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Chapter 16 Money Growth and Inflation • The Classical Theory of Inflation • The Chapter 16 Money Growth and Inflation • The Classical Theory of Inflation • The Costs of Inflation 1

 • Over the past sixty years, prices have risen on average about 4 • Over the past sixty years, prices have risen on average about 4 percent per year. • Deflation, a situation of decreasing prices. The average level of prices in the Canadian economy was 37% lower in 1933 than in 1920. • In the 1970’s prices rose by 7 percent per year. • In the 1990’s prices rose about 2 percent per year. • Hyperinflation, an extraordinarily high rate of inflation. Eg, in Germany after WW I, the price of a news paper rose from 0. 3 marks in January 1921 to 70, 000 marks less than two years later The classical Theory of Inflation • Inflation is a sustained increase in the price level. It is a continuous increase versus a “once-and-for-all” increase in 2 prices.

 • Inflation deals with the increase in the average of prices and not • Inflation deals with the increase in the average of prices and not just significant increases in the price of a few goods. • So, when the price level rises, people have to pay more for the goods and services they buy. • Or alternatively, we can say that a rise in the price level means a lower value of money because each dollar in your wallet now buys a smaller quantity of goods and services. • Therefore, inflation is an economy-wide monetary phenomenon that concerns, first and foremost, the value of an economy’s 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. 3

 • Money Demand has several determinants including: – interest rates – average level • Money Demand has several determinants including: – interest rates – average level of prices in the economy ( the most important one) • People hold money because it is the medium of exchange. People can use money to buy the goods and services on their shopping lists. How much money they choose to hold for this purpose depends on the prices of those goods and services. The higher prices are, the more money the typical transaction requires, and the more money people will choose to hold in their wallets and chequing accounts. • That is, a higher price level ( a lower value of money) increases the quantity of money demanded. 4

 • Money Supply is a variable of the Bank of Canada. Through instruments • Money Supply is a variable of the Bank of Canada. Through instruments such as open market operations, the B of C directly controls the quantity of money supplied. • In the long-run, the overall level of prices adjusts to the level at which the demand for money equals the supply. • See Figure 16 -1 • At the equilibrium, point A, the level of money ( on the left axis) and the price level ( on the right axis) have adjusted to bring the quantity of money supplied and the quantity of money demanded into balance. • The effects of a monetary injection • The B of C 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 5 – The equilibrium price level increasing

 • This process is referred to as the quantity theory of money. • • This process is referred to as the quantity theory of money. • According to the quantity theory, the quantity of money available in the economy determines the value of money, and growth in the quantity of money is the primary cause of inflation. • See Figure 16 -2 • The injection of money increases the demand for goods and services. Thus, the greater demand for goods and services causes the prices of goods and service to increase. The increase in the price level, in turn, increases the quantity of money demanded because people are using more dollars for every transaction. • When an increase in the money supply makes dollars more plentiful, the price level increases, making each dollar less 6 valuable.

 • The classical Dichotomy and monetary neutrality • We have seen how changes • The classical Dichotomy and monetary neutrality • We have seen how changes in the money supply lead to changes in the average level of prices of goods and services. How do these monetary changes affect other important macroeconomic variables, such as production, employment, real wages, and real interest rates? • David Hume suggested that all economic variables should be divided into two groups. – Nominal variables: variables measured in monetary units ; Eg: income of corn farmers, nominal GDP – Real variables: variables measured in physical units; Eg: real GDP, relative prices ( a number without dollar sign) – Classical dichotomy: theoretical separation of nominal and real variables. 7

– He argued, nominal variables are heavily influenced by development in the economy’s monetary – He argued, nominal variables are heavily influenced by development in the economy’s monetary system, whereas the monetary system is largely irrelevant for understanding the determinants of important real variables. • Changes in the supply of money, according to Hume, affect nominal variables but not real variables. • 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. 8

 • Velocity and The Quantity Equation • “How many times per year is • 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. • 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. Mx. V=Px. Y 9

 • The quantity equation shows that an increase in the quantity of money • The quantity equation shows that an increase in the quantity of money in an economy must be reflected in one of the other three variables: the price level must rise, the quantity of output must rise, or the velocity of money must fall. • See Figure 16 -3. • 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. Changes in the money supply which induce parallel changes in the nominal value of output are also reflected in changes in the price level. 10

 When the B of C increases the money supply rapidly, the result is When the B of C increases the money supply rapidly, the result is a high rate of inflation. • Hyperinflation is inflation that exceeds 50 percent per month. This means that the price level increases more than 100 -fold over the course a a year. • Hyperinflation in some countries is caused because the government prints too much money to pay for their spending. • See Figure 16 -4. This figure shows the quantity of money and the price level during four hyperinflations. The slope of the money line represents the rate at which the quantity of money was growing, and the slope of the price line represents the inflation rate. The steeper the lines, the higher the rates of money growth or inflation. It is worth noting that in each graph the quantity of money and the price level are almost parallel. 11

 • The inflation tax • When the government raises revenue by printing money, • The 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. • 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. • 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. 12 • See Figure 16 -5

The inflation fallacy • Why is inflation bad? “ Inflation robs people of the The inflation fallacy • Why is inflation bad? “ Inflation robs people of the purchasing power of their hard-earned dollars. ” Is it true? • When prices rise, buyers of goods and services pay more for what they buy. However, at the same time, sellers of goods and services get more for that they sell. Because most people earn their incomes by selling their services, such as their labour, inflation in incomes goes hand in hand with inflation in prices. • Fact: “One person’s inflated price is another’s 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. • Thus, inflation does not in itself reduce people’s real 13 purchasing power.

Why is inflation a problem? Economists have identified several costs of inflation. They are: Why is inflation a problem? Economists have identified several costs of inflation. They are: • 1. Shoeleather costs. • 2, Menu Costs. • 3, Increased variability of relative prices. • 4, Tax liabilities. • 5, Confusion and inconvenience. • 6, Arbitrary redistribution of wealth 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 14 activities.

Menu Costs • During inflationary times, it is necessary to update price lists and 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. 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. • See Table 16 -1 15

Confusion and Inconvenience • With rising prices, it is necessary to constantly make corrections 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. 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. 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. 16 – Recall the Fisher Effect.