MACROECONOMICS M.B.A.

III

Money growth and inflation

Aman
12 April 2013

The meaning of money

The meaning of money Money is the set of assets in an economy that people regularly use to buy goods and services from other people. The classical theory of inflation
Inflation is an increase in the overall level of prices. Hyperinflation is an extraordinarily high rate of inflation.

Inflation: Historical Aspect

Over the past 60 years, prices have risen on average about 5 percent per year in the US. Deflation, meaning decreasing average prices, occurred in NZ between 1933 and 1934 and in the U.S. in the nineteenth century. Disinflation, meaning declining inflation rate, occurred in the US in the early 80s and in New Zealand in the early 90s. Hyperinflation refers to high rates of inflation such as the recent experience of Zimbabwe.

The classical theory of inflation

Inflation in Pakistan
Over the past 60 years, prices in Pakistan have risen by about 8 percent per year, on average.

Pakistan has experienced periods of very high inflation and even periods of deflation.
In the 1970s, prices rose by more than 12 percent per year, on average. During the 1980s and 1990s, prices rose at an average rate of 7-9 percent per year.
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History of inflation in Pakistan since 1960

Consumer Price Index
30 25

20

15

10

0 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 -5

The classical theory of inflation

The level of prices and the value of money
The quantity theory of money is used to explain the long-run determinants of the price level and the inflation rate. Inflation is an economy-wide phenomenon that concerns the value of the economys medium of exchange.

When the overall price level rises, the value of money falls.

Money Supply, Money Demand, and Monetary Equilibrium

The money supply can be used as a policy variable under a system with required reserve ratio.
By controlling the required reserve ratio the SBP directly control the quantity of money supplied. Other countries such as the US and the UK continue to use this system.

The classical theory of inflation

Money supply, money demand and monetary equilibrium
Assume that the money supply is a policy variable that is controlled by the SBP. Also, suppose that the SBP directly controls the quantity of money supplied through instruments such as open-market operations.

The classical theory of inflation

Money supply, money demand and monetary equilibrium
Money demand has several determinants, including interest rates and the average level of prices in the economy.

Money supply, money demand and monetary equilibrium People hold money because it is the medium of exchange and hence money demand depends on the exchange norm and facilities. However, by holding money they forgo interest earnings and hence vary their demand inversely with changes in the interest rate. Also, the amount of money people choose to hold depends on their income, the prices of goods and services.
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Money supply, money demand and monetary equilibrium

Money Demand: A Summary Money demand (MD) depends on: Income (Y), nominal interest rate (not on the CMR) the price level (P) and

the technology of exchange (norms and facilities) such as the frequency of use of credit cards, bank charges, etc.

Money supply, money demand and monetary equilibrium

How we study monetary equilibrium

Short run prices do not change, nominal interest rates change. Long run prices are fully flexible, nominal interest rates are fixed by the Fishers rule for offsetting the effects of inflation.

The Fisher Effect

The Fisher effect refers to a one-to-one adjustment of the nominal interest rate to the inflation rate. According to the Fisher effect, when the rate of inflation rises, the nominal interest rate rises by the same amount. The real interest rate stays the same. Interest rate (i, nominal or $ unit) = interest rate (r, real or goods unit) + expected inflation rate (pe).

The Nominal Interest Rate and the Inflation Rate in NZ

Figure 7 Nominal interest rate 25% 20% 15% 10% 5% 0% 1960 1965 1970 1975 1980 1985 1990 1995 2000 Inflation

i p r, p e p .

Copyright 2004 South-Western

Money supply, money demand and monetary equilibrium

How we study monetary equilibrium

In the LONG RUN, interest rates are determined as follows: (1) real interest rate (r) is determined in the financial market such that S = I and (2) nominal interest rate (i) is determined by the Fishers effect such that given expected inflation (pe)

i r p

Money supply, money demand and monetary equilibrium

How we study monetary equilibrium

In the long run, the overall level of prices adjusts to the level at which the demand for money equals the supply.

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Money supply, money demand and monetary equilibrium

How we study monetary equilibrium

We assume that, everything else (such as national income, Y) remaining constant, if price level increases, the amount of money we demand increases too. Lets define the purchasing power of a $1 = 1/P to be the price of money. By that definition, the demand for money would be a downward sloping function of its price, 1/P.

How the supply and demand for money determine the equilibrium price level

An increase in the money supply

The Effects of Increase in Money Demand

Value of Money, 1 /P (High) 1

MS1

Price Level, P 1 (Low)

2. . . . increases the value of money . . .

/4

1.33

C
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3. . . . and decreases the price level.

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New MD (High)

(Low) 0 M1 Old MD

Quantity of Money

The Effects of Increase in Money Demand

Value of Money, 1 /P (High) 1

MS1

MS2

Price Level, P 1 (Low)

/4

1.33

C
12

D
2

14

B
M2

New MD (High)

(Low) 0 M1 Old MD

Quantity of Money

The classical theory of inflation

The effects of a monetary injection
How the price level is determined and why it might change over time is called the quantity theory of money. The quantity of money available in the economy determines the value of money. The primary cause of inflation is the growth in the quantity of money.

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The classical theory of inflation

The adjustment process
An increase in money supply to an economy in equilibrium, means the quantity of money supplied is larger than the quantity demanded.

Individuals now hold more money than they desire. They will increase consumption to compensate.

The classical theory of inflation

The adjustment process
The economys ability to produce goods and services has not been altered by the increase in money supply. The excess demand for goods and services means prices must rise. People then demand more money, as they require more to consume at the new level.

The classical theory of inflation

The adjustment process
Eventually money demand will equal money supply and the economy will be in equilibrium. The price level acts to bring the supply and demand for money into equilibrium.

The classical theory of inflation

The classical dichotomy and monetary neutrality
Nominal variables are variables measured in monetary units. Real variables are variables measured in physical units.

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The classical theory of inflation

The classical dichotomy and monetary neutrality
According to Hume and others, real economic variables do not change with changes in the money supply. Changes in the money supply affect nominal variables but not real variables.

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The classical theory of inflation

The classical dichotomy and monetary neutrality
The separation of real and nominal variables is now known as the classical dichotomy. The irrelevance of monetary changes for real variables is called monetary neutrality.

The classical theory of inflation

Velocity and the quantity equation
The velocity of money refers to the speed at which the typical dollar coin travels around the economy from wallet to wallet.

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The classical theory of inflation

Velocity and the quantity equation
The quantity equation takes the form: 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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The classical theory of inflation

Velocity and the quantity equation
The quantity equation relates to the quantity of money (M) to the nominal value of output (P Y). Rewriting the equation gives the quantity equation: MV=PY

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The classical theory of inflation

Velocity and the quantity equation
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.

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The classical theory of inflation

Inflation and GDP growth
The inflation rate can be defined by the formula:
Inflation rate = growth of money supply growth of real GDP

Inflation results when the money supply grows faster than real GDP.

Nominal GDP, the quantity of money and the velocity of money

Money growth and Inflation rate

The inflation rate and the money growth rate

The inflation rate and the money growth rate
35 30 25 20 15 10 5 0 Year -5 -10 Money growth (annual %) Inflation, consumer prices (annual %) 1961 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011

Hyperinflation
Case study: Money and prices during four hyperinflations
Hyperinflation is inflation that exceeds 50 percent per month. Hyperinflation occurs in some countries because the government prints too much money to pay for its spending.

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Money and Prices During Four Hyperinflations

(a) Austria Index (Jan. 1921 = 100) 100,000 10,000 1,000 100 Price level Money supply Index (July 1921 = 100) 100,000

(b) Hungary

Price level 10,000 1,000 100 Money supply

1921

1922

1923

1924

1925

1921

1922

1923

1924

1925

Copyright 2004 South-Western

Money and Prices During Four Hyperinflations

(c) Germany Index (Jan. 1921 = 100) 100,000,000,000,000 1,000,000,000,000 10,000,000,000 100,000,000 1,000,000 10,000 100 1 Price level Money supply Index (Jan. 1921 = 100) 10,000,000 1,000,000 100,000 10,000 1,000 1921 1922 1923 1924 1925 100 1921 1922

(d) Poland

Price level Money supply

1923

1924

1925

Copyright 2004 South-Western

Hyper Inflation

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Inflation tax
When the government raises revenue by printing money, it is said to levy an inflation tax. An inflation tax is like a tax on everyone who holds money. The inflation ends when the government institutes fiscal reforms such as cuts in government spending.

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The Fisher effect

The Fisher effect refers to a one-to-one adjustment of the nominal interest rate to the inflation rate. According to the Fisher effect, when the rate of inflation rises, the nominal interest rate rises by the same amount. The real interest rate stays the same.

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The costs of inflation

Purchasing power

Shoe leather costs

Menu costs Relative price variability Tax distortions Confusion and inconvenience Arbitrary redistribution of wealth
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The cost of inflation

Purchasing power
Inflation does not in itself reduce peoples real purchasing power. This fallacy is due to a lack of understanding about the neutrality of money.

Remember, real incomes are determined by real variables.

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The cost of inflation

Shoe leather costs
Shoe leather costs are the resources wasted when inflation encourages people to reduce their money holdings. Inflation reduces the real value of money, so people have an incentive to minimise their cash holdings.

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The cost of inflation

Shoe leather costs
Less cash requires more frequent trips to the bank to withdraw money from interest-bearing accounts. The actual cost of reducing your money holdings is the time and convenience you must sacrifice to keep less money on hand. Also, extra trips to the bank take time away from productive activities.

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The cost of inflation

Menu costs
Menu costs are 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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The cost of inflation

Relative-price variability and the misallocation of resources
Inflation distorts relative prices. When inflation occurs, prices of different G&S rise at different rates, some G&S become cheaper or more expensive in a relative sense. These relative price distortions, in turn, affect the allocation of resources toward different G&S in a way that would not happen if relative prices remained stable. Consumer decisions are distorted, and markets are less able to allocate resources to their best use.
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The cost of inflation

Inflation-induced tax distortions
Inflation exaggerates the size of capital gains and increases the tax burden on this type of income. With progressive taxation, capital gains are taxed more heavily.

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The cost of inflation

Inflation-induced tax distortions
The income tax treats the nominal interest earned on savings as income, even though part of the nominal interest rate merely compensates for inflation. The after-tax real interest rate falls, making saving less attractive.

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How inflation raises the tax burden on saving

The cost of inflation

Confusion and inconvenience
When the SBP increases the money supply and creates inflation, it erodes the real value of the unit of account. Inflation causes dollars at different times to have different real values. Therefore, with rising prices, it is more difficult to compare real revenues, costs and profits over time.

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A Special Cost of Unexpected Inflation: Arbitrary Redistribution of Wealth

Unexpected inflation redistributes wealth among the population in a way that has nothing to do with either merit or need. Recall, i = r + pe or, equivalently, r = i - pe . Consequently, given a promised dollar value for the nominal interest rate (i), if p>pe then real rate of return r would be less than anticipated. Savers Lose and the Borrowers Gain. These redistributions occur because many loans in the economy are specified in terms of the unit of account money.

Summary
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.

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Summary
The principle of money neutrality asserts that changes in the quantity of money influence nominal variables but not real variables. A government can pay for its spending simply by printing more money. This can result in an inflation tax and hyperinflation.

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Summary
According to the Fisher effect, when the inflation rate rises, the nominal interest rate rises by the same amount and the real interest rate stays the same. Many people think that inflation makes them poorer because it raises the cost of what they buy. This view is a fallacy because inflation also raises nominal incomes.
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Summary
Economists have identified six costs of inflation: shoe leather costs menu costs increased variability of relative prices unintended tax liability changes confusion and inconvenience arbitrary redistributions of wealth.
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