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Money Growth and Inflation
Dr. Katherine Sauer
Principles of Macroeconomics
ECO 2010
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Overview:
I. Money MarketII. Classical Dichotomy and Money Neutrality
III. Quantity Theory of Money
IV. Fisher Effect
V. Costs of Inflation
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A little history
Inflation originally referred to increases in the amount of money
in circulation.
When gold was used as currency:
- government pulls coins out of circulation
- melts them down- mixes them with other metals
- reissues them at the same nominal value
The government could issue more coins without needing to
increase the amount of gold used to make them.
The money supply would rise, but the value of each coin fell.
Consumers needed more coins to make the same purchases.3
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US:
Currency was printed during the Civil War.
The term inflation referred to the currency depreciation that
happened when the quantity of bank notes exceeded the quantity
of metal available for their redemption.
- did not refer to an increase in prices
In modern times, inflation is an increase in the overall price
level.
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The Classical Theory of Inflation: (long run theory)
The price level is inversely related to the value of money.
- if prices are low, dont need much money to make your
transactions the value of money is high
- if prices are high, need more money to make your
transactions the value of money is low
(Think of the value of money aspurchasing power.)
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value of
money
Quantity of Money
MS
0
low
The Money Supply is
verticalbecause it is set by
the Fed.
It will shift when the Fed
changes monetary policy.
- Fed buys bonds, MS
shifts right
- Fed sells bonds, MS
shifts left
price
level
low
high
high
(P)(1/P)
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value of
money
Quantity of Money
MS
MD
0
low
The Money Demand is
downward sloping.
-As the value of money
falls, the quantity ofmoney needed to make
your purchases rises
-A
s the price level rises,the quantity of money
needed to make your
purchases rises
The Money Demand curvewill shift if income
changes.
- increase in income,
rightward shift
price
level
low
high
high
(P)(1/P)
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In the long run, the overallprice level adjusts to bring money
supply and money demand into equality.- if money supply > money demand, price level rises
- if money supply < money demand, price level falls
(In the short run, interest rates play a key role)
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value of
money
Quantity of Money
MS
MDlow
Ex: The effect of a
monetary injection
1) Fed buys bonds
2) Money Supply increases
(shifts right)
3) value of money falls and
price level rises (inflation)
4) quantity of money rises
price
level
low
high
high
(P)(1/P)
QM1
value1 P1
MS2
value2 P2
QM2
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value of
money
Quantity of Money
MS
MDlow
Ex: The effect of a
decrease in consumer
incomes
1) Lower incomes mean
fewer transactions
2) Money Demanddecreases (shifts left)
3) value of money falls and
price level rises (inflation)
4) quantity of money stays
constant
price
level
low
high
high
(P)(1/P)
QM1
value1 P1
MD2
value2 P2
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value of
money
Quantity of Money
MS
MDlow
To counteract the rising
price level, the Fed may
wish to contract the money
supply and stabilize prices.
1) Fed sells bonds
2) Money Supply decreases
3) Value of money and
price level stabilize at
initial level
price
level
low
high
high
(P)(1/P)
QM1
value1 P1
MD2
value2 P2
MS2
P3value3
QM3
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II. The Classical Dichotomy and Money Neutrality
Divide all economic variables into 2 groups:- nominal (measured in monetary units)
- real (measured in physical units)
This separation of real and nominal variables is called theclassical dichotomy.
Money Neutrality says that changes in the money supply will
affect nominal variables but not real variables.
(true in long run, not in short run)
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III. The Quantity Theory of Money (monetarists)
The quantity of money determines its value and the price level.
Inflation is caused by growth in the money supply.
(How the price level is determined and why it changes over time.)
The Quantity Equation:
M V = P Y
M: money supply (M1 or M2)
P: price level (CPI or GDPdeflator)
Y: real GDP
V: velocity of money: rate at which money circulates
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The term ofP Y is nominal GDP.
The quantity equation shows that when the money supply changes,
the price level, velocity, or real GDP must change.
M V = P Y
M = P Y
V
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For the US, velocity has been fairly stable over time.
M V = P Y
So, an increase in the money supply will increase nominal GDP.
If money neutrality is true, then real variables arent affected by
changes in the money supply.
M V = P Y
So, any increase in the money supply will cause an increase in the
price level.
In other words, an increase in the money supply leads to inflation.
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This is assuming that the change is initiated by a change in the
money supply.
If the change stems from an increase in RGDP, then the money supply
can grow without causing inflation.
Recap: if velocity is constant and money neutrality is true, then any
increase in the money supply will cause aproportional increase in theprice level (inflation)
We will usually assume velocity is constant, but not necessarily that
money neutrality is true.
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Example: In 2002 the Money Supply was $200b and the GDP
deflator was 4. In 2003 the Money Supply was $240b, the GDP
deflator was 4.6, and nominal GDP was $1200b.
Assuming velocity is stable, by how much did real GDP change?
2002
MV = PY
200V = 4Y
200x5=4Y
1000 = 4Y
250 = Y
2003
MV = PY
240V = 1200
V = 5
PY = 12004.6Y=1200
Y = 260.9
Between 2002 and 2003 real GDP increased by $10.9b.
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IV. The Fisher Effect
Recall: i = r +
The Supply and Demand for Loanable funds determine the real
interest rate.
Growth in the money supply determines the inflation rate.
The Fisher Effect is the one for one adjustment of the nominal
interest rate to the rate of inflation.
- long run (in the short run inflation can be unexpected)
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V. The Costs of Inflation
Inflation reduces purchasing powerin many different ways:
1. Shoeleather costs are the resources that are wasted when
inflation encourages people to decrease their money holdings.
- cost, time, inconvenience of physically getting more
cash
2. Menu costs are the costs of physically changing prices.
- reprint menu- new price tags on shelves
- update electronic database
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3. Relative price variability and misallocation of resources
- not all prices can adjust immediatelybecause of contracts
4.Arbitrary redistribution of wealth
- helps borrowers, harms lenders
5. Tax distortions- the nominal value of interest and capital gains are taxed
6. Confusion and inconvenience
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Note on hyperinflation:
Hyperinflation is inflation that exceeds 50% per month.
It usually occurs when the government prints way to much
money to pay for things.
Historical Examples:
In the 1920s, the WeimarRepublic of Germany was issuing
2trillion Mark notes
- postage stamps had a face value of 50 billion Mark- largest note was 100trillion Mark
- exchange rate was 1 US dollar to 4trillion Mark
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In 1946 the Hungarian National Bank issued the largest
denomination banknote ever issued for circulation
100 quintillion pengo 10
hundred million billion pengo
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Hungarys hyperinflation held the record for the highest monthly
inflation rate ever.
41,900,000,000,000,000% (4.19 1016%) in July, 1946
This meant prices doubled every 13.5 hours.
More recently, Zimbabwe has experienced hyperinflation and as of
February 2009 people stopped using the currency all together.
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It is not a secret that increasing the money supply by too much will
cause hyperinflation.
So why do some governments still do it?
Governments may print money topay for purchases or to pay off
debt. (seigniorage revenue)
- TheU
S does not do this!!!!!!
This increases the money supply and results in inflation so
everyones purchasing power falls.
All money becomes less valuable as more is printed and so theprice level rises.
It is as if there is a tax on everyone who holds money.
The Inflation Tax
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