Chap 12 Mankiw

8/2/2019 Chap 12 Mankiw

1/34

MacroeconomicsTaught by Dr. Ahmad A. Kader

Chapter 12

Money Growth and Inflation


2/34

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


3/34

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


4/34

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


5/34

Figure 2 The Effects of Monetary Injection


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


6/34

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


7/34

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


8/34

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


9/34


(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


10/34

Velocity and the Quantity

Equation

Thevelocity of moneyrefers to the speedat which the typical dollar bill travelsaround the economy from wallet to wallet


11/34


Equation (Cont)

V = (P Y)/M

Where:V = velocity

P = the price level

Y = the quantity of output

M = the quantity of money


12/34


Equation (Cont)

Rewriting the equation gives the

quantity equation:M V = P Y


13/34


Equation (Cont)

The quantity equationrelates the quantity ofmoney(M) to the nominal value of output(P Y)


14/34


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


15/34

Figure 3 Nominal GDP, the Quantity of Money,and the Velocity of Money


Indexes(1960 = 100)

2,000

1,000

500

0

1,500

1960 1965 1970 1975 1980 1985 1990 1995 2000

Nominal GDP

Velocity

M2


16/34

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


17/34


(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


18/34

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


19/34

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


20/34

Figure 4 Money and Prices During FourHyperinflations


(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


21/34

Figure 4 Money and Prices During FourHyperinflations


(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


22/34

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


23/34

Figure 5 The Nominal Interest Rate and theInflation Rate


Percent(per year)

1960 1965 1970 1975 1980 1985 1990 1995 20000

3

6

9

12

15

Inflation

Nominal interest rate


24/34

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


25/34

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


26/34

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


27/34

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


28/34

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


29/34

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


30/34

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


31/34

Table 1 How Inflation Raises the Tax Burden onSaving

Copyright2004 South-Western


32/34

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


33/34

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


34/34

END

Documents

Chap 12 Mankiw