Money Supply and InflationChap. 30

How does an increase in money supply cause inflation?

Learning Targets:•Neutrality of Money•Real Goods vs. Nominal Goods

What is Inflation?• Inflation has more to do with money losing

value than goods increasing in price. •How tall is a regulation basketball net?

10 ft. (12 inches = 1 foot)•What if the government decided that 6 inches now equal 1 foot instead of 12 inches. Now, how tall is a regulation basketball net?

20 ft•Did the “real” height of the basketball net change? The real height didn’t change, but the nominal height doubled, because the value of a foot was cut in half.

Money is like the “feet” in the last example!Money is merely a “unit of measurement.”

Question:If money loses ½ its value and it costs twice as much to get a haircut, has the real value of that haircut changed?

This is the idea behind …THE “NEUTRALITY” OF MONEY

Changes in the value of money only affect the “nominal” value of goods, not the “real” value.

Real Variables vs. Nominal Variables•Goods measured in dollars are “nominal” variables. •Goods measured in units are “real” variables. ExampleA farmer grows 10 bushels of corn = Real VariableThe Farmer’s income from selling the 10 bushels of corn for $70 = Nominal Variable

The Neutrality of MoneyIf 1 bu. of corn costs $7 and 1 bu. of Wheat costs $3.5Then the “real” value of 1 bu. of corn is 2 bu. of

Wheat …(1bu. Corn = 2 bu. Wheat)

If money loses ½ its value… then 1 bu. Corn = $14 and 1 bu. Wheat = $7So, what is the “real” value of corn and wheat now?

1 bu. Corn = 2 bu. WheatThe real values of real variables have not changed!! It still

takes 1 bu. Corn to buy 2 bu. Wheat!

So, the quantity of money people demand = price of goods = value of $

• If the value of money goes down by 50%, what happens to prices?

–PRICES DOUBLE– What happens to the quantity of money people

will demand?

–QUANTITY OF MONEY PEOPLE DEMAND WILL DOUBLE

Let’s try another example• 1 oz. Gold = $1300• 1 Ford Mustang (2014 Convertible) = $26,000

1 Mustang = 20 Oz. GoldIf Money loses ½ its value, how much will each good cost?($2,600 and $52,000)How many ounces of gold will it now take to buy one

Mustang?20 ounces!

What’s the moral of this story????

If you think the value of money is going to decrease…

• Don’t store your wealth in NOMINAL goods (money)- Inflation hurts people who hold money.

• Store your wealth in REAL goods!The Price of Gold is up 100% in 6 years!

Remind me…When did the Fed. announce their first round of Quantitative easing?

THE VALUE OF REAL GOODS DOESN’T CHANGE WITH INFLATION!

• So, if you are worried about inflation, where should you choose to store your wealth?

MONEY? OR REAL GOODS?

REAL GOODS

Can money really lose value that fast? • Hyperinflation = Periods of time when

inflation is 50% per month or more!

Hyperinflation in Zimbabwe (2007-2008)

Supply and Demand for MONEY• Money has a demand curve and a supply

curve.• What factors determine the demand for

money?– People demand money to buy things– If what you want to buy costs many dollars, your

demand for dollars will be greater.

What factors determine the supply of money?•The Supply of Money is fixed at any given time by the Fed.

Figure 1 Money Supply, Money Demand, and the Equilibrium Price Level

Copyright © 2004 South-Western

Quantity ofMoney

Value ofMoney, 1/P

Price Level, P

Quantity fixedby the Fed

Money supply

0

1

(Low)

(High)

(High)

(Low)

1/2

1/4

3/4

1

1.33

2

4

Equilibriumvalue ofmoney

Equilibriumprice level

Moneydemand

A

Money has a demand curve and a supply curve.

In the long run, prices adjust to the equilibrium between money supply and money demand.

The Quantity Theory of Money

• The quantity of money in the economy determines the value of money.

• So, if there is a lot of money available in the economy, will the value of money be high or low?– low

• What affect will that have on prices?– Higher Prices – (Value of Money = 1/Price of Goods)

Figure 2 The Effects of Monetary Injection

Copyright © 2004 South-Western

Quantity ofMoney

Value ofMoney, 1/P

Price Level, P

Moneydemand

0

1

(Low)

(High)

(High)

(Low)

1/2

1/4

3/4

1

1.33

2

4

M1

MS1

M2

MS2

2. . . . decreasesthe value ofmoney . . .

3. . . . andincreasesthe pricelevel.

1. An increasein the moneysupply . . .

A

B

The Fed decides to increase the money supply. What will be the affect on prices and the value of money?

Figure 4 Money and Prices During Four Hyperinflations

Copyright © 2004 South-Western

(a) Austria (b) Hungary

Money supply

Price level

Index(Jan. 1921 = 100)

Index(July 1921 = 100)

Price level

100,000

10,000

1,000

10019251924192319221921

Money supply

100,000

10,000

1,000

10019251924192319221921

Figure 4 Money and Prices During Four Hyperinflations

Copyright © 2004 South-Western

(c) Germany

1

Index(Jan. 1921 = 100)

(d) Poland

100,000,000,000,000

1,000,000

10,000,000,0001,000,000,000,000

100,000,000

10,000100

Moneysupply

Price level

19251924192319221921

Price levelMoneysupply

Index(Jan. 1921 = 100)

100

10,000,000

100,000

1,000,000

10,000

1,000

19251924192319221921

The Velocity Theory of Money

Velocity and the Quantity Equation

• The velocity of money refers to the speed at which the typical dollar bill travels around the economy from wallet to wallet.

Velocity and the Quantity Equation

V = (P Y)/M

– Where: V = velocityP = the price levelY = the quantity of outputM = the quantity of moneyVELOCITY IS CONSIDERED TO BE FAIRLY

CONTSTANT

Velocity and the Quantity Equation• Rewriting the equation gives the quantity equation:

M V = P YWhat happens if output increases, but Money Supply

stays the same?Prices decrease

What happens if Money Supply increases, but output stays the same?

Prices increaseWhat happens if output increases 10%, and Money Supply

also increases 10%?

Figure 3 Nominal GDP, the Quantity of Money, and the Velocity of Money

Copyright © 2004 South-Western

Indexes(1960 = 100)

2,000

1,000

500

0

1,500

1960 1965 1970 1975 1980 1985 1990 1995 2000

Nominal GDP

Velocity

M2

Velocity has remained stable over time

Velocity and the Quantity Equation

• Rewriting the equation gives the quantity equation:

M V = P Y

So, if velocity has remained stable over time, an increase in the money supply must result in either an increase in prices or an increase in real output!

Velocity and the Quantity Equation

• The quantity equation relates the quantity of money (M) to the nominal value of output (P Y).

Velocity and the Quantity Equation

• The quantity equation shows that an increase in the quantity of money in an economy must be reflected in one of three other variables:– the price level must rise,– the quantity of output must rise, or– the velocity of money must fall.

How Does Inflation Affect Interest Rates?

Some Basic VocabularyNominal Interest Rate = the official interest rate on a loan or investmentReal Interest Rate = real return after taking inflation into account

So, the nominal interest rate is created by the lender/borrower, but the real interest rate is derived…

Real Interest Rate (return) = Nominal rate – Inflation rate

How Does Inflation Affect Interest Rates?

Fisher Effect • Nominal Interest Rate = Real Interest Rate + Inflation RateRemember: Real variables are unaffected by inflation.

So, the nominal rate MUST change 1 to 1, with inflation over the long term

• Inflation benefits borrowers who borrow at fixed rates.

Borrowers PAY the nominal rate, but pay off the loan in “cheaper” dollars in the future.Example: Borrow at nominal 6%, inflation = 10%,

the borrowers effective real rate = -4%• Inflation hurts lenders if they lend at lower interest

rates and then get paid off in money that has lost its value.

Example: LEND at nominal 6%, inflation = 10%, the lenders effective real rate of return = -4%!!

Who wins and who loses with unexpected inflation??

So, if you think inflation will increase where do you want to store your wealth ?

•In your piggy bank?NO

•In gold or silver?YES

•In corn, wheat or other agricultural futures?YES

•In real estate?YES, but be careful

• In Stocks?Think about it… What does stock ownership represent?How about stocks of oil companies??

• In Bonds?Definitely not long-term at fixed rates!

• In a New Car?Sure

• In artwork or other collectibles?O.K.

What Lessons Can be Learned by all this?If you expect inflation to be higher you don’t want to hold money, because it will lose value.

You want to have your money in assets that will increase if prices of everything goes higher.Like what?

Mineral Resources, like oil, copper, gold, silverReal EstateCommodities like farm products (rice, corn, wheat, soybeans)Stocks of companies with good products

What’s your answer?If inflation = 50%The cost of all goods increases by 50%

Now, what would you rather be paid in, bikes or money?If you receive payment in dollars you have a negative 50% return on your investment, because your $1000 is now worth 50% less.

What if you receive payment in bikes?Now, 1 Bike = $150You would rather be paid in 10 Bikes (Real Variable)

Real Variables are not affected by changes in the value of money!!

Does Inflation Hurt Everybody?No.Workers often will get paid more money to compensate for inflation.

If workers wages increase at the same rate as inflation there is no loss to them

What about your savings?Your savings lose value if they don’t earn a rate of interest that matches inflation.

The Federal Funds Rate : The interest rate the Fed charges to lend money to banks. “It’s the rate the Fed can move if it wants to implement changes to money supply.