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Chapter 4: Money and Inflation*
MACROECONOMICS
Seventh Edition
N. Gregory Mankiw
Chapter 4: Money and Inflation 1/67*Slides based on Ron Cronovich's slides, adjusted for course in Macroeconomics at the Wang Yanan Institute for Studies in Economics at Xiamen University.
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Introduction:U.S. Inflation and Its Trend, 1960-2009
12%
15%
% change in CPI from 12 months earlier
3%
6%
9%
12%
long-run trend
12 months earlier
Chapter 4: Money and Inflation 2/67
-3%
0%
3%
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
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Introduction:Connection Between Money and Prices
Inflation rate = the percentage increase in the average level of prices. of prices.
Price = amount of money required to buy a good.
Because prices are defined in terms of money, we need to
Chapter 4: Money and Inflation 3/67
Because prices are defined in terms of money, we need to consider the nature of money, the supply of money, and how it is controlled.
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Learning Objectives
This chapter introduces you to understanding:
What is moneyWhat is money
The quantity theory of money
Seigniorage: The revenue from printing money
Inflation and interest rates
The nominal interest rate and the demand for money
The social costs of inflation
Chapter 4: Money and Inflation 4/67
The social costs of inflation
Hyperinflation
The classical dichotomy
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MoneyMoney is the stock is the stock
→ Definition
4.1) What is Money?
MoneyMoney is the stock is the stock of assets that can be readily of assets that can be readily used to make transactions.used to make transactions.
Chapter 4: Money and Inflation 5/67
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Medium of exchangewe use it to buy stuff
→ Functions of Money
4.1) What is Money?
we use it to buy stuff
Store of valuetransfers purchasing power from the present to the future
Unit of account
Chapter 4: Money and Inflation 6/67
Unit of accountthe common unit by which everyone measures prices and values
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1. Fiat money
→ Types of Money
4.1) What is Money?
1. Fiat moneyhas no intrinsic valueexample: the paper currency we use
2. Commodity moneyhas intrinsic valueexamples:
Chapter 4: Money and Inflation 7/67
examples: gold coins, cigarettes in P.O.W. camps
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The money supply is the quantity of money available in
→ Money Supply and Monetary Policy
4.1) What is Money?
The money supply is the quantity of money available in the economy.
Monetary policy is the control over the money supply.
Chapter 4: Money and Inflation 8/67
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Monetary policy is conducted by a country’s central bank .
→ The Central Bank
4.1) What is Money?
Monetary policy is conducted by a country’s central bank .
In China, the central bank is called the People‘s Bank of China .
Chapter 4: Money and Inflation 9/67
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Amount ($ billions)
Assets includedSymbol
→ Money Supply Measures, May 2009
4.1) What is Money?
M1 + small time deposits,
$1596C + demand deposits, travelers’ checks, other checkable deposits
M1
$850CurrencyC
($ billions)
Chapter 4: Money and Inflation 10/67
$8328
M1 + small time deposits, savings deposits, money market mutual funds, money market deposit accounts
M2
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Learning Objectives
This chapter introduces you to understanding:
what is moneywhat is money
the quantity theory of money
Seigniorage: The revenue from printing money
Inflation and interest rates
The nominal interest rate and the demand for money
The social costs of inflation
Chapter 4: Money and Inflation 11/67
The social costs of inflation
Hyperinflation
The classical dichotomy
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Provides the leading explanation of how money affects
4.2) The Quantity Theory of Money
Provides the leading explanation of how money affects the economy in the long run.
A simple theory linking the inflation rate to the growth rate of the money supply.
Chapter 4: Money and Inflation 12/67
Begins with the concept of velocity …
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Basic concept: the rate at which money circulates
→ Velocity
4.2) The Quantity Theory of Money
Definition: the number of times the average dollar bill changes hands in a given time period
Example: In 2007, $500 billion in transactions
Chapter 4: Money and Inflation 13/67
$500 billion in transactionsMoney supply = $100 billionThe average dollar is used in five transactions in 2007So, velocity = 5
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This suggests the following definition:
→ Velocity
4.2) The Quantity Theory of Money
TV
M=
where
V = velocity
T = value of all transactions
Chapter 4: Money and Inflation 14/67
T = value of all transactions
M = money supply
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Use nominal GDP as a proxy for total transactions.
→ Velocity
4.2) The Quantity Theory of Money
Then, P YV
M×=
where
P = price of output (GDP deflator)
Y = quantity of output (real GDP)
Chapter 4: Money and Inflation 15/67
Y = quantity of output (real GDP)
P ××××Y = value of output (nominal GDP)
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The quantity equation
→ The Quantity Equation
4.2) The Quantity Theory of Money
The quantity equationM ××××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 16/67
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When analyzing how money affects the economy, it is useful to express the quantity of money in terms of G & S
→ Money demand and the Quantity Equation
4.2) The Quantity Theory of Money
useful to express the quantity of money in terms of G & S it can buy: M/P = real money balances
Use money demand function to show how much real money balances people wish to hold: (M/P )d = k Y
Chapter 4: Money and Inflation 17/67
where:k = how much money people wish to hold for each dollar of income. (k is exogenous)
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Money demand: (M/P )d = k Y
→ Money demand and the Quantity Equation
4.2) The Quantity Theory of Money
Quantity equation: M ××××V = P ××××Y
The connection between them: k = 1/V
Chapter 4: Money and Inflation 18/67
When people hold lots of money relative to their incomes (k is high), money changes hands infrequently (V is low).
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If we assume V is constant and exogenous ( ), then the quantity equation becomes a usefull theory about the effects of money.
=V V
→ Deriving the Quantity Theory of Money
4.2) The Quantity Theory of Money
effects of money.
Given the assumption, the quantity equation can be written as
A change in the quantity of money (M) must cause a proportionate change in nominal GDP (PY).
× = ×M V P Y
Chapter 4: Money and Inflation 19/67
proportionate change in nominal GDP (PY).
If velocity is fixed, the quantity of money determines the dollar value of the economy‘s output.
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× = ×M V P Y
→Explaining an Economy‘s Overall Level of Prices
4.2) The Quantity Theory of Money
How the price level is determined:
Real GDP is determined by the economy’s supplies of K and L and the production function (Chap 3).
With V constant, the money supply determines nominal GDP (P ×Y ).
Chapter 4: Money and Inflation 20/67
nominal GDP (P ×Y ).
The price level is P = (nominal GDP)/(real GDP).
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The growth rate of a product equals the sum of the growth rates (See Mankiw Ch. 2).
4.2) The Quantity Theory of Money→Explaining an Economy‘s Overall Level of Prices
growth rates (See Mankiw Ch. 2).
The quantity equation in percentage change form:
M V P Y
M V P Y
∆ ∆ ∆ ∆+ = +Exogenous
Inflation
Chapter 4: Money and Inflation 21/67
The quantity theory of money assumes
is constant, so = 0.∆V
VV
Inflation
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4.2) The Quantity Theory of Money→Explaining an Economy‘s Overall Level of Prices
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 (w.r.t. Real GDP growth), the price level will be
Chapter 4: Money and Inflation 22/67
(w.r.t. Real GDP growth), the price level will be stable.
If the central bank increases the money supply rapidly (w.r.t. Real GDP growth), the price level will rise rapidly.
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4.2) The Quantity Theory of Money→U.S. Inflation and Money Supply
Chapter 4: Money and Inflation 23/67
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International Data on Inflation and Money Growth
100
Inflation rate (percent,
Indonesia
Turkey
BelarusEcuador
1
10
(percent, logarithmic scale)
Singapore
U.S.
Switzerland
Argentina
Indonesia Belarus
Chapter 4: Money and Inflation 24/67
0,11 10 100
Money Supply Growth (percent, logarithmic scale)
Singapore
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U.S. inflation and money growth, 1960-2009
12%
15%
M2 growth
Over the long run, the rates of inflation and money growth
move together,
Over the long run, the rates of inflation and money growth
move together,
3%
6%
9%
12% M2 growth rate
move together, as the Quantity Theory predicts.
move together, as the Quantity Theory predicts.
Chapter 4: Money and Inflation 25/67
-3%
0%
3%
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
inflation rate
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Learning Objectives
This chapter introduces you to understanding:
what is moneywhat is money
the quantity theory of money
Seigniorage: The revenue from printing money
Inflation and interest rates
The nominal interest rate and the demand for money
The social costs of inflation
Chapter 4: Money and Inflation 26/67
The social costs of inflation
Hyperinflation
The classical dichotomy
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To spend more without raising taxes or selling bonds, the govt can print money.
4.3) Seigniorage
govt can print money.
The “revenue” raised from printing money is called seigniorage .
Chapter 4: Money and Inflation 27/67
The inflation tax : Printing money to raise revenue causes inflation. Inflation is like a tax on people who hold money.
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Learning Objectives
This chapter introduces you to understanding:
what is moneywhat is money
the quantity theory of money
Seigniorage: The revenue from printing money
Inflation and interest rates
The nominal interest rate and the demand for money
The social costs of inflation
Chapter 4: Money and Inflation 28/67
The social costs of inflation
Hyperinflation
The classical dichotomy
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Interest rates are the market price at which ressources are transferred between the present and the future
4.4) Inflation and Interest Rates
In this subchapter we investigate the relation between interest and inflation
Nominal interest rate, i, not adjusted for inflation
Real interest rate, r, adjusted for inflation:
Chapter 4: Money and Inflation 29/67
Real interest rate, r, adjusted for inflation:r = i − π
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The Fisher equation: i = r + ππππ
4.4) Inflation and Interest Rates→The Fisher Effect
Chap 3: S = I determines r .
Hence, an increase in ππππ causes an equal increase in i.
Chapter 4: Money and Inflation 30/67
This one-for-one relationship is called the Fisher effect .
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4.4) Inflation and Interest Rates→Inflation and Nominal Interest Rate in the U.S.
Nominal interest rateinterest rate
Chapter 4: Money and Inflation 31/67
Inflation rate
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Nominal interest rate
(percent, RomaniaGeorgia
4.4) Inflation and Interest Rates→Infl. and Nom. Interest Rates Across Countries
(percent, logarithmic
scale)Zimbabwe
Romania
TurkeyBrazil
Israel
U.S.
Kenya
Georgia
Chapter 4: Money and Inflation 32/67
Inflation rate(percent, logarithmic scale)
U.S.
GermanyEthiopia
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ππππ = actual inflation rate (not known until after it has occurred)
4.4) Inflation and Interest Rates→ Two Real Interest Rates
(not known until after it has occurred)
ππππ e = expected inflation rate
i – ππππ e = ex ante real interest rate: the real interest rate people expect at the time they make a loan
Chapter 4: Money and Inflation 33/67
i – ππππ = ex post real interest rate:the real interest rate actually realized
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Suppose V is constant, M is growing 5% per year, Y is growing 2% per year, and r = 4.
→ 该你们了
4.4) Inflation and Interest Rates
Y is growing 2% per year, and r = 4.
a. Using the quantity theory of money and the Fisher equation, what is the nominal interest rate, i, given the above values?
b. If the Fed increases the money growth rate by 2 percentage points per year, find ∆∆∆∆i.
Chapter 4: Money and Inflation 34/67
percentage points per year, find ∆∆∆∆i.
c. Suppose the growth rate of Y falls to 1% per year.
What will happen to ππππ ?
What must the Fed do if it wishes to keep ππππ constant?
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Learning Objectives
This chapter introduces you to understanding:
what is moneywhat is money
the quantity theory of money
Seigniorage: The revenue from printing money
Inflation and interest rates
The nominal interest rate and the demand for money
The social costs of inflation
Chapter 4: Money and Inflation 35/67
The social costs of inflation
Hyperinflation
The classical dichotomy
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In the quantity theory of money, the demand for real money balances depends only on real income Y.
4.5) Money Demand and Nominal Interest
money balances depends only on real income Y.
Another determinant of money demand: the nominal interest rate, i.
It is the opportunity cost of holding money (instead of bonds or other interest-earning assets).
Chapter 4: Money and Inflation 36/67
bonds or other interest-earning assets).
Hence, ↑i ⇒ ↓ in money demand.
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( ) ( , )dM P L i Y=
4.5) Money Demand and Nominal Interest
→ The Money Demand Function
(M/P )d = real money demand,
depends negatively on i. i is the opp. cost of holding money
depends positively on Y higher Y ⇒ more spending
Chapter 4: Money and Inflation 37/67
higher Y ⇒ more spending ⇒ so, need more money
(“L” is used for the money demand function because money is the most liquid asset.)
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( ) ( , )dM P L i Y=
4.5) Money Demand and Nominal Interest
→ The Money Demand Function
When people are deciding whether to hold money or bonds, they don’t know what inflation will turn out to be.
( , )e
L r Y+= π
Chapter 4: Money and Inflation 38/67
Hence, the nominal interest rate relevant for money demand is r + ππππ e.
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( , )eM
L r YP
= + π
4.5) Money Demand and Nominal Interest
→ Equilibrium: Money Supply=Money Demand
The supply of real money balances Real money Pmoney balances Real money
demand
�The level of real money balances depends on the expected rate of inflation.
Chapter 4: Money and Inflation 39/67
expected rate of inflation.� Today‘s price level does not only depend on today‘s money supply but also on the money supply expected in the future
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Learning Objectives
This chapter introduces you to understanding:
what is moneywhat is money
the quantity theory of money
Seigniorage: The revenue from printing money
Inflation and interest rates
The nominal interest rate and the demand for money
The social costs of inflation
Chapter 4: Money and Inflation 40/67
The social costs of inflation
Hyperinflation
The classical dichotomy
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→ The Economist, Running on M3
Economic Text:
1. Do you know any central banks which give or gave ‘money ’ (that is, the development of monetary aggregates) an (that is, the development of monetary aggregates) an important role in the conduct of monetary policy?
2. What is meant with the statement in the text “We didn’t abandon the monetary aggregates, they abandoned us.”?
3. Which theoretical concept can be used to justify the statement that “Inflation is always and everywhere a monetary phenomenon”?
4. Which are the two pillars of the ECB’s monetary policy
Chapter 4: Money and Inflation 41/67
strategy?5. Which important information -- that might not be contained in
short-term measures of inflation -- can be contained in monetary aggregates?
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Common misperception: Inflation reduces real wages
→ A Common Misperception About Inflation?
4.6) The Social Costs of Inflation
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
Chapter 4: Money and Inflation 42/67
level or inflation rate.
Consider the data…
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Hourly w
age in May 2009 dollars
$20800
900
Real average
→ Average Hourly Earnings and the CPI, 1964-2006
4.6) The Social Costs of Inflation19
65 =
100
Hourly w
age in May 2009 dollars
$10
$15
300
400
500
600
700
Nominal average hourly earnings,
(1965 = 100)
Real average hourly earnings in 2009 dollars,
right scale
Chapter 4: Money and Inflation 43/67
Hourly w
age in May 2009 dollars
$0
$5
0
100
200
300
1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
CPI (1965 = 100)
(1965 = 100)
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A change in the price level is merely a change in the units of measurement.
→ The Classical View of Inflation
4.6) The Social Costs of Inflation
of measurement.
� So why, then, is inflation a social problem?
Social costs of inflation fall into two categories:
Chapter 4: Money and Inflation 44/67
1. Costs when inflation is expected
2. Costs when inflation is different than people had expected
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Definition: the costs and inconveniences of reducing money
→ Expected Inflation: Shoeleather Costs
4.6) The Social Costs of Inflation
Definition: the costs and inconveniences of reducing money balances to avoid the inflation tax.
↑ππππ ⇒ ↑i
⇒ ↓ real money balances
Remember: In the long run, inflation does not affect real income or real spending.
Chapter 4: Money and Inflation 45/67
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.
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Definition: The costs of changing prices.
→ Expected Inflation: Menue Cost
4.6) The Social Costs of Inflation
Definition: 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 46/67
change their prices and incur these costs.
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Firms facing menu costs change prices infrequently.
→ Expected Inflation: Relative Price Distortions
4.6) The Social Costs of Inflation
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
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Different firms change their prices at different times, leading to relative price distortions…
…causing microeconomic inefficiencies in the allocation of resources.
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Some taxes are not adjusted to account for inflation, such as the capital gains tax.
→ Expected Inflation: Unfair Tax Treatment
4.6) The Social Costs of Inflation
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 ππππ = 10% during the year.
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Suppose ππππ = 10% during the year. Your real capital gain is $0.
But the govt requires you to pay taxes on your $1000 nominal gain
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Inflation makes it harder to compare nominal values from
→ Expected Inflation: General Inconvenience
4.6) The Social Costs of Inflation
Inflation makes it harder to compare nominal values from different time periods.
This complicates long-range financial planning.
Chapter 4: Money and Inflation 49/67
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Many long-term contracts not indexed, but based on ππππ e.
→ Unexpected Inflation: Arbitrary Redistribution
4.6) The Social Costs of Inflation
If ππππ turns out different from ππππ e, then some gain at others’ expense. Example: borrowers & lenders
If ππππ > ππππ e, then (i −−−− ππππ) < (i −−−− ππππ e) and purchasing power is transferred from lenders to borrowers.
ππππ ππππ
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If ππππ < ππππ e, then purchasing power is transferred from borrowers to lenders.
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When inflation is high, it’s more variable and unpredictable: ππππ ππππ e
→ High Inflation: Increased Uncertainty
4.6) The Social Costs of Inflation
When inflation is high, it’s more variable and unpredictable: ππππ turns out different from ππππ e more often, and the differences tend to be larger (though not systematically positive or negative)
Arbitrary redistributions of wealth become more likely.
This creates higher uncertainty, making risk averse people
Chapter 4: Money and Inflation 51/67
This creates higher uncertainty, making risk averse people worse off.
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Nominal wages are rarely reduced, even when the
→ One Benefit of Inflation
4.6) The Social Costs 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.
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Therefore, moderate inflation improves the functioning of labor markets.
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Learning Objectives
This chapter introduces you to understanding:
what is moneywhat is money
the quantity theory of money
Seigniorage: The revenue from printing money
Inflation and interest rates
The nominal interest rate and the demand for money
The social costs of inflation
Chapter 4: Money and Inflation 53/67
The social costs of inflation
Hyperinflation
The classical dichotomy
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Definition: ππππ ≥≥≥≥ 50% per month
4.7) Hyperinflation
Definition: ππππ ≥≥≥≥ 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
Chapter 4: Money and Inflation 54/67
serve its other functions (unit of account, medium of exchange).
People may conduct transactions with barter or a stable foreign currency.
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Hyperinflation is caused by excessive money supply
→ What Causes Hyperinflation
4.7) 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 55/67
hyperinflation.
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Money growth (%) Inflation (%)
→ A Few Examples
4.7) Hyperinflation
Israel, 1983-85 295 275
Poland, 1989-90 344 400
Brazil, 1987-94 1350 1323
Argentina, 1988-90 1264 1912
Chapter 4: Money and Inflation 56/67
1264 1912
Peru, 1988-90 2974 3849
Nicaragua, 1987-91 4991 5261
Bolivia, 1984-85 4208 6515
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→ Why Governments Create Hyperinflation
4.7) 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
Chapter 4: Money and Inflation 57/67
In the real world, this requires drastic and painful fiscal restraint.
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Learning Objectives
This chapter introduces you to understanding:
what is moneywhat is money
the quantity theory of money
Seigniorage: The revenue from printing money
Inflation and interest rates
The nominal interest rate and the demand for money
The social costs of inflation
Chapter 4: Money and Inflation 58/67
The social costs of inflation
Hyperinflation
The classical dichotomy
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Note: Real variables were explained in Chap 3, nominal ones in Chapter 4.
4.8) The Classical Dichotomy
→ The Separation of Real and Nominal Variables
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
Chapter 4: Money and Inflation 59/67
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.
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Real variables (Chap 3): Measured in physical units –
4.8) The Classical Dichotomy
→ The Separation of Real and Nominal Variables
Real variables (Chap 3): 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
Chapter 4: Money and Inflation 60/67
real interest rate: output earned in the future by lending one unit of output today
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4.8) The Classical Dichotomy
→ The Separation of Real and Nominal Variables
Nominal variables (Chap 4): 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.
Chapter 4: Money and Inflation 61/67
by lending one dollar today.
the price level: The amount of dollars needed to buy a representative basket of goods.
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Chapter Summary
Money:
the stock of assets used for transactions the stock of assets used for transactions
serves as a medium of exchange, store of value, and unit of account.
Commodity money has intrinsic value, fiat money does not.
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Central bank controls the money supply.
Quantity theory of money assumes velocity is stable, concludes that the money growth rate determines the inflation rate.
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Chapter Summary (ctd.)
Nominal interest rate
equals real interest rate + inflation rateequals 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
Chapter 4: Money and Inflation 63/67
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.
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Chapter Summary (ctd.)
Costs of inflation
Expected inflationExpected inflationshoeleather costs, menu costs, tax & relative price distortions, inconvenience of correcting figures for inflation
Unexpected inflationall of the above plus arbitrary redistributions of wealth between debtors and creditors
Chapter 4: Money and Inflation 64/67
between debtors and creditors
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Chapter Summary (ctd.)
HyperinflationHyperinflation
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 4: Money and Inflation 65/67
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Chapter Summary (ctd.)
Classical dichotomyIn classical theory, money is neutral--does not affect In classical theory, money is neutral--does not affect real variables.
So, we can study how real variables are determined without reference to nominal ones.
Then, money market equilibrium determines price level and all nominal variables.
Chapter 4: Money and Inflation 66/67
and all nominal variables.
Most economists believe the economy works this way in the long run.
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→ The Economist, Running on M3
Economic Text:
1. Do you know any central banks which give or gave ‘money ’ (that is, the development of monetary aggregates) an (that is, the development of monetary aggregates) an important role in the conduct of monetary policy?
2. What is meant with the statement in the text “We didn’t abandon the monetary aggregates, they abandoned us.”?
3. Which theoretical concept can be used to justify the statement that “Inflation is always and everywhere a monetary phenomenon”?
4. Which are the two pillars of the ECB’s monetary policy
Chapter 4: Money and Inflation 67/67
strategy?5. Which important information -- that might not be contained in
short-term measures of inflation -- can be contained in monetary aggregates?