SEVENTH EDITION

MACROECONOMICS
N. Gregory Mankiw
PowerPoint® Slides by Ron Cronovich

CHAPTER 5
Inflation

© 2010 Worth Publishers, all rights reserved

 In this chapter, you will learn:
 The classical theory of inflation
 causes
 effects
 social costs
 “Classical” – assumes prices are flexible &
markets clear
 Applies to the long run
 The Quantity Theory of Money
 We need a theory that tells us how the quantity
of money is related to other economic variables
such as prices and income.
 A simple theory linking the inflation rate to the
growth rate of the money supply.
 Begins with the concept of velocity…

CHAPTER 4 Money and Inflation 2

 Velocity
 basic concept:
the rate at which money circulates
 definition: the number of times the average
dollar bill changes hands in a given time period
 example: In 2009,
 $500 billion in transactions
 money supply = $100 billion
 The average dollar is used in five transactions
in 2009
 So, velocity = 5
CHAPTER 4 Money and Inflation 3
 Velocity, cont.
 This suggests the following definition:
T
V
M
where
V = velocity
T = value of all transactions
M = money supply

CHAPTER 4 Money and Inflation 4

 Velocity, cont.
 Use nominal GDP as a proxy for total
transactions.
Then, P Y
V 
M
where
P = price of output (GDP deflator)
Y = quantity of output (real GDP)
P Y = value of output (nominal GDP)

CHAPTER 4 Money and Inflation 5

 The quantity equation
 The quantity equation
M V = P Y
follows from the preceding definition of velocity.
 It is an identity:
it holds by definition of the variables.

CHAPTER 4 Money and Inflation 6

 Money demand and the quantity
equation
 M/P = real money balances, the purchasing
power of the money supply.
 A simple money demand function:
(M/P )d = kY
where
k = how much money people wish to hold for
each dollar of income.
(k is exogenous)
 Here the good is the convenience of holding real money balances.

CHAPTER 4 Money and Inflation 7

 Money demand and the quantity
equation
 money demand: (M/P )d = kY
 quantity equation: M V = P Y
 The connection between them: k = 1/V
 When people hold lots of money relative
to their incomes (k is large),
money changes hands infrequently (V is small).

CHAPTER 4 Money and Inflation 8

 Back to the quantity theory of money

 starts with quantity equation

 assumes V is constant & exogenous: V V
Then, quantity equation becomes:

M V  P Y

CHAPTER 4 Money and Inflation 9

 The quantity theory of money, cont.

M V  P Y
How the price level is determined:
 With V constant, the money supply determines
nominal GDP (P Y ).
 Real GDP is determined by the economy’s
supplies of K and L and the production
function (Chap 3).
 The price level is
P = (nominal GDP)/(real GDP).
CHAPTER 4 Money and Inflation 10
 The quantity theory of money, cont.

 Recall from Chapter 2:

The growth rate of a product equals
the sum of the growth rates.
 The quantity equation in growth rates:
M V P Y
  
M V P Y

The quantity theory of money assumes

V
V is constant, so = 0.
V
CHAPTER 4 Money and Inflation 11
CHAPTER 4 Money and Inflation 12
 The quantity theory of money, cont.

 (Greek letter “pi”) P

denotes the inflation rate:  
P
The result from the M P Y
 
preceding slide: M P Y

Solve this result M Y

for :   
M Y

CHAPTER 4 Money and Inflation 13

 The quantity theory of money, cont.
M Y
  
M Y

 Normal economic growth requires a certain

amount of money supply growth to facilitate the
growth in transactions.
 Money growth in excess of this amount leads
to inflation.

CHAPTER 4 Money and Inflation 14

 The quantity theory of money, cont.
M Y
  
M Y

Y/Y depends on growth in the factors of

production and on technological progress
(all of which we take as given, for now).

Hence, the Quantity Theory predicts

a one-for-one relation between
changes in the money growth rate and
changes in the inflation rate.
CHAPTER 4 Money and Inflation 15
  In our model, the quantity theory of money
states that the central bank, which controls the
money supply, has ultimate control over the rate
of inflation. If the central bank keeps the money
supply stable, the price level will be stable. If the
central bank increases the money supply
rapidly, the price level will rise rapidly.

CHAPTER 4 Money and Inflation 16

 Seigniorage
 To spend more without raising taxes or selling
bonds, the govt can print money.
 The “revenue” raised from printing money
is called seigniorage
(pronounced SEEN-your-idge).
 The inflation tax:
Printing money to raise revenue causes inflation.
Inflation is like a tax on people who hold money.

CHAPTER 4 Money and Inflation 20

 Inflation and interest rates
 Nominal interest rate, i
not adjusted for inflation
 Real interest rate, r
adjusted for inflation:
r = i 

CHAPTER 4 Money and Inflation 21

 The Fisher effect
 The Fisher equation: i = r + 
 It shows that the nominal interest rate can change for
two reasons: because the real interest rate changes or
because the inflation rate changes.

 Chap 3: S = I determines r.
 Hence, an increase in 
causes an equal increase in i.
 This one-for-one relationship
is called the Fisher effect.

CHAPTER 4 Money and Inflation 22

NOW YOU TRY:
Applying the theory
Suppose V is constant, M is growing 5% per year,
Y is growing 2% per year, and r = 4.
a. Solve for i.
b. If the Fed increases the money growth rate by
2 percentage points per year, find i.
c. Suppose the growth rate of Y falls to 1% per
year.
 What will happen to  ?
 What must the Fed do if it wishes to
keep  constant?
NOW YOU TRY:
Answers
V is constant, M grows 5% per year,
Y grows 2% per year, r = 4.
a. First, find  = 5  2 = 3.
Then, find i = r +  = 4 + 3 = 7.
b. i = 2, same as the increase in the money
growth rate.
c. If the Fed does nothing,  = 1.
To prevent inflation from rising,
Fed must reduce the money growth rate by
1 percentage point per year.
 Two real interest rates
Notation:
  = actual inflation rate
(not known until after it has occurred)
 E = expected inflation rate
Two real interest rates:
 i – E = ex ante real interest rate:
the real interest rate people expect
at the time they buy a bond or take out a loan
 i –  = ex post real interest rate:
the real interest rate actually realized
CHAPTER 4 Money and Inflation 27
 Fisher Effect
 i = r + E
 The nominal interest rate I moves one-to-one
with changes in expected inflation E.

CHAPTER 4 Money and Inflation 28

 Money demand and
the nominal interest rate
 In the quantity theory of money,
the demand for real money balances
depends only on real income Y.
 Another determinant of money demand:
the nominal interest rate, i.
 the opportunity cost of holding money (instead
of bonds or other interest-earning assets).
 Hence, i   in money demand.

CHAPTER 4 Money and Inflation 29

 The money demand function
(M P )  L (i ,Y )
d

(M/P)d = real money demand, depends

 negatively on i
i is the opp. cost of holding money
 positively on Y
higher Y  more spending
 so, need more money
(“L” is used for the money demand function
because money is the most liquid asset.)
CHAPTER 4 Money and Inflation 30
 The money demand function
(M P )  L (i ,Y )
d

 L (r  E  , Y )
When people are deciding whether to hold
money or bonds, they don’t know what inflation
will turn out to be.
Hence, the nominal interest rate relevant for
money demand is r + E.

CHAPTER 4 Money and Inflation 31

 Equilibrium
M
 L (r  E  , Y )
P
The supply of real
money balances Real money
demand

CHAPTER 4 Money and Inflation 32

 What determines what
M
 L (r  E  , Y )
P
variable how determined (in the long run)
M exogenous (the Fed)
r adjusts to ensure S = I
Y Y  F (K , L )
M
P adjusts to ensure  L (i ,Y )
P

CHAPTER 4 Money and Inflation 33

 How P responds to M
M
 L (r  E  , Y )
P
 For given values of r, Y, and E ,
a change in M causes P to change by the
same percentage – just like in the quantity
theory of money.

CHAPTER 4 Money and Inflation 34

 What about expected inflation?
 Over the long run, people don’t consistently
over- or under-forecast inflation,
so E =  on average.
 In the short run, E may change when people
get new information.
 EX: Fed announces it will increase M next year.
People will expect next year’s P to be higher,
so E rises.
 This affects P now, even though M hasn’t
changed yet….
CHAPTER 4 Money and Inflation 35
 How P responds to E
M
 L (r  E  , Y )
P
 For given values of r, Y, and M ,
 E    i (the Fisher effect)
  M P 
d

  P to make M P  fall
to re-establish eq'm

CHAPTER 4 Money and Inflation 36

CHAPTER 4 Money and Inflation 37
NOW YOU TRY:
Discussion Question
Why is inflation bad?
 What costs does inflation impose on society?
List all the ones you can think of.
 Focus on the long run.
 Think like an economist.
 A common misperception
 Common misperception:
inflation reduces real wages
 This is true only in the short run, when nominal
wages are fixed by contracts.
 (Chap. 3) In the long run,
the real wage is determined by
labor supply and the marginal product of labor,
not the price level or inflation rate.

CHAPTER 4 Money and Inflation 39

 The classical view of inflation

 The classical view:

A change in the price level is merely a change
in the units of measurement.

Then, why is inflation

a social problem?

CHAPTER 4 Money and Inflation 41

 The social costs of inflation

…fall into two categories:

1. costs when inflation is expected

2. costs when inflation is different than

people had expected

CHAPTER 4 Money and Inflation 42

 The costs of expected inflation:
1. Shoeleather cost

 def: the costs and inconveniences of reducing

money balances to avoid the inflation tax.
   i
  real money balances
 Remember: In long run, inflation does not
affect real income or real spending.
 So, same monthly spending but lower average
money holdings means more frequent trips to
the bank to withdraw smaller amounts of cash.
CHAPTER 4 Money and Inflation 43
 The costs of expected inflation:
2. Menu costs

 def: The costs of changing prices.

 Examples:
 cost of printing new menus
 cost of printing & mailing new catalogs
 The higher is inflation, the more frequently
firms must change their prices and incur
these costs.

CHAPTER 4 Money and Inflation 44

 The costs of expected inflation:
3. Relative price distortions

 Firms facing menu costs change prices infrequently.

 Example:
A firm issues new catalog each January.
As the general price level rises throughout the year,
the firm’s relative price will fall.
 Different firms change their prices at different times,
leading to relative price distortions…
…causing microeconomic inefficiencies
in the allocation of resources.

CHAPTER 4 Money and Inflation 45

 The costs of expected inflation:
4. Unfair tax treatment
Some taxes are not adjusted to account for
inflation, such as the capital gains tax.
Example:
 Jan 1: you buy $10,000 worth of IBM stock
 Dec 31: you sell the stock for $11,000,
so your nominal capital gain is $1000 (10%).
 Suppose  = 10% during the year.
Your real capital gain is $0.
 But the govt requires you to pay taxes on your
$1000 nominal gain!!
CHAPTER 4 Money and Inflation 46
 The costs of expected inflation:
5. General inconvenience

 Inflation makes it harder to compare nominal

values from different time periods.
 This complicates long-range financial planning.
 For example, a changing price level complicates
personal financial planning. One important decision that
all households face is how much of their income to
consume today and how much to save for retirement.
the real value of that dollar amount—which will
determine the retiree’s living standard—depends on the
future price level.

CHAPTER 4 Money and Inflation 47

 Additional cost of unexpected inflation:
Arbitrary redistribution of purchasing power
 Many long-term contracts not indexed,
but based on E .
 If  turns out different from E ,
then some gain at others’ expense.
Example: borrowers & lenders
 If  > E , then (i  ) < (i  E )
and purchasing power is transferred from
lenders to borrowers.
 If  < E , then purchasing power is
transferred from borrowers to lenders.
CHAPTER 4 Money and Inflation 48
 Additional cost of high inflation:
Increased uncertainty
 When inflation is high, it’s more variable and
unpredictable:
 turns out different from E more often,
and the differences tend to be larger

 Arbitrary redistributions of wealth

become more likely.
 This creates higher uncertainty,
making risk averse people worse off.

CHAPTER 4 Money and Inflation 49

 One benefit of inflation
 Nominal wages are rarely reduced, even when
the equilibrium real wage falls.
This hinders labor market clearing.
 Inflation allows the real wages to reach
equilibrium levels without nominal wage cuts.
 Therefore, moderate inflation improves the
functioning of labor markets.

CHAPTER 4 Money and Inflation 50

 Hyperinflation

 Common definition:   50% per month

 All the costs of moderate inflation described
above become HUGE under hyperinflation.

 Money ceases to function as a store of value,

and may not serve its other functions (unit of
account, medium of exchange).
 People may conduct transactions with barter
or a stable foreign currency.
CHAPTER 4 Money and Inflation 51
 What causes hyperinflation?
 Hyperinflation is caused by excessive money
supply growth:
 When the central bank prints money, the price
level rises.
 If it prints money rapidly enough, the result is
hyperinflation.

CHAPTER 4 Money and Inflation 52

 Why governments create hyperinflation
 When a government cannot raise taxes or sell
bonds, it must finance spending increases by
printing money.
 In theory, the solution to hyperinflation is simple:
stop printing money.
 In the real world, this requires drastic and painful
fiscal restraint.

CHAPTER 4 Money and Inflation 54

 The Classical Dichotomy
Real variables: Measured in physical units – quantities and relative prices,
for example:
 quantity of output produced
 real wage: output earned per hour of work
 real interest rate: output earned in the future
by lending one unit of output today

Nominal variables: Measured in money units, e.g.,

 nominal wage: Dollars per hour of work.
 nominal interest rate: Dollars earned in future
by lending one dollar today.
 the price level: The amount of dollars needed
to buy a representative basket of goods.

CHAPTER 4 Money and Inflation 55

 The Classical Dichotomy
 Note: Real variables were explained in Chap 3,
nominal ones in Chapter 4.
 Classical dichotomy:
the theoretical separation of real and nominal
variables in the classical model, which implies
nominal variables do not affect real variables.
 Neutrality of money: Changes in the money
supply do not affect real variables.
In the real world, money is approximately neutral
in the long run.
CHAPTER 4 Money and Inflation 56
 Chapter Summary
 Quantity theory of money assumes velocity is stable,
concludes that the money growth rate determines the
inflation rate.
 Seigniorage is the revenue that the government
raises by printing money. It is a tax on money holding.
 Chapter Summary
Nominal interest rate
 equals real interest rate + inflation rate
 the opp. cost of holding money
 Fisher effect: Nominal interest rate moves
one-for-one w/ expected inflation.
Money demand
 depends only on income in the Quantity Theory
 also depends on the nominal interest rate
 if so, then changes in expected inflation affect the
current price level.
 Chapter Summary
Costs of inflation
 Expected inflation
shoeleather costs, menu costs,
tax & relative price distortions,
inconvenience of correcting figures for inflation
 Unexpected inflation
all of the above plus arbitrary redistributions of
wealth between debtors and creditors
 Chapter Summary
Hyperinflation
 caused by rapid money supply growth when
money printed to finance govt budget deficits
 stopping it requires fiscal reforms to eliminate
govt’s need for printing money
 Chapter Summary
Classical dichotomy
 In classical theory, money is neutral--does not
affect real variables.
 So, we can study how real variables are
determined w/o reference to nominal ones.
 Then, money market eq’m determines price level
and all nominal variables.
 Most economists believe the economy works this
way in the long run.