281
WHAT’S NEW IN THE SEVENTH EDITION:
There are no major changes to this chapter.
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
➢ why inflation 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 hyperinflation.
➢ how the nominal interest rate responds to the inflation rate.
➢ the various costs that inflation imposes on society.
CONTEXT AND PURPOSE:
Chapter 17 is the second chapter in a two-chapter sequence dealing with money and prices in the long
run. Chapter 16 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 inflation rate.
The purpose of this chapter is to acquaint students with the causes and costs of inflation. Students will
find that, in the long run, there is a strong relationship between the growth rate of money and inflation.
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 inflation.
17
MONEY GROWTH AND
INFLATION
282 ❖ Chapter 17/Money Growth and 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.
• 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.
CHAPTER OUTLINE:
I. The inflation rate is measured as the percentage change in the Consumer Price Index, the GDP
deflator, 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.
II. The Classical Theory of Inflation
Start off the chapter by differentiating 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 inflation means that the average level of prices in the
economy is rising rather than the prices of all goods.
It is instructive to review the inflation history of the United States. While your
students are likely fully aware of inflation, they may not realize that, prior to World
War II, the United States experienced several periods of deflation. Also point out to
the students that the rate of inflation has varied significantly since World War II.
Chapter 17/Money Growth and Inflation ❖ 283
A. The Level of Prices and the Value of Money
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.
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 reflects 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.
Figure 1
284 ❖ Chapter 17/Money Growth and Inflation
C. The Effects 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. Definition 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 inflation rate.
D. A Brief Look at the Adjustment Process
1. The immediate effect 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.
Figure 2
Chapter 17/Money Growth and Inflation ❖ 285
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. Definition of nominal variables: variables measured in monetary units.
b. Definition of real variables: variables measured in physical units.
3. Definition 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 different forces influence real and nominal variables.
a. Changes in the money supply affect nominal variables but not real variables.
F. Velocity and the Quantity Equation
1. Definition 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 deflator),
Y
is real GDP, and
M
is the quantity of money:
velocity = nominal GDP/money supply
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.
286 ❖ Chapter 17/Money Growth and Inflation
5. Definition 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 reflected
in one of the other three variables.
b. Specifically, 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 affects 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
).
G.
Case Study: Money and Prices during Four Hyperinflations
1. Hyperinflation is generally defined as inflation that exceeds 50% per month.
Figure 3
ALTERNATIVE CLASSROOM EXAMPLE:
Suppose that:
Real GDP = $5,000
Velocity = 5
Chapter 17/Money Growth and Inflation ❖ 287
2. Figure 4 shows data from four classic periods of hyperinflation during the 1920s in Austria,
Hungary, Germany, and Poland.
H. The Inflation Tax
1. Some countries use money creation to pay for spending instead of using tax revenue.
2. Definition of inflation tax: the revenue the government raises by creating money.
3. The inflation tax is like a tax on everyone who holds money.
4. Almost all hyperinflations 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.
5.
FYI: Hyperinflation in Zimbabwe
a. In the 2000s, Zimbabwe faced one of history’s most extreme examples of hyperinflation.
b. Before the period of hyperinflation, 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 Effect
1. Recall that the real interest rate is equal to the nominal interest rate minus the inflation rate.
2. This, of course, means that:
Figure 4
Point out that an inflation tax is a more subtle form of taxation than the standard
forms of taxation (income tax, sales tax, etc.).
nominal interest rate = real interest rate + inflation rate
288 ❖ Chapter 17/Money Growth and Inflation
3. When the Fed increases the rate of growth of the money supply, the inflation rate increases.
This in turn will lead to an increase in the nominal interest rate.
reflect the rise in prices.
5. Figure 5 shows the nominal interest rate and the inflation rate in the U.S. economy since
1960.
III. The Costs of Inflation
A. A Fall in Purchasing Power? The Inflation Fallacy
1. Most individuals believe that the major problem caused by inflation is that inflation lowers the
purchasing power of a person’s income.
2. However, as prices rise, so do incomes. Thus, inflation does not in itself reduce the
purchasing power of incomes.
B. Shoeleather Costs
1. Because inflation erodes the value of money that you carry in your pocket, you can avoid this
drop in value by holding less money.
Figure 5
Point out to students that prices involve both buyers and sellers. This implies that the
higher prices paid by consumers are exactly offset 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.
ALTERNATIVE CLASSROOM EXAMPLE:
Real interest rate = 5%
Inflation rate = 2%
This means that the nominal interest rate will be 5% + 2% = 7%.
If the inflation rate rises to 3%, the nominal interest rate will rise to 5% + 3% = 8%.
Chapter 17/Money Growth and Inflation ❖ 289
C. Menu Costs
1. Definition of menu costs: the costs of changing prices.
2. During periods of inflation, firms must change their prices more often.
D. Relative-Price Variability and the Misallocation of Resources
E. Inflation-Induced Tax Distortions
1. Lawmakers fail to take inflation 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 inflation and the other lives in a country with 8% inflation.
b. The person living in the country with inflation ends up with a smaller after-tax real
interest rate.
3. This implies that higher inflation will tend to discourage saving.
4. A possible solution to this problem would be to index the tax system.
Students find this section intriguing. Most have not considered the fact that tax laws
do not differentiate between nominal and real interest income and capital gains, and
they soon realize that this can lead to effects on rates of saving. Work through an
example of the after-tax real interest rate under different inflation scenarios as is
done in the text.
Table 1
Nominal interest rate
4
13
Reduced interest due to 20% tax
0.8
2.6
After-tax nominal interest rate
3.2
After-tax real interest rate
2.2
1.4
290 ❖ Chapter 17/Money Growth and Inflation
F. Confusion and Inconvenience
1. Money is the yardstick that we use to measure economic transactions.
2. When inflation occurs, the value of money falls. This alters the yardstick that we use to
measure important variables like incomes and profit.
G. A Special Cost of Unexpected Inflation: 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.
3. Because inflation is often hard to predict, it imposes risk on both Sam and the bank that the
real value of the debt will differ from that expected when the loan is made.
4. Inflation is especially volatile and uncertain when the average rate of inflation is high.
H. Inflation Is Bad, but Deflation May Be Worse
1. Although inflation 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. Deflation leads to lower shoeleather costs, but still creates menu costs and relative-price
variability.
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% inflation rate, while Miley lives in a country with a 10%
inflation rate. Both countries have a 20% tax on income.
Hannah
Miley
Real interest rate
3%
3%
Inflation rate
1
10
Chapter 17/Money Growth and Inflation ❖ 291
3. Deflation also results in the redistribution of wealth toward creditors and away from debtors.
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 deflation, redistributing wealth from
farmers (with outstanding loans) to banks.
6. Within 15 years, prices were back up and the farmers were better able to handle their debts.
Activity 1—The Inflation Fairy
Type: In-class demonstration
Topics: Inflation
Materials needed: None
Time: 10 minutes
Class limitations: Works in any size class
Purpose
This activity demonstrates the effects of inflation.
Instructions
Ask the class to consider the effect 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.
292 ❖ Chapter 17/Money Growth and Inflation
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
1. When the government of a country increases the growth rate of the money supply from 5
And even cash balances double. The inflation fairy sneaks in at night and replaces the $10 bill
in their wallet with a new $20 bill. The inflation fairy even doubles the coins in their piggy
banks.
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 effect. 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 inflation: 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 effect on the economy.
The problem, of course, is there is no inflation fairy ensuring that everything adjusts
smoothly. Some prices adjust quickly and others do not.
Cash balances would not double without the inflation 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 inflation. 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 inflation is an ongoing process, everyone would try to borrow, but no one would be
willing to lend. Credit markets would collapse.
Chapter 17/Money Growth and Inflation ❖ 293
Questions for Review
1. An increase in the price level reduces the real value of money because each dollar in your
294 ❖ Chapter 17/Money Growth and Inflation
Quick Check Multiple Choice
1. d
Problems and Applications
1. In this problem, all amounts are shown in billions.
2. a. If people need to hold less cash, the demand for money shifts to the left, because there
Chapter 17/Money Growth and Inflation ❖ 295
c. If the Fed wants to keep the price level stable, it should reduce the money supply from
3. With constant velocity, reducing the inflation rate to zero would require the money growth
4. If a country’s inflation rate increases sharply, the inflation tax on holders of money increases
b. If the price of beans rises to $2 and the price of rice rises to $4, then the cost of the
c. If the price of beans rises to $2 and the price of rice falls to $1.50, then the cost of the
296 ❖ Chapter 17/Money Growth and Inflation
d. The relative price of rice and beans matters more to Bob and Rita than the overall
6. The following table shows the relevant calculations:
(a)
(b)
(c)
(1) Nominal interest rate
10.0
6.0
4.0
(2) Inflation rate
5.0
2.0
1.0
(3) Before-tax real interest rate
5.0
4.0
3.0
(4) Reduction in nominal interest rate due to 40% tax
4.0
2.4
1.6
(5) After-tax nominal interest rate
6.0
3.6
2.4
(6) After-tax real interest rate
1.0
1.6
1.4
7. The functions of money are to serve as a medium of exchange, a unit of account, and a store
of value. Inflation mainly affects the ability of money to serve as a store of value, because
8. a. Unexpectedly high inflation helps the government by providing higher tax revenue and
reducing the real value of outstanding government debt.
9. a. The statement that “Inflation hurts borrowers and helps lenders, because borrowers
Chapter 17/Money Growth and Inflation ❖ 297