chapter 11 inflation and the quantity theory of money

Modern Principles: Macroeconomics

Tyler Cowen

and Alex Tabarrok

Copyright © 2010 Worth Publishers • Modern Principles: Macroeconomics • Cowen/Tabarrok

Chapter 11

Inflation and the Quantity Theory of Money

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Introduction

• Robert Mugabe, president of Zimbabwe had a problem. His policies pushed his country, once called the

breadbasket of Africa, to the verge of starvation.

With nothing left to tax he turned to the last refuge of needy governments, the printing press.

Result: Hyperinflation• Inflation went from 50 percent a year to 50

percent a month to 50 percent a day!

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Introduction

• In this chapter, we learn… How inflation is defined and measured What causes inflation The costs and benefits of inflation Why governments sometimes resort to

inflation.

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Defining and Measuring Inflation

• Inflation: an ↑in the average level of prices.

• Measured using the following formula.

• The average change of all prices. Some prices go up and some go down. Think of an elevator containing many prices that

change relative to each other. As the elevator rises, all of the prices rise. The following figure may help.

100P

PPrate Inflation

1-t

1-tt

Where Pt is the average price level in year t

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At any one point in time some prices are going upand some are going down. Inflation is an increase in the price level.

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• Price Indexes are used to measure inflation. An index is a number that compares the price

level in one period relative to the prices in some base year.

An index is only a number; it is not expressed in dollars.

There are several price indexes• Consumer price index (CPI)• Producer price index (PPI)• GDP deflator

Let’s take a closer look at each of these…

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1.CPI: The average price of goods bought by a typical American consumer. Covers 80,000 goods. Weighted so that higher priced items count more.

2.Producer price indexes (PPI): The average price received by producers. Includes intermediate goods as well as final goods.

3.GDP deflator: Measures the average price of all final goods and services.

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Defining and Measuring Inflation• Inflation in the United States and Around

the World

• Using the CPI to calculate real prices• Real price is the price of a good that has

been corrected for inflation. Example:

• 1982 price of gasoline was $1.25/gal• 2006 it was double that at $2.50/gal.• CPI was 100 in 1982 and 202 in 2006.• Conclusion: The real price of gasoline

was about the same in 2006 as it was in 1982.

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• Inflation in the United States and Around the World (cont.) Hyperinflation: extremely high rates of inflation

that make inflation in the U.S. look pretty tame by comparison.

A lot of governments have fallen into the trap of inflating their currency in order to pay debts.

The next table shows some pretty dramatic examples.

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• Inflation in the United States and Around the World (cont.)

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• Inflation in the United States and Around the World (cont.)• Hungary’s hyperinflation is the highest on

record. What cost 1 Hungarian pengo in 1945 cost

1.3 septillion pengos at the end of 1946. Prices doubled every 15 hours!

World's highest denomination banknote Hungary (1946) 100 Quintillion pengo

100,000,000,000,000,000,000

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CHECK YOURSELFIf the CPI was 120 this time last year and is

125 right now, what is the inflation rate?If the inflation rate goes from 1 percent to 4

percent to 7 percent over two years, what will happen to the prices of the great majority of goods: will they go up, stay the same, go down, or do you not have enough information to say?

Why do we use real prices to compare the price of goods across time?

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The Quantity Theory of Money

• The quantity theory of money does two things:1. Sets out the general relationship between

inflation, money, real output, and prices.

2. Presents the critical role of the money supply in regulating the level of prices.

• For the nation as a whole…

Velocity (vaverage number of times that a dollar is spent on goods and services in a year.

GDP RealRY money ofVelocity

level PriceP Supply Money M

v

v RPYM

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• The quantity theory of money depends on two assumptions…1. Real GDP is stable compared to the

money supply.

• Real GDP is fixed by the real factors of production—capital, labor, and technology.

• The growth rate of real GDP is limited by how fast these factors can increase.

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• The quantity theory of money depends on two assumptions…(cont.)2. The velocity of money, v, is stable compared

to the money supply.• It is determined by various factors such as:

Whether workers are paid monthly or biweekly.

How long it takes to clear a check or electronic transaction.

How easy it is to find an ATM.• Factors like these may change, but they will

change slowly.

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• The Cause of Inflation The quantity theory is a theory of inflation.

If YR is fixed by real factors of production and v is stable, then it follows that inflation is caused by an increase in the supply of money.

The quantity theory of money can also be written in terms of growth rates:

• Which translates as: Growth rate of money + growth rate of v is

identically equal to the rate of inflation + growth rate of real GDP.

RYPvM

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• The Cause of Inflation (cont.) Important implication: If the growth rates of v

and YR are small compared to the growth rate of M, the rate of inflation will be approximately equal to the increase in money supply.

v RYMP Inflation, of Rate

MP Or more generally:

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• The Cause of Inflation (cont.) One of the most important truths of economics.

• “Inflation is always and everywhere a monetary phenomenon”, Milton Friedman, Nobel Prize Winner Milton Friedman (1912-2006)

• Ph.D. - Columbia University• Professor - University of

Chicago• Leader of the Chicago

“school of economics”

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• The Cause of Inflation (cont.) How well does the theory hold up?

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• The Cause of Inflation (cont.)

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• The Cause of Inflation (cont.) Some Important Caveats:

1. If M and v grow more slowly than YR, prices will fall; this is called deflation.

2. Changes in velocity will affect prices. Hyperinflation: People will spend their

money faster (increase v) → even faster increase in prices.

Great Depression: Fear → ↓spending (decreased v) → deflation → worse depression.

3. In the long run, money is neutral.

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• An Inflation Parable Under some circumstances, changes in M can temporarily change YR. Let’s

see how… Consider a mini-economy consisting of a baker, tailor, and carpenter who buy

and sell products among themselves.

Government prints money to pay army

Soldiers buy frombaker, tailor, and carpenter

All three workharder to increase output and raise theirprices.

When the baker, tailor,and carpenter go to buyfrom each other, they find they are no better off than before because of higher prices

Eventually they catch on and stopworking harder to produce more output.

At first

Conclusion: Increase in M can boost the economy in the short run but as firms and workers come to expect and adjust to the influx of new money, output (real GDP) will not grow any faster than normal.

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CHECK YOURSELF

In the long run, what causes inflation?What is the equation that represents

the quantity theory of money?

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The Costs of Inflation

• If all prices including wages are going up, then what is the problem with inflation?

• We will look at four problems with inflation.1. Price confusion and money illusion.

2. Inflation redistributes wealth.

3. Inflation interacts with other taxes.

4. Inflation is painful to stop.

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1. Price Confusion and Money Illusion Price confusion

• Inflation makes price signals more difficult to interpret.

• A decision maker does not always know if the price of a product is increasing… Because of increased demand or As a result of all prices going up with

inflation.

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1. Price Confusion and Money Illusion (cont.) Money Illusion: when people mistake

changes in nominal prices for changes in real prices.• Example: Mary receives a 10% increase in

salary. Feeling she can now afford it, she takes on a higher mortgage payment. The rate of inflation is 10% and she is no better off in terms of real salary. She now has a higher house payment and is in danger of losing her home.

• Result: resources are wasted in unprofitable activities.

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2. Inflation Redistributes Wealth Inflation is type of tax. It transfers wealth to the

government.

• Even tax cheats can’t avoid this tax!

• Governments that print money to pay their bills are using this type of tax.

Inflation redistributes wealth among the public.

• The real rate of return for a lender is given by…

rateInflation

rateinterest Nominal return, of rate Actual

actual

actual

ir

ir

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2. Inflation Redistributes Wealth (cont.) Example:

• Suppose a bank makes a 30 year home loan at an interest rate of 7%. If the rate of inflation is 3% over that period: bank’s actual rate of return = 7% - 3% = 4%

• If inflation rises unexpectedly to 13% as it did in late 1970s, the actual rate of return = 7% - 13% = - 6%! The lender is now losing money on the

loan. The borrower gains.

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2. Inflation Redistributes Wealth (cont.) What happens if people expect inflation to go

up?• Lenders will increase nominal rates of

interest.• Fisher effect: the tendency for nominal

interest rates to rise with expected inflation. This effect says that the nominal rate of

interest will be equal to expected inflation rate plus the equilibrium rate of return.

The Fisher effect is seen in the next diagram.

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The Costs of Inflation2. Inflation Redistributes Wealth (cont.)

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2. Inflation Redistributes Wealth (cont.) The actual rate of return: determined in

large part by the difference between expected inflation and actual inflation.

From earlier equations we have:(2) mequilibriu and (1) actual rEiπir

mequilibriuactual )( rEr

Substituting i from equation (2) into equation (1) we get:

The following table summarizes what we learn from this result.

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2. Inflation Redistributes Wealth (cont.)

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2. Inflation Redistributes Wealth (cont.) Monetizing the debt: when the government

pays off its debts by printing money.

• Why don’t they always inflate their debt away? Two reasons:

1. The Fisher effect: if banks know the government is doing this, they will simply raise interest rates.

2. Political cost: People who buy government bonds usually vote.

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2. Inflation Redistributes Wealth (cont.) Workers and firms are affected by inflation.

• Wage agreements are often made several years in advance. Underestimating inflation → wages being

too low → supply of labor: too low. Overestimating inflation → wages being

too high → demand for labor: too low. Conclusion: errors in estimating the rate of

inflation → a misallocation of resources → lower economic growth.

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2. Inflation Redistributes Wealth (cont.) Hyperinflation and the Breakdown of Financial

Intermediation

• If inflation is moderate and stable: Lenders and borrowers can forecast well. Loans can be signed with rough certainty

regarding the value of future payment.

• If inflation is high and volatile: Long-term risk becomes high and loans

may not be signed at all. Financial intermediation breaks down. Let’s look at some examples…

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The Costs of Inflation Hyperinflation and the Breakdown of Financial

Intermediation (cont.)• Peru (1987-1992)

Private loans virtually disappeared. Investment fell and the economy collapsed.

• Mexico 1980s: Inflation rate at times exceeded 100%.

• Long-term loans were hard to get.

• As recently as 2002, 90% of debt matured within one year.

Since the 1990s: inflation has been tamed. Result: rapidly growing capital markets and

increased investment.

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2. Inflation Redistributes Wealth (cont.) Conclusions:

1. Unexpected inflation redistributes wealth throughout society in arbitrary ways.

2. When inflation is high and volatile Unexpected inflation is difficult to

avoid. Long-term contracting grinds to a

halt.

• Result: economic growth suffers.

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3. Inflation Interacts with Other Taxes Inflation will produce tax burdens and tax

liabilities that do not make economic sense.• People pay taxes on illusory capital gains.

Example: Taxes are collected on nominal capital gains.

Results: • Longer-run effect is to discourage

investment in the first place.• Inflation increases the costs of complying

with the tax system.

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4. Inflation is Painful to Stop Slowing down the money supply can create a

recession. A good lesson:

• Inflation in 1980 was 13.5%.• Tough monetary policy reduced the rate of

inflation to 3%, but the consequence was… The worst recession since the Great

Depression. Unemployment rate over 10%. The unemployment rate didn’t return to

near 5.5% until 1988.

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CHECK YOURSELFConsider unexpected inflation and

unexpected disinflation. How is wealth redistributed between borrowers and lenders under each case?

What happens to nominal interest rates when expected inflation increases? What do we call this effect?

What does unexpected inflation do to price signals?

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Takeaway

• Inflation is an increase in the average level of prices as measured by an index such as the CPI.

• Sustained inflation is always and everywhere a monetary phenomenon.

• Inflation makes price signals difficult to interpret. This is especially true when people may

suffer from money illusion.

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Takeaway

• Workers and firms adjust to predictable inflation by incorporating inflation rates into wages and contract agreements.

• Anything above a mild sustained inflation is bad for the economy.

Modern Principles: Macroeconomics

Tyler Cowen and Alex Tabarrok

Copyright © 2010 Worth Publishers • Modern Principles: Macroeconomics • Cowen/Tabbarrok

Chapter 11 Appendix:

Get Real! An Excellent Adventure

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Get Real! An Excellent AdventureSuppose you want to convert a nominaldata series into a inflation-corrected orreal data series.Step I: Download your data into a spreadsheet.

Source: http://www.census.gov/const/www/newressalesindex.html

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Get Real! An Excellent AdventureSuppose you want to convert a nominaldata series into a inflation-corrected orreal data series.Step I: Download your data into a spreadsheet.Step II: We need a price index. Input your data into your spreadsheet.

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Get Real! An Excellent AdventureSuppose you want to convert a nominaldata series into a inflation-corrected orreal data series.Step I: Download your data into a spreadsheet.Step II: We need a price index. Input your data into your spreadsheet.Step III: Calculate your deflator. You do this by dividing all of the CPIs by the CPI in the period you use as the “base period”. In this case it is August 2006. The deflator equals 1 in the base period.

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Get Real! An Excellent Adventure

Suppose you want to convert a nominaldata series into a inflation-corrected orreal data series.Step I: Download your data into a spreadsheet.Step II: We need a price index. Input your data into your spreadsheet.Step III: Calculate your deflator. You do this by dividing all of the CPIs by the CPI in the period you use as the “base period”. In this case it is August 2006. The deflator equals 1 in the base period.Step IV: Divide the average house price by the deflator.

Result: There has been a real increase In the price of housing. What would cause this?

chapter 11 inflation and the quantity theory of money

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