of Money), measured in goods. - Example: basket contains one candy bar. + If P = $2, value of $1 is 1/2 candy bar + If P = $3, value of $1 is 1/3 candy bar - Inflation drives up prices and drives down the value of money.
At the initial P, an increase in MS causes an excess supply of money
- People get rid of their excess money + by spending it on g&s + or by loaning it to others, who spend it. + Result: increased demand for goods. - But supply of goods does not increase, so prices must rise.
Money Demand (MD)
- Refers to how much wealth people want to hold in liquid form. - Depends on P:An increase in P reduces the value of money, so more money is required to buy g&s. - Money demand is negatively related to the value of money and positively related to P, other things equal.
The Effects of a Monetary Injection
- Suppose the Fed increases the money supply. - eq'm value of money - decrease - Then the value of money falls, and Price level rises. - eq'm price level - icrease - increase the demand of goods and services - does not affect the ability of supply
Shoeleather costs
- The resources wasted when inflation encourages people to reduce their money holdings + Includes the time and transactions costs of more frequent bank withdrawals
If central bank doubles the money supply:
- all nominal variables—including prices, price level, dollar wage — will double. - all real variables—including relative prices, production, employment, real wages, real interest rates — unchanged.
Suppose each good costs $5 per unit and Megan holds $40. What is the real value of the money she holds?
8 units of goods. If the price of goods rises, to maintain the real value of her money holdings she needs to hold more dollars.
Nominal Interest Rate
= Inflation Rate + Real interest rate
One good: corn. The economy has enough labor, capital, and land to produce Y = 800 bushels of corn. V is constant. In 2008, MS = $2000, P = $5/bushel. For 2009, the Fed increases MS by 5%, to $2100. a. Compute the 2009 values of nominal GDP and P. Compute the inflation rate for 2008-2009. b. Suppose tech. progress causes Y to increase to 824 in 2009. Compute 2008-2009 inflation rate.
A. Nominal GDP = P x Y = M x V (Quantity Eq'n) = $2100 x 2 = $4200 P = (PxY)/Y = $4200/800 = $5.25 Inflation rate = ($5.25 - 5.00)/ 5.00 = 5% (same as MS!) B. First, use Quantity Eq'n to compute P in 2009: P = (PxY)/Y = $4200/824 = $5.10 Inflation Rate = ($5.10 - 5.00)/ 5.00 = 2%
You deposit $1000 in the bank for one year. CASE 1: inflation = 0%, nom. interest rate = 10% CASE 2: inflation = 10%, nom. interest rate = 20% a. In which case does the real value of your deposit grow the most? Assume the tax rate is 25%. b. In which case do you pay the most taxes? c. Compute the after-tax nominal interest rate, then subtract inflation to get the after-tax real interest rate for both cases.
In both cases, the real interest rate is 10%, so the real value of the deposit grows 10% (before taxes). b. CASE 1: interest income = $100, so you pay $25 in taxes. CASE 2: interest income = $200, so you pay $50 in taxes. c. CASE 1: nominal = 0.75 x 10% = 7.5% real = 7.5% - 0% = 7.5% CASE 2: nominal = 0.75 x 20% = 15% real = 15% - 10% = 5%
A Brief Look at the Adjustment Process
Increasing MS causes P to rise.
3. Summary & Lessons Deposit = $1000. Tax rate = 25%. CASE 1: inflation = 0%, nom. interest rate = 10% CASE 2: inflation = 10%, nom. interest rate = 20%
Inflation... - raises nominal interest rates (Fisher effect) but not real interest rates - increases savers' tax burdens - lowers the after-tax real interest rate
Hyperinflation in Zimbabwe
Large govt budget deficits led to the creation of large quantities of money and high inflation rates.
The principle of monetary neutrality asserts that changes in the quantity of money influence nominal variables but not real variables
Most economists believe that monetary neutrality approximately describes the behavior of the economy in the long run.
Quantity Equation
Multiply both sides of formula by M: M x V = P x Y
V = (P x Y) / M
P x Y = nominal GDP = (price level) x (real GDP) M = money supply V = velocity
Menu costs
The costs of changing prices + Printing new menus, mailing new catalogs, etc.
Doubling money supply causes all nominal prices to double; what happens to relative prices (a real variable)?
The relative price is unchanged.
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.
Velocity formula
V = (P x Y) / M
U.S. Nominal GDP, M2, and Velocity 1960-2016
Velocity is fairly stable over the long run.
A government can pay for some of its spending simply by printing money
When countries rely heavily on this "inflation tax," the result is hyperinflation.
A rise in the price level means - the overall price level rises means
a lower value of money (each dollar can buy less goods and services) - the value of money falls - increase the quantity of money demanded
inflation rate leads to
an increase in the price level
When inflation rises, people will desire to hold
b.less money and will go to the bank more frequently.
In the long run, money supply and money demand are
brought into equilibrium by the overall level of prices - price level must rise/fall to balance supply and demand
When shopping you notice that a pair of jeans costs $20 and that a tee-shirt costs $10. You compute the price of jeans relative to tee-shirt
c.The dollar price of jeans is a nominal variable; the relative price of jeans is a real variable.
Suppose the money market, drawn with the value of money on the vertical axis, is in equilibrium. If the money supply increases, then at the old value of money there is an
c.excess supply of money that will result in an increase in spending.
Nominal variables are inlfuenced by developments in the economy's monetary system
changes in supply of money affects nominal variables but not real ones
The price level falls. This might be because the Federal Reserve
d.sold bonds which reduced the money supply.
relative prices
doesn't change
people want to hold more money when
each dollar buys less (the demand curve for money slopes downwards)
nominal value
effective
The higher price level (a lower value of money)
increases the quantity of money demanded
The overall level of prices in an economy adjusts to bring money supply and money demand into balance. When the central bank increases the supply of money
it causes the price level to rise. Persistent growth in the quantity of money supplied leads to continuing inflation
Fed buys government bonds
it pays out dollars and expands the money supply
real variables
measured in physical units (ex: quantity of corn they prouce, real GDP, real interest rate, real wage) - RELATIVE PRICE
price increase = value of money decrease
more money =
when the value of money is low (price level is high)
people demand a larger quantity of it to buy goods and services
The Inflation Tax
printing money causes inflation, which is like a tax on everyone who holds money - When tax revenue is inadequate and ability to borrow is limited, govt may print money to pay for its spending. - Almost all hyperinflations start this way. - The inflation tax today accounts for less than 3% of total revenue in the U.S.
an increase of money supply makes dollars more plentiful
the result is an increase in the price level and each dollar less valuable
The Classical Dichotomy
the theoretical separation of nominal and real variables that monetary developments affect nominal variables but not real variables.
inflation is more about the value of the money than
the value of goods