Chapter 22: Money Growth and Inflation: 22 Chapter summary

Book Title: Essentials of Economics

Printed By: Kevin Pham ([email protected])
© 2024 Cengage Learning, Inc., Cengage Learning, Inc.

22 Chapter Overview with Helpful Hints

Chapter Review

Introduction

Inflation is an increase in the overall level of prices. Deflation is a decrease in the overall
level of prices. Hyperinflation is extraordinarily high inflation. There is great variation in
inflation over time and across countries. In this chapter, we address two questions: What
causes inflation, and why is inflation a problem? While many things can affect the price level
in the short run, most economists believe that the answer to the first question is that
substantial or persistent inflation is caused when the government prints too much money.
The answer to the second question requires more thought and will be the focus of the
second half of this chapter.

The Classical Theory of Inflation

This section develops and employs the quantity theory of money as an explanation of the
long-run determinants of the price level and inflation. It is termed "classical" because the
theory has been recognized by leading economists for many years.

When prices rise, it is rarely because products are more valuable but rather because the
money used to buy them is less valuable. Thus, inflation is more about the value of
money than about the value of goods. An increase in the overall price level is equivalent
to a proportionate fall in the value of money. If P is the price level (the value of goods and
services measured in money), then 1/P is the value of money measured in terms of goods
and services. If prices double, the value of money has fallen to 1/2 its prior value.

The value of money is determined by the supply and demand for money. If we ignore the
banking system, the Fed directly controls the money supply. Money demand reflects how
much wealth people want to hold in liquid form. While money demand has many
determinants, in the long run, one is dominant—the price level. People hold money because
it is a medium of exchange. If prices are higher, more money is needed for the same
transaction, and the quantity of money demanded is higher.

Money supply and money demand need to balance for there to be monetary equilibrium.
Monetary equilibrium is shown in Exhibit 1 for money supply at point A. Recall that the
value of money measured in goods and services is 1/P. When the value of money is high,
the price level is low, and the quantity of money demanded is low. Therefore, the money
demand curve slopes down in the graph. Because the Fed fixes the quantity of money, the
money supply curve is vertical. In the long run, the overall level of prices adjusts to equate
the quantity of money demanded to the quantity of money supplied.

Suppose the Fed doubles the quantity of money in the economy from to . There is
now an excess supply of money at the original price level. Because people are now holding
more money than they desire, they will rid themselves of the excess supply of money by
buying things—goods and services or bonds. Even if people buy bonds (lend money), the
bond issuer (borrower) will take the money and buy goods and services. Either way, an
injection of money increases the demand for goods and services. Because the ability of the
economy to produce goods and services has not changed, an increase in the demand for
goods and services raises the price level. The price level will continue to rise (and the value
of money will fall) until the quantity of money demanded is raised to the level of the quantity
of money supplied (point B). That is, the price level adjusts to equate money supply and
money demand. Thus, the conclusions of the quantity theory of money are: (1) the
quantity of money in the economy determines the price level (and the value of money), and
(2) an increase in the money supply increases the price level, which means that growth in
the money supply causes inflation.

The classical dichotomy suggests that economic variables can be divided into two groups—
nominal variables (those measured in monetary units) and real variables (those measured in
physical units). Although prices are nominal variables, relative prices are real variables. For
example, the ratio of your earnings per hour to the price of candy bars is a real variable
measured in candy bars per hour. Changes in the money supply affect nominal variables but
not real variables. Real output is determined by technology and factor supplies and not by
the quantity of money. However, the value of nominal variables is determined by and is
proportional to the quantity of money. For example, if the money supply doubles, prices
double, wages double, and all dollar values double but real output, employment, real
interest rates, and real wages remain unchanged. This result is known as monetary
neutrality. Money is unlikely to be neutral in the short run, but it is likely to be neutral in the
long run.

The classical dichotomy and monetary neutrality can be demonstrated with the quantity
equation. To begin, we define the velocity of money as the speed of circulation of money.
Then V = (P × Y)/M where V is the velocity of money, P is the price of output, Y is the
amount of real output (and P × Y = nominal GDP), and M is the quantity of money. If
nominal output is $500 (500 items at $1 each) and M is $100, then V = 5. That is, in order
for $100 to accommodate $500 of purchases and sales, each dollar must be spent, on
average, five times.

Rearranged, we get the quantity equation: M × V = P × Y. If the quantity of money

increases, P or Y must rise, or V must fall. Our theory of inflation takes five steps:

1. V is relatively stable in the long run.

2. Therefore, changes in M cause proportional changes in nominal output (P × Y).

3. Real output (Y) is determined by technology and factor supplies in the long run and is
not affected by changes in M.

4. If Y is fixed, an increase in M causes proportional changes in P.

5. Thus, inflation results from rapid growth in the money supply.

Hyperinflation is sometimes defined as inflation that exceeds 50 percent per month. In those
cases, the data show that there is a close link between money growth and inflation. This
supports the conclusions of the quantity theory.

Why do countries print too much money if they know it causes inflation? Governments do it
to pay for expenditures. When governments spend, they get the money by taxing,
borrowing, or printing more money. Countries that have high spending, inadequate tax
revenue, and limited ability to borrow may turn to printing money. When a government
raises revenue by printing money, it has engaged in an inflation tax. When the government
prints money and prices rise, the value of the existing money held by people falls. An
inflation tax is a tax on people who hold money.

If money is neutral, changes in money will have no effect on the real interest rate. Recall
the relationship between the real interest rate, nominal interest rate, and inflation:

Real interest rate = nominal interest rate – inflation rate

Solving for the nominal interest rate:

Nominal interest rate = real interest rate + inflation rate

The real interest rate depends on the supply and demand for loanable funds. In the long
run, money is neutral and only affects nominal variables, not real variables. Thus, when a
central bank increases the growth rate of money, there is an increase in the inflation rate
and a one-for-one increase in the nominal interest rate while the real interest rate remains
unchanged. The one-for-one adjustment of the nominal interest rate to inflation is called the
Fisher effect. Note that the nominal interest rate is set when the loan is first made, and thus,
the Fisher effect actually says that the nominal interest rate adjusts one-for-one with
expected inflation.

The Costs of Inflation

People often argue that inflation is a serious economic problem because when prices rise,
their incomes can’t buy as many goods and services. Thus, they believe that inflation
directly lowers their standard of living. This argument, however, has a fallacy. Because
people earn incomes by selling services, such as labor, inflation in nominal incomes goes
hand in hand with inflation in prices. Therefore, inflation generally does not directly affect
people’s real purchasing power.

There are, however, a number of more subtle costs of inflation:

Shoeleather costs: Recall that inflation is a tax on people who hold money. To avoid the
tax, people hold less money and keep more invested in interest-bearing assets when
inflation is high than they do when inflation is low. As a result, people have to go to the
bank and withdraw money more often than they would if there were no inflation. These
costs are sometimes metaphorically called shoeleather costs (since your shoes are worn
out from all those trips to the bank). The actual cost of holding less cash is wasted time
and inconvenience. At high rates of inflation, this cost is significant.

Menu costs: There are numerous costs associated with changing prices—the cost of
printing new menus, price lists, and catalogs; mailing costs to distribute them; the cost of
advertising new prices; and the cost of deciding the new prices themselves.

Relative-price variability and the misallocation of resources: Because it is costly to

change prices, firms change prices as rarely as possible. When there is inflation, the
relative price of goods whose price is held constant for a period of time is falling with
respect to the average price level. This misallocates resources because economic
decisions are based on relative prices. A good whose price is changed only once per
year is artificially expensive at the beginning of the year and artificially inexpensive by the
end of the year.

Inflation-induced tax distortions: Inflation raises the tax burden on income earned from
saving and, thus, discourages saving and growth. Inflation affects two types of taxes on
saving:

(1) Capital gains are the profits made from selling an asset for more than its
purchase price. Nominal capital gains are subject to taxation. Suppose you
buy a stock for $20 and sell it for $50. Also, suppose the price level doubled
while you owned the stock. You only have a $10 real gain (because you would
need to sell the stock for $40 just to break even), yet you must pay taxes on
the $30 nominal capital gain because the tax code does not account for
inflation.

(2) Nominal interest is taxed even though part of the nominal interest rate is to
compensate for inflation. When government takes a fixed percentage of the
nominal interest rate as taxes, the after-tax real return grows smaller as
inflation increases. This is because the nominal interest rate rises one-for-one
 with inflation, and taxes increase with the nominal interest rate, yet the pretax
real return is unaffected by inflation. Therefore, the after-tax real return falls.

Because there are taxes on nominal capital gains and nominal interest, inflation
lowers the after-tax real return on saving, and thus, inflation discourages saving
and growth. This problem can be solved by eliminating inflation or by indexing the
tax system so that taxes are assessed only on real gains.

Confusion and inconvenience: Money serves as the unit of account, which means that
the dollar is the yardstick by which we measure economic values. When the Fed
increases the money supply and causes inflation, it decreases the value of money and
shrinks the size of the economic measuring stick. This makes accounting for firms’ profits
more difficult and, thus, makes choosing investments more complicated. It also makes
daily transactions more confusing.

A special cost of unexpected inflation—arbitrary redistribution of wealth: The costs

of inflation previously described exist even if inflation is stable and predictable. Inflation
has an additional cost to the economy, however, if it is unexpected because it arbitrarily
redistributes wealth. For example, the terms of a loan are generally expressed in nominal
values based on a certain amount of expected inflation (see the Fisher effect equation).
However, if inflation becomes higher than expected, borrowers are allowed to repay the
loan with dollars that purchase less than expected. Borrowers gain at the expense of
lenders. The opposite is true when inflation is less than expected. If inflation were
perfectly predictable, regardless of its size, this redistribution would not take place.
However, high inflation is never stable. Therefore, low inflation is preferred because it is
more stable and predictable.

Deflation: The Friedman rule argues that small and predictable deflation equal to the
real interest rate could be desirable because it would drive nominal interest rates to near
zero, reducing shoeleather costs. Alternatively, the costs of deflation can mirror the other
costs of inflation. In addition, deflation is usually a sign of broader economic problems
such as a sudden monetary contraction leading to a reduction in overall demand for
output.

Helpful Hints

1. The price of money is 1/P. Because we measure the price of goods and services in
terms of money, we measure the price of money in terms of the quantity of goods and
services for which money can be exchanged. For example, if a basket of goods and
services costs $5, then P = $5. The price of a dollar is then 1/P or 1/5 of the basket of
goods. That is, you can exchange one dollar for 1/5 of the basket of goods. If the price
of the basket of goods doubles so it now sells for $10, the price of money has fallen to
one-half its original value. Numerically, because the price of the basket is now $10, or
P = $10, the price of money has fallen to 1/P or 1/10 of the basket of goods. To
summarize, when the price of a basket of goods and services doubles from $5 to $10,
the price of money falls by half from 1/5 to 1/10 of the basket of goods.
 2. When dealing with the quantity theory, imagine you are at an auction. At the end of the
auction, we can calculate the number of items sold and the average price of each item
sold. Suppose we repeat the auction, only now the doorman doubles the money each
buyer takes into the auction—if you had $20, you now have $40, and so on. If all
participants spend the same percentage of their money as at the prior auction
(equivalent to a constant velocity) and if the items available to buy are unchanged
(equivalent to a constant real output), what must happen to the average price of
goods sold at the auction? Prices at the auction will precisely double, showing that
prices are proportional to the quantity of money.

3. We know that unexpected inflation redistributes wealth. However, it can be difficult to

remember who wins and who loses on nominal contracts when there is unexpected
inflation. To keep things straight, remember that unexpected inflation works like a
tax on money received in the future and a subsidy to money paid in the future.
Therefore, when inflation turns out to be higher than we thought it would be when a
loan contract was written, the recipient of the future payments is worse off because
they receive dollars with less purchasing power than they had expected. The person
who borrowed is better off because they are able to use the money when it has
greater value, yet they repay the loan with money of lower value. Therefore, when
inflation is higher than expected, wealth is redistributed from lenders to borrowers.
Alternatively, when inflation is less than expected, winners and losers are reversed.

This concept can be applied to any contract that extends across time. Consider a
labor contract. Recall that when inflation is greater than we expected, those who
receive money in the future are harmed and those who pay are helped. Therefore,
firms gain at the expense of workers when inflation is greater than anticipated. When
inflation is less than expected, winners and losers are reversed.

Chapter 22: Money Growth and Inflation: 22 Chapter summary

Book Title: Essentials of Economics
Printed By: Kevin Pham ([email protected])
© 2024 Cengage Learning, Inc., Cengage Learning, Inc.

© 2024 Cengage Learning Inc. All rights reserved. No part of this work may by reproduced or used in any form or by any means -
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