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Lecture 11: Inflation: Its Causesand Costs
Rob GodbyUniversity of Wyoming
Inflation: DefinitionQ Inflation is a sustained, continuous
increase in the price level. It doesnot refer to a “once-and-for-all”increase in prices.
Q The opposite is termed deflation.Q Inflation deals with the increase in
the average of prices and not justsignificant increases in the price ofa few goods.
Q It is measured using the CPI.
Inflation: Historical AspectsQ Over the past sixty years, prices
have risen on average about 5% peryear.
Q Deflation occurred in the 19thcentury and briefly in the 20thcentury.
Q In the 1970’s prices rose by 7% peryear.
Q From 1990 to 1998 prices roseabout 2% per year.
The Causes of InflationQ Inflation is an economy-wide
monetary phenomenon.Q Since it concerns, first and
foremost, the value of theeconomy’s medium of exchange, itis the prime concern of the Fed.
Q To understand the cause of inflationwe must understand the concepts ofMoney Supply, Money Demand,and Monetary Equilibrium.
Money Supply and MoneyDemand
Q Money Supply is controlled by theFederal Reserve Banks. Throughinstruments such as open marketoperations, the Fed directlycontrols the quantity of moneysupplied.
Q Money Demand has severaldeterminants including:X interest ratesX price level in the economy
X income levels
Q The amount of money peoplechoose to hold depends on theprices of the goods and services.
Q The “value” of dollar is inverselyrelated to the price levelX the higher are prices the less a
single dollar buys.
Q In the long run, the overall level ofprices adjusts to the level at whichthe demand for money equals thesupply.
Money Supply and Money Demand
Money Supply, Money Demand andEquilibrium Price Level
Value ofMoney
Price Level
MoneyDemand
QFixed
Money Supply
Equilibrium Value ofMoney
Equilibrium Price Level
High
Low
Low
High
Monetary EquilibriumQ The Fed could inject money
(monetary injection) into theeconomy by buying governmentbonds. Results would be:X The supply curve shifting to the right
X The equilibrium value of moneydecreasing
X The equilibrium price levelincreasing
Q This process is referred to as the quantity theory of money.
The Effects of Monetary InjectionValue ofMoney
Price Level
MoneyDemand
QFixed
MS1
The Effects of Monetary InjectionValue ofMoney
Price Level
MoneyDemand
QFixed
VME PE
MS1
The Effects of Monetary InjectionValue ofMoney(High)
Price Level(Low)
MoneyDemand
QFixed
VME PE
Low High
MS1
The Effects of Monetary InjectionValue ofMoney(High)
Price Level(Low)
MoneyDemand
QFixed
VME PE
Low High
MS2MS1
The Effects of Monetary InjectionValue ofMoney(High)
Price Level(Low)
MoneyDemand
QFixed
VME PE
Low High
MS2MS1
VME PE
Cause of Inflation:The Quantity of MoneyTheoryQ The quantity of money available in
the economy determines the valueof money. Growth in the quantityof money is the primary cause ofinflation in the long run.
Q In the long run, the quantity ofmoney affects only nominalvariables in the economy.
Monetary NeutralityQ An increase in the rate of money
growth raises the inflation rate butdoes not affect any “real” variables(e.g. real GDP, employment, realwages, and real interest rates.)Such irrelevance of monetarychanges for “real” variables iscalled monetary neutrality.
Q Nominal variables are affected(prices, nominal interest rates,nominal GDP).
Velocity and TheQuantity EquationQ “How many times per year is the
typical dollar bill used to pay for anewly produced good or service?”
Q The velocity of money refers to thespeed at which the typical dollar billtravels around the economy fromwallet to wallet.
Velocity and TheQuantity Equation
V = (P x Y) ÷ MWhere: V = Velocity
P = the average price level Y = the quantity of output M = the quantity of money
Q Rewriting the equation gives the
quantity equation.MV = PY
Five Step Foundation to TheQuantity Theory of Money
�The velocity of money (V) isrelatively stable over time.
�A proportionate change in thenominal value of output (PY) isrelated to changes in the quantity ofmoney (M) by the Fed.
�Because money is neutral, moneydoes not affect output (Y).
Five Step Foundation to TheQuantity Theory of Money
�Therefore, changes in the moneysupply (M) that induce parallelchanges in the nominal value ofoutput (PY) are also reflected inchanges in the price level, sincethey do not affect real output (Y).
�When the Fed increases themoney supply rapidly, the result isa higher rate of inflation.
Hyperinflation &Inflation TaxQ Hyperinflation is inflation that
exceeds 50 percent per month.Q Hyperinflation in some countries is
caused because the governmentprints too much money to pay fortheir spending.X Financing government expenditure
by printing money is calledseigniorage.
Hyperinflation &Inflation TaxQ Financing government expenditure
by printing money increases pricesfor everyone, reducing theirspending power just as a tax tofinance the spending would.
Q This is called an inflation tax.Q The inflation ends when the
government institutes fiscal reformssuch as cuts in governmentspending.
Relationship Between Money,Inflation and Interest RatesQ Nominal Interest Rate (i) =
Real Interest Rate (r) + Inflation Rate (π).Q Over the long run, a change in the money growth
should not affect the Real Interest Rate (r) due tomoney neutrality thus, the Nominal Interest Ratemust adjust one-for-one to changes in the InflationRate.
Q When the Fed increases the rate of money growth,the result is both a high inflation rate and a highernominal interest rate. This is called the Fisher Effect
The Inflation Fallacy
Q Fallacy: “Inflation reducesindividuals’ incomes and causesliving standards to decline.”
Q Fact: “One person’s inflated priceis another’s inflated income.”Unless incomes are fixed innominal terms, the higher pricespaid by consumers are exactlyoffset by the higher incomesreceived by sellers.
The True Costs ofInflationQ The four major costs of inflation
are:X Unproductive activities provoked
by inflation
X Increased variability of relative prices
X Unintended changes in taxliabilities
X Arbitrary redistribution of wealth
Unproductive activitiesprovoked by inflationQ These include:
X shoeleather costs
X menu costs
X confusion and inconvenience
Q All of these reasons lead to peoplepursuing unproductive activities inorder to avoid the effects ofinflation.
Increased Variability ofRelative Prices
Q During times of rising prices, not allprices are increased at the sametime. It then becomes difficult toknow exact relative prices asprices change irregularly.
Q This makes it difficult to makespending decisions that maximizethe people’s standards of living.
Unintended Changes inTax LiabilityQ With inflation, nominal incomes
rise yet real incomes do not.Q Taxes do not differentiate between
nominal and real income, soincome increases are treated asreal gains.
Q With progressive taxation, risingnominal incomes are taxed moreheavily even though people are nobetter off.
Arbitrary Redistribution ofWealth
Q With unexpected inflation, wealth isredistributed between netmonetary debtors and creditors.This may result in wealth transfersthat would not otherwise beacceptable.X Recall the Fisher Effect.
Q People on fixed incomes (seniorson pension for example) are alsomade worse off.
SummaryQ Inflation refers to continuously increasing price levels.Q Price levels are determined in the long run by money
supply and money demand. The more scarce moneyis the higher it’s value and the less money will beneeded to buy things (prices are lower).
Q Higher rates of money growth cause higher inflationrates.
Q Money does not affect real variables (neutrality).Q Higher inflation rates cause higher nominal interest
rates (the Fisher Effect).Q The true costs of inflation include redistribution of
income, tax distortions, changes in relative prices, andunproductive reactions to inflation.
