Inflation's Causes and Costs

Chapter 16
Money Growth and Inflation

Rubayyat Hashmi
Principles of Macroeconomics: Ch. 16
Second Canadian Edition
Overview
The
causes of inflation
Money supply, demand and equilibrium
The effects of monetary injection
The quantity of money theory
The costs of inflation
Inflation: Its Causes and Costs

Inflation
is a sustained increase in the

price level. It is a continuous increase
versus a once-and-for-all increase in
prices.
Inflation deals with the increase in the
average of prices and not just
significant increases in the price of a
few goods.
Inflation: Historical Aspects

Over
the past sixty years, prices have risen

on average about 4 percent per year.
Deflation, a situation of decreasing prices,
occurred in the nineteenth century.
In the 1970s prices rose by 7 percent per
year.
In the 1990s prices rose about 2 percent
per year.
The Causes of Inflation

Inflation
is an economy-wide monetary
phenomenon that concerns, first and
foremost, the value of an economys
medium of exchange.
To understand the cause of inflation as
a monetary phenomenon we must
understand the concepts of Money
Supply, Money Demand, and Monetary
Equilibrium.
Overview
The
causes of inflation
Money Supply and Money Demand

Money
Supply is a variable of the Bank

of Bangladesh. Through instruments
such as open market operations, the B
of B directly controls the quantity of
money supplied.
Money Demand has several
determinants including:
interest rates
average level of prices in the economy
Money Supply and Money Demand

People
hold money because it is the

medium of exchange. The amount of
money people choose to hold depends
on the prices of the goods and
services.
In the long-run, the overall level of
prices adjusts to the level at which the
demand for money equals the supply.
Money Supply, Money Demand and

Equilibrium Price Level
Value of
Money
Money Supply
Price
Level
Equilibrium
Price Level
Equilibrium
Value of
Money
Money
Demand
QFixed
Monetary Equilibrium
The
B of B could inject money

(monetary injection) into the economy
by buying government bonds. Results
would be:
The supply curve shifting to the right
The equilibrium value of money decreasing
The equilibrium price level increasing
This
process is referred to as the

quantity theory of money.
Overview
The
causes of inflation
The Effects of Monetary Injection

Value of
Money
MS1
Price
Level
Money
Demand
QFixed

Value of
Money
VM
MS1
Price
Level
PE
Money
Demand
QFixed

Value of
Money
(High)
VM
MS1
Price
Level
(Low)
PE
Money
Demand
Low
High
QFixed

Value of
Money
(High)
VM
MS1 MS2
Price
Level
(Low)
PE
Money
Demand
Low
High
QFixed

Value of
Money
(High)
MS1 MS2
Price
Level
(Low)
PE
VM
VME
E
Money
Demand
Low
PE
High
QFixed
Overview
The
causes of inflation
Cause of Inflation:
The Quantity of Money Theory
The
quantity of money available in the

economy determines the value of
money. Growth in the quantity of
money is the primary cause of
inflation.
Some macroeconomic variables are
unchanged, given changes in the
supply of money. (Hume)
Monetary Neutrality
An increase in the rate of money
growth raises the inflation but does
not affect any real variables (e.g.
production, employment, real wages,
and real interest rates.) Such
irrelevance of monetary changes for
real variables is called monetary
neutrality.
Velocity and The Quantity Equation

How
many times per year is the

typical dollar bill used to pay for a
newly produced good or service?
The velocity of money refers to the
speed at which the typical dollar bill
travels around the economy from
wallet to wallet.
Velocity and The Quantity Equation
V = (P x Y) M
Where: V = Velocity
P = The average price level
Y = the quantity of output
M = the quantity of money
Rewriting
the equation gives the

quantity equation.
MxV=PxY
Five Step Foundation to The Quantity

Theory of Money
The velocity of money is relatively
stable over time.

A proportionate change in the
nominal value of output is related to
changes in the quantity of money by
the B of C.
Because money is neutral, money
does not affect output.
Five Step Foundation to The Quantity

Theory of Money
Changes in the money supply which
induce parallel changes in the nominal
value of output are also reflected in
changes in the price level.
When the B of C increases the money
supply rapidly, the result is a high rate
of inflation.
Hyperinflation & Inflation Tax

Hyperinflation
is inflation that exceeds

50 percent per month.
Hyperinflation in some countries is
caused because the government prints
too much money to pay for their
spending.
Hyperinflation & 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.
Relationship Between Money, Inflation

and Interest Rates
Nominal
Interest Rate =
Real Interest Rate + Inflation Rate
Over the long run, a change in the
money growth should not affect the
Real Interest Rate thus, the Nominal
Interest Rate must adjust one-for-one
to changes in the Inflation Rate.
Relationship Between Money, Inflation

and Interest Rates
When
the B of C increases the rate of

money growth, the result is both a high
inflation rate and a higher nominal
interest rate. This is called the
Fisher Effect
Quick Quiz!
The
government of a
country increases the
growth rate of the money
supply from 5 percent per
year to 50 percent per year.
What happens to prices?
What happens to nominal
interest rates?
Why would the government
be doing this?
Overview
The
causes of inflation
The Costs of Inflation

At
least six costs of inflation are

identified as:
1 . Shoeleather costs
2 . Menu Costs
3 . Increased variability of relative prices
4 . Tax liabilities
5 . Confusion and inconvenience
6 . Arbitrary redistribution of wealth
The Costs of Inflation:
Shoeleather Costs
Inflation
reduces the real value of

money, so people have an incentive to
minimize their cash holdings. Less
cash requires people to make frequent
trips to the bank because they keep
their money in interest bearing
accounts.
Extra trips to the bank takes time away
from productive activities.
Menu Costs
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.
Increased Variability of Relative Prices

During
times of rising prices, there will

be a delay between price increases.
While these prices are constant, other
prices will be rising. It then becomes
difficult to know exact relative prices
as prices change irregularly.
Unintended Changes in Tax Liability

With
inflation, unadjusted incomes are

treated as real gains. Consequently,
with progressive taxation, rising
nominal incomes are taxed more
heavily.
Confusion and Inconvenience

With
rising prices, it is necessary to

constantly make corrections in order
to compare real revenues, costs, and
profits over time. The time spent
making these adjustments could have
been spent producing more goods and
services.
Arbitrary Redistribution of Wealth

With
unanticipated or incorrectly
anticipated inflation, wealth is
redistributed between net monetary
debtors and creditors. This may result
in wealth transfers that would not
otherwise be acceptable.
Recall the Fisher Effect.
The Inflation Fallacy

Fallacy:
Inflation reduces individuals

incomes and causes living standards
to decline.
Fact: One persons inflated price is
anothers inflated income. Unless
incomes are fixed in nominal terms,
the higher prices paid by consumers
are exactly offset by the higher
incomes received by sellers.
Overview
The
causes of inflation
Monetary policy
Monetary policy is the process by which a government, central bank, or

monetary authority manages the money supply to achieve specific goals.
Usually the goal of monetary policy is to accommodate economic growth in

an environment of stable prices. For example, it is clearly stated in the
Federal Reserve Act that the Board of Governors and the Federal Open
Market Committee should seek to promote effectively the goals of
maximum employment, stable prices, and moderate long-term interest
rates.
A failed monetary policy can have significant detrimental effects on an

economy and the society that depends on it. These include hyperinflation,
stagflation, recession, high unemployment, shortages of imported goods,
inability to export goods, and even total monetary collapse and the adoption
of a much less efficient barter economy. This happened in Russia, for
instance, after the fall of the Soviet Union.
39
Tools to control money supply

Open market operations (selling
or buying bonds)
Raising or lowering bank reserve
requirements
Bank rates
40
The Quantity Equation

In this section we will discuss the quantity theory of money,
discuss inflation and interest rates, and
the relationship between the nominal interest rate
and the demand for money.
This model allows us to see the effect that the quantity of

money has on the economy.
To do this we must see how the quantity of money is
related to price and incomes.
41
The Quantity Equation

MoneyVelocity = PriceTransactions
M V P T
The velocity of money refers to the

speed at which the typical dollar bill
travels around the economy from
wallet to wallet.
V PT / M
Economists usually use GDP Y as a

proxy for T since data on the number
of transactions is difficult to obtain.
M V P Y
42
Money, Prices, and Inflation

PY
P
Y
MV PY
in percent terms:
%M + %V = %P + %Y
This equation shows the relationship between change in
money supply and inflation
43
Money Supply, Money Demand, and

Monetary Equilibrium
Money demand has several determinants,
including interest rates and the average level of
prices in the economy.
People hold money because it is the medium of
exchange.
The amount of money people choose to hold
depends on the prices of goods and
services.
In the long run, the overall level of prices
adjusts to the level at which the demand for
money equals the supply.
44
Money Supply, Money Demand, and the

Equilibrium Price Level
Value of
Money (1/P)
Price
Level (P)
Money supply
(High) 1
1 (Low)
1.33
1/2
1/4
(Low) 0
Money
demand
Quantity fixed
by the Fed
Quantity of
Money
Equilibrium
price level
Equilibrium
value of money
3/4
(High)
45

Value of
Money (1/P)
MS1
1. An increase
in the money
supply...
3/4
A
(Low) 0
Money
demand
M1
1.33
2
1/4
1 (Low)
M2
Quantity of
Money
3. and
increases the
price level
2. ...decreases the
value of money ...
(High) 1
1/2
Price
Level (P)
MS
(High)
46
Money, Prices, and Inflation

So, the quantity theory of money states that the central bank,
which controls the money supply, has ultimate control over
the rate of inflation.
If the central bank keeps the money supply stable, the price
level will be stable. If the central bank increases the money
supply rapidly, the price level will rise rapidly.
47
Inflation and the Interest Rate
i r
Nominal interest rate =

Real interest rate + Inflation rate
r i
48
An expansionary monetary policy:
Can be applied in case of unemployment and recession

i
Ms
Ms2
i
i2
Md
q2
Qm
If the central bank increases the money supply

lower
interest rate
stimulate consumption and investment
expenditure , i.e increases AE (other things are kept same)
49
A contractionary monetary policy :

Can be applied in case of an inflation
Ms2
Ms
i2
i
Md
q2
Qm
If the central bank reduces the money supply

raise
interest rate
reduced consumption and investment
expenditure , i.e reduce AE (other things are kept same)
50
Tools of Monetary Policy

1- Discount rate: the interest rate that the central bank charges
on the commercial banks.
2- Required reserve ratio: the percentage of deposits that is

required by the commercial bank to keep as reserves in the
central bank
3- Open market operation: the purchase and sale of

government securities (bonds) by the central bank
51
Discount rate and Supply of money by banks
Discount rate: the interest rate that the central bank charges on the
commercial banks.
Government control the commercial bank to accumulate government fund

for loan
Lower discount rate is easy money policy, commercial bank can supply loan
at a lower interest rate
52
Required reserve ratio and Supply of money by bank
Required reserve ratio (RRR): percentage of deposits that is required

by the commercial bank to keep as reserves in the central bank.
Example: if RRR =10% , of an initial deposit = Tk 100
Required reserve = Tk 100 * 10% = Tk 10
Excess reserves = Tk 100 -10 = Tk 90
Total Reserve = Required reserve + Excess reserve
53
An expansionary monetary policy tools:

Reducing discount rate :
reduce interest rate

stimulate consumption & investment expenditure
increase AE
Reducing RRR :
increase money supply
lower
interest rate
stimulate consumption & investment
expenditure
increase AE
Buying government securities :

increase money
supply
lower interest rate
stimulate consumption &
investment expenditure
increase AE
54
A contractionary monetary policy tools:

Increasing the discount rate :
increase interest
rate
lower consumption & investment expenditure
lower AE
Raising RRR :
reduce money supply
raise
interest rate
reduce consumption & investment
expenditure
reduce AE
Selling government securities :

lower money
supply
raise interest rate
reduce consumption &
investment expenditure
reduce AE
55

Inflation's Causes and Costs

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Inflation's Causes and Costs

Uploaded by

Copyright:

Available Formats

Chapter 16

Money Growth and Inflation

Principles of Macroeconomics: Ch. 16

Second Canadian Edition

Principles of Macroeconomics: Ch. 16

Second Canadian Edition

Inflation: Its Causes and Costs

is a sustained increase in the

Second Canadian Edition

Inflation: Historical Aspects

the past sixty years, prices have risen

Second Canadian Edition

The Causes of Inflation

Second Canadian Edition

Principles of Macroeconomics: Ch. 16

Second Canadian Edition

Money Supply and Money Demand

Supply is a variable of the Bank

Second Canadian Edition

Money Supply and Money Demand

hold money because it is the

Second Canadian Edition

Money Supply, Money Demand and

Second Canadian Edition

B of B could inject money

process is referred to as the

Principles of Macroeconomics: Ch. 16

Second Canadian Edition

Principles of Macroeconomics: Ch. 16

Second Canadian Edition

The Effects of Monetary Injection

Second Canadian Edition

The Effects of Monetary Injection

Second Canadian Edition

The Effects of Monetary Injection

Second Canadian Edition

The Effects of Monetary Injection

Second Canadian Edition

The Effects of Monetary Injection

Second Canadian Edition

Principles of Macroeconomics: Ch. 16

Second Canadian Edition

quantity of money available in the

Second Canadian Edition

Second Canadian Edition

Velocity and The Quantity Equation

many times per year is the

Second Canadian Edition

Velocity and The Quantity Equation

the equation gives the

Second Canadian Edition

Five Step Foundation to The Quantity

stable over time.

Second Canadian Edition

Five Step Foundation to The Quantity

Second Canadian Edition

Hyperinflation & Inflation Tax

is inflation that exceeds

Principles of Macroeconomics: Ch. 16

Second Canadian Edition

Hyperinflation & Inflation Tax

the government raises revenue