Transcript general rise in prices

Lecture 18
Money
What is money?
Anything people will accept in place of the goods
they seek to obtain.
Trust is critical.
Examples from history: salt in Egypt; rice in Japan;
dried fish in Iceland; cotton cloth in Africa;
cigarettes in Romania in the 1970s; liquor in
Germany after World War II; QQ coin in China;
rocks such as gold and silver
Roles of Money
 Account keeping
 Store of Value
 Medium of Exchange
 More efficient than barter
 If people do not trust official money, they use
other things
Money Creation
 Governments create money
 Role of central banks
 Independence from politics important
 Many views on how the banks should
manage money creation — fixed rules versus
flexibility
Inflation
What is inflation? It is a general rise in prices —
not an increase in one price, such as higher
price for wheat one year due to bad crops
causing a short supply.
 Usually it is caused by more money in the
hands of people who are trying to buy the same
quantity of goods in an economy.
Inflation Is Not an
Increase in One Price
 If the price of one good rises, it does not cause
inflation. It is a change in relative prices.
 People have no more money to spend than before,
they change spending mix.
 Example: Price of gasoline up in U.S. 2006: 4.6% of
personal expenditures on gas; in 1997: 2.6%
 Where does the extra money spent on gas (2% of
personal income) come from? Less spending on
other goods.
MV = PT
 The quantity theory of money is:
 MV = PT
 M = money in circulation
 V = velocity (number of times money spent per
year)
 P = average price level
 T = number of transactions
 Note: this is national income.
Price of Gas Rises
 MV = PT
 Assume M and V constant.
 P of gasoline rises; T constant
 If Demand for gasoline constant (T not changing),
since more spent on gas, other transactions must fall
(and their prices may too as a result).
Gas Goes Up —
What Goes Down?
 Consumers do not make money, so M constant.
 Velocity rarely changes in stable economies.
 Price of gas goes up; but Demand constant, so something
gives—in U.S. the drop occurred in spending at higher class
stores and nicer restaurants. Spending on luxury goods
dropped (boat sales and jewelry). Lower income people cut
spending at Wal-Mart.
 Same thing from increase in mortgage rates—consumers must
cut back in other areas.
 It hurts, but it is not inflation.
So What Causes Inflation?
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In general, inflation is caused by more money
(M) chasing the same quantity of goods.
If M rises and V constant then PT must rise to
balance equation.
People have more money so make more
purchases (T rises) increase in T means more
demand for same level of goods, so prices (P)
bid higher.
Origins of Inflation
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1.
2.
So why do we get inflation?
The government creates more money.
Why? Not stupidity. It is deficit spending.
Print money.
Borrow money from Central Bank or from
foreigners.
Destructive Effects
 When inflation rising (and is expected to
continue to rise):
▲ spending and borrowing
▼ savings and investment
▲ incentive to inflate currency even more,
depending on political forces
Real vs. Nominal
Interest Rate
 Suppose inflation averages 10% per year (the
value of the currency falls by 10% each year).
 If interest rate paid is 12%, that is the nominal
interest rate.
 What is real (after inflation) interest rate?
12% – 10% = 2%
Inflation Hurts People,
Business, and Society
 Businesses have a difficult time planning for
future — which means less investment.
 How do you time payments?
 Do you accept currency?
 There are winners and losers in every
transaction just due to changes in the value of
the currency — up or down.
Real World Example
 Assume a person in the U.S. invested $10,000 in 1971 for
their retirement in 1991 when the investment is worth
$35,000 — a normal rate of return.
 What is the gain? Due to inflation, $10,000 in 1971 =
$34,000 in 1991. So gain is only $1,000. But the entire
“gain” of $25,000 is subject to taxes of about $7,000,
leaving $28,000 in 1991 — less than the original
investment in real spending power.
 So if people think there will be inflation—what actions
do they rationally take?
Rational Decision Makers
 People try to avoid losses imposed by inflation:
● invest in hard assets
● invest in other countries
● avoid currency of own country
Due to international flows of currency, inflation is
punished in the market. Local people with few options
suffer the most. Political instability more likely if
currency unstable.