Transcript My lecture

Mankiw: Brief Principles of
Macroeconomics, Second Edition
(Harcourt, 2001)
Ch. 11: Money Growth and Inflation
Quantity Theory of Money
• It explains the price level in the long run.
• Long run means when the economy is
operating at full employment (at the natural
rate of unemployment).
• The theory has been around since the 18th
century.
• The theory is summarized as “Prices rise
when too much money is printed.”
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Monetary Neutrality
• In the long run, the real GDP will depend on
available labor, capital and technology.
• Doubling the amount of money in the system will
not increase the output in the long run.
• The impact of more money will be on the price
level but real variables (real GDP, real saving,
real investment, real interest rates, etc.) will not
be affected.
• Monetary neutrality means the amount of money
in the system is not relevant to the amount of
output.
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Monetary Neutrality and the Short
Run
• In the short run, prices take some time to adjust.
– An increase in money supply, until price level
increases and equates money demand to money
supply, will have output response.
– When there is excess money and prices are lower
than they should be, more goods and services will be
purchased, signaling to the producers to produce
more.
• In the short run, monetary policy will have
impact on real variables.
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Income Velocity of Money
• Given the amount of money stock in the system,
how many times it has to turn over as the GDP
is created.
• If US nominal GDP is $9 trillion and M1 is $1
trillion, then the velocity of M1 is 9.
• Y is used to denote real GDP and P is used to
denote the price level. YP, then is nominal
GDP.
• V = (YP)/M
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Quantity Equation
• MV = PY is called the quantity equation.
• It says that the value of nominal GDP is
equal to the money stock times its velocity.
• If there is an increase in money stock (M),
one or more of the following will happen to
bring the equation into balance.
– Velocity should decline.
– Price level should rise.
– Output should rise.
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Prediction with Quantity Equation
• Velocity is relatively stable.
• Increases in M, therefore, will be matched by
increases in nominal GDP (PY).
• In the long run, real GDP (Y) is determined by
factor supplies and technology, i.e., money is
neutral.
• Therefore, the increase in money stock will be
matched by an increase in the price level.
• This reasoning is called Quantity Theory of
Money.
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Measuring the Value of Money
• Just like any price, the value of money
should respond to supply of money and
demand for money.
• The value of money is the reciprocal of the
price level, 1/P.
– As the price level rises, the same $1 can
purchase fewer commodities.
– 1/P shows the value of $1 in terms of goods and
services.
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Money Demand
• Money demand means how much liquidity
households desire to hold.
– Liquidity here means currency and demand deposits.
• There are many factors that affect the demand
for money.
–
–
–
–
Income
Interest rates
Frequency of payments
Price level
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Price Level and Money Demand
• As the price level rises, the value of money
declines.
– Just like any commodity, the lower the price of
a commodity, the higher will be quantity
demanded.
• As the price level rises, the same basket of
goods cost more.
– In order to fulfill their shopping lists,
households have to hold larger amounts of
money.
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Money Demand
Price
Level
Value of
Money (1/P)
2
0.5
1.5
0.67
1
1
0.5
2
As the price level
rises, the value of
money declines.
The higher the price
level, the more
money is demanded,
i.e., people need to
hold higher balances
of currency and
demand deposits.
Quantity of Money
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Money Supply
• Money supply is determined by the Fed and the
banking system.
• Assuming that banks always keep the required
reserve ratio and households prefer to keep their
money in checking accounts, the Fed will be able
to control the amount of money in the economy.
• Through open market operations, the Fed will
manipulate the money supply.
– Buying US securities will increase money supply.
– Selling US securities will decrease money supply.
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Money Demand and Money Supply
Value of
Money (1/P)
2
Price
Level
Ms
0.5
1.5
0.67
1
1
0.5
2
Md
Quantity of Money
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In the long run, when
the Fed keeps a certain
amount of money
available, price level
will adjust to equate
supply and demand.
At P=0.67, there is
excess supply. To
increase the Md to the
level of Ms, P has to
rise up to P=2.
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Reducing Money Supply
Value of
Money (1/P)
2
Ms’
Price
Level
Ms
0.5
1.5
0.67
1
1
0.5
2
Md
Quantity of Money
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If the Fed targeted Ms’
there will be excess
demand at P=2. In
order to fulfill the
demand, people will
reduce purchases. The
lower expenditures will
reduce the price level,
assuming the economy
operates at full
employment.
Equilibrium will come
at P=0.67.
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Inflation
• Inflation is an economy-wide phenomenon.
– Price increases in a few commodities do not
portend inflation.
• Inflation takes place when a basket of goods
cost more to purchase.
• Inflation lowers the value of money.
– The same amount of money (currency+demand
deposits) can buy a smaller amount of goods.
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Inflation Tax
• When governments spend money, they raise the funds
either from taxes or from borrowing or from printing
money.
• Governments that found taxing or borrowing difficult
have turned to inflation to finance their activities.
• Governments get goods and services through the printed
money they spend. The larger stock of money and the
smaller amount of goods and services left for the private
sector force prices to rise.
• The nominally valued assets lose value and owners of
these assets are in fact taxed.
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Examples of Inflation Tax
• Continental Congress in 1770s needed funds to
pay for military.
– Their limited ability to raise taxes or to borrow forced
them to print money.
– Prices rose more than a 100-fold over a few years.
• After WWI, the Allies imposed war reparations
on Germany. Not being able to make the
payments, German government resorted to
printing money.
– Between 1921 and 1923 prices rose 100-fold.
– Between 1923 and 1924 prices rose one-billion fold.
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Examples of Inflation Tax
• To pay its creditors in 1998 Russia resorted to
inflation tax.
– Between Mar. 1998 and Mar. 1999, inflation in
Russia was 130.5%. (The Economist, April 17, 1999, p. 112)
– The latest inflation numbers from Russia are
between Aug. 1999 and Aug. 2000: 18.8%. (The
Economist, October 7, 2000, p. 124)
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The Fisher Effect
• Lenders always lend funds above the expected inflation
rate; otherwise, they would lose wealth.
• Nominal interest rate is the interest rate the bank offers
for deposits or charges for loans.
• Real interest rate is nominal interest rate minus
expected inflation rate. (Fisher equation)
• Real interest rate is determined in the loanable funds
market through the interaction of supply and demand.
• Inflation is determined through the growth of money
supply.
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Inflation Does Not Make Everyone
Poorer
• If everyone received a raise in their incomes
equal to the inflation rate, their purchasing
power will not change.
• The society as a whole does increase its income
in line with inflation; however, some gain and
others lose.
• Inflation is a tax on holders of money. It
transfers income from them to the government.
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Costs of Inflation
•
•
•
•
•
Shoeleather costs
Menu costs
Increased variability of relative prices
Tax consequences
Confusion because of the change in unit of
account
• Arbitrary redistribution of wealth
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Shoeleather Costs
• People change their behavior to avoid the
inflation tax.
• To get rid of money and other assets that have
fixed values forces people to undertake efforts
that use time and other resources that could have
been devoted to productive use.
• How could you beat inflation?
– Keep lower money balances. (Demand for money
low).
– Exchange currency or other assets with fixed values
to real assets or to currencies that are stable in value.
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Menu Costs
• During high inflation the prices of goods
and services will be adjusted upward
frequently.
• This takes time and effort and is a cost of
business.
• Catalogues, menus, price tags all need to be
changed.
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Relative-price Variability
• In an efficient market economy, prices reflect
scarcity and allow efficient allocation of
resources through the decisions of consumers and
producers who respond to these prices.
• During inflationary times, if prices aren’t updated
as fast as the inflation, the relative price of an
item will start being high and then will fall.
• Consumers and producers will make their choices
according to the changing relative prices,
distorting efficient allocation of resources and,
therefore, wasting resources.
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Inflation Induced Tax Distortions
• Impact on capital gains.
– You buy a house in 2000 for $100,000. In 2020 you
sell the house for $200,000.
– You have a capital gain of $100,000.
– If the capital gain tax is 20%, you have to pay
$20,000 in taxes.
– Suppose during these twenty years CPI moved from
100 to 200.
– In real terms, the value of your house stayed the
same.
– Yet you had to pay taxes on gains you did not have.
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Inflation Induced Tax Distortions
• Impact on interest income.
– You deposit $1000 in a certificate-of-deposit that
pays 6% interest.
– At the end of the year your interest earnings are $60.
– You are in the income tax bracket of 30%.
– You pay $18 in taxes.
– Suppose inflation during this time was 4%.
– The real rate of interest you earned is 2% (6-4=2).
– Your real interest income was $20.
– After paying the tax, your earnings were $2 or 0.2%.
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Inflation Induced Tax Distortions
• In both cases, returns are much lower than they
would have been if there were no inflation.
• Lower returns will discourage saving.
– Remember, saving is not-consuming.
• Lower savings will have dampening effect on
investments and future growth.
• Indexing could solve this problem but would
complicate calculations.
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Confusion and Inconvenience
• In an inflationary environment, firms will show
huge revenue gains.
• They might even show huge profit gains.
• Because these gains aren’t adjusted for inflation,
evaluating the health and reliability of firms
becomes more difficult.
• It increases adverse selection problem and
reduces the savings channeled into these firms.
• If every accounting number were given in real
terms, this problem wouldn’t have arisen.
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Arbitrary Redistribution of Wealth
• Unexpected inflation redistributes wealth from
creditors to debtors.
–
–
–
–
Today you borrow $10,000 at 8% interest rate.
The inflation rate people expect is 4%.
Suppose the inflation turns out to be 10%.
When you pay your loan back next year you pay less
money in real terms than you borrowed.
– You pay $10,800 but the real value of the $10,000
you borrowed is $11,000.
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Arbitrary Redistribution of Wealth
• Unexpected inflation redistributes income away
from fixed income earners to their employers.
– You negotiate wages of $1000 per month hoping
that there would be no inflation.
– A monthly inflation of 1% takes place (over 12%
annual inflation).
– Your 12th payment is worth about $833 in real terms
instead of the $1000 you expected to receive.
– Your employer gained by paying less real wages
each month.
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Arbitrary Redistribution of Wealth
• Countries that have high inflation rates also
have high variability in inflation rates.
• High variability makes uncertainty arise.
– Long term planning suffers.
– Savings are reduced (adverse selection).
• High variability makes unexpected inflation
to become more of a force.
– Winners and losers keep on changing creating
social unrest.
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The Wizard of Oz
• During unexpected inflation debtors win.
• During unexpected deflation creditors win.
• A unexpected decline in the price level between
1880 and 1896 hurt the farmers and workers
because they were both heavily in debt.
– Farmers borrowed from banks to plow and plant.
– Workers borrowed from company stores.
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The Wizard of Oz
• In accordance with the Quantity Theory of
Money, an increase in price level could come
through increasing money supply.
• During this time US was under the gold standard.
– The amount of money available in the system was
determined by the amount of gold.
• By allowing silver to be used along with gold to
back money, the amount of money could be
increased.
• William Jennings Bryan
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