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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 ination 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 hyperination.
how the nominal interest rate responds to the ination rate.
the various costs that ination 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 ination rate.
The purpose of this chapter is to acquaint students with the causes and costs of
ination. Students will )nd that, in the long run, there is a strong relationship between the
growth rate of money and ination. Students will also )nd that there are numerous costs to
the economy from high ination, but that there is not a consensus on the importance of
these costs when ination 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 ination.
The principle of monetary neutrality asserts that changes in the quantity of money
inuence nominal variables but not real variables. Most economists believe that
485
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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.
30 MONEY GROWTH AND
INFLATION
486 ❖ Chapter 30/Money Growth and Ination
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 “ination tax,” the result is hyperination.
One application of the principle of monetary neutrality is the Fisher eDect. According to
the Fisher eDect, when the ination rate rises, the nominal interest rate rises by the
same amount, so that the real interest rate remains the same.
Many people think that ination makes them poorer because it raises the cost of what
they buy. This view is a fallacy, however, because ination also raises nominal incomes.
Economists have identi)ed six costs of ination: 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 hyperination, but the size of these costs for
moderate ination is less clear.
CHAPTER OUTLINE:
I. The ination rate is measured as the percentage change in the Consumer Price Index,
the GDP deator, 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 ination experiences. In 2015,
ination was 1.5% in China, 4.9% in India, 15.4% in Russia, and 84.1% in Venezuela.
II. The Classical Theory of Ination
A. The Level of Prices and the Value of Money
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
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It is instructive to review the ination history of the United States. While
your students are likely fully aware of ination, they may not realize that,
prior to World War II, the United States experienced several periods of
deation. Also point out to the students that the rate of ination 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 ination means that
the average level of prices in the economy is rising rather than the prices
of all goods.
Chapter 30/Money Growth and Ination ❖ 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 reects 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.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
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Figure 1
488 ❖ Chapter 30/Money Growth and Ination
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.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
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.
Figure 2
Chapter 30/Money Growth and Ination ❖ 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 inuence 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 deator), Y is real GDP, and M is the quantity of
money:
4. Rearranging, we get the quantity equation:
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
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
´
= M V P Y´ ´
490 ❖ Chapter 30/Money Growth and Ination
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
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 Ination ❖ 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 reected 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 ination.
G. Case Study: Money and Prices during Four Hyperinations
1. Hyperination is generally de)ned as ination that exceeds 50% per month.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
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.
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 Ination
2. Figure 4 shows data from four classic periods of hyperination 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 Ination 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 ination tax is like a tax on everyone who holds money.
4. Almost all hyperinations 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 ination.
e. The hyperination ends when the government cuts its spending and
eliminates the need to create new money.
5. FYI: Hyperination in Zimbabwe
a. In the 2000s, Zimbabwe faced one of history’s most extreme examples of
hyperination.
b. Before the period of hyperination, 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
ination rate.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
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.
Point out that an ination tax is a more subtle form of taxation than the
standard forms of taxation (income tax, sales tax, etc.).
Chapter 30/Money Growth and Ination ❖ 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 ination rate.
3. When the Fed increases the rate of growth of the money supply, the ination 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 ination is
unanticipated.
b. If ination catches borrowers and lenders by surprise, the nominal interest
rate will fail to reect the rise in prices.
5. Figure 5 shows the nominal interest rate and the ination rate in the U.S.
economy since 1960.
III. The Costs of Ination
A. A Fall in Purchasing Power? The Ination Fallacy
1. Most individuals believe that the major problem caused by ination is that
ination lowers the purchasing power of a person’s income.
2. However, as prices rise, so do incomes. Thus, ination does not in itself reduce
the purchasing power of incomes.
B. Shoeleather Costs
1. Because ination 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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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.
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 + ination rate
ALTERNATIVE CLASSROOM EXAMPLE:
Real interest rate = 5%
Ination rate = 2%
This means that the nominal interest rate will be 5% + 2% = 7%.
If the ination rate rises to 3%, the nominal interest rate will rise to 5% + 3% =
8%.
Figure 5
494 ❖ Chapter 30/Money Growth and Ination
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 hyperination.
C. Menu Costs
1. De)nition of menu costs: the costs of changing prices.
2. During periods of ination, )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),
ination causes relative prices to vary more than they would otherwise.
2. When ination distorts relative prices, consumer decisions are distorted and
markets are less able to allocate resources to their best use.
E. Ination-Induced Tax Distortions
1. Lawmakers fail to take ination 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 ination and the other lives in a
country with 8% ination.
b. The person living in the country with ination ends up with a smaller after-tax
real interest rate.
3. This implies that higher ination will tend to discourage saving.
4. A possible solution to this problem would be to index the tax system.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
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.
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 ination scenarios as is done in the text.
Table 1
Chapter 30/Money Growth and Ination ❖ 495
F. Confusion and Inconvenience
1. Money is the yardstick that we use to measure economic transactions.
2. When ination 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 Ination: 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 ination.
a. If the economy has a hyperination, 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 deation, Sam will )nd the $40,000 a greater burden than
he anticipated.
3. Because ination 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. Ination is especially volatile and uncertain when the average rate of ination is
high.
H. Ination Is Bad, but Deation May Be Worse
1. Although ination 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. Deation leads to lower shoeleather costs, but still creates menu costs and
relative-price variability.
3. Deation also results in the redistribution of wealth toward creditors and away
from debtors.
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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.
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% ination rate, while Miley lives in a
country with a 10% ination rate. Both countries have a 20% tax on income.
Hannah Miley
Real interest rate 3% 3%
Ination 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 Ination
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 deation, 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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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 Ination ❖ 497
Activity 1—The In1ation Fairy
Type: In-class demonstration
Topics: Ination
Materials needed: None
Time: 10 minutes
Class limitations: Works in any size class
Purpose:
This activity demonstrates the eDects of ination.
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 ination fairy sneaks in at night and replaces
the $10 bill in their wallet with a new $20 bill. The ination fairy even doubles the
coins in their piggy banks.
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
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498 ❖ Chapter 30/Money Growth and Ination
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 ination: 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 ination fairy ensuring that everything
adjusts smoothly. Some prices adjust quickly and others do not.
Cash balances would not double without the ination 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
ination. 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 ination 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 ination will lose.
Anyone whose costs rise less than ination 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 ination is distributional, but there are real
consequences as well. Time spent worrying about ination, or pro)ting from
ination, is a diversion of resources away from productive activity.
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
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