Chapter 4. U.S. inflation & its trend, The connection between money and prices

Transcription

1 Chapter 4 The classical theory of inflation causes effects social costs Classical -- assumes prices are flexible & markets clear. Applies to the long run. slide 0 16 U.S. inflation & its trend, % per year inflation rate inflation rate trend slide 1 The connection between money and prices Inflation rate = the percentage increase in the average level of prices. price = amount of money required to buy a good. Because prices are defined in terms of money, we need to consider the nature of money, the supply of money, and how it is controlled. slide 2 1

2 Basics Definitions of money $ medium of exchange $ store of value $ unit of account Types of money $ Fiat money (no intrinsic value) $ Commodity (intrinsic value) slide 3 The money supply & monetary policy The money supply is the quantity of money available in the economy. Monetary policy is the control over the money supply. Monetary policy is conducted by a country s central bank slide 4 Example (today s s news) Bank of England in policy U-turn Sept.2007: The Bank of England has made a U-turn in its treatment of banks struggling to deal with the credit crunch. It has announced that it will inject 10bn into the money markets in an attempt to bring three-month inter-bank interest rates down. slide 5 2

3 Money supply measures, Sep 05 _Symbol Assets included Amount (billions)_ C Currency 715 M1 C + demand deposits, 1363 travelers checks, other checkable deposits M2 M1 + small time deposits, 6588 savings deposits, money market mutual funds, money market deposit accounts M3 M2 + large time deposits, 9976 repurchase agreements, institutional money market mutual fund balances slide 6 The Quantity Theory of Money Links the inflation rate to the growth rate of the money Begins with a concept called velocity VELOCITY: the number of times the average dollar bill changes hands in a given time period example: In a given year: $500 billion in transactions; MS = $100 billion Average bill used in 5 transactions So, velocity = 5 Therefore: V = T / M slide 7 From velocity to quantity equation Use nominal GDP as a proxy for T Then, P Y V = M Rearrange to obtain: M V = P Y quantity equation It is an identity: it holds by definition of the variables. slide 8 3

4 Money demand and the quantity equation money demand: (M/P ) d = ky k = how much money people wish to hold for each dollar of income (k is exogenous) [ Idea: money facilitates transactions, the richer you are the more money you hold ] quantity equation: M V = P Y The connection between them: k = 1/V When people hold lots of money (k is high), money changes hands infrequently (V is low). slide 9 The Quantity Theory of Money,, cont. If k constant V is constant M V = P Y How the price level is determined: With V constant, M determines nominal GDP (P Y ) Y = f (K,L) only The price level is P = (nominal GDP)/(real GDP) slide 10 The Quantity Theory of Money,, cont. The quantity equation in growth rates: ΔM π = M ΔM ΔV ΔP ΔY + = + M V P Y ΔY Y Economic growth requires a certain amount of money supply growth to facilitate the growth in transactions. Money growth in excess of this amount leads to inflation. slide 11 4

5 The Quantity Theory of Money,, cont. ΔY/Y depends on growth in the factors of production and on technological progress (all of which we take as given, for now). Hence, the Quantity Theory of Money predicts a one-for-one relation between changes in the money growth rate and changes in the inflation rate. slide 12 Inflation rate (percent) U.S. data on inflation and money growth 1950s 1990s 1960s 1900s 1980s 1910s 1970s 1940s s 1920s 1870s 1890s 1880s Growth in money supply (percent) slide 13 Seigniorage To spend more without raising taxes or selling bonds, the govt can print money. The revenue raised from printing money is called seigniorage Seigniorage is also called the inflation tax: Printing money to raise revenue causes inflation. Inflation is like a tax on people who hold money. slide 14 5

6 Inflation, Nominal interest rates and the Fisher effect Nominal rate, i Real rate, adjusted for inflation: r = i π Rearrange to get The Fisher equation : i = r + π S = I determines r. Hence, an increase in π causes an equal increase in i. This one-for-one relationship is the Fisher effect. slide 15 U.S. inflation and nominal interest rates Percent Nominal interest rate Inflation rate Year slide 16 Two real interest rates π = actual inflation rate π e = expected inflation rate i π e = ex ante real interest rate: what people expect at the time they buy a bond or take out a loan (Fisher effect applies to expected inflation) i π = ex post real interest rate: what people actually end up earning slide 17 6

7 Money demand and the nominal interest rate Quantity Theory of Money money demand depends only on Y. Another determinant of money demand i d ( M P) = L( i, Y ) Use Fisher equation to get d e ( M P) = L( i, Y ) = L( r + π, Y ) slide 18 How P responds to ΔM Exogenous: Y, r M e Lr (, Y) P = +π For given values of r, Y, and π e, a change in M causes P to change by the same percentage --- just like in the Quantity Theory of Money. slide 19 What about expected inflation? Over the long run, people don t consistently over- or under-forecast inflation, π e = π Short run, π e may change EX: Fed announces it will increase M next year. People will expect next year s P to be higher, so π e rises. This will affect P now slide 20 7

8 How P responds to Δπ e M e Lr (, Y) P = +π For given values of r, Y, and M, e π i (the Fisher effect) ( M P ) d P to make ( M P ) fall to re-establish eq'm slide 21 Why is inflation bad? Classical theory says that change in P is just a change in the unit of measurement Economist have looked into costs of expected and unexpected inflation slide 22 A common misperception inflation reduces real wages True in the short run In the long run, the real wage is determined by supply-side factors, not the price level or inflation rate. Data: real wages rise with real GDP over time slide 23 8

9 The costs of expected inflation: 1. shoeleather cost def: the costs and inconveniences of reducing money balances to avoid the inflation tax. π i real money balances So, same monthly spending but lower average money holdings means more frequent trips to the bank slide 24 The costs of expected inflation: 2. menu costs def: The costs of changing prices. Examples: print new menus print & mail new catalogs The higher is inflation, the more frequently firms must change their prices and incur these costs. slide 25 The costs of expected inflation: 3. relative price distortions Firms facing menu costs change prices infrequently. Example: Suppose a firm issues new catalog each January. As the general price level rises throughout the year, the firm s relative price will fall. Different firms change their prices at different times, leading to relative price distortions which cause microeconomic inefficiencies in the allocation of resources. slide 26 9

10 The costs of expected inflation: 4. unfair tax treatment Some taxes are not adjusted to account for inflation, such as the capital gains tax. Example: 1/1/2001: buy $10,000 of Starbucks stock 12/31/2001: sell for $11,000 Suppose π = 10% in Govt requires you to pay taxes on a zero real capital gain slide 27 The costs of expected inflation: 5. General inconvenience Inflation makes it harder to compare nominal values from different time periods. This complicates long-range financial planning. slide 28 Additional cost of unexpected inflation: arbitrary redistributions of purchasing power Many long-term contracts not indexed, but based on π e. If π turns out different from π e, then some gain at others expense. Example: borrowers & lenders If π > π e, then (r π) < (r π e ) and purchasing power is transferred from lenders to borrowers. If π < π e, then purchasing power is transferred from borrowers to lenders. slide 29 10

11 Additional cost of high inflation: increased uncertainty When inflation is high, it s more variable and unpredictable: π turns out different from π e more often, and the differences tend to be larger (though not systematically positive or negative) Arbitrary redistributions of wealth become more likely. This creates higher uncertainty, which makes risk averse people worse off. slide 30 One benefit of inflation Nominal wages are are rarely reduced, even when the the equilibrium real real wage falls. Inflation allows the the real real wages to to reach equilibrium levels without nominal wage cuts. Therefore, moderate inflation improves the the functioning of of labor markets. slide 31 Hyperinflation def: π 50% per month Money ceases to function as a store of value, and may not serve its other functions (unit of account, medium of exchange). People may conduct transactions with barter or a stable foreign currency. Zimbabwe % inflation (prices double every 3 months) $145,750 for a toilet paper roll (69 US cents) (A single two-ply sheet would cost 417$: lots of jokes about what you can do with a 500$ bill) slide 32 11

12 Why governments create hyperinflation When a government cannot raise taxes or sell bonds, it must finance spending increases by printing money (Seigniorage). In theory, the solution to hyperinflation is simple: stop printing money. In the real world, this requires drastic and painful fiscal restraint. slide 33 Conclusion: the Classical Dichotomy Real variables : Y, W/P, r Nominal ones : M, P, i Classical Dichotomy : the theoretical separation of real and nominal variables in the classical model. Nominal variables do not affect real variables. Neutrality of Money: Changes in the money supply do not affect real variables. slide 34 12