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8/2/2019 Chap 12 Mankiw
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MacroeconomicsTaught by Dr. Ahmad A. Kader
Chapter 12
Money Growth and Inflation
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The Classical Theory of Inflation Level of price and thevalue of money
When the price level rises , people have to pay more for goods and services thatthey purchase
A rise in the price level also means that the value of money is now lower becauseeach dollar now buys a smaller quantity of goods and services
If p is the price level, then the quantity of goods and services that can be purchasedwith one dollar is equal to 1/p
Money supply , money demand and monetary equilibrium The value of money is determined by the supply and demand for money
In the previous chapter, we learned that the Fed does not control the money supply100 percent
To simplify the analysis, we shall assume in this chapter that the Fed has a completecontrol over the money supply
Thus, the supply of money is treated as vertical (completely inelastic)
There are many determinants of the demand for money One important variable is the price level
The higher the price level, the more money that is needed to perform transactions
Thus, a higher price level leads to a higher quantity of money demanded
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The Classical Theory of Inflation
(Cont)
In the long-run, the overall price level adjusts to the level atwhich the demand for money and the supply of money are
equal If the price level is above equilibrium level, people will want to hold
more money than is available and prices will have to decline
If the price level is below the equilibrium, people will want to holdless money than is available and the price level will rise
We can show the supply and demand for money using a graph The left-hand vertical axis is the value of money, measured by 1/p
The right-hand vertical axis is the price level (p)
Note that p is inverted- a high value of money means a low price leveland vice versa
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Figure 1 Money Supply, Money Demand, and theEquilibrium Price Level
Copyright 2004 South-Western
Quantity ofMoney
Value ofMoney, 1/P
Price
Level, P
Quantity fixedby the Fed
Money supply
0
1
(Low)
(High)
(High)
(Low)
1/2
1/4
3/
4
1
1.33
2
4Equilibriumvalue ofmoney
Equilibriumprice level
Moneydemand
A
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Figure 2 The Effects of Monetary Injection
Copyright 2004 South-Western
Quantity ofMoney
Value ofMoney, 1/P PriceLevel,P
Moneydemand
0
1
(Low)
(High)
(High)
(Low)
1/2
1/4
3/
4
1
1.33
2
4
M1
MS1
M2
MS2
2. . . . decreasesthe value ofmoney . . . 3. . . . and
increasesthe pricelevel.
1. An increasein the moneysupply . . .
A
B
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A brief Look at the Adjustment
Process Assume that the economy is currently in equilibrium and the Fed suddenly
increases the money supply The supply of money shifts to the right The immediate effect of an increase in the money supply is to create an excess of
supply of money
People try to get rid of this excess in a variety of ways: They may buy goods and services with the funds They may use these funds to make loans to others These loans are then likely used to buy goods and services In either case , the increase in the money supply leads to an increase in the
demand for goods and services Because the supply of goods and services has not changed, the result of anincrease in the demand for goods and services will be higher prices
When an increase in the supply of money makes dollars more plentiful, theresult is an increase in the price level that makes each dollar less valuable
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The Classical Dichotomy and
Monetary Neutrality
In the 18th century, David Hume and other economistswrote about the relationship between monetary changesand important macroeconomic variables such asproduction , employment, real wages , and real interestrate
They suggested that economic variables should bedivided into two groups: nominal variables and real
variables
Nominal variables: variable measured in monetary units Real variables: variables measured in physical units
Classical dichotomy: the theoretical separation ofnominal and real variables
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The Classical Dichotomy and
Monetary Neutrality (Cont)
Prices in the economy are nominal, but relative
prices are real According to the classical dichotomy, different forces
influence real and nominal variables
According to Hume, changes in the money supply affect
nominal variables but not real variables Monetary neutrality (money is neutral): the
proposition that changes in the money supply donot affect real variables
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The Classical Theory of Inflation
(Cont.) The quantity theory of money: a theory asserting
that the quantity of money available determines
the price level and that growth rate in the quantityof money available determines the inflation rate
Inflation is an economy-wide phenomenon that
concerns the value of money When the overall price level rises, the value of
money falls
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Velocity and the Quantity
Equation
Thevelocity of moneyrefers to the speedat which the typical dollar bill travelsaround the economy from wallet to wallet
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Velocity and the Quantity
Equation (Cont)
V = (P Y)/M
Where:V = velocity
P = the price level
Y = the quantity of output
M = the quantity of money
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Velocity and the Quantity
Equation (Cont)
Rewriting the equation gives the
quantity equation:M V = P Y
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Velocity and the Quantity
Equation (Cont)
The quantity equationrelates the quantity ofmoney(M) to the nominal value of output(P Y)
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Velocity and the Quantity
Equation (Cont.) The quantity equation shows that an increase in the quantity of
money in an economy must be reflected in one of three other
variables: the price level must rise, the quantity of output must rise, or the velocity of money must fall
Because the economys output of goods and services (Y) is
determined by available resources and technology, changes inthe money supply do not affect output( money is neutral) Furthermore, since velocity of money is stable over time, an increase in
M leads to a proportionate increase in P Also, an increase in M leads to a proportionate change in the nominal
value of output (P x Y)
Fi 3 N i l GDP h Q i f M
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Figure 3 Nominal GDP, the Quantity of Money,and the Velocity of Money
Copyright 2004 South-Western
Indexes(1960 = 100)
2,000
1,000
500
0
1,500
1960 1965 1970 1975 1980 1985 1990 1995 2000
Nominal GDP
Velocity
M2
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Monetarists And Keynesians Views
on the Quantity Equation and on
Inflation Monetarists believe in the following;
Velocity of money (V) is stable
In the short-run, the effect of money supply (M2) increase, could be felt on prices or outputor both
If the economy is in a recession, the effect of money supply increase would be felt on outputand if the economy is operating at full employment, the impact will be on prices
However, in the long-run, the effect of money supply increase will be strictly inflationarywhich is similar to the classic view
Keynesians believe in the following; Velocity of money is unstable since holding money (M1) is affected by the opportunity cost
of holding it which is the interest rate
In the short-run, their view is similar to monetarists in that money supply increases affectprices or output or both but that this effect is felt through interest rate Keynesians also believe that in the short-run inflation could be the results of demand (other
than money) or supply shocks
In the long-run, their views are similar to those of Monetarists and Classical economists
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The Classical Theory of Inflation
(Cont) Inflation: Historical Aspects
Over the past 60 years, prices have risen on average about5 percent per year
However, inflation exhibited tremendous variability during theperiod, with prices rising an average of 7% in the 1970s and 2% inthe 1990s
Deflation: Meaning decreasing average prices andthey occurred in the U.S. in the nineteenth centuryand during the great depression of the 1920s
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Money and Prices during
Hyperinflation
Hyperinflation - An inflation that exceeds 50
percent per monthThe periods of hyperinflation in Austria,
Hungary, Germany, and Poland show the
quantity of money and the price level arealmost parallel
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The Inflation Tax
Almost all hyperinflations follow the same pattern
The government has a high level of spending and inadequate
tax revenue to pay for its spending The government ability to borrow funds is limited
As a result, the government turns to printing money to payfor its spending
The large increase in the money supply leads to high rate ofinflation
The hyperinflation ends when the government cuts itsspending and eliminates the need to create money
Fig re 4 Mone and Prices D ring Fo r
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Figure 4 Money and Prices During FourHyperinflations
Copyright 2004 South-Western
(a) Austria (b) Hungary
Money supply
Price level
Index(Jan. 1921 = 100) Index(July 1921 = 100)
Price level100,00010,0001,000
10019251924192319221921
Money supply100,00010,0001,000
10019251924192319221921
Figure 4 Money and Prices During Four
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Figure 4 Money and Prices During FourHyperinflations
Copyright 2004 South-Western
(c) Germany
1
Index(Jan. 1921 = 100)
(d) Poland
100,000,000,000,000
1,000,00010,000,000,0001,000,000,000,000
100,000,00010,000
100
Moneysupply
Price level
19251924192319221921
Price levelMoneysupply
Index(Jan. 1921 = 100)
100
10,000,000
100,0001,000,000
10,0001,000
19251924192319221921
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The Fisher Effect
The one for one adjustment of the nominal interestrate to the inflation rate When the Fed increases the rate of growth of the money
supply, the inflation rate increases and this in turn will leadto an increase in the nominal interest rate
The fisher effect does not hold in the short run to the
extent that inflation is unanticipated If inflation catches borrowers and lenders by surprise, the
nominal interest rate they set will fail to reflect the rise inprices
Figure 5 The Nominal Interest Rate and the
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Figure 5 The Nominal Interest Rate and theInflation Rate
Copyright 2004 South-Western
Percent(per year)
1960 1965 1970 1975 1980 1985 1990 1995 20000
3
6
9
12
15
Inflation
Nominal interest rate
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The Costs of Inflation
A fall in purchasing power? The fallacy of inflation Most individuals believe that the major problem caused by inflation is
that it lowers the purchasing power of persons income However, as prices rise, so do incomes. Thus, inflation does not in
itself reduce thepurchasing power of incomes; reasons? Prices involve both buyers and sellers. Higher prices paid by consumers areexactly
offset by the higher incomes received by sellers.
Also, individuals often get pay increases over time to compensate for increases in thecost of living.
However, there are cost associated with inflation and
they are of two types,expected and unexpected The costs of expected inflation include shoeleather costs, menu costs,
the costs of relative price variability, tax distortions, and theinconvenience of making inflation corrections
The costs of unexpected inflation causes arbitrary redistributions ofwealth between debtors and creditors
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Shoeleather Costs
Shoeleather costsare the resources wastedwhen inflation encourages people to reducetheir money holdings
Inflation reduces the real value of money, so
people have an incentive to minimize theircash holdings
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Shoeleather Costs (Cont)
Less cash requires more frequent trips to thebank to withdraw money from interest-
bearing accountsThe actual cost of reducing your money
holdings is the time and convenience you
must sacrifice to keep less money on handAlso, extra trips to the bank take time away
from productive activities
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Menu Costs
Menu costsare the costs of adjusting prices During inflationary times, it is necessary to
update price lists and other posted prices
This is a resource-consuming process that takes
away from other productive activities
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Relative-Price Variability and the
Misallocation of Resources
Inflation distorts relative prices
Consumer decisions are distorted, and marketsare less able to allocate resources to their bestuse
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Inflation-Induced Tax Distortion
Inflation exaggerates the size of capital gains
and increases the tax burden on this type ofincome
With progressive taxation, capital gains are
taxed more heavily
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Inflation-Induced Tax Distortion
(Cont)
The income tax treats the nominal interest
earned on savings as income, even though partof the nominal interest rate merelycompensates for inflation
The after-tax real interest rate falls, making
saving less attractiveA possible solution to this problem would be
to index the tax system
Table 1 How Inflation Raises the Tax Burden on
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Table 1 How Inflation Raises the Tax Burden onSaving
Copyright2004 South-Western
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Confusion and Inconvenience
When the Fed increases the money supply andcreates inflation, it erodes the real value of theunit of account
Inflation causes dollars at different times to havedifferent real values
Therefore, with rising prices, it is more difficultto compare real revenues, costs, and profits overtime
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A Special Cost of Unexpected
Inflation: Arbitrary Redistribution ofWealth
Unexpected inflation redistributes wealthamong the population in a way that hasnothing to do with either merit or need
These redistributions occur because manyloans in the economy are specified in terms ofthe unit of account - money
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END