6/16/2008. Money and Inflation. In this chapter, you will learn. The connection between money and prices. Money: Functions.

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1 C H A P T E R 4 ony and Inflation In this chaptr, you will larn Th classical thory of inflation causs ffcts social costs Classical assums prics ar flxibl & markts clar Applis to th long run slid 1 15% 12% 9% 6% 3% U.S. inflation and its trnd, % chang in CPI from 12 months arlir long-run trnd Th connction btwn mony and prics Inflation rat = th prcntag incras in th avrag lvl of prics. Pric = amount of mony rquird to buy a good. Bcaus prics ar dfind in trms of mony, w nd to considr th natur of mony, th supply of mony, and how it is controlld. 0% slid 2 slid 3 ony: Dfinition ony is th stock of assts that can b radily usd to mak transactions. ony: Functions mdium of xchang w us it to buy stuff stor of valu transfrs purchasing powrfrom th prsnt to th futur unit of account th common unit by which vryon masurs prics and valus slid 4 slid 5 1

2 ony: Typs 1. fiat mony has no intrinsic valu xampl: th papr currncy w us 2. commodity mony has intrinsic valu xampls: gold coins, cigartts in P.O.W. camps Discussion Qustion Which of ths ar mony? a. Currncy b. Chcks c. Dposits in chcking accounts ( dmand dposits ) d. Crdit cards. Crtificats of dposit ( tim dposits ) slid 6 slid 7 Th mony supply and montary policy dfinitions Th mony supply is th quantity of mony availabl in th conomy. ontary policy is th control ovr th mony supply. Th cntral bank ontary policy is conductd by a country s cntral bank. In th U.S., th cntral bank is calld th Fdral Rsrv ( th Fd ). Th Fdral Rsrv Building Washington, DC slid 8 slid 9 Th Quantity Thory of ony A simpl thory linking th inflation rat to th growth rat of th mony supply. Bgins with th concpt of vlocity Vlocity basic concpt: th rat at which mony circulats dfinition: th numbr of tims th avrag dollar bill changs hands in a givn tim priod xampl: In 2007, $500 billion in transactions mony supply = $100 billion Th avrag dollar is usd in fiv transactions in 2007 So, vlocity = 5 slid 10 slid 11 2

3 Vlocity, cont. This suggsts th following dfinition: T V = whr V = vlocity T = valu of all transactions = mony supply Vlocity, cont. Us nominal GDP as a proxy for total transactions. Thn, P Y V = whr P = pric of output (GDP dflator) Y = quantity of output (ral GDP) P Y = valu of output (nominal GDP) slid 12 slid 13 Th quantity quation Th quantity quation V = P Y follows from th prcding dfinition of vlocity. It is an idntity: it holds by dfinition of th variabls. ony dmand and th quantity quation /P = ral mony balancs, th purchasing powr of th mony supply. A simpl mony dmand function: (/P) d = ky whr k = how much mony popl wish to hold for ach dollar of incom. (k is xognous) slid 14 slid 15 ony dmand and th quantity quation mony dmand: (/P) d = ky quantity quation: V = P Y Th connction btwn thm: k = 1/V Whn popl hold lots of mony rlativ to thir incoms (k is high), mony changs hands infrquntly (V is low). Back to th quantity thory of mony starts with quantity quation assums V is constant & xognous: With this assumption, th quantity quation can b writtn as V = P Y V = V slid 16 slid 17 3

4 Th quantity thory of mony, cont. V = P Y How th pric lvl is dtrmind: With V constant, th mony supply dtrmins nominal GDP (P Y ). Ral GDP is dtrmind by th conomy s supplis of K and L and th production function (Chap 3). Th pric lvl is P = (nominal GDP)/(ral GDP). slid 18 Th quantity thory of mony, cont. Rcall from Chaptr 2: Th growth rat of a product quals th sum of th growth rats. Th quantity quation in growth rats: Δ ΔV ΔP ΔY + = + V P Y Th quantity thory of mony assums ΔV V is constant, so = 0. V slid 19 Th quantity thory of mony, cont. Th quantity thory of mony, cont. π (Grk lttr pi ) dnots th inflation rat: Th rsult from th prcding slid was: Solv this rsult for π to gt π = ΔP P Δ ΔP ΔY = + P Y Δ ΔY π = Y Δ ΔY π = Y Normal conomic growth rquirs a crtain amount of mony supply growth to facilitat th growth in transactions. ony growth in xcss of this amount lads to inflation. slid 20 slid 21 Th quantity thory of mony, cont. Δ ΔY π = Y ΔY/Y dpnds on growth in th factors of production and on tchnological progrss (all of which w tak as givn, for now). Hnc, th Quantity Thory prdicts a on-for for-on on rlation btwn changs in th mony growth rat and changs in th inflation rat. slid 22 Confronting th quantity thory with data Th quantity thory of mony implis 1. countris with highr mony growth rats should hav highr inflation rats. 2. th long run trnd bhavior of a country s inflation should b similar to th long run trnd in th country s mony growth rat. Ar th data consistnt with ths implications? slid 23 4

5 Inflation rat (prcnt, logarithmic scal) 10 Intrnational data on inflation and mony growth 100 Ecuador Indonsia Turky Blarus 15% 12% U.S. inflation and mony growth, Ovr th long run, th inflation and mony growth rats mov togthr, as th quantity thory prdicts. 2 growth rat 1 U.S. Singapor Switzrland Argntina 9% 6% ony Supply Growth (prcnt, logarithmic scal) slid 24 3% inflation rat 0% slid 25 Signiorag To spnd mor without raising taxs or slling bonds, th govt can print mony. Th rvnu raisd from printing mony is calldsigniorag (pronouncd SEEN your idg). Th inflation tax: Printing mony to rais rvnu causs inflation. Inflation is lik a tax on popl who hold mony. Inflation and intrst rats Nominal intrst rat, i not adjustd for inflation Ral intrst rat, r adjustd dfor inflation: r = i π slid 26 slid 27 Th Fishr ffct Th Fishr quation: i = r + π Chap 3: S = I dtrmins r. Hnc, an incras in π causs an qual incras in i. This on for on rlationship is calld th Fishr ffct. prcnt pr yar 15% 12% 9% 6% 3% 0% Inflation and nominal intrst rats in th U.S., inflation rat nominal intrst rat slid 28-3% slid 29 5

6 Nominal Intrst Rat (prcnt, logarithmic scal) Inflation and nominal intrst rats across countris Grmany Switzrland Isral Brazil U.S. Romania Zimbabw Bulgaria Inflation Rat (prcnt, logarithmic scal) slid 30 Exrcis: Suppos V is constant, is growing 5% pr yar, Y is growing 2% pr yar, and r = 4. a. Solv for i. b. If th Fd incrass th mony growth rat by 2 prcntag points pr yar, find Δi. c. Suppos th growth rat of Y falls to 1% pr yar. What will happn to π? What must th Fd do if it wishs to kp π constant? slid 31 Answrs: Two ral intrst rats V is constant, grows 5% pr yar, Y grows 2% pr yar, r = 4. a. First, find π = 5 2 = 3. Thn, find i = r + π = = 7. b. Δi = 2, sam as th incras in th mony growth rat. c. If th Fd dos nothing, Δπ = 1. To prvnt inflation from rising, Fd must rduc th mony growth rat by 1 prcntag point pr yar. slid 32 π = actual inflation rat (not known until aftr it has occurrd) π = xpctd inflation rat i π = x ant ral intrst trat: th ral intrst rat popl xpct at th tim thy buy a bond or tak out a loan i π = x post ral intrst rat: th ral intrst rat actually ralizd slid 33 ony dmand and th nominal intrst rat In th quantity thory of mony, th dmand for ral mony balancs dpnds only on ral incom Y. Anothr dtrminant of mony dmand: th nominal intrst rat, i. th opportunity cost of holding mony (instad of bonds or othr intrst arning assts). Hnc, i in mony dmand. Th mony dmand function d ( P) = L( i, Y ) (/P) d = ral mony dmand, dpnds ngativly on i i is th opp. cost of holding mony positivly on Y highr Y mor spnding so, nd mor mony ( L is usd for th mony dmand function bcaus mony is th most liquid asst.) slid 34 slid 35 6

7 Th mony dmand function d ( P) = L( i, Y ) = L( r + π, Y ) Whn popl ar dciding whthr to hold mony or bonds, thy don t tknow what htinflation will turn out to b. Hnc, th nominal intrst rat rlvant for mony dmand is r + π. Equilibrium Th supply of ral mony balancs Lr (, Y) P = +π Ral mony dmandd slid 36 slid 37 What dtrmins what variabl r Y P Lr (, Y) P = +π how dtrmind (in th long run) xognous (th Fd) adjusts to mak S = I Y = F ( K, L) adjusts to mak LiY (, ) P = How P rsponds to Δ Lr (, Y) P = +π For givn valus of r, Y, and π, a chang in causs P to chang by th sam prcntag just lik in th quantity thory of mony. slid 38 slid 39 What about xpctd inflation? How P rsponds to Δπ Ovr th long run, popl don t consistntly ovr or undr forcast inflation, so π = π on avrag. In th short run, π may chang whn popl gt nw information. EX: Fd announcs it will incras nxt yar. Popl will xpct nxt yar s P to b highr, so π riss. This affcts P now, vn though hasn t changd yt. slid 40 Lr (, Y) P = +π For givn valus of r, Y, and, π ii (th Fishr ffct) ( P ) d ( ) P to mak P fall to r-stablish q'm slid 41 7

8 Discussion qustion Why is inflation bad? What costs dos inflation impos on socity? List all th ons you can think of. Focus on th long run. Think lik an conomist. A common misprcption Common misprcption: inflation rducs ral wags This is tru only in th short run, whn nominal wags ar fixd by contracts. (Chap. 3) In th long run, th ral wag is dtrmind by labor supply and th marginal product of labor, not th pric lvl or inflation rat. Considr th data slid 42 slid 43 Avrag hourly arnings and th CPI, Th classical viw of inflation hourly wag $20 $18 $16 $14 $12 $10 $8 $6 CPI (right scal) $4 wag in currnt dollars $2 wag in 2007 dollars $ CPI ( = 100) slid 44 Th classical viw: A chang in th pric lvl is mrly a chang in th units of masurmnt. So why, thn, is inflation a social problm? slid 45 Th social costs of inflation fall into two catgoris: 1. costs whn inflation is xpctd 2. costs whn inflation is diffrnt than popl hd had xpctd td Th costs of xpctd inflation: 1. Sholathr cost df: th costs and inconvnincs of rducing mony balancs to avoid th inflation tax. π i ral mony ybalancsa Rmmbr: In long run, inflation dos not affct ral incom or ral spnding. So, sam monthly spnding but lowr avrag mony holdings mans mor frqunt trips to th bank to withdraw smallr amounts of cash. slid 46 slid 47 8

9 Th costs of xpctd inflation: 2. nu costs df: Th costs of changing prics. Exampls: cost of printing nw mnus cost of printing & mailing nw catalogs Th highr is inflation, th mor frquntly firms must chang thir prics and incur ths costs. Th costs of xpctd inflation: 3. Rlativ pric distortions Firms facing mnu costs chang prics infrquntly. Exampl: A firm issus nw catalog ach January. As th gnral pric lvl riss throughout th yar, th firm s rlativ pric will fll fall. Diffrnt firms chang thir prics at diffrnt tims, lading to rlativ pric distortions causing microconomic infficincis in th allocation of rsourcs. slid 48 slid 49 Th costs of xpctd inflation: 4. Unfair tax tratmnt Som taxs ar not adjustd to account for inflation, such as th capital gains tax. Exampl: Jan 1: you buy $10,000 worth of IB stock Dc 31: you sll th stock for $11,000, so your nominal capital gain is $1000 (10%). Suppos π = 10% during th yar. Your ral capital gain is $0. But th govt rquirs you to pay taxs on your $1000 nominal gain!! slid 50 Th costs of xpctd inflation: 5. Gnral inconvninc Inflation maks it hardr to compar nominal valus from diffrnt tim priods. This complicats long rang financial planning. slid 51 Additional cost of unxpctd inflation: Arbitrary rdistribution of purchasing powr any long trm contracts not indxd, but basd on π. If π turns out diffrnt from π, thn som gain at othrs xpns. Exampl: borrowrs & lndrs If π > π, thn (i π) < (i π ) and purchasing powr is transfrrd from lndrs to borrowrs. If π < π, thn purchasing powr is transfrrd from borrowrs to lndrs. Additional cost of high inflation: Incrasd uncrtainty Whn inflation is high, it s mor variabl and unprdictabl: π turns out diffrnt from π mor oftn, and th diffrncs tnd to b largr (though not systmatically positiv or ngativ) Arbitrary rdistributions of walth bcom mor likly. This crats highr uncrtainty, making risk avrs popl wors off. slid 52 slid 53 9

10 On bnfit of inflation Nominal wags ar rarly rducd, vn whn th quilibrium ral wag falls. This hindrs labor markt claring. Inflation allows th ral wags to rach quilibrium lvls without nominal wag cuts. Thrfor, modrat inflation improvs th functioning of labor markts. Hyprinflation df: π 50% pr month All th costs of modrat inflation dscribd abov bcom hug undr hyprinflation. ony cass to function as a stor of valu, and may not srv its othr functions (unit of account, mdium of xchang). Popl may conduct transactions with bartr or a stabl forign currncy. slid 54 slid 55 What causs hyprinflation? Hyprinflation is causd by xcssiv mony supply growth: Whn th cntral bank prints mony, th pric lvl riss. If it prints mony rapidly nough, th rsult is hyprinflation. A fw xampls of hyprinflation mony growth (%) inflation (%) Isral, Poland, Brazil, Argntina, Pru, Nicaragua, Bolivia, slid 56 slid 57 Why govrnmnts crat hyprinflation Whn a govrnmnt cannot rais taxs or sll bonds, it must financ spnding incrass by printing mony. In thory, th solution to hyprinflation is simpl: stop printing mony. In th ral world, this rquirs drastic and painful fiscal rstraint. Th Classical Dichotomy Ral variabls: asurd in physical units quantitis and rlativ prics, for xampl: Nominal quantity variabls: of output asurd producd in mony units,.g., nominal ral wag: wag: output Dollars arnd pr pr hour hour of of work. nominal ral intrst intrst rat: rat: output Dollars arnd arnd in th futur in futur by by lnding on unit dollar of today. output today th pric lvl: Th amount of dollars ndd to buy a rprsntativ baskt of goods. slid 58 slid 59 10

11 Th Classical Dichotomy Not: Ral variabls wr xplaind in Chap 3, nominal ons in Chaptr 4. Classical dichotomy: th thortical sparation of ral and nominal variabls in th classical modl, which implis nominal variabls do not affct ral variabls. Nutrality of mony: Changs in th mony supply do not affct ral variabls. In th ral world, mony is approximatly nutral in th long run. slid 60 ony Chaptr Summary th stock of assts usd for transactions srvs as a mdium of xchang, stor of valu, and unit of account. Commodity mony has intrinsic i i valu, fiat mony dos not. Cntral bank controls th mony supply. Quantity thory of mony assums vlocity is stabl, concluds that th mony growth rat dtrmins th inflation rat. slid 61 Chaptr Summary Nominal intrst rat quals ral intrst rat + inflation rat th opp. cost of holding mony Fishr ffct: Nominal intrst rat movs on for on w/ xpctd inflation. i ony dmand dpnds only on incom in th Quantity Thory also dpnds on th nominal intrst rat if so, thn changs in xpctd inflation affct th currnt pric lvl. Chaptr Summary Costs of inflation Expctd inflation sholathr costs, mnu costs, tax & rlativ pric distortions, inconvninc of corrcting figurs for inflation Unxpctd inflation all of th abov plus arbitrary rdistributions of walth btwn dbtors and crditors slid 62 slid 63 Chaptr Summary Hyprinflation causd by rapid mony supply growth whn mony printd to financ govt budgt dficits stopping it rquirs fiscal rforms to liminat govt s nd for printing mony Chaptr Summary Classical dichotomy In classical thory, mony is nutral dos not affct ral variabls. So, w can study how ral variabls ar dtrmind w/o rfrnc to nominal ons. Thn, mony markt q m dtrmins pric lvl and all nominal variabls. ost conomists bliv th conomy works this way in th long run. slid 64 CHAPTER 4 ony 4 ony and Inflation and Inflation slid 65 11