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Money and InflationMoney and Inflation
The Quantity Theory of MoneyThe Quantity Theory of Money
Economics Senior Seminar 2005Economics Senior Seminar 2005
22
The “Equation of Exchange”The “Equation of Exchange”
MMVV = = PPYYMoney supplyMoney supply x x velocityvelocity = = price levelprice level x x incomeincome
We can treat velocity as fairly constantWe can treat velocity as fairly constant
We know that income is affected by real We know that income is affected by real inputs like the availability of labor, capital, inputs like the availability of labor, capital, and technology—and technology—not not the money supplythe money supply
44
Money Supply and PricesMoney Supply and Prices
MMVV = = PPYY If If velocityvelocity is constant and is constant and incomeincome is not is not
determined by the money supply (in the long determined by the money supply (in the long run), then:run), then: All that’s left is All that’s left is MM and and PP, and they have to move , and they have to move
together.together.
When MWhen M↑↑, P, P↑↑..
5
Money Supply and the Price Level
Source: Mankiw, Principles of Macroeconomics, 3rd ed. (2004), instructor ancillaries
6
Money Supply and the Price Level
Source: Mankiw, Principles of Macroeconomics, 3rd ed. (2004), instructor ancillaries
77
Early KeynesiansEarly Keynesians
Early Keynesians suggested that apparent Early Keynesians suggested that apparent money supply increases were ineffective in money supply increases were ineffective in stopping the Great Depressionstopping the Great Depression
During the Depression, rates on U.S. During the Depression, rates on U.S. Treasury securities dropped very lowTreasury securities dropped very low
Investment also stayed low despite low Investment also stayed low despite low interest ratesinterest rates
Fiscal policy was their prescriptionFiscal policy was their prescription
88
Early MonetaristsEarly Monetarists
In the 1960s, the monetarists showed that In the 1960s, the monetarists showed that Depression-era monetary policy was Depression-era monetary policy was contractionarycontractionary, and that real interest rates , and that real interest rates were actually considerably higher than the were actually considerably higher than the Keynesians had indicated.Keynesians had indicated.
They concluded that in the short run, the Fed They concluded that in the short run, the Fed should have increased the money supply to should have increased the money supply to counteract the contraction caused by bank counteract the contraction caused by bank failures, etc.failures, etc.
99
Costs of InflationCosts of Inflation
““Shoeleather costs”Shoeleather costs”With higher interest rates, the opportunity cost With higher interest rates, the opportunity cost
of holding money is higherof holding money is higherSo people make more frequent transactions So people make more frequent transactions
with a bank to hold lower average money with a bank to hold lower average money balancesbalances
1010
Costs of InflationCosts of Inflation
Menu costsMenu costsInflation means that firms have to change Inflation means that firms have to change
their nominal prices more oftentheir nominal prices more often Print and mail new catalogsPrint and mail new catalogs Communicate new prices to sales forceCommunicate new prices to sales force
1111
Costs of InflationCosts of Inflation
Changing relative costsChanging relative costsNot all prices change at the same rate—some Not all prices change at the same rate—some
are “stickier” than othersare “stickier” than othersTherefore, relative prices changeTherefore, relative prices change
Price level increase
Apples Pears
People switch from apples to pears—decisions are distorted!
1212
Costs of InflationCosts of Inflation
Price “stickiness” is not the only reason for Price “stickiness” is not the only reason for relative price changesrelative price changesWhere the new money enters the economy is Where the new money enters the economy is
important.important.If the government spends the new money first, If the government spends the new money first,
then the things government buys will see then the things government buys will see price increases firstprice increases first Who gains? People who sell to the governmentWho gains? People who sell to the government Who loses? People who are in competition with the Who loses? People who are in competition with the
government, who buy what it buysgovernment, who buy what it buys
1313
Costs of InflationCosts of Inflation
Changing relative costsChanging relative costsPrice of a good may fall out of step with Price of a good may fall out of step with
inflation over time, so that sales timing is inflation over time, so that sales timing is distorteddistorted
Price level
Time
Price of widgetsRelatively high
price—sales low
Relatively low price—sales high
Relatively high price—sales lowPrice
increase
1414
Costs of InflationCosts of Inflation
Loss of informationLoss of informationInconveniences associated with a changing Inconveniences associated with a changing
standardstandard
1515
Costs of InflationCosts of Inflation
Unexpectedly high inflation is redistributiveUnexpectedly high inflation is redistributiveWith fixed interest rates, lenders lose, as With fixed interest rates, lenders lose, as
purchasing power of repayment is lower than purchasing power of repayment is lower than was anticipated.was anticipated.
Borrowers gainBorrowers gain
Unexpectedly low inflation redistributes as Unexpectedly low inflation redistributes as wellwellLenders gain, borrowers loseLenders gain, borrowers lose
1616
Costs of InflationCosts of Inflation
Inflation can create business cyclesInflation can create business cyclesPushing interest rates down can create the Pushing interest rates down can create the
impression that long-term projects are more impression that long-term projects are more profitableprofitable
People invest in those long-term projects by People invest in those long-term projects by buying capital for thembuying capital for them
When the interest rate comes back up from its When the interest rate comes back up from its artificially low levels, the capital investments artificially low levels, the capital investments lose valuelose value
Stock prices drop, people are laid off.Stock prices drop, people are laid off.
1717
Inflation and Business CyclesInflation and Business Cycles
D
S S’
Loanable funds
Inte
rest
ra
te
i’
i
S=I S’=I’
Increase in willingness to save
D
S S+M
Loanable funds
Inte
rest
rat
e
i’
i
S=I I’S’
Unsustainable separation of saving & investment
Increase in money supplyvs.
1818
Hyperinflation in GermanyHyperinflation in Germany
At the end of World War I, Germany was At the end of World War I, Germany was required to pay reparations to the Alliesrequired to pay reparations to the Allies
Germany began running large deficitsGermany began running large deficitsUnable to tax or borrow enough to pay, Unable to tax or borrow enough to pay,
Germany began printing large quantities of Germany began printing large quantities of money.money.
Prices started to rise.Prices started to rise.
1919
Hyperinflation in GermanyHyperinflation in Germany
Price of a Price of a newspaper in newspaper in Germany, Germany, 1921-1923:1921-1923:
January 1921January 1921 0.300.30
May 1922May 1922 11
October 1922October 1922 88
February 1923February 1923 100100
September 1923September 1923 1,0001,000
October 1, 1923October 1, 1923 2,0002,000
October 15October 15 20,00020,000
October 29October 29 1,000,0001,000,000
November 9November 9 15,000,00015,000,000
November 17November 17 70,000,00070,000,000
Date Price in marks
Source: Mankiw, Macroeconomics, 5th ed., pp. 105-106
21
Hyperinflation in Germany
Source: Mankiw, Principles of Macroeconomics, 3rd ed. (2004), instructor ancillaries
2222
Hyperinflation in GermanyHyperinflation in Germany
Fiscal reform ended the inflationFiscal reform ended the inflationAt the end of 1923, the number of government At the end of 1923, the number of government
employees was cut by a thirdemployees was cut by a thirdA new central bank was createdA new central bank was created
This demonstrated a commitment to not printing This demonstrated a commitment to not printing moneymoney
Source: Mankiw, Macroeconomics, 5th ed., pp. 105-106
2323
Hyperinflation in YugoslaviaHyperinflation in Yugoslavia
From 1971-1991, Yugoslavia had an From 1971-1991, Yugoslavia had an average annual inflation rate of 76%average annual inflation rate of 76%Only Zaire and Brazil had a higher inflation Only Zaire and Brazil had a higher inflation
rate.rate.
In December 1990, the Serbian parliament In December 1990, the Serbian parliament ordered the Serbian National Bank (a ordered the Serbian National Bank (a regional central bank) to issue large regional central bank) to issue large amounts of credits to friends of Slobodan amounts of credits to friends of Slobodan Milosevic.Milosevic.
Source: Steve Hanke in April 28, 1999 Wall Street Journal
2424
Hyperinflation in YugoslaviaHyperinflation in Yugoslavia
This amounted to more than half the This amounted to more than half the planned increase in the money supply for planned increase in the money supply for all of Yugoslavia in 1991all of Yugoslavia in 1991
Croatia and Slovenia broke awayCroatia and Slovenia broke awayIn January 1992, hyperinflation beganIn January 1992, hyperinflation began
Source: Steve Hanke in April 28, 1999 Wall Street Journal
2525
Hyperinflation in YugoslaviaHyperinflation in Yugoslavia
In January 1994, the official monthly In January 1994, the official monthly inflation rate reached 313 million percentinflation rate reached 313 million percentThis was the second-highest monthly rate This was the second-highest monthly rate
(after Hungary in 1946)(after Hungary in 1946)……and the second-longest (after the Soviet and the second-longest (after the Soviet
hyperinflation of the early 1920s)hyperinflation of the early 1920s)People spent their time trying to exchange People spent their time trying to exchange
dinars for marks or dollars on the black dinars for marks or dollars on the black marketmarket
Source: Steve Hanke in April 28, 1999 Wall Street Journal
2626
Hyperinflation in YugoslaviaHyperinflation in Yugoslavia
The Yugoslav mint was producing 900,000 The Yugoslav mint was producing 900,000 bank notes a month, in denominations of bank notes a month, in denominations of up to 500 billion dinarsup to 500 billion dinars
Source: Steve Hanke in April 28, 1999 Wall Street Journal; image from National Bank of Serbia
2727
Hyperinflation in YugoslaviaHyperinflation in Yugoslavia
On January 6, 1994, the government gave On January 6, 1994, the government gave up and declared the German mark legal up and declared the German mark legal tendertenderTying a “superdinar” to the mark reduced Tying a “superdinar” to the mark reduced
inflationinflation
Source: Steve Hanke in April 28, 1999 Wall Street Journal
2828
Three Other HyperinflationsThree Other Hyperinflations
Austria (1921-1923) Austria (1921-1923) Hungary (1921-1924)Hungary (1921-1924)Poland (1922-1924)Poland (1922-1924)
29
Hyperinflation in Austria
Source: Mankiw, Principles of Macroeconomics, 3rd ed. (2004), instructor ancillaries
30
Hyperinflation in Hungary
Source: Mankiw, Principles of Macroeconomics, 3rd ed. (2004), instructor ancillaries
3131
Hyperinflation in HungaryHyperinflation in Hungary
1946 hyperinflation was even worse1946 hyperinflation was even worseResulted in largest denomination note ever Resulted in largest denomination note ever
issued by any country:issued by any country:
Image source: Tom Chao’s Paper Money Gallery: http://www.tomchao.com/eu/eu29a.html
100 Million Bil-Pengo (1946): 100,000,000,000,000,000 units
32
Hyperinflation in Poland
Source: Mankiw, Principles of Macroeconomics, 3rd ed. (2004), instructor ancillaries
3333
Inflation TodayInflation Today
1984-19931984-1993 1994-19981994-1998 1999-20031999-2003 20032003
USUS 3.83.8 2.42.4 1.81.8 1.71.7
Advanced Advanced economieseconomies
4.24.2 2.22.2 1.81.8 1.71.7
Developing Developing countriescountries
48.548.5 22.922.9 6.16.1 6.06.0
Transitional Transitional economieseconomies
72.872.8 100.0100.0 20.120.1 8.88.8
Consumer Price Inflation Rates, 1984-2003
Source: http://business.baylor.edu/Steve_Gardner/LECOUT02c.html
3434
Inflation TodayInflation Today
Source: http://www.infoplease.com/ipa/A0762380.html
HIGHEST INFLATION3: 20031. Zimbabwe 383.4%
2. Angola 106.0
3. Myanmar 52.8
4. Haiti 37.3
5. Venezuela 31.1
6. Belarus 30.0
7. Iraq 27.5
8. Malawi 27.4
9. Ghana 26.4
10. Uzbekistan 21.9
3535
Stopping InflationStopping InflationPreserve alternative means of raising fundsPreserve alternative means of raising fundsPrice controlsPrice controls
Hidden inflation—monetary price increases but is not Hidden inflation—monetary price increases but is not measuredmeasured Black market transactionsBlack market transactions Hidden quality deteriorationHidden quality deterioration
Repressed inflation—shortages and queues developRepressed inflation—shortages and queues develop
Central bank independenceCentral bank independence More independent central banks produce less inflationMore independent central banks produce less inflation
Source: http://business.baylor.edu/Steve_Gardner/LECOUT02c.html
3636
Stopping InflationStopping InflationCurrency boardsCurrency boards
Link currency to a trusted foreign currencyLink currency to a trusted foreign currency Can still fail (Argentina) Can still fail (Argentina)
Commodity standardCommodity standard Historically—metals, tobacco, real estate…Historically—metals, tobacco, real estate…
3737
Price StabilityPrice Stability
To minimize uncertainty, Friedman and others To minimize uncertainty, Friedman and others have suggested a have suggested a fixed money growth rate fixed money growth rate rulerule..
New classicals: active monetary and fiscal New classicals: active monetary and fiscal policy is generally a bad idea.policy is generally a bad idea.
However, even countries that have required However, even countries that have required their central banks to follow such rules have their central banks to follow such rules have allowed them some discretion—because it is allowed them some discretion—because it is understood that money growth will have a understood that money growth will have a short-run impact.short-run impact.
3838
What About Gold?What About Gold?
What if the U.S. were to return to a gold What if the U.S. were to return to a gold standard?standard?
Central bank, and/or private banks, would Central bank, and/or private banks, would be required to exchange dollars for gold at be required to exchange dollars for gold at a fixed ratea fixed rate
Appeal: nature fixes supply of gold, not Appeal: nature fixes supply of gold, not subject to political whimsubject to political whim
3939
What About Gold?What About Gold?
David Ricardo (1817):David Ricardo (1817):
““Though it (paper money) has no intrinsic value, yet, Though it (paper money) has no intrinsic value, yet, by limiting its quantity, its value in exchange is as by limiting its quantity, its value in exchange is as great as an equal denomination of coins…. great as an equal denomination of coins…. Experience, however, shows that neither a state nor Experience, however, shows that neither a state nor bank ever has had the unrestricted power of issuing bank ever has had the unrestricted power of issuing paper money without abusing that power…paper money without abusing that power…
4040
What About Gold?What About Gold?
David Ricardo (1817):David Ricardo (1817):
“…“…in all states, therefore, the issue of paper money in all states, therefore, the issue of paper money ought to be under some check and control; and none ought to be under some check and control; and none seems so proper for that purpose as that of subjecting seems so proper for that purpose as that of subjecting the issuers…to the obligation of paying their notes the issuers…to the obligation of paying their notes either in gold coin or bullion.”either in gold coin or bullion.”
4141
What About Gold?What About Gold?
Problem 1: what about the official dollar-to-Problem 1: what about the official dollar-to-gold ratio?gold ratio?Inflation can occur even under a gold standardInflation can occur even under a gold standardAltering the ratio has been doneAltering the ratio has been done
Jan. 31, 1934: FDR changed the dollar from $20.67 Jan. 31, 1934: FDR changed the dollar from $20.67 per ounce to $35 per ounceper ounce to $35 per ounce
Devaluation may impose a credibility cost…Devaluation may impose a credibility cost…but some avoid announcement and allow black but some avoid announcement and allow black
marketsmarkets
4242
What About Gold?What About Gold?
Problem 2: what about emergencies when Problem 2: what about emergencies when the government leaves the gold standard?the government leaves the gold standard?This has been doneThis has been done
1933: FDR prohibited withdrawals of gold or silver1933: FDR prohibited withdrawals of gold or silver 1971: Nixon ended the last vestiges of the gold 1971: Nixon ended the last vestiges of the gold
standard by preventing foreign central banks from standard by preventing foreign central banks from “cashing in” their dollars for gold“cashing in” their dollars for gold
4343
What About Gold?What About Gold?
Gold standard is not foolproof guard Gold standard is not foolproof guard against untrustworthy governmentsagainst untrustworthy governments--But inflation has been higher without it!--But inflation has been higher without it!
4444
What About Gold?What About Gold?
Inflation can still occur under a gold Inflation can still occur under a gold standardstandardWhen Spain imported gold and silver from the When Spain imported gold and silver from the
New World, the money supply in Europe tripled.New World, the money supply in Europe tripled. Spanish prices were 340% higher in 1600 than they Spanish prices were 340% higher in 1600 than they
had been in 1500had been in 1500 England had a price increase of almost 260%England had a price increase of almost 260% France had a rise of about 220%France had a rise of about 220% This is still far less than even the relatively low-This is still far less than even the relatively low-
inflation US in the 20inflation US in the 20 thth century century
4545
Main PointsMain Points
Increases in the money supply produce Increases in the money supply produce increases in pricesincreases in prices
Price increases cause misallocation of Price increases cause misallocation of resourcesresources
Inflation might be reduced by Inflation might be reduced by preserving alternative means of raising fundspreserving alternative means of raising fundscentral bank independencecentral bank independencetying currency to a foreign currency, or tying currency to a foreign currency, or a commodity standarda commodity standard