978-1305971509 Chapter 30_17 Lecture Notes

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WHAT’S NEW IN THE EIGHTH EDITION:

There are no major changes to this chapter.

LEARNING OBJECTIVES:

By the end of this chapter, students should understand:

 why ination results from rapid growth in the money supply.

 the meaning of the classical dichotomy and monetary neutrality.

 why some countries print so much money that they experience hyperination.

 how the nominal interest rate responds to the ination rate.

 the various costs that ination imposes on society.

CONTEXT AND PURPOSE:

Chapter 30 is the second chapter in a two-chapter sequence dealing with money and prices

in the long run. Chapter 29 explained what money is and how the Federal Reserve controls

the quantity of money. Chapter 17 establishes the relationship between the rate of growth of

money and the ination rate.

The purpose of this chapter is to acquaint students with the causes and costs of

ination. Students will )nd that, in the long run, there is a strong relationship between the

growth rate of money and ination. Students will also )nd that there are numerous costs to

the economy from high ination, but that there is not a consensus on the importance of

these costs when ination is moderate.

KEY POINTS:

 The overall level of prices in an economy adjusts to bring money supply and money

demand into balance. 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 ination.

 The principle of monetary neutrality asserts that changes in the quantity of money

inuence nominal variables but not real variables. Most economists believe that

485

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30 MONEY GROWTH AND

INFLATION

486 ❖ Chapter 30/Money Growth and Ination

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 “ination tax,” the result is hyperination.

 One application of the principle of monetary neutrality is the Fisher eDect. According to

the Fisher eDect, when the ination rate rises, the nominal interest rate rises by the

same amount, so that the real interest rate remains the same.

 Many people think that ination makes them poorer because it raises the cost of what

they buy. This view is a fallacy, however, because ination also raises nominal incomes.

 Economists have identi)ed six costs of ination: shoeleather costs associated with

reduced money holdings, menu costs associated with more frequent adjustment of

prices, increased variability of relative prices, unintended changes in tax liabilities due to

nonindexation of the tax code, confusion and inconvenience resulting from a changing

unit of account, and arbitrary redistributions of wealth between debtors and creditors.

Many of these costs are large during hyperination, but the size of these costs for

moderate ination is less clear.

CHAPTER OUTLINE:

I. The ination rate is measured as the percentage change in the Consumer Price Index,

the GDP deator, or some other index of the overall price level.

A. Over the past 80 years, prices have risen on average 3.6% per year in the United

States.

1. There has been substantial variation in the rate of price changes over time.

2. From 2005 to 2015, prices rose at an average rate of 1.2% per year, while prices

rose by 7.8% per year during the 1970s.

B. International data shows an even broader range of ination experiences. In 2015,

ination was 1.5% in China, 4.9% in India, 15.4% in Russia, and 84.1% in Venezuela.

II. The Classical Theory of Ination

A. The Level of Prices and the Value of Money

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It is instructive to review the ination history of the United States. While

your students are likely fully aware of ination, they may not realize that,

prior to World War II, the United States experienced several periods of

deation. Also point out to the students that the rate of ination has

varied signi)cantly since World War II.

Start oD the chapter by diDerentiating between a “once-and-for-all”

increase in the average level of prices and a continuous increase in the

price level. Also make sure that students realize that ination means that

the average level of prices in the economy is rising rather than the prices

of all goods.

Chapter 30/Money Growth and Ination ❖ 487

1. When the price level rises, people have to pay more for the goods and services

they buy.

2. A rise in the price level also means that the value of money is now lower because

each dollar now buys a smaller quantity of goods and services.

3. If P is the price level, then the quantity of goods and services that can be

purchased with $1 is equal to 1/P.

4. Suppose you live in a country with one good (ice cream cones).

a. When the price of an ice cream cone is $2, the value of a dollar is 1/2 cone.

b. When the price of an ice cream cone rises to $3, the value of a dollar is 1/3

cone.

B. Money Supply, Money Demand, and Monetary Equilibrium

1. The value of money is determined by the supply and demand for money.

2. For the most part, the supply of money is determined by the Fed.

3. The demand for money reects how much wealth people want to hold in liquid

form.

a. One variable that is very important in determining the demand for money is

the price level.

b. The higher prices are, the more money that is needed to perform transactions.

c. Thus, a higher price level (and a lower value of money) leads to a higher

quantity of money demanded.

4. In the long run, money supply and money demand are brought into equilibrium by

the overall level of prices.

a. If the price level is above the equilibrium level, people will want to hold more

money than is available and prices will have to decline.

b. If the price level is below equilibrium, people will want to hold less money

than that available and the price level will rise.

5. We can show the supply and demand for money using a graph.

a. The horizontal axis shows the quantity of money.

b. The left-hand vertical axis is the value of money, measured by 1/P.

c. The right-hand vertical axis is the price level (P ). Note that it is inverted—a

high value of money means a low price level and vice versa.

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Figure 1

488 ❖ Chapter 30/Money Growth and Ination

d. The supply curve is vertical because the Fed has )xed the quantity of money

available.

e. The demand curve for money is downward sloping. When the value of money

is low, people demand a larger quantity of it to buy goods and services.

f. At the equilibrium, the quantity of money demanded is equal to the quantity

of money supplied.

C. The EDects of a Monetary Injection

1. Assume that the economy is currently in equilibrium and the Fed suddenly

increases the supply of money.

2. The supply of money shifts to the right.

3. The equilibrium value of money falls and the price level rises.

4. When an increase in the money supply makes dollars more plentiful, the result is

an increase in the price level that makes each dollar less valuable.

5. De)nition of quantity theory of money: a theory asserting that the

quantity of money available determines the price level and that the

growth rate in the quantity of money available determines the in1ation

rate.

D. A Brief Look at the Adjustment Process

1. The immediate eDect of an increase in the money supply is to create an excess

supply of money.

2. People try to get rid of this excess supply in a variety of ways.

a. They may buy goods and services with the excess funds.

b. They may use these excess funds to make loans to others by buying bonds or

depositing the money in a bank account. These loans will then be used by

others to buy goods and services.

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Figure 2

Chapter 30/Money Growth and Ination ❖ 489

c. In either case, the increase in the money supply leads to an increase in the

demand for goods and services.

d. Because the supply of goods and services has not changed, the result of an

increase in the demand for goods and services will be higher prices.

E. The Classical Dichotomy and Monetary Neutrality

1. In the 18th century, David Hume and other economists wrote about the

relationship between monetary changes and important macroeconomic variables

such as production, employment, real wages, and real interest rates.

2. They suggested that economic variables should be divided into two groups:

nominal variables and real variables.

a. De)nition of nominal variables: variables measured in monetary units.

b. De)nition of real variables: variables measured in physical units.

3. De)nition of classical dichotomy: the theoretical separation of nominal

and real variables.

4. Prices in the economy are nominal (because they are quoted in units of money),

but relative prices are real (because they are not measured in money terms).

5. Classical analysis suggested that diDerent forces inuence real and nominal

variables.

a. Changes in the money supply aDect nominal variables but not real variables.

b. De)nition of monetary neutrality: the proposition that changes in the

money supply do not a2ect real variables.

F. Velocity and the Quantity Equation

1. De)nition of velocity of money: the rate at which money changes hands.

2. To calculate velocity, we divide nominal GDP by the quantity of money.

3. If P is the price level (the GDP deator), Y is real GDP, and M is the quantity of

money:

4. Rearranging, we get the quantity equation:

in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise

on a password-protected website or school-approved learning management system for classroom use.

Mankiw’s analogy of changing the size of a yard from 36 inches to 18

inches is a useful way to explain the confusion that a change in a unit of

measurement (or a unit of account) can cause.

velocity = nominal GDP/money supply

velocity = P Y

= M V P Y´ ´

490 ❖ Chapter 30/Money Growth and Ination

in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise

on a password-protected website or school-approved learning management system for classroom use.

Chapter 30/Money Growth and Ination ❖ 491

5. De)nition of quantity equation: the equation M × V = P × Y, which relates

the quantity of money, the velocity of money, and the dollar value of the

economy’s output of goods and services.

a. The quantity equation shows that an increase in the quantity of money must

be reected in one of the other three variables.

b. Speci)cally, the price level must rise, output must rise, or velocity must fall.

c. Figure 3 shows nominal GDP, the quantity of money (as measured by M2) and

the velocity of money for the United States since 1960. It appears that

velocity is fairly stable, while nominal GDP and the money supply have grown

dramatically.

6. We can now explain how an increase in the quantity of money aDects the price

level using the quantity equation.

a. The velocity of money is relatively stable over time.

b. When the central bank changes the quantity of money (M ), it will

proportionately change the nominal value of output (P × Y ).

c. The economy’s output of goods and services (Y ) is determined primarily by

available resources and technology. Because money is neutral, changes in the

money supply do not aDect output.

d. This must mean that P increases proportionately with the change in M.

e. Thus, when the central bank increases the money supply rapidly, the result is

a high rate of ination.

G. Case Study: Money and Prices during Four Hyperinations

1. Hyperination is generally de)ned as ination that exceeds 50% per month.

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ALTERNATIVE CLASSROOM EXAMPLE:

Suppose that:

Real GDP = $5,000

Velocity = 5

Money supply = $2,000

Price level = 2

We can show that:

M x V = P x Y

$2,000 x 5 = 2 x $5,000

$10,000 = $10,000

Figure 3

Figure 4

492 ❖ Chapter 30/Money Growth and Ination

2. Figure 4 shows data from four classic periods of hyperination during the 1920s in

Austria, Hungary, Germany, and Poland.

3. We can see that, in each graph, the quantity of money and the price level are

almost parallel.

4. These episodes illustrate Principle #9: Prices rise when the government prints too

much money.

H. The Ination Tax

1. Some countries use money creation to pay for spending instead of using tax

revenue.

2. De)nition of in1ation tax: the revenue the government raises by creating

money.

3. The ination tax is like a tax on everyone who holds money.

4. Almost all hyperinations follow the same pattern.

a. The government has a high level of spending and inadequate tax revenue to

pay for its spending.

b. The government’s ability to borrow funds is limited.

c. As a result, it turns to printing money to pay for its spending.

d. The large increases in the money supply lead to large amounts of ination.

e. The hyperination ends when the government cuts its spending and

eliminates the need to create new money.

5. FYI: Hyperination in Zimbabwe

a. In the 2000s, Zimbabwe faced one of history’s most extreme examples of

hyperination.

b. Before the period of hyperination, one Zimbabwe dollar was worth a bit more

than one U.S. dollar.

c. By 2009, the Zimbabwe government was issuing notes with denominations as

large as 10 trillion Zimbabwe dollars (which were worth about three U.S.

dollars).

I. The Fisher EDect

1. Recall that the real interest rate is equal to the nominal interest rate minus the

ination rate.

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on a password-protected website or school-approved learning management system for classroom use.

Point out that an ination tax is a more subtle form of taxation than the

standard forms of taxation (income tax, sales tax, etc.).

Chapter 30/Money Growth and Ination ❖ 493

2. This, of course, means that:

a. The supply and demand for loanable funds determines the real interest rate.

b. Growth in the money supply determines the ination rate.

3. When the Fed increases the rate of growth of the money supply, the ination rate

increases. This in turn will lead to an increase in the nominal interest rate.

4. De)nition of Fisher e2ect: the one-for-one adjustment of the nominal

interest rate to the in1ation rate.

a. The Fisher eDect does not hold in the short run to the extent that ination is

unanticipated.

b. If ination catches borrowers and lenders by surprise, the nominal interest

rate will fail to reect the rise in prices.

5. Figure 5 shows the nominal interest rate and the ination rate in the U.S.

economy since 1960.

III. The Costs of Ination

A. A Fall in Purchasing Power? The Ination Fallacy

1. Most individuals believe that the major problem caused by ination is that

ination lowers the purchasing power of a person’s income.

2. However, as prices rise, so do incomes. Thus, ination does not in itself reduce

the purchasing power of incomes.

B. Shoeleather Costs

1. Because ination erodes the value of money that you carry in your pocket, you

can avoid this drop in value by holding less money.

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Point out to students that prices involve both buyers and sellers. This

implies that the higher prices paid by consumers are oDset by the higher

incomes received by the sellers. Also remind students that workers often

get pay increases over time to compensate for increases in the cost of

living.

nominal interest rate = real interest rate + ination rate

ALTERNATIVE CLASSROOM EXAMPLE:

Real interest rate = 5%

Ination rate = 2%

This means that the nominal interest rate will be 5% + 2% = 7%.

If the ination rate rises to 3%, the nominal interest rate will rise to 5% + 3% =

8%.

Figure 5

494 ❖ Chapter 30/Money Growth and Ination

2. However, holding less money generally means more trips to the bank.

3. De)nition of shoeleather costs: the resources wasted when in1ation

encourages people to reduce their money holdings.

4. This cost can be considerable in countries experiencing hyperination.

C. Menu Costs

1. De)nition of menu costs: the costs of changing prices.

2. During periods of ination, )rms must change their prices more often.

D. Relative-Price Variability and the Misallocation of Resources

1. Because prices of most goods change only once in a while (instead of constantly),

ination causes relative prices to vary more than they would otherwise.

2. When ination distorts relative prices, consumer decisions are distorted and

markets are less able to allocate resources to their best use.

E. Ination-Induced Tax Distortions

1. Lawmakers fail to take ination into account when they write tax laws.

2. The nominal values of interest income and capital gains are taxed (not the real

values).

a. Table 1 shows a hypothetical example of two individuals, living in two

countries earning the same real interest rate, and paying the same tax rate,

but one individual lives in a country without ination and the other lives in a

country with 8% ination.

b. The person living in the country with ination ends up with a smaller after–tax

real interest rate.

3. This implies that higher ination will tend to discourage saving.

4. A possible solution to this problem would be to index the tax system.

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on a password-protected website or school-approved learning management system for classroom use.

Students )nd this section intriguing. Most have not considered the fact

that tax laws do not diDerentiate between nominal and real interest

income and capital gains, and they soon realize that this can lead to

eDects on rates of saving. Work through an example of the after-tax real

interest rate under diDerent ination scenarios as is done in the text.

Table 1

Chapter 30/Money Growth and Ination ❖ 495

F. Confusion and Inconvenience

1. Money is the yardstick that we use to measure economic transactions.

2. When ination occurs, the value of money falls. This alters the yardstick that we

use to measure important variables like incomes and pro)t.

G. A Special Cost of Unexpected Ination: Arbitrary Redistributions of Wealth

1. Example: Sam Student takes out a $20,000 loan at 7% interest (nominal). In 10

years, the loan will come due. After his debt has compounded for 10 years at 7%,

Sam will owe the bank $40,000.

2. The real value of this debt will depend on ination.

a. If the economy has a hyperination, wages and prices will rise so much that

Sam may be able to pay the $40,000 out of pocket change.

b. If the economy has deation, Sam will )nd the $40,000 a greater burden than

he anticipated.

3. Because ination is often hard to predict, it imposes risk on both Sam and the

bank that the real value of the debt will diDer from that expected when the loan is

made.

4. Ination is especially volatile and uncertain when the average rate of ination is

high.

H. Ination Is Bad, but Deation May Be Worse

1. Although ination has been the norm in recent U.S. history, from 1998 to 2012

Japan experienced a 4-percent decline in its overall price level.

2. Deation leads to lower shoeleather costs, but still creates menu costs and

relative-price variability.

3. Deation also results in the redistribution of wealth toward creditors and away

from debtors.

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ALTERNATIVE CLASSROOM EXAMPLE:

Hannah and Miley each earn a real interest rate on their savings account of 3%.

However, Hannah lives in a country with a 1% ination rate, while Miley lives in a

country with a 10% ination rate. Both countries have a 20% tax on income.

Hannah Miley

Real interest rate 3% 3%

Ination rate 1 10

Nominal interest rate 4 13

Reduced interest due to 20% tax 0.8 2.6

After-tax nominal interest rate 3.2 11.4

After-tax real interest rate 2.2 1.4

Note that the after-tax return on saving is lower in Miley’s country than in

Hannah’s. This means that individuals in Miley’s country will be less likely to

save.

496 ❖ Chapter 30/Money Growth and Ination

I. Case Study: The Wizard of Oz and the Free Silver Debate

1. Some scholars believe that the book The Wizard of Oz was written about U.S.

monetary policy in the late 19th century.

2. From 1880 to 1896, the United States experienced deation, redistributing wealth

from farmers (with outstanding loans) to banks.

3. Because the United States followed the gold standard at this time, one possible

solution to the problem was to start to use silver as well. This would increase the

supply of money, raising the price level, and reduce the real value of the farmers’

debts.

4. There has been some debate over the interpretation assigned to each character,

but it is clear that the story revolves around the monetary policy debate at that

time in history.

5. Even though those who wanted to use silver were defeated, the money supply in

the United States increased in 1898 when gold was discovered in Alaska and

supplies of gold were shipped in from Canada and South Africa.

6. Within 15 years, prices were back up and the farmers were better able to handle

their debts.

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Chapter 30/Money Growth and Ination ❖ 497

Activity 1—The In1ation Fairy

Type: In-class demonstration

Topics: Ination

Materials needed: None

Time: 10 minutes

Class limitations: Works in any size class

Purpose:

This activity demonstrates the eDects of ination.

Instructions:

Ask the class to consider the eDect of an overnight doubling of prices.

Tell them everything doubled in price while they slept. A soft drink that sold for a

dollar, now sells for two dollars; a car that sold for $20,000 now sells for $40,000.

The price of labor doubled as well, so a job paying $6 an hour now pays $12; a

$30,000 annual salary becomes a $60,000 annual salary.

The value of all assets doubled as well. Stock prices are twice what they were at

yesterday’s closing. A $1,000 bond becomes a $2,000 bond. A $35 balance in a

checking account becomes $70, and so on.

Debts have also doubled. The $5 borrowed from a roommate becomes $10. The

$3,000 in student loans becomes $6,000. A $75,000 home mortgage becomes a

$150,000 mortgage.

And even cash balances double. The ination fairy sneaks in at night and replaces

the $10 bill in their wallet with a new $20 bill. The ination fairy even doubles the

coins in their piggy banks.

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498 ❖ Chapter 30/Money Growth and Ination

If the prices of everything doubled overnight, what would happen?

POINTS FOR DISCUSSION

If the prices of everything doubled overnight, what would happen: NOTHING.

If all prices adjusted perfectly there would be no real eDect. Everyone would have

exactly the same purchasing power. They have twice as much money but

everything costs twice as much. There have been no relative changes in price.

This is a fantastic rate of ination: 100% daily. Prices would increase more than a

billion-fold in a month at this rate of price change. Yet, if everything adjusts

perfectly there will be no real eDect on the economy.

The problem, of course, is there is no ination fairy ensuring that everything

adjusts smoothly. Some prices adjust quickly and others do not.

Cash balances would not double without the ination fairy, so people would not be

willing to hold cash or accept cash in payment. This would increase transaction

costs considerably.

If prices do not change at the same rate, there will be winners and losers from

ination. For example, if everything doubled in price overnight except debt, then

borrowers would see the real value of their loan payments halved. Borrowers

would win and lenders would lose. If the overnight ination is an ongoing process,

everyone would try to borrow, but no one would be willing to lend. Credit markets

would collapse.

More generally, anyone whose income does not keep up with ination will lose.

Anyone whose costs rise less than ination will come out ahead.

Other problems can be introduced here: bracket creep, increased uncertainty,

weakening of price signals, shoeleather costs, menu costs, etc.

Much of the problem with ination is distributional, but there are real

consequences as well. Time spent worrying about ination, or pro)ting from

ination, is a diversion of resources away from productive activity.

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