11/21/2016
1
© 2009 South-Western, a part of Cengage Learning, all rights reserved
C H A P T E R
Money Growth and Inflation
Economics P R I N C I P L E S O F
N. Gregory Mankiw
Premium PowerPoint Slides
by Ron Cronovich
12 In this chapter,
look for the answers to these questions:
How does the money supply affect inflation and
nominal interest rates?
Does the money supply affect real variables like
real GDP or the real interest rate?
How is inflation like a tax?
What are the costs of inflation? How serious are
they?
1
2
Introduction This chapter introduces the quantity theory of money to
explain one of the Ten Principles of Economics from
Chapter 1:
Prices rise when the govt prints too much money.
Most economists believe the quantity theory is a good
explanation of the long run behavior of inflation.
Inflation
Increase in the overall level of prices
Deflation
Decrease in the overall level of prices
Hyperinflation
Extraordinarily high rate of inflation
Inflation
3
Inflation
Economy-wide phenomenon
Concerns the value of economy’s medium of
exchange
Inflation - rise in the price level
Lower value of money
Each dollar - buys a smaller quantity of goods
and services
11/21/2016
2
4
The Value of Money
P = the price level
(e.g., the CPI or GDP deflator)
P is the price of a basket of goods, measured in
money.
1/P is the value of $1, 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.
5
The Classical Theory of Inflation
Money demand
Reflects how much wealth people want to hold in
liquid form
Depends on
Credit cards
Availability of ATM machines
Interest rate
Average level of prices in economy
Demand curve – downward sloping
6
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.
Thus, quantity of money demanded is negatively
related to the value of money and positively
related to P, other things equal.
(These “other things” include real income,
interest rates, availability of ATMs.)
7
The Classical Theory of Inflation
Money supply (MS)
Determined by the Fed, the banking system and
consumers in the real world
Supply curve – vertical
In the long run
Overall level of prices adjusts to:
The level at which the demand for money equals
the supply
In this model, we assume the Fed precisely
controls MS and sets it at some fixed amount.
11/21/2016
3
MONEY GROWTH AND INFLATION 8
The Money Supply-Demand Diagram
Value of Money, 1/P
Price Level, P
Quantity of Money
1 1
¾ 1.33
½ 2
¼ 4
As the value of
money rises, the
price level falls.
MONEY GROWTH AND INFLATION 9
The Money Supply-Demand Diagram
Value of Money, 1/P
Price Level, P
Quantity of Money
1
¾
½
¼
1
1.33
2
4
MS1
$1000
The Fed sets MS
at some fixed value,
regardless of P.
MONEY GROWTH AND INFLATION 10
The Money Supply-Demand Diagram
Value of Money, 1/P
Price Level, P
Quantity of Money
1
¾
½
¼
1
1.33
2
4 MD1
A fall in value of money
(or increase in P)
increases the quantity
of money demanded:
MONEY GROWTH AND INFLATION 11
MS1
$1000
Value of Money, 1/P
Price Level, P
Quantity of Money
1
¾
½
¼
1
1.33
2
4
The Money Supply-Demand Diagram
MD1
P adjusts to equate
quantity of money
demanded with
money supply.
eq’m price level
eq’m value
of money
A
11/21/2016
4
12
How the Supply and Demand for Money Determine the
Equilibrium Price Level
Quantity of Money 0
(high)
(low)
Value of
Money, 1/P
1
¾
½
¼
Price
Level, P
1
1.33
2
4
(high)
(low)
Money
Demand
Quantity fixed
by the Fed
Money Supply
A
Equilibrium
value of
money
Equilibrium
price level
The horizontal axis shows the quantity of money. The left vertical axis shows the value of money, and
the right vertical axis shows the price level. The supply curve for money is vertical because the quantity
of money supplied is fixed by the Fed. The demand curve for money is downward sloping because
people want to hold a larger quantity of money when each dollar buys less. At the equilibrium, point A,
the value of money (on the left axis) and the price level (on the right axis) have adjusted to bring the
quantity of money supplied and the quantity of money demanded into balance.
Effects of a Monetary Injection
Economy – in equilibrium
The Fed doubles the supply of money
Prints bills
Drops them on market
Or: The Fed – open-market purchase
New equilibrium
Supply curve shifts right
Value of money decreases
Price level increases
13
MONEY GROWTH AND INFLATION 14
MS1
$1000
The Effects of a Monetary Injection
Value of Money, 1/P
Price Level, P
Quantity of Money
1
¾
½
¼
1
1.33
2
4 MD1
eq’m price level
eq’m value
of money
A
MS2
$2000
B
Then the value
of money falls,
and P rises.
Suppose the Fed
increases the
money supply.
15
An Increase in the Money Supply
Quantity of
Money
0
(high)
(low)
Value of
Money, 1/P
1
¾
½
¼
Price
Level, P
1
1.33
2
4
(high)
(low)
Money
Demand
M1
MS1
A
When the Fed increases the supply of money, the money supply curve shifts from MS1 to MS2.
The value of money (on the left axis) and the price level (on the right axis) adjust to bring supply
and demand back into balance. The equilibrium moves from point A to point B. Thus, when an
increase in the money supply makes dollars more plentiful, the price level increases, making
each dollar less valuable.
M2
MS2
B
1. An increase
in the money
supply . . .
2. . . .
decreases
the value of
money . . .
3. . . . and
increases the
price level.
11/21/2016
5
Effects of a Monetary Injection Quantity theory of money
The quantity of money available in the economy
determines (the value of money) the price level
Growth rate in quantity of money available
determines the inflation rate
16
Adjustment process
Excess supply of money
Increase in demand of goods and services
Price of goods and services increases
Increase in price level
Increase in quantity of money demanded
New equilibrium 17
The Adjustment Process, Alternatively
How does this work? Short version:
At the initial P, an increase in MS causes
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.
(Other things happen in the short run, which we will
study in later chapters.)
Result from graph: Increasing MS causes P to rise.
Classical Dichotomy
Nominal variables
Variables measured in monetary units
Dollar prices
Real variables
Variables measured in physical units
Relative prices, real wages, real interest rate
Classical dichotomy
Theoretical separation of nominal and real
variables
18 MONEY GROWTH AND INFLATION 19
Real vs. Nominal Variables
Nominal variables are measured in monetary
units.
Examples: nominal GDP,
nominal interest rate (rate of return measured in $)
nominal wage ($ per hour worked)
Real variables are measured in physical units.
Examples: real GDP,
real interest rate (measured in output)
real wage (measured in output)
11/21/2016
6
MONEY GROWTH AND INFLATION 20
Real vs. Nominal Variables
Prices are normally measured in terms of money.
Price of a compact disc: $15/cd
Price of a pepperoni pizza: $10/pizza
A relative price is the price of one good relative to
(divided by) another:
Relative price of CDs in terms of pizza:
price of cd
price of pizza
$15/cd
$10/pizza =
Relative prices are measured in physical units,
so they are real variables.
= 1.5 pizzas per cd
MONEY GROWTH AND INFLATION 21
Real vs. Nominal Wage
An important relative price is the real wage:
W = nominal wage = price of labor, e.g., $15/hour
P = price level = price of g&s, e.g., $5/unit of output
Real wage is the price of labor relative to the price
of output:
W
P = 3 units output per hour
$15/hour
$5/unit of output =
Classical Dichotomy Developments in the monetary system
Influence nominal variables
Irrelevant for explaining real variables
Monetary neutrality
Changes in money supply don’t affect real variables
Not completely realistic in short-run
Correct in the long run
22
If central bank doubles the money supply, classical
thinkers contend that:
all nominal variables – including prices – will double.
all real variables – including relative prices – will
remain unchanged.
23
The Neutrality of Money Monetary neutrality: the proposition that changes
in the money supply do not affect real variables
Doubling money supply causes all nominal prices
to double; what happens to relative prices?
Initially, relative price of cd in terms of pizza is
price of cd
price of pizza = 1.5 pizzas per cd
$15/cd
$10/pizza =
After nominal prices double,
price of cd
price of pizza = 1.5 pizzas per cd
$30/cd
$20/pizza =
The relative price
is unchanged.
11/21/2016
7
MONEY GROWTH AND INFLATION 24
The Neutrality of Money
Similarly, the real wage W/P remains unchanged, so
quantity of labor supplied does not change
quantity of labor demanded does not change
total employment of labor does not change
The same applies to employment of capital and
other resources.
Since employment of all resources is unchanged,
total output is also unchanged by the money supply.
Monetary neutrality: the proposition that changes
in the money supply do not affect real variables
MONEY GROWTH AND INFLATION 25
The Velocity of Money
Velocity of money: the rate at which money
changes hands
Notation:
P x Y = nominal GDP
= (price level) x (real GDP)
M = money supply
V = velocity
Velocity formula: V = P x Y
M
Velocity & the Quantity Equation
Quantity equation: M × V = P × Y
Quantity of money (M)
Velocity of money (V)
Dollar value of the economy’s output of goods and
services (P × Y )
Shows: an increase in quantity of money
Must be reflected in:
– Price level must rise
– Quantity of output must rise
– Velocity of money must fall
26 27
The Velocity of Money: An Example
Example with one good: pizza.
In 2008,
Y = real GDP = 3000 pizzas
P = price level = price of pizza = $10
P x Y = nominal GDP = value of pizzas = $30,000
M = money supply = $10,000
V = velocity = $30,000/$10,000 = 3
The average dollar was used in 3 transactions (it
changed hands 3 times).
Velocity formula: V = P x Y
M
11/21/2016
8
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.
Compute nominal GDP and velocity in 2008.
A C T I V E L E A R N I N G 1
Exercise
28
A C T I V E L E A R N I N G 1
Answers
29
Given: Y = 800, V is constant,
MS = $2000 and P = $5 in 2005.
Compute nominal GDP and velocity in 2008.
Nominal GDP = P x Y = $5 x 800 = $4000
V = P x Y
M =
$4000
$2000 = 2
30
Nominal GDP, the Quantity of Money, and the Velocity of Money This figure shows
the nominal value
of output as
measured by
nominal GDP, the
quantity of money
as measured by
M2, and the
velocity of money
as measured by
their ratio. For
comparability, all
three series have
been scaled to
equal 100 in 1960.
Notice that nominal
GDP and the
quantity of money
have grown
dramatically over
this period, while
velocity has been
relatively stable.
MONEY GROWTH AND INFLATION 31
The Quantity Equation
Multiply both sides of formula by M:
M x V = P x Y
Called the quantity equation
Velocity formula: V = P x Y
M
11/21/2016
9
MONEY GROWTH AND INFLATION 32
The Quantity Theory in 5 Steps
1. V is stable.
2. So, a change in M causes nominal GDP (P x Y)
to change by the same percentage.
3. A change in M does not affect Y:
money is neutral,
Y is determined by technology & resources
4. So, P changes by same percentage as
P x Y and M.
5. Rapid money supply growth causes rapid inflation.
Start with quantity equation: M x V = P x Y
A C T I V E L E A R N I N G 2
Exercise
33
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 C T I V E L E A R N I N G 2
Answers
34
Given: Y = 800, V is constant,
MS = $2000 and P = $5 in 2008.
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.
Nominal GDP = P x Y = M x V (Quantity Eq’n)
P = P x Y
Y
= $4200
800 = $5.25
= $2100 x 2 = $4200
Inflation rate = $5.25 – 5.00
5.00 = 5% (same as MS!)
A C T I V E L E A R N I N G 2
Answers
35
Given: Y = 800, V is constant,
MS = $2000 and P = $5 in 2005.
For 2009, the Fed increases MS by 5%, to $2100.
b. Suppose tech. progress causes Y to increase 3%
in 2009, to 824. Compute 2008-2009 inflation rate.
First, use Quantity Eq’n to compute P:
P = M x V
Y =
$4200
824 = $5.10
Inflation rate = $5.10 – 5.00
5.00 = 2%
11/21/2016
10
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.
A C T I V E L E A R N I N G 2
Summary and Lessons about the Quantity Theory of Money
36
Quantity Theory of Money
1. Velocity of money
Relatively stable over time
2. Changes in quantity of money, M
Proportionate changes in nominal value of
output (P × Y)
3. Economy’s output of goods & services, Y
Primarily determined by factor supplies
And available production technology
Money does not affect output
37
Quantity Theory of Money
4. Change in money supply, M
Induces proportional changes in the nominal
value of output (P × Y)
Reflected in changes in the price level (P)
5. Central bank - increases the money supply
rapidly
High rate of inflation
38
Money and prices during four hyperinflations
Hyperinflation
Inflation that exceeds 50% per month
Price level - increases more than a hundredfold
over the course of a year
Data on hyperinflation
Clear link between
Quantity of money
And the price level
39
11/21/2016
11
40
Money and Prices during Four Hyperinflations
This figure shows the quantity of money and the price level during four hyperinflations. (Note that
these variables are graphed on logarithmic scales. This means that equal vertical distances on
the graph represent equal percentage changes in the variable.) In each case, the quantity of
money and the price level move closely together. The strong association between these two
variables is consistent with the quantity theory of money, which states that growth in the money
supply is the primary cause of inflation. 41
Money and Prices during Four Hyperinflations
This figure shows the quantity of money and the price level during four hyperinflations. (Note that
these variables are graphed on logarithmic scales. This means that equal vertical distances on
the graph represent equal percentage changes in the variable.) In each case, the quantity of
money and the price level move closely together. The strong association between these two
variables is consistent with the quantity theory of money, which states that growth in the money
supply is the primary cause of inflation.
42
Money and Prices during Four Hyperinflations
This figure shows the quantity of money and the price level during four hyperinflations. (Note that
these variables are graphed on logarithmic scales. This means that equal vertical distances on
the graph represent equal percentage changes in the variable.) In each case, the quantity of
money and the price level move closely together. The strong association between these two
variables is consistent with the quantity theory of money, which states that growth in the money
supply is the primary cause of inflation. 43
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part,
except for use as permitted in a license distributed with a certain product or service or otherwise on a password-
protected website for classroom use.
Money and Prices during Four Hyperinflations
This figure shows the quantity of money and the price level during four hyperinflations. (Note that
these variables are graphed on logarithmic scales. This means that equal vertical distances on
the graph represent equal percentage changes in the variable.) In each case, the quantity of
money and the price level move closely together. The strong association between these two
variables is consistent with the quantity theory of money, which states that growth in the money
supply is the primary cause of inflation.
11/21/2016
12
44
The Inflation Tax
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 revenue from printing money is the
inflation tax: printing money causes inflation,
which is like a tax on everyone who holds
money.
45
The Fisher Effect Rearrange the definition of the real interest rate:
The real interest rate is determined by saving &
investment in the loanable funds market.
Money supply growth determines inflation rate.
So, this equation shows how the nominal interest rate is
determined.
Principle of monetary neutrality
An increase in the rate of money growth raises the rate
of inflation but does not affect any real variable
Real interest rate
Nominal interest rate
Inflation rate
+ =
46
The Fisher Effect
In the long run, money is neutral,
so a change in the money growth rate affects
the inflation rate but not the real interest rate.
- When the Fed increases the rate of money growth, the
long-run result is (i) higher inflation rate, and (ii) higher
nominal 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.
Real interest rate
Nominal interest rate
Inflation rate
+ =
47
The Nominal Interest Rate and the Inflation Rate
This figure uses annual data since 1960 to show the nominal interest rate on three-month
Treasury bills and the inflation rate as measured by the consumer price index. The close
association between these two variables is evidence for the Fisher effect: When the inflation rate
rises, so does the nominal interest rate.
11/21/2016
13
MONEY GROWTH AND INFLATION 48
The Fisher Effect & the Inflation Tax
The inflation tax applies to people’s holdings of
money, not their holdings of wealth.
The Fisher effect: an increase in inflation causes
an equal increase in the nominal interest rate,
so the real interest rate (on wealth) is unchanged.
Real interest rate
Nominal interest rate
Inflation rate
+ =
49
The Implications of Inflation
The inflation fallacy: most people think inflation
erodes real incomes (Inflation does not in itself
reduce people’s real purchasing power).
But inflation is a general increase in prices
of the things people buy and the things they sell
(e.g., their labor).
When prices rise
Buyers – pay more
Sellers – get more
In the long run, real incomes are determined by
real variables, not the inflation rate.
MONEY GROWTH AND INFLATION 50
The Costs of Inflation
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 (can be substantial)
Menu costs: the costs of changing prices
Printing new menus, mailing new catalogs, etc.
51
The Costs of Inflation Relative-price Variability and the Misallocation
of Resources:
Relative prices - allocate scarce resources
Consumers – compare quality and prices of
various goods and services
Determine allocation of scarce factors of
production
Inflation - distorts relative prices
Consumer decisions – distorted
Markets - less able to allocate resources to their
best use
11/21/2016
14
52
The Costs of Inflation Tax distortions (Taxes – distort incentives)
- Many taxes - more problematic in the presence of inflation
- Tax treatment of capital gains
Capital gains – Profits:
Sell an asset for more than its purchase price
Higher inflation discourages people from saving
Exaggerates the size of capital gains, increases
the tax burden
- So, inflation causes people to pay more taxes
even when their real incomes don’t increase.
A C T I V E L E A R N I N G 3
Tax distortions
53
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 off inflation to get the
after-tax real interest rate for both cases.
A C T I V E L E A R N I N G 3
Answers
54
a. In which case does the real value of your
deposit grow the most?
In both cases, the real interest rate is 10%,
so the real value of the deposit grows 10%
(before taxes).
Deposit = $1000.
CASE 1: inflation = 0%, nom. interest rate = 10%
CASE 2: inflation = 10%, nom. interest rate = 20%
A C T I V E L E A R N I N G 3
Answers
55
b. In which case do you pay the most taxes?
CASE 1: interest income = $100,
so you pay $25 in taxes.
CASE 2: interest income = $200,
so you pay $50 in taxes.
Deposit = $1000. Tax rate = 25%.
CASE 1: inflation = 0%, nom. interest rate = 10%
CASE 2: inflation = 10%, nom. interest rate = 20%
11/21/2016
15
A C T I V E L E A R N I N G 3
Answers
56
c. Compute the after-tax nominal interest rate,
then subtract off inflation to get the
after-tax real interest rate for both cases.
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%
Deposit = $1000. Tax rate = 25%.
CASE 1: inflation = 0%, nom. interest rate = 10%
CASE 2: inflation = 10%, nom. interest rate = 20%
A C T I V E L E A R N I N G 3
Summary and lessons
57
Inflation…
raises nominal interest rates (Fisher effect)
but not real interest rates
increases savers’ tax burdens
lowers the after-tax real interest rate
Deposit = $1000. Tax rate = 25%.
CASE 1: inflation = 0%, nom. interest rate = 10%
CASE 2: inflation = 10%, nom. interest rate = 20%
Confusion and Inconvenience
Money
Yardstick with which we measure economic
transactions
The Fed’s job
Ensure the reliability of money
When the Fed increases money supply
Creates inflation
Erodes the real value of the unit of account
58 59
A Special Cost of Unexpected Inflation
Arbitrary redistributions of wealth
Unexpected inflation
Redistributes wealth among the population
Not by merit
Not by need
Redistribute wealth among debtors and
creditors
Inflation - volatile & uncertain
When the average rate of inflation is high
11/21/2016
16
Deflation May Be Worse
Small and predictable amount of deflation
May be desirable
The Friedman rule: moderate deflation will
Lower the nominal interest rate
Reduce the cost of holding money
Shoeleather costs of holding money - minimized
by a nominal interest rate close to zero
Deflation equal to the real interest rate
60
Deflation May Be Worse
Costs of deflation
Menu costs
Relative-price variability
If not steady and predictable
Redistribution of wealth toward creditors and
away from debtors
Arises because of broader macroeconomic
difficulties
Symptom of deeper economic problems
61