1 Dr. Savvas C Savvides-- School of Business, EUROPEAN UNIVERSITY CYPRUS

PRINCIPLES OF MACROECONOMICS Overview In the previous chapter we explained what money is and how the Central Bank (the Federal Reserve in the United States) controls the quantity of money. In this chapter we establish the relationship between the rate of growth of money and the inflation rate and investigate the causes and costs of inflation. We will establish that, in the long run, there is a strong relationship between the growth rate of money and inflation. Students will also find that there are numerous costs to the economy from high inflation, but that there is not a consensus on the importance of these costs when inflation is moderate. We also examine a number of issues connected with inflation – the quantity theory of money; the Philips curve; Central Bank independence, and the role of the monetary policy committee. Each seem independent from the other, and indeed each can be covered separately, but taken together they begin to give us a more complete picture of policy makers thinking, particularly with regard to inflation and its relation to other real issues in the economy such as unemployment. Learning Outcomes 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. Key Points 1. 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.

2. 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. 3. 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.

4. 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. 5. Economists have identified six costs of inflation: 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 hyperinflation, but the size of these costs for moderate inflation is less clear.

Chapter 30 Inflation

2 Dr. Savvas C Savvides-- School of Business, EUROPEAN UNIVERSITY CYPRUS

Defining Inflation

Inflation is the consistent rise in the general price level. So, we are not referring to a “once-off” increase in the average level of prices, but rather to a continuous increase in the price level. Also you need to realize that inflation measures the increase in the average level of prices in the economy. This does not mean that the prices of ALL goods are rising. The prices of some may be stable or even be falling over the same period. In Cyprus, the annual rate of change of the generals price level (the inflation rate) is shown in the graph below. In the period 1960-2007, the average inflation rate was 4.1%. Notice from the graph that during some years (especially in 1974 and 1980-81) Cyprus (and the World) experienced very rapid inflation rates due to the quadrupling of oil prices then. Excluding those two periods, the average inflation rate is 3.5%

Inflation in Cyprus, 1960-2007

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1950 1960 1970 1980 1990 2000 2010

Calculating the Inflation Rate We defined the inflation rate as the increase in the general price level. But, how is the general price level measured. The answer is by the retail price index (RPI), also called consumer price index (CPI). The retail price index (RPI): this is a measure of the overall cost of the goods and services bought by a typical consumer. How is the RPI calculated? First, Governments determine what the “typical” (or representative”) basket of goods purchased by a typical consumer is by conducting surveys. The number of goods and services may be 400-500 or more. The formula for calculating the price index is:

= cost of basket in current yearcost of basket in base year

100⎛⎝⎜

⎞⎠⎟

×

3 Dr. Savvas C Savvides-- School of Business, EUROPEAN UNIVERSITY CYPRUS

In the example below we will assume that the basket is comprised of three groups of goods in the following quantities (units): 1000 units of food, 10 units of clothing, and one unit of education.

Year Price of Food Price of Clothing Price of Education 2005 €1.0 €20 €6,000 2006 1.2 25 6,500 2007 1.5 30 7,000

1. In order to calculate the RPI, we first calculate the cost of the basket of goods and services. In our case the basket is composed of the three goods shown in the table above:

Cost in 2005 = (1000 units of food x €1.0) + (10 units of clothing x €20) + (1 unit of education x €6,000) = €7,200. Cost in 2006 = (1000 units of food x €1.2) + (10 units of clothing x €25) + (1 unit of education x €6,500) = €7,950. Cost in 2007 = (1000 units of food x €1.5) + (10 units of clothing x €30) + (1 unit of education x €7,000) = €8,800

2. In order to compute the RPI we choose a base year. The base year is the benchmark against which other years are compared. 3. Using 2005 as the base year, we now compute the RPI index. Note that the RPI in the base year is always equal to 100.

RPI in 2005 = (€7200/€7200) × 100 = 1 × 100 = 100 RPI in 2006 = (€7950/€7200) × 100 = 1.104 × 100 = 110.4 RPI in 2007 = (€8800/€7200) × 100 = 1.222 × 100 = 122.2

4. We can now calculate the inflation rate, which is the percentage increase in the RPI from the previous year. The formula used to calculate the inflation rate is: So in terms of our example,

Inflation rate for 2006 = [(110.4 – 100)/100] × 100% = 10.4% Inflation rate for 2007 = [(122.2 – 110.4)/110.4] × 100% = 10.69%

Hyperinflation and its effects

We have already talked about hyperinflation and how it hit Germany in the 1920s. It is obvious that inflation

does not occur in a vacuum. The historical study of inflation and hyperinflation, provide some interesting

observations.

Hyperinflation is an extraordinarily high rate of inflation, such as the one Germany experienced in the

1920s. During such periods there tends to be a ‘flight from cash’ ie people hold as little cash as possible, e.g.

Germany in 1922-23, Hungary 1945-46, Brazil in the late 1980s. Large government budget deficits help to

explain such periods. Persistent inflation must be accompanied by continuing money supply growth.

inflation rate = CPI - CPI

CPI 100%Year 2 Year 1

Year 1

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4 Dr. Savvas C Savvides-- School of Business, EUROPEAN UNIVERSITY CYPRUS

3Copyright © 2004 South-Western

(c) Germany

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Index(Jan. 1921 = 100)

(d) Poland

100,000,000,000,000

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10,000,000,0001,000,000,000,000

100,000,000

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Price level

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Price levelMoneysupply

Index(Jan. 1921 = 100)

100

10,000,000

100,000

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Hyperinflation in Germany and Poland

Almost all hyperinflations follow the same pattern.

1. The government has a high level of spending and inadequate tax revenue to pay for its spending.

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

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

4. The large increases in the money supply lead to large amounts of inflation.

5. The hyperinflation ends when the government cuts its spending and eliminates the need to create new money.

The Level of Prices and the Value of Money When the price level rises, people have to pay more for the goods and services that they purchase. 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. If P is the price level, then the quantity of goods and services that can be purchased with $1 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. For the most part, the supply of money is determined by the Central Bank, as we examined in the previous chapter. This implies that the quantity of money supplied is fixed (until the Central Bank decides to change it). Thus, the supply of money will be vertical (perfectly inelastic). There are many determinants of the demand for money.

• One variable that is very important in determining the demand for money is the price level.

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

5 Dr. Savvas C Savvides-- School of Business, EUROPEAN UNIVERSITY CYPRUS

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

In the long run, the overall price level adjusts to the level at which the demand for money and the supply of money are equal.

• 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.

• If the price level is below equilibrium, people will want to hold less money than that 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 it is inverted ― a high value of money means a low price level and vice versa. At the equilibrium, the quantity of money demanded is equal to the quantity of money supplied.

Money and Inflation

Recall that in Chapter 29 we defined the real money supply as the nominal money supply divided by the

price level (Ms/P). We have also concluded that people demand real money balances because they are

concerned with what money can buy, not money itself. Having in mind the various motives (reasons) for

holding real money balances (transaction, precautionary, and speculative), we can express the demand for

real money balances as

Ms/P = L (Y, r) Let’s now ask the question: What is the effect of an increase in the nominal money supply? In the short run

we assume that prices do not adjust. Let’s examine the transmission process. Initially, this shifts the money

supply curve to the right, creating an excess supply of money at the current interest rates. In time, the

excess supply of real money bids down interest rates, thus boosting the demand for goods (through its

impact on spending on consumption and investment due to the wealth and credit effects).

Gradually this increased aggregate demand (spending) pushes up the prices of goods and services as well

as to increased output to satisfy this increased demand. Businesses demand to hire more labour and in the

process nominal wages start to rise. In the long run, after complete adjustment of wages and prices, the

once-off rise in nominal money has led to an equivalent once-off rise in wages and prices. Output,

employment, interest rates and real money revert to their original levels.

6 Dr. Savvas C Savvides-- School of Business, EUROPEAN UNIVERSITY CYPRUS

The theoretical basis for this process is seen in the equation

MV = PT Where M is the stock of money, V is the Velocity of money (that is, the number of times the stock of money

turns around to satisfy the volume of transactions, P is the price level, and T is the volume of transactions.

PT can also be represented as Y, the nominal value of GDP or national income, since the number of

transactions times the price level gives us the value of all transactions which is none other than GDP.

The above equation describes what is known as the quantity theory of money.

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.

Briefly, the quantity theory of money states that changes in nominal money lead to equivalent changes in the

price level (and money wages), but have no effect on output and employment. This theory is espoused by

monetarists, who believe that if the demand for real money is constant, then the supply must likewise be

constant – thus changes in nominal money are matched by equivalent rises in price.

The real insight of the quantity theory of money is that (since real income and interests rates usually change

very slowly) real variables such as real money demand usually change slowly – i.e. in practice, large

changes in nominal money will be accompanied by large changes in other nominal variables such as prices

and wages, thus keeping real money and wages at or near their equilibrium values.

The Effects of a Monetary Injection

7 Dr. Savvas C Savvides-- School of Business, EUROPEAN UNIVERSITY CYPRUS

Assume that the economy is currently in equilibrium and the Fed suddenly increases the supply of money. The supply of money shifts to the right. The equilibrium value of money falls and the price level rises. 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. Velocity and the Quantity Equation Definition of velocity of money: the rate at which money changes hands. To calculate velocity, we divide nominal GDP by the quantity of money. If P is the price level (the GDP deflator), Y is real GDP, and M is the quantity of money: Rearranging, we get the quantity equation. 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

The Fisher Hypothesis

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

Real interest rate = (nominal interest rate – inflation rate)

The above formula suggests that growth in the money supply determines the inflation rate. In other words, at

higher inflation rates, the nominal interest rates will also be higher (he suggests that real interest rates do not

in fact change very much). Another result of inflation -- particularly in its hyperinflation phase -- is the flight

from cash (remember the stealing of the wheelbarrow rather than the paper money in it, which suggests that

this is seen as a more valuable asset!). Secondly that money and prices can get quite out of line when

inflation and nominal interest rates are rising. Here we see faster money growth leading to higher inflation

velocity = nominal GDP /money supply

velocity = P YM×

M V P Y× × =

8 Dr. Savvas C Savvides-- School of Business, EUROPEAN UNIVERSITY CYPRUS

and higher (nominal) interest rates. Thus the demand for real money declines (as shown above) until the real

money supply adjusts to the change in real money demand.

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%.

The Costs of Inflation Here we need to examine inflation illusion before going on to the real costs of inflation. We then look at the

costs of living with fully anticipated inflation – problems of institutions not adapting successfully (such as non-

inflation adjusted tax rates, allowing fiscal drag etc). Unexpected inflation causes additional specific

problems – redistribution (people with nominal assets gain, those with nominal liabilities lose; redistribution

tends to take place from the old to the young – older people tend to have more assets in the form of nominal

bonds etc). Finally uncertainties over inflation cause their own specific problems, due to the difficulty of

planning, which now needs more resources.

The Costs of Inflation

1. A Fall in Purchasing Power? o The Inflation Fallacy. Most individuals believe that the major problem caused by inflation is

that inflation lowers the purchasing power of a person’s income. However, as prices rise, so do incomes. Thus, inflation does not in itself reduce the purchasing power of incomes.

2. Shoeleather Costs.

o Definition of shoeleather costs: the resources wasted when inflation encourages people to reduce their money holdings.

o Because inflation erodes the value of money that you carry in your pocket, you can avoid this drop in value by holding less money. However, holding less money generally means more trips to the bank.

o This cost can be considerable in countries experiencing hyperinflation.

3. Menu Costs. o Definition of menu costs: the costs of changing prices. During periods of inflation, firms

must change their prices more often.

4. Relative-Price Variability and the Misallocation of Resources. o Because prices of most goods change only once in a while (instead of constantly), inflation

causes relative prices to vary more than they would otherwise. When inflation distorts relative prices, consumer decisions are distorted and markets are less able to allocate resources to their best use.

5. Inflation-Induced Tax Distortions.

o Lawmakers rarely take into account inflation when they write tax laws. The nominal values of interest income and capital gains are taxed (not the real values).