Chapter 12 Money Growth and Inflation
Chapter 12 Money Growth and Inflation Econ 202 - 01
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Date Created: 04/12/16
Chapter 12 ~ Money Growth and Inflation Part 1 ~ The Classical Theory of Inflation & The Quantity Theory of Money Inflation ~ is an overall increase in the level of prices. Inflation is more about the “value of money” than the value of goods. Inflation concerns an economy’s medium of exchange. Inflation is similar to a tax on the holders of money in which monetary resources from households gets transferred to the government The public often views high rates of inflation as a major economic problem; and is a problem because people don’t like it The Costs of moderate inflation are not nearly as large as the public believes David Hume developed and Milton Friedman expanded the Quantity Theory of Money which helps to explain moderate inflation and hyper-inflation. Prices rise when the government prints too much money. Inflation → ↑ price (P) → ↓ money value (1/P) → ↑ demand for money Deflation ~ is an overall decrease in the level of prices. Hyperinflation ~ is an extaordinary high rate of inflation. An increase (↑) in prices of 50% or more in one month for an economy is considered to be hyperinflation. Prices rise when the government prints too much money Textual graphs demonstrate a clear link between the quantity of money and price levels Excessive growth in the money supply “always” causes hyper-inflation. 2 ways to view price levels Price level of a basket of goods and services o Price ~ measures the number of dollars needed to buy a basket of goods or services and is measured in “money, dollars” ($ per unit, $ an hour) o Price ↑ when money suppy ↑ → demand for money ↑ Measure of value of money o 1/P ~ measures the “value of money” and is measured in units of goods or services o 1/P is the inverse of Price (P) o 1/P ↓ when money supply ↑ (quantity of money affects the value of money) o Money value (1/P) decreases (↓) when prices (P) increases (↑) and visa versa Money Demand ~ is the amount of wealth people want to hold in liquid (easy exchangable) form. Money demand depends upon prices (P); such that, an increase in (P) reduces the value of money, so more money is needed to buy goods and services. Quantity of money demanded is negatively related to the the value of money and positively related to (P), other things (real income, interest rates, availability of ATM.s) being equal. o Real Income ~ determines the quantity of goods and services people demand. o Price ~ determines how many dollars will be needed to buy this quanity of goods and services The quantity (supply) of money determines the value of money (1/P) and its corresponding (P) price level: (David Hume & Milton Friedman) Supply of money (quantity) ~ is determined and regulated by the “Fed” via OMO by the FOMC. Demand for money ~ reflects how much wealth people want to “hold” as a liquid item which is affected by the average level of prices in the economy. The higher the prices are, the more money the typical transaction requires, and the more money people will choose to hold in their wallets and checking accounts. ???? o ↑ Prices → ↓ 1/P (value) → ↑ demand for money (Note: Price & ????????????????????are inverses) In the long-run, money supply and money demand are brought into equilibrium by the overall level of prices. o When prices are greater than the equilibrium level, the demand for money increases o When prices are less than the equilibrium level, the demand for money decreases o The equilibrium of money supply and money demand determines the value of money and the price level. Quantity Theory of Money ~ asserts that the quantity (supply) of money available determines the price level and that the growth rate in the quantity (supply) of money available determines the inflation rate. When an increase in the money supply makes dollars more plentiful, the result is an increase in the price level (inflation) that makes each dollar less valuable. Based upon long-run behavior When the quantity of money supplied now exceeds the quantity demand, at the prevailing price level, the injection of money increases the demand for goods and services. However, the economy’s output of goods and services is determined by the availablility of labor, physical capital, human capital, natural resources and technological knowledge; which are NOT altered by by the injection of money. And then the greater demand for goods and services causes their prices to increase. Y = A × F[L, K, H, N] David Hume suggested that economic variables should be divided into two (2) groups: 1. Nominal Variables ~ are variables such that are measured (reported) in monetary units like dollars. The nominal GDP (nGDP) is a nominal value because it is measured in dollars. Influenced by developments in the economy’s monetary system and money supply When the central bank doubles the money supply, the price level doubles, the dollar wage doubles, all other dollar values double and the value of money (1/P) ↓ by 2X. Any variable expressing “dollars” (wages, income, nominal GDP, $/hour, rate-of-return that’s measured in $ and any $/unit of a good or service as a value). 1. Note: Watch for the dollar sign! 2. Nominal wage (W) ~ $/hour 2. Real Variables ~ are variables such that are measured (reported) in physical units of quantity like real GDP (rGDP), pounds, ounces, miles, bushels, gallons, time, rates, percentages, purchasing power, out puts and etc. Note: Real variables are not influenced by the current prices of the goods and services. Money is largely irrelevant for explaining real variables and NOT affected by changes in the money supply Production, employment, real wages and real interest rates are NOT changed by a doubling of the money supply: 1. Real wage ( ) ~ is the purchasing power of that wage; whereas, it’s the ???? price of labor “relative” to the price of “output, units, items.” The separation of nominal variables and real variables is now called: Classical Dichotomy. Classical Dichotomy ~ is the theoretical separation of nominal and real variables. Money is “neutral” in the long-run Monetary developments affect nominal variables but NOT real variables Doubling the money supply causes all nominal variables and prices to double Doubling the money supply will leave “relative prices” and real variables unchanged Relative Price ~ is the price (P) of one thing (item) as compared to another (different) thing (item) and is NOT measured in terms of money. When comparing the prices of any two goods, apples to oranges, the dollar sign cancels out, and the resulting number is measured in physical units: Relative prices are real variables. o Real wage (W/P) ~ the dollar wage adjusted for inflation and measures the rate at which people exchange goods and services for a unit of labor. o Real interest rate ~ is the nominal interest rate adjusted for inflation and measures the rate at which people exchange goods and services in the future. ???? $100/ℎ???????????? $100 ???????????????????? ???????????????????? o Dollar sign cancels out: = = × = ???? $10/???????????????? ℎ???????????? $10 ℎ???????????? Money Neutrality ~ is the proposition that the changes in the money supply do NOT affect real variables; such as outputs, but does affect nominal variables. When the central bank doubles the money supply, the price level doubles, the dollar wage doubles and all other “dollar” values double. However, real variables do NOT change. o Doubling the money supply causes all nominal variables to double ???? o Real wage ( )????is unaffected and remains unchanged Since the employment of all resources (quantity of labor demanded, quantity of labor supplied and total employment of labor) is unchanged, total output is also unchanged by the money supply: Y = A × F[L, K, H, N] Most economists believe that the “classical dichotomy” and the “neutrality of money” describe the economy in the long-run. Velocity of Money ~ is the rate (speed) at which the number of times that “money” (a dollar bill) changes hands in order to pay for a good or service in one (1) year: V = (P × Y) ÷ M. 1. Velocity is “relatively” constant and stable 2. A change in money supply (M) yields a change in nGDP (P × Y) 3. Money is “neutral” and “Y” doesn’t change: Y = A × F[L, K, H, N] 4. Changes in Price (P) occurs by changes in money supply (M) and/or a change in output (Y) 5. Rapid money supply (M) growth causes rapid inflation (∆M = ∆P + ∆Y) The Quantity Equation: Since velocity is relatively stable and constant, (M × V = P × Y) shows that an increase in the quantity of money in an economy must be reflected in one of these other two (2) variables. If output (Y) doesn’t change, then money supply (M) will only affect price (P): If output (Y) changes, then price (P) changes in relation to the amount of the money supply (M) and output (Y). Velocity and the Quantity Equation (QE) Price Level (P) = dGDP and Quantity of output (Y) = rGDP then nGDP = dGDP × rGDP V = ???? × whereas V = velocity, P = price, Y = quantity of output, and M = money supply ???? ???????????????? ???????????????????? ???????????????????? × ???????????????????????????????? ???????? ???????????????? × ???? V = ???? = ???? = ???? and then the QE is: (M × V) = (P × Y) Example Problem: The economy has enough labor, capital and land to produce 800 (Y) of corn. Velocity (V) is constant. Originally, MS = $2,000 and P = $5/bushel and thusly nGDP = $4,000: M × V = P × Y ~ 2,000 × V = 5 × 800 then V = 2 ~ and then a year later M ↑ by 5% to $2,100 M × V = P × Y ~ 2,100 × 2 = P × 800 then P = $5.25/bushel and nGDP = P × Y = 5.25 × 800 = $4,200 Inflation rate =5.25 –5.0× 100 = 0.05 × 100 = 5% or by nGDP (no ∆ in Y), 4,200 –4,00= 0.05 × 100 = 5% 5.00 4,000 Now, assume technology (A) increased bushels to 824 via the equation: Y = “A” × F[L, K, H, N] M × V = P × Y ~ 2,100 × 2 = P × 824 ~ Price = $5.10 and inflation = 5.10 –5.0× 100 = 0.05 × 100 = 2% 5.00 Note: An ↑ in production (Y) leads to a decreased inflation rate because of a lowered price. Just a quick review of 8 key points: 1. If rGDP (real GDP) is constant, then inflation equals money growth 2. If rGDP is growing, then money growth is greater than inflation 3. Economic growth increases the number of transactions, and some money growth is needed for these extra transactions 4. The velocity of money is relatively constant and stable 5. Because velocity is stable, when the central bank changes the quantity of money (M), it causes proportionate changes in the nominal value of output (P × Y) that’s also nGDP. 6. The economy’s output of goods and services (Y) is primarily determined by factor supplies (labor, physical capital, human capital and natural resources) and the available production technology. In particular, because money is neutral, money does NOT affect output. 7. With output (Y) determined by factor supplies and technology, when the central bank alters the money supply (M) and induces proportional changes in the nominal value of output (P × Y), these changes changes are reflected in the changes in the price level (P). 8. Therefore, when the central bank increases the money supply rapidly, the result is a high rate of inflation and possibly hyper-inflation. An Inflation Tax ~ is the revenue the government raises by creating (printing) money and is a tax on holding money, because price levels rise and money in your wallet loses value. When tax revenue is inadequate and the ability to borrow is limited, the government may print money to pay for its spending. The inflation tax is approximately 3% now-a-days in the U.S. The 3 Elements of Hyper-Inflation: (Public Savings = Tax Revenues – Government Spending) 1. The government has high levels of spending 2. The government has inadequate tax revenue 3. The government has limited ability to borrow The Fisher Effect ~ is the one-for-one adjustment of the nominal interest rate to the inflation rate. In the long-run, in which money is neutral, a change in money growth should NOT affect the real interest rate since the real interest rate is a real variable. The nominal interest rate does adjust to expected inflation. 1. Rearranges the definition of the real interest rate 2. The real interest rate is detemined by saving and investment (supply and demand) in the loanable funds market 3. The growth in money supply determines the inflation rate 4. The equation shows how the nominal interest rate is determined and changes with inflation 5. When the “Fed” increases the rate of money growth, whereas money is neutral, the long-run result is both a higher inflation rate and a higher nominal interest rate. The Fisher Effect Real Interest Rate = Nominal Interest Rate – Inflation Rate Nominal Interest Rate = Real Interest Rate + Inflation Rate The inflation tax applies to people’s holdings of money and NOT to their holdings of wealth The Fisher Effect verifies that an increase in inflation causes an equal increase in the nominal interest rate, so the real interest rate (on wealth) is unchanged. Part 2 ~ The Costs of Inflation Ranking of 3 (three) news-worthy macro-economic variables on the public’s radar: 1. Inflation 2. Unemployment 3. Productivity Inflation of itself does NOT reduce people’s real purchasing power (wealth), because incomes will rise when prices increase and that real incomes are determined by real variables. Nominal incomes are determined by overall price levels and by factor supplies. The Six (6) Costs of Inflation: 1. Shoeleather Costs 2. Menu Costs 3. Increased Variability of Relative Prices 4. Inflation-Induced Tax Distortions and Liabilities 5. Confusion and Inconvenience 6. Arbitrary Redistribution of Wealth 1. Shoeleather Costs ~ are those wasted resources (time, effort, inconveniences) and deadweight loss that occur when inflation encourages people to reduce their money holdings. This comes from the concept that a person makes frequent (transactional) trips to the bank for small withdrawls in order to protect their holdings. Shoeleather costs are magnified with hyper-inflation. 2. Menu Costs ~ are the costs accrued because of price changes. This term comes from the restaurant business in regards to the cost of printing new annual prices whenever prices changed. When high inflation makes firm’s costs rise rapidly, the annual price adjustment is impractical because of expenses. 3. Misallocation of Resources from Relative-Price Variability ~ occurs when inflation happens because relative prices are distorted: It’s a comparison of prices to other prices in the economy over time and can be a comparison of prices on a month-by-month basis (relative prices fall with inflation). Market economies (firms) rely on relative prices to allocate investment resources for their businesses. 4. Inflation-Induced Tax Distortions and Liabilities ~ Inflation tends to raise the tax burden on income earned from savings and capital gains. The income tax treats the nominal interest earned on savings and capital gains as income, even though part of the nominal interest rate and capital gains merely compensates for inflation. Plus, the tax code doesn’t take into account how inflation effects captial gains in regards to stock trades and purchasing power. Economy A Economy B (price stability) (Inflation) Assume that there is a 25% (0.25) tax on interest income: Real Interest Rate 4% 4% Inflation Rate 0% 8% Nominal Inflation Rate (real interest rate + inflation rate) 4% 12% Reduced Interest related to 25% tax (0.25 × nominal interest rate) 1% 3% After-tax nominal interest rate (nominal inflation rate – reduced inter3%t) 9% Also calculated by: (1 – 0.25 = 0.75 × nominal interest rate) After-tax real interest rate (after-tax nominal interest rate – inflati3% rate) 1% Inflation causes nominal incomes to grow faster than real income which causes people to pay more in taxes o Inflation raises the nominal interest rates (Fisher Effect) but not real interest rates o Inflation increases savers’ tax burden o Inflation lowers after-tax real interest rate Taxes are based on nominal income and nominal interest rates; and some are not adjusted for inflation o One solution to the tax code in regards to earned interest and capital gains is to “index” the tax system which would account for the effects of inflation. Capital Gains ~ are the profits one takes when selling appreciated financial assets 5. Confusion and Inconvenience ~ occurs when the “Fed” increases the money supply and creates inflation, it erodes the real value of the “unit of account.” This causes disruptions in the fundamental analysis of companies (firms) by security analysts which in turn impedes financial markets in their role of allocating the economy’s saving to alternative types of investment. Inflation changes the yardstick we use to measure transactions, and it complicates long-range planning and the comparison of dollar amounts over time 6. Arbitrary Redistribution of Wealth ~ occurs when there is an redistribution of wealth (transfer of purchasing power) when unexpected inflation happens: If one takes out a loan at a given interest rate and inflation sets in afterwards, the bank (creditor) loses, because prices increased and the value of the dollar decreased. However, if one takes out a loan, at a high interest rate, and “deflation” hits, then the borrower (debtor) loses, because prices decreased and the value of the dollar increased. Inflation is especially volatile, unstable and uncertain when the average rate of inflation is high. Deflation can come as a surprise where debtor’s wealth is given to the creditors. A small and predictable amount of deflation may be desirable. An inflation rate of less than (<) 10% is considered low inflation Chapter 12 Summary and Review The overall level of prices in an economy adjusts to bring money supply and money demand into balance and equilibrium. When the central bank increases the supply of money, it causes the price level to rise. Persistent growth in the quantity of money supplied leads to continuing inflation. The principle of monetary neutrality asserts that changes in the quantity of money influence nominal variables but not real variables. Most economists believe that monetary neutrality approximately describes the behavior of the economy in the long run. A government can pay for some of its spending simply by printing money. When countries rely heavily on this “inflation tax,” the result is hyperinflation. One application of the principle of monetary neutrality is the Fisher Effect. According to the Fisher Effect, when the inflation rate rises, the nominal interest rate rises by the same amount so that the real interest rate remains the same and unchanged: (nominal ir = real ir + inflation). Many people think that inflation makes them poorer because it raises the cost of what they buy. This view is a fallacy; however, because inflation also raises nominal incomes. Economists have identified six costs of inflation: (1) shoeleather costs associated with reduced money holdings, (2) menu costs associated with more frequent adjustment of prices, (3) increased variability of relative prices, (4) unintended changes in tax liabilities due to non-indexation of the tax code, (5) confusion and inconvenience resulting from a changing unit of account (6) and arbitrary redistributions of wealth between debtors and creditors. Many of these costs are large during hyperinflation, but the size of these costs for moderate inflation is less clear. The price level (P) is the price of goods and services measured in terms of money. The value of money (1/P) is the value of money measured in terms of goods and services. Nominal variables are measured in monetary units. Any price or wage denominated in money, such as someone’s $14.00 per hour wage, is an example of a nominal variable. Real variables are measured in physical units. Any price or wage stated in terms of goods is a real variable. The real interest rate adjusts the nominal interest rate for the rate of inflation and equals the nominal rate minus the inflation rate. The real interest rate also reflects the change in purchasing power the lender receives for lending money to the borrower. If inflation rises unexpectedly, in the short run borrowers and lenders will not set the nominal interest rate to reflect the increase in the inflation rate. The actual real interest rate will, therefore, turn out to be different from the expected real interest rate. The unexpected increase in the inflation rate causes the actual real interest rate to be less than the expected real interest rate in the short run. The borrowers benefit from paying a lower real interest rate. The lower real interest rate harms lenders, who now receive a smaller-than-expected increase in purchasing power in return for the funds they lend to borrowers. The Fisher effect describes the long-run behavior of nominal interest rates and inflation based on monetary neutrality—the notion that monetary changes are irrelevant for real variables in the long run. In the long run, borrowers and lenders will agree to a new nominal interest rate as their expectations of inflation adjust. Rapid inflation imposes an inflation tax on people who hold money. As the price level rises, the value of money declines. To avoid the inflation tax, people minimize their money holdings during periods of rapid inflation. They may make more frequent withdrawals from the bank and move quickly to deposit their cash earnings in interest-bearing accounts. They may also attempt to spend their earnings on physical goods as quickly as possible, or convert their money to the currency of a nation with a lower and more stable rate of inflation. The trips and errands associated with reducing money holdings wear on people's shoes; therefore, the inconveniences associated with minimizing money holdings are known as shoe-leather costs. Of course, shoe-leather costs refer to the time and energy devoted to reducing money holdings in an inflationary environment, not just the wear and tear on your shoes! When the government taxes nominal interest income, inflation distorts the real returns to saving. Compared with higher rates of inflation, lower inflation rates lead to higher after-tax real interest rates. A higher after-tax real return tends to encourage saving. The economy's level of investment depends on the pool of savings available to finance investment projects like acquiring new tools or machinery or building new plants or office buildings. The higher level of saving will increase the quantity of investment, thereby increasing the economy's rate of physical capital accumulation and increasing the long-run economic growth rate. To the extent that the central bank can reduce inflation in an economy where government taxes nominal interest income, it will encourage saving, investment and growth.
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