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CHAPTER 5
Inflation: Its Causes, Effects, and
Social Costs
Notes to the Instructor
Chapter Summary
This chapter explains the classical theory of the causes, effects, and social costs of inflation. It
introduces topics that are central for understanding the economy and presents concepts used
elsewhere in the textbook. These topics include:
2. The effects of monetary policy when prices are flexible;
3. The social costs of inflation.
The material in this chapter builds upon the discussion of money and the monetary system
presented in Chapter 4.
Comments
This chapter can probably be covered in two lectures, although the material on hyperinflation is
difficult and so may require a little extra time. Since hyperinflations are both fascinating and
instructive, this part of the chapter is ultimately very rewarding for the students.
The Fisher equation and the distinction between nominal and real rates of interest are
Use of the Web Site
This is a good time to use the data plotter to explain and illustrate the Fisher equation.
Use of the Dismal Scientist Web Site
Go to the Dismal Scientist Web site and download annual data for the past 40 years for the two
key measures of the money supply: M1 and M2. Also download data over the same period for
nominal GDP. Compute two measures of the velocity of money by dividing GDP by each of the
two measures of the money supply. Discuss how the velocity of money has changed over time
for these two measures.
Chapter Supplements
This chapter includes the following supplements:
5-2 Data on Money Growth and Inflation (Case Study)
5-4 Deriving the Fisher Equation
5-6 Transactions Models of Money Demand
5-7 Inflation and Economic Growth
5-9 The Welfare Costs of Inflation Revisited
5-11 U.S. Treasury Issues Indexed Bonds
5-13 Are Monetary Allegories in the Eye of the Beholder? The Case of Mary Poppins (Case
5-14 How to Stop a Hyperinflation
5-16 Additional Readings
Lecture Notes | 89
Lecture Notes
Introduction
So far, our entire analysis of the economy has been in real terms, since economists think that
different goods. The weights are based on the relative importance of the goods in consumption.
The recent U.S. experience has been one of moderate but positive inflation. In recent
years, prices have been rising by around 2.5 percent per year on average, while the average rate
of inflation was somewhat higher in the 1970s and early 1980s and slightly lower in the 1950s
and 1960s. But this is not the experience of all countries at all times. Earlier in this century, the
= 1.32. Here, a pizza that cost $10 in 1990 would cost $12 in 1991 and $13.20 in 1992. Goods
are becoming more expensive over time, but prices rose more between 1990 and 1991 (20
percent) than between 1991 and 1992 (10 percent). This situation, in which prices are rising but
the rate of inflation is falling, is known as disinflation.
5-1 The Quantity Theory of Money
Transactions and the Quantity Equation
Having briefly considered the supply of money, we now turn to the demand for money. We
begin with a very simple theory of money demand, known as the quantity theory. The starting
point for this theory is the observation that people hold money largely to facilitate transactions.
90 | CHAPTER 5: Inflation: Its Causes, Effects, and Social Costs
From Transactions to Income
Suppose that each transaction represents one unit of GDP. This would be true if the only
transactions that took place were those that involved the final sale of newly produced goods.
Then, we could replace T with Y and get an amended form of the quantity equation:
V=PY /M
⇒MV =PY
.
If Y is proportional to T, the income velocity of money will be proportional to the transactions
velocity. For example, if there are three transactions for every transaction involving a unit of
GDP, then the transactions velocity of money is three times the income velocity of money.
The advantage of the income velocity of money is that we can easily measure it; it is
The Money Demand Function and the Quantity Equation
A simple idea about money demand is that people hold money to carry out transactions and that
the amount of money they want to hold is roughly proportional to the number of transactions
they want to perform. If the number of transactions is, in turn, proportional to income, then the
amount of money that people want to hold is proportional to income. Also, we might expect that
the amount of money that people want to hold will be proportional to the price of a transaction;
if the cost of the average transaction doubles, then we would expect that the demand for money
would double. This leads to a money demand function of the form
Md = kPY.
As elsewhere, we prefer to carry out our analysis in real terms. The term M/P is called real
money balances; it tells you the value of M in terms of goods. So we can rewrite our money
demand function in real terms as
The Assumption of Constant Velocity
The quantity equation, therefore, becomes a theory of the demand for money by supposing that
money demand is proportional to output. This means, in essence, that we are assuming that the
Lecture Notes | 91
!Figures 5-1, 5-2
!Supplement 5-2,
“Data on Money
Growth and
Inflation”
!Supplement 5-3,
“Seignorage as an
Inflation Tax”
velocity of money is constant. The assumption of constant velocity is not fully satisfactory, for
reasons that we will come to, but it is a useful starting point. Note, moreover, where this theory
leads us. If V is fixed (V), then nominal GDP must be proportional to the money supply. If Y is
also fixed, then the price level is proportional to the money supply.
Money, Prices, and Inflation
Let us explore this a little further. Writing the quantity equation in terms of growth rates gives
As we will see in Chapters 8 and 9, the growth of output depends on exogenous factors such as
population growth and technical progress. It follows that the inflation rate depends on the growth
rate of the money supply. If the Fed keeps the money supply stable, prices will be stable. To put
it another way, if the Fed wishes the inflation rate to be zero, it should increase the money
supply at a rate equal to that of output growth. In that case, there would be just enough extra
money each year to absorb the extra demand due to extra transactions.
Case Study: Inflation and Money Growth
Data for the U.S. economy since 1870 provide broad support for the link between money growth
and inflation implied by the quantity theory. Decadal averages over this period reveal a positive
relationship between the GDP deflator and the growth of M2. International data show the
correlation even more clearly.
5-2 Seigniorage: The Revenue from Printing Money
The discussion of the circular flow of income in Chapter 3 revealed that the government deficit
equals the difference between government spending and government income from taxation. The
government can finance its deficit by borrowing from the public or by printing money. New
money is a source of government revenue, like taxation. The revenue that the government
obtains by printing money is known as seigniorage.
Case Study: Paying for the American Revolution
The Continental Congress depended significantly on seigniorage to finance the Revolution. New
issues of continental currency grew approximately twentyfold between 1775 and 1779, leading
in turn to substantial inflation.
5-3 Inflation and Interest Rates
Two Interest Rates: Real and Nominal
We now turn to the distinction between nominal and real interest rates. This is an occasion when
macroeconomics teaches an important, simple, yet often overlooked, insight. The interest rate
quoted in the newspapers is a nominal interest rate. It gives the number of dollars that will be
92 | CHAPTER 5: Inflation: Its Causes, Effects, and Social Costs
!Figures 5-3, 5-4
!Supplement 5-5,
“Using Interest
Rates to Forecast
Inflation”
paid next year for a dollar deposited today. For example, a 10 percent interest rate implies that
$100 deposited today earns $110 next year. But suppose that prices also rise at 10 percent per
The Fisher Effect
Notice that we now have two implications of an increase in the money growth rate. First, our
theory predicts that an increase in the money growth rate of, say, 1 percent should increase the
inflation rate by 1 percent. In turn, this should imply a 1 percent increase in the nominal interest
rate. This link between the inflation rate and the nominal interest rate is known as the Fisher
effect.
Case Study: Inflation and Nominal Interest Rates
The data for the U.S. and other economies clearly reveal the connection between the inflation
rate and the nominal interest rate suggested by the Fisher effect. They also reveal that the real
interest rate changes over time.
Two Real Interest Rates: Ex Ante and Ex Post
The previous discussion is misleading in one respect. When people make intertemporal
economic decisions, they don’t know for sure what the inflation rate will be. This means that,
rather than the actual inflation rate, we should use the expected inflation rate. The relevant real
Case Study: Nominal Interest Rates in the Nineteenth Century
The Fisher effect is not evident in U.S. data the late nineteenth and early twentieth centuries.
Years when the inflation rate was high were not necessarily years when nominal interest rates
5-4 The Nominal Interest Rate and the Demand for Money
Our earlier discussion of money demand noted that one function of money is that it serves as a
store of value. In times of inflation, it serves less well in this role. If prices are rising, a dollar
bill buys less and less as time goes by. This suggests that our previous analysis of the demand
for money, where money demand depends only on income, is incomplete.
Lecture Notes | 93
!Supplement 5-6,
“Transactions
Models of Money
Demand”
!Supplement 5-7,
“Inflation and
The Cost of Holding Money
The observation that inflation reduces the value of money suggests that, if the inflation rate is
high, people will be less inclined to hold their wealth in the form of money. This intuition is
basically correct, but not complete. It turns out that money demand depends on the nominal
interest rate and, hence, indirectly (through the Fisher effect) on the inflation rate.
To see this, note that money is simply one way in which people can hold wealth. The
advantage of money is that it is convenient for transactions. But it has an associated
disadvantage: If an individual holds wealth in the form of money, she gives up the interest she
could earn if she instead put her wealth into interest-bearing assets. The interest that she could
have earned but didn’t is an opportunity cost. An interest-bearing asset pays an interest rate of i;
Future Money and Current Prices
We have now made life, or at least our theory, more complicated. Suppose that we see a 1
percent increase in the growth rate of the money supply. This will increase the inflation rate. But
through the Fisher effect, this will, in turn, increase the nominal interest rate and so decrease the
5-5 The Social Costs of Inflation
The Layman’s View and the Classical Response
The general public views inflation as a major social problem because of the mistaken belief that
rising prices make a person poorer. This notion reflects a lack of understanding about how a
Case Study: What Economists and the Public Say About
Inflation
The economist Robert Shiller used a survey to examine the attitudes of economists and the
general public with respect to inflation. He discovered that the public was more inflation averse
The Costs of Expected Inflation
94 | CHAPTER 5: Inflation: Its Causes, Effects, and Social Costs
!Supplement 5-8,
“The Welfare
Costs of Inflation
and the Optimum
Quantity of
Money”
!Supplement 5-9,
“The Welfare
Costs of Inflation
Revisited”
!Supplement 5-11,
“U.S. Treasury
Issues Indexed
Bonds”
In considering the social costs of inflation, a useful starting point is the distinction between
anticipated and unanticipated inflation. First, consider those costs of inflation that exist when all
prices and wages are rising at some steady, well-understood rate.
The first social cost of inflation is shoe-leather costs. Remember that the demand for
money depends negatively on the nominal interest rate and, hence, on the inflation rate. When
the interest rate is high, it is worthwhile for people to put some time and effort into economizing
on their holdings of cash; they go to the bank more often and, metaphorically, wear out their
shoes more quickly.
A second cost of steady, anticipated inflation is also referred to in metaphorical terms:
menu costs. The idea here is that, in times of inflation, restaurants have to print new menus with
changed prices. More generally, the act of changing prices may absorb real resources in the
economy. While this cost is undoubtedly real, it seems unlikely that it is substantial.
A third cost of inflation arises because it may introduce unwanted variation in relative
The Costs of Unexpected Inflation
Unanticipated inflation introduces extra uncertainty into the economic environment. Generally,
we think that people dislike uncertainty; in economists’ terminology, they are risk averse. Thus,
unanticipated inflation hurts people because it leads to arbitrary and unpredictable
redistributions. Consider two people who enter into a contract specified in nominal terms. If
inflation is higher than predicted, then the debtor “wins”—she pays less in real terms than she
expected—and the creditor loses since, he gets less in real terms than he expected.
From a social point of view, such redistributions are not themselves necessarily costly, but
it is important to recognize that they do occur. Furthermore, if increased uncertainty discourages
Lecture Notes | 95
!Supplement 5-12,
“A Guide to Oz”
!Supplement 5-13,
“Are Monetary
Allegories in the
Eye of the
Beholder? The
Case of Mary
Poppins”
!Supplement 5-14,
“How to Stop a
Hyperinflation”
!Figure 5-6
Case Study: The Free Silver Movement, the Election of 1896,
and the Wizard of Oz
The Wizard of Oz has been argued to be an allegory of the debate over the gold standard during
the 1896 presidential election. Some people believe that this reveals more about economists than
it does about the Wizard of Oz.
One Benefit of Inflation
The costs associated with both anticipated and unanticipated inflation have often been cited as
justification for why policymakers should target a zero rate of inflation. But it may be the case
5-6 Hyperinflation
Hyperinflation simply means very rapid inflation, usually 50 percent per month or more.
Inflation at this rate means that goods become more than 100 times more expensive over the
course of a year. Lenin is reported to have said that the best way to destroy capitalism was
through such inflation.
The Costs of Hyperinflation
Some of the costs of inflation discussed in the previous section become very severe in the case
of a hyperinflation. Shoe-leather costs are probably small under low inflation but become very
The Causes of Hyperinflation
If the quantity theory were correct, so that real money demand were simply proportional to GDP,
then analyzing hyperinflations would be straightforward. Excessive money growth would lead to
large inflation; to stop a hyperinflation, it would be sufficient to control the growth rate of the
money supply. But the quantity theory is not a good guide to the demand for money in this
Case Study: Hyperinflation in Interwar Germany
During the period 1922 to 1924, Germany experienced a massive hyperinflation. Over the last 15
months of this inflation, prices rose at an average of well over 300 percent per month. The
hyperinflation arose because the German government resorted to money creation to pay for
96 | CHAPTER 5: Inflation: Its Causes, Effects, and Social Costs
Case Study: Hyperinflation in Zimbabwe
Over the past couple of decades, the government of Robert Mugabe in Zimbabwe implemented
land reforms intended to redistribute wealth from the white minority to the historically
disenfranchised black population. Productivity and output in farming fell as experienced white
farmers left the country. The drop in output caused government tax revenue to decline. With tax
5-7 Conclusion: The Classical Dichotomy
The analysis of Chapter 3 revealed that, in the long run, real variables in the economy (that is,
quantities such as GDP and relative prices such as the real wage) can be determined
independently of nominal variables. This separation of real and nominal variables is known as
Appendix: The Cagan Model: How Current and Future Money
Affect the Price Level
Chapter 5 explains that the demand for real money balances depends on the nominal interest rate
and, hence, on the inflation rate. For a given supply of nominal money, therefore, the current
price level depends on the expected future price level. Consequently, the current price level
depends on both the current money supply and the expected future money supply.
We can see this more formally by assuming that money market equilibrium can be written
as
where Mt is the money supply, Pt is the price level, πt is the inflation rate, γ measures the
sensitivity of money demand to the nominal interest rate, and k is an unimportant constant. By
writing the money demand function in this form, we are assuming that income and real interest
rates are constant (their effects are subsumed in the constant k), so we can focus attention on the
effects of changes in the inflation rate. Letting lowercase letters denote logarithms (and ignoring
Lecture Notes | 97
pt=1
1+
γ
mt+
γ
1+
γ
mt+1+
γ
1+
γ
2
mt+2+
γ
1+
λ
3
mt+3+
.
So the current price level depends upon the entire future path of the money supply. If money
98
LECTURE SUPPLEMENT
5-1 The Velocity of Money in Poetry and Song
The subject matter of economics does not usually provide a great deal of inspiration for songwriters and
poets. The velocity of money seems to be an exception.
The Dollar Bill Song1
She took a dollar bill from her pocket
She picked up a fountain pen.
She wrote the words “I love you”
By the picture of George Washington.
Anyway the Rabbi spent the bill on a ham and cheese to go.
They gave the bill to a guy named Phil who gave it to his best friend Joe.
Joe had planned to spend the bill on some flowers for his bride
But he was mugged by a junkie named Doug in the parking lot outside.
Doug’s old lady spent the bill on a couple of bottles of beer.
She eventually becomes a very famous poet, but that don’t matter here.
The liquor store guy put the dollar bill in his register but then
Doug the junkie said “Stick ’em up” and the dollar was his again.
99
You know I will be there.
My friend you don’t need no dime
You don’t need no subway fare
Just give a tug along the line
I’m with you everywhere.
Ten Pence Story2
My lowest ebb was a seven month spell
spent head down in a stagnant wishing well,
half eclipsed by an oxidized tuppence
which impressed me with its green circumference.
When they fished me out I made a few phone calls,
fed a few meters, hung round the pool halls.
I slotted in well, but all that vending
blunted my edges and did my head in.
100
My own ambition? Well, that was simple:
to be flipped in Wembley’s centre circle,
to twist, to turn, to hang like a planet,
to touch down on that emerald carpet.
101
CASE STUDY EXTENSION
5-2 Data on Money Growth and Inflation
The case study “Inflation and Money Growth” shows the relationship between money growth (M1) and
inflation that exists in long-run data and notes that such a relationship is not evident in short-run data.
Figure 1 illustrates this by showing annual data on money growth and inflation in the United States for the
last half century.
Note: Money growth is annual percentage change in M1. Inflation is annual percentage change in official CPI.
Source: Federal Reserve Board and U.S. Department of Labor, Bureau of Labor Statistics.
Figure 2 shows the relationship between money growth and nominal GDP growth for the same period. If
the velocity of money were constant, money growth would equal nominal GDP growth. In the 1960s and
102
LECTURE SUPPLEMENT
5-3 Seigniorage as an Inflation Tax
The textbook explains that seigniorage arises because a government can print money at essentially zero
cost and use it to buy goods. It also describes seigniorage as an inflation tax, because holders of existing
money balances see the real value of their money decline with inflation. The equivalence of the two may
not be immediately obvious, however.
( )
We therefore find an equivalence between the two measures of seigniorage if the inflation rate (∆P/P)
equals the money growth rate (∆M/M). As explained in the textbook, the two will be equal in the long run
in an economy without output growth.
If output is growing, the money growth rate will exceed the inflation rate. In a growing economy,
money demand is increasing through time, so the monetary authorities can print money to accommodate
104
LECTURE SUPPLEMENT
5-4 Deriving the Fisher Equation
Section 4-4 of the textbook explains the Fisher equation—that is, the relationship between the real interest
rate, the nominal interest rate, and the rate of inflation. Specifically, the real interest rate is shown to equal
the nominal interest rate minus the inflation rate (r = i – π). Here, we derive that relationship more
formally.
Think about two people (Bill and Hillary) who agree to a loan specified in real terms. Hillary agrees
to give goods (units of GDP) to Bill today on the understanding that, for every unit Bill receives, he will
repay 1 + r units next year. In this setup, r is the real interest rate; that is, it is the interest rate in terms of
commodities.
units of GDP next period. Thus, the real return on this dollar-denominated loan is (1 + i)/(1 + π).
We thus find that
1+r=
1+i
( )
1+
π
( )
⇒1+r
( )
1+
π
( )
=1+i
( )
.
Multiplying out the left-hand side and subtracting 1 from each side gives
