Chapter 16
Money Growth and Inflation
Principles of Macroeconomics: Ch. 16 Second Canadian Edition
Overview
The causes of inflation
Money supply, demand and
equilibrium
The effects of monetary injection
The quantity of money theory
The costs of inflation
Principles of Macroeconomics: Ch. 16 Second Canadian Edition
Inflation: Its Causes and Costs
Inflation is a sustained increase in the
price level. It is a continuous increase
versus a “once-and-for-all” increase in
prices.
Inflation deals with the increase in the
average of prices and not just
significant increases in the price of a
few goods.
Principles of Macroeconomics: Ch. 16 Second Canadian Edition
Inflation: Historical Aspects
Over the past sixty years, prices have risen
on average about 4 percent per year.
Deflation, a situation of decreasing prices,
occurred in the nineteenth century.
In the 1970’s prices rose by 7 percent per
year.
In the 1990’s prices rose about 2 percent
per year.
Principles of Macroeconomics: Ch. 16 Second Canadian Edition
The Causes of Inflation
Inflationis an economy-wide monetary
phenomenon that concerns, first and
foremost, the value of an economy’s
medium of exchange.
To understand the cause of inflation as
a monetary phenomenon we must
understand the concepts of Money
Supply, Money Demand, and Monetary
Equilibrium.
Principles of Macroeconomics: Ch. 16 Second Canadian Edition
Overview
Thecauses of inflation
Money supply, demand and
equilibrium
The effects of monetary injection
The quantity of money theory
The costs of inflation
Principles of Macroeconomics: Ch. 16 Second Canadian Edition
Money Supply and Money Demand
Money Supply is a variable of the Bank
of Bangladesh. Through instruments
such as open market operations, the B
of B directly controls the quantity of
money supplied.
Money Demand has several
determinants including:
– interest rates
– average level of prices in the economy
Principles of Macroeconomics: Ch. 16 Second Canadian Edition
Money Supply and Money Demand
People hold money because it is the
medium of exchange. The amount of
money people choose to hold depends
on the prices of the goods and
services.
In the long-run, the overall level of
prices adjusts to the level at which the
demand for money equals the supply.
Principles of Macroeconomics: Ch. 16 Second Canadian Edition
Money Supply, Money Demand and
Equilibrium Price Level
Value of Money Supply Price
Money Level
Equilibrium
Equilibrium
Price Level
Value of
Money
Money
Demand
QFixed
Principles of Macroeconomics: Ch. 16 Second Canadian Edition
Monetary Equilibrium
The B of B could inject money
(monetary injection) into the economy
by buying government bonds. Results
would be:
– The supply curve shifting to the right
– The equilibrium value of money decreasing
– The equilibrium price level increasing
This process is referred to as the
quantity theory of money.
Principles of Macroeconomics: Ch. 16 Second Canadian Edition
Overview
The causes of inflation
Money supply, demand and
equilibrium
The effects of monetary injection
The quantity of money theory
The costs of inflation
Principles of Macroeconomics: Ch. 16 Second Canadian Edition
The Effects of Monetary Injection
Value of MS1 Price
Money Level
Money
Demand
QFixed
Principles of Macroeconomics: Ch. 16 Second Canadian Edition
The Effects of Monetary Injection
Value of MS1 Price
Money Level
VM E PE
Money
Demand
QFixed
Principles of Macroeconomics: Ch. 16 Second Canadian Edition
The Effects of Monetary Injection
Value of MS1 Price
Money Level
(High) (Low)
VM E PE
Money
Low Demand High
QFixed
Principles of Macroeconomics: Ch. 16 Second Canadian Edition
The Effects of Monetary Injection
Value of MS1 MS2 Price
Money Level
(High) (Low)
VM E PE
Money
Low Demand High
QFixed
Principles of Macroeconomics: Ch. 16 Second Canadian Edition
The Effects of Monetary Injection
Value of MS1 MS2 Price
Money Level
(High) (Low)
VM E PE
VME PE
Money
Low Demand High
QFixed
Principles of Macroeconomics: Ch. 16 Second Canadian Edition
Overview
The causes of inflation
Money supply, demand and
equilibrium
The effects of monetary injection
The quantity of money theory
The costs of inflation
Principles of Macroeconomics: Ch. 16 Second Canadian Edition
Cause of Inflation:
The Quantity of Money Theory
The quantity of money available in the
economy determines the value of
money. Growth in the quantity of
money is the primary cause of
inflation.
Some macroeconomic variables are
unchanged, given changes in the
supply of money. (Hume)
Principles of Macroeconomics: Ch. 16 Second Canadian Edition
Monetary Neutrality
An increase in the rate of money
growth raises the inflation but does
not affect any “real” variables (e.g.
production, employment, real wages,
and real interest rates.) Such
irrelevance of monetary changes for
“real” variables is called monetary
neutrality.
Principles of Macroeconomics: Ch. 16 Second Canadian Edition
Velocity and The Quantity Equation
“How many times per year is the
typical dollar bill used to pay for a
newly produced good or service?”
The velocity of money refers to the
speed at which the typical dollar bill
travels around the economy from
wallet to wallet.
Principles of Macroeconomics: Ch. 16 Second Canadian Edition
Velocity and The Quantity Equation
V = (P x Y) ÷ M
Where: V = Velocity
P = The average price level
Y = the quantity of output
M = the quantity of money
Rewriting the equation gives the
quantity equation.
MxV=PxY
Principles of Macroeconomics: Ch. 16 Second Canadian Edition
Five Step Foundation to The Quantity
Theory of Money
The velocity of money is relatively
stable over time.
A proportionate change in the
nominal value of output is related to
changes in the quantity of money by
the B of C.
Because money is neutral, money
does not affect output.
Principles of Macroeconomics: Ch. 16 Second Canadian Edition
Five Step Foundation to The Quantity
Theory of Money
Changes in the money supply which
induce parallel changes in the nominal
value of output are also reflected in
changes in the price level.
When the B of C increases the money
supply rapidly, the result is a high rate
of inflation.
Principles of Macroeconomics: Ch. 16 Second Canadian Edition
Hyperinflation & Inflation Tax
Hyperinflation is inflation that exceeds
50 percent per month.
Hyperinflation in some countries is
caused because the government prints
too much money to pay for their
spending.
Principles of Macroeconomics: Ch. 16 Second Canadian Edition
Hyperinflation & Inflation Tax
When the government raises revenue
by printing money, it is said to levy an
inflation tax. An inflation tax is like a
tax on everyone who holds money.
The inflation ends when the
government institutes fiscal reforms
such as cuts in government spending.
Principles of Macroeconomics: Ch. 16 Second Canadian Edition
Relationship Between Money, Inflation
and Interest Rates
Nominal Interest Rate =
Real Interest Rate + Inflation Rate
Over the long run, a change in the
money growth should not affect the
Real Interest Rate thus, the Nominal
Interest Rate must adjust one-for-one
to changes in the Inflation Rate.
Principles of Macroeconomics: Ch. 16 Second Canadian Edition
Relationship Between Money, Inflation
and Interest Rates
When the B of C increases the rate of
money growth, the result is both a high
inflation rate and a higher nominal
interest rate. This is called the
Fisher Effect
Principles of Macroeconomics: Ch. 16 Second Canadian Edition
Quick Quiz!
The government of a
country increases the
growth rate of the money
supply from 5 percent per
year to 50 percent per year.
What happens to prices?
What happens to nominal
interest rates?
Why would the government
be doing this?
Principles of Macroeconomics: Ch. 16 Second Canadian Edition
Overview
The causes of inflation
Money supply, demand and
equilibrium
The effects of monetary injection
The quantity of money theory
The costs of inflation
Principles of Macroeconomics: Ch. 16 Second Canadian Edition
The Costs of Inflation
At least six costs of inflation are
identified as:
1 . Shoeleather costs
2 . Menu Costs
3 . Increased variability of relative prices
4 . Tax liabilities
5 . Confusion and inconvenience
6 . Arbitrary redistribution of wealth
Principles of Macroeconomics: Ch. 16 Second Canadian Edition
The Costs of Inflation:
Shoeleather Costs
Inflation reduces the real value of
money, so people have an incentive to
minimize their cash holdings. Less
cash requires people to make frequent
trips to the bank because they keep
their money in interest bearing
accounts.
Extra trips to the bank takes time away
from productive activities.
Principles of Macroeconomics: Ch. 16 Second Canadian Edition
The Costs of Inflation:
Menu Costs
During inflationary times, it is
necessary to update price lists and
other posted prices.
This is a resource-consuming process
that takes away from other productive
activities.
Principles of Macroeconomics: Ch. 16 Second Canadian Edition
The Costs of Inflation:
Increased Variability of Relative Prices
During times of rising prices, there will
be a delay between price increases.
While these prices are constant, other
prices will be rising. It then becomes
difficult to know exact relative prices
as prices change irregularly.
Principles of Macroeconomics: Ch. 16 Second Canadian Edition
The Costs of Inflation:
Unintended Changes in Tax Liability
With inflation, unadjusted incomes are
treated as real gains. Consequently,
with progressive taxation, rising
nominal incomes are taxed more
heavily.
Principles of Macroeconomics: Ch. 16 Second Canadian Edition
The Costs of Inflation:
Confusion and Inconvenience
With rising prices, it is necessary to
constantly make corrections in order
to compare real revenues, costs, and
profits over time. The time spent
making these adjustments could have
been spent producing more goods and
services.
Principles of Macroeconomics: Ch. 16 Second Canadian Edition
The Costs of Inflation:
Arbitrary Redistribution of Wealth
With unanticipated or incorrectly
anticipated inflation, wealth is
redistributed between net monetary
debtors and creditors. This may result
in wealth transfers that would not
otherwise be acceptable.
– Recall the Fisher Effect.
Principles of Macroeconomics: Ch. 16 Second Canadian Edition
The Inflation Fallacy
Fallacy: “Inflation reduces individuals’
incomes and causes living standards
to decline.”
Fact: “One person’s inflated price is
another’s inflated income.” Unless
incomes are fixed in nominal terms,
the higher prices paid by consumers
are exactly offset by the higher
incomes received by sellers.
Principles of Macroeconomics: Ch. 16 Second Canadian Edition
Overview
The causes of inflation
Money supply, demand and
equilibrium
The effects of monetary injection
The quantity of money theory
The costs of inflation
Principles of Macroeconomics: Ch. 16 Second Canadian Edition
