Money Growth and Inflation

Dr. Katherine Sauer

Principles of Macroeconomics
ECO 2010
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Overview:

I.Money Market
II.Classical Dichotomy and Money Neutrality
III.Quantity Theory of Money
IV.Fisher Effect
V.Costs of Inflation

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A little history…
Inflation originally referred to increases in the amount of money
in circulation.

When gold was used as currency:

- government pulls coins out of circulation
- melts them down
- mixes them with other metals
- reissues them at the same nominal value

The government could issue more coins without needing to

increase the amount of gold used to make them.

The money supply would rise, but the value of each coin fell.

Consumers needed more coins to make the same purchases. 3

US:
Currency was printed during the Civil War.

The term inflation referred to the currency depreciation that

happened when the quantity of bank notes exceeded the quantity
of metal available for their redemption.
- did not refer to an increase in prices

In modern times, inflation is an increase in the overall price

level.
The Classical Theory of Inflation: (long run theory)

The price level is inversely related to the value of money.

- if prices are low, don’t need much money to make your
transactions … the value of money is high

- if prices are high, need more money to make your

transactions… the value of money is low

(Think of the value of money as purchasing power.)

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I. Money Market

The money supply is M1 or M2.

- set and controlled by the Fed

The money demand is the amount of money held in “pockets” and

checking accounts. (money needed for transactions)
- determined by purchasing power and the price level

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 The Money Supply is
(1/P) (P) vertical because it is set by
value of price the Fed.
money MS level

It will shift when the Fed

high
changes monetary policy.
low
- Fed buys bonds, MS
shifts right

- Fed sells bonds, MS

shifts left

low high

Quantity of Money 7
 The Money Demand is
(1/P) (P) downward sloping.
value of price - As the value of money
money MS level
falls, the quantity of
money needed to make
high
your purchases rises
low

- As the price level

rises,
the quantity of money
needed to make your
purchases rises
MD high
low
The Money Demand curve
will shift if income
0 changes.
Quantity of Money - increase in income,
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rightward shift
In the long run, the overall price level adjusts to bring money
supply and money demand into equality.
- if money supply > money demand, price level rises
- if money supply < money demand, price level falls

(In the short run, interest rates play a key role)

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 Ex: The effect of a
(1/P) (P) monetary injection
value of price
money MS MS2 level
1) Fed buys bonds
high
2) Money Supply increases
low
(shifts right)
value1 P1
3) value of money falls and
value2 P2 price level rises (inflation)

4) quantity of money rises

MD high
low

QM1 QM2
Quantity of Money
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 Ex: The effect of a
(1/P) (P) decrease in consumer
value of price incomes
money MS level

1) Lower incomes mean

high
fewer transactions
low

value1 P1 2) Money Demand

decreases (shifts left)
value2 P2
3) value of money falls and
price level rises (inflation)
MD high
low
MD2 4) quantity of money stays
QM1
constant
Quantity of Money
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 To counteract the rising
(1/P) (P) price level, the Fed may
value of price wish to contract the money
money MS2 MS level
supply and stabilize prices.
high
1) Fed sells bonds
low

value1 P1 P3 2) Money Supply decreases

value3

value2 P2 3) Value of money and

price level stabilize at
initial level
MD high
low
MD2

QM3 QM1
Quantity of Money
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II. The Classical Dichotomy and Money Neutrality

Divide all economic variables into 2 groups:

- nominal (measured in monetary units)
- real (measured in physical units)

This separation of real and nominal variables is called the

classical dichotomy.

Money Neutrality says that changes in the money supply will

affect nominal variables but not real variables.
(true in long run, not in short run)

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III. The Quantity Theory of Money (monetarists)

The quantity of money determines its value and the price level.

Inflation is caused by growth in the money supply.

(How the price level is determined and why it changes over time.)

The Quantity Equation:

M V = P Y

M: money supply (M1 or M2)

P: price level (CPI or GDPdeflator)
Y: real GDP
V: velocity of money: rate at which money circulates
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The term of P Y is nominal GDP.

The quantity equation shows that when the money supply changes,
the price level, velocity, or real GDP must change.

M V = P Y

M=PY
V
For the US, velocity has been fairly stable over time.

M V = P Y

So, an increase in the money supply will increase nominal GDP.

If money neutrality is true, then real variables aren’t affected by

changes in the money supply.

M V = P Y

So, any increase in the money supply will cause an increase in

the price level.

In other words, an increase in the money supply leads to

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inflation.
This is assuming that the change is initiated by a change in the
money supply.

If the change stems from an increase in RGDP, then the money

supply can grow without causing inflation.

Recap: if velocity is constant and money neutrality is true, then any

increase in the money supply will cause a proportional increase in the
price level (inflation)

We will usually assume velocity is constant, but not necessarily that

money neutrality is true.

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Example: In 2002 the Money Supply was $200b and the GDP
deflator was 4. In 2003 the Money Supply was $240b, the GDP
deflator was 4.6, and nominal GDP was $1200b.

Assuming velocity is stable, by how much did real GDP change?

2002 2003
MV = PY MV = PY
200V = 4Y 240V = 1200
200x5=4Y V=5
1000 = 4Y
250 = Y PY = 1200
4.6Y=1200
Y = 260.9

Between 2002 and 2003 real GDP increased by $10.9b.

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IV. The Fisher Effect

Recall: i = r + Π

The Supply and Demand for Loanable funds determine the real
interest rate.

Growth in the money supply determines the inflation rate.

The Fisher Effect is the one for one adjustment of the nominal
interest rate to the rate of inflation.
- long run (in the short run inflation can be unexpected)

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V. The Costs of Inflation

Inflation reduces purchasing power in many different ways:

1. Shoeleather costs are the resources that are wasted when

inflation encourages people to decrease their money holdings.
- cost, time, inconvenience of physically getting more
cash

2. Menu costs are the costs of physically changing prices.

- reprint menu
- new price tags on shelves
- update electronic database

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3. Relative price variability and misallocation of resources
- not all prices can adjust immediately because of contracts

4. Arbitrary redistribution of wealth

- helps borrowers, harms lenders

5. Tax distortions
- the nominal value of interest and capital gains are taxed

6. Confusion and inconvenience

Note on hyperinflation:

Hyperinflation is inflation that exceeds 50% per month.

It usually occurs when the government prints way to much

money to pay for things.

Historical Examples:

In the 1920s, the Weimar Republic of Germany was issuing

2trillion Mark notes
- postage stamps had a face value of 50 billion Mark
- largest note was 100trillion Mark
- exchange rate was 1 US dollar to 4trillion Mark

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In 1946 the Hungarian National Bank issued the largest
denomination banknote ever issued for circulation
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100 quintillion pengo 10

“hundred million billion” pengo

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Hungary’s hyperinflation held the record for the highest monthly
inflation rate ever.
41,900,000,000,000,000% (4.19 × 1016%) in July, 1946

This meant prices doubled every 13.5 hours.

More recently, Zimbabwe has experienced hyperinflation and as of

February 2009 people stopped using the currency all together.

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It is not a secret that increasing the money supply by too much
will cause hyperinflation.

So why do some governments still do it?

Governments may print money to pay for purchases or to pay off

debt. (seigniorage revenue)
- The US does not do this!!!!!!

This increases the money supply and results in inflation so

everyone’s purchasing power falls.

All money becomes less valuable as more is printed and so the

price level rises.

It is as if there is a “tax” on everyone who holds money.

The Inflation Tax 26