MACROECONOMICS I
The Money Growth and Iflation
Lecture 7
March 25, 2022
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LOOK FOR THE ANSWERS TO THESE
QUESTIONS:
How does the money supply affect inflation and
nominal interest rates?
Does the money supply affect real variables like
real GDP or the real interest rate?
How is inflation like a tax?
What are the costs of inflation? How serious are
they?
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INTRODUCTION
This chapter introduces the quantity theory of money
to explain one of the Ten Principles of Economics:
Prices rise when the government prints too much money.
 Most economists believe the quantity theory is a
good explanation of the long run behavior of
inflation.
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THE VALUE OF MONEY
P = the price level (e.g., the CPI or GDP deflator)
 P is the price of a basket of goods, measured in
money.
1/P is the value of $1, measured in goods.
 Example: basket contains one candy bar.
 If P = $2, value of $1 is 1/2 candy bar
 If P = $3, value of $1 is 1/3 candy bar
Inflation drives up prices and drives down the value of
money. 4
THE QUANTITY THEORY OF MONEY
 Developed by 18th century philosopher
David Hume and the classical economists.
 Advocated more recently by Nobel Prize Laureate
Milton Friedman.
 Asserts that the quantity of money determines the
value of money
 We study this theory using two approaches:
1. A supply-demand diagram
2. An equation
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MONEY SUPPLY (MS)
Money supply in the real world
 Determined by the Fed, the banking
system, and consumers.
Money supply in this model
 We assume the Fed precisely controls MS
and sets it at some fixed amount.
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MONEY DEMAND (MD)
Money demand
 Refers to how much wealth people want to hold in
liquid form.
 Depends on P: an increase in P reduces the value
of money, so more money is required to buy goods
and services.
Quantity of money demanded
 Is negatively related to the value of money
 And positively related to P, other things equal.
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THE MONEY SUPPLY-DEMAND DIAGRAM
8
Value of
Money, 1/P
Price
Level, P
Quantity of Money
1 1
¾ 1.33
½ 2
¼ 4
As the value of
money rises, the
price level falls.
THE MONEY SUPPLY-DEMAND DIAGRAM
9
Value of
Money, 1/P
Price
Level, P
Quantity of Money
1
¾
½
¼
1
1.33
2
4
MS1
$1000
The Fed sets MS
at some fixed value,
regardless of P.
THE MONEY SUPPLY-DEMAND DIAGRAM
10
Value of
Money, 1/P
Price
Level, P
Quantity of Money
1
¾
½
¼
1
1.33
2
4
MD1
A fall in value of money
(or increase in P)
increases the quantity
of money demanded:
MS1
$1000
Value of
Money, 1/P
Price
Level, P
Quantity
of Money
1
¾
½
¼
1
1.33
2
4
THE MONEY SUPPLY-DEMAND DIAGRAM
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MD1
P adjusts to equate
quantity of money
demanded with
money supply.
eq’m
price
level
eq’m
value
of
money
A
MS1
$1000
THE EFFECTS OF A MONETARY INJECTION
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Value of
Money, 1/P
Price
Level, P
Quantity
of Money
1
¾
½
¼
1
1.33
2
4
MD1
eq’m
price
level
eq’m
value
of
money
A
MS2
$2000
B
Then the value
of money falls,
and P rises.
Suppose the Fed
increases the
money supply.
A BRIEF LOOK AT THE ADJUSTMENT
PROCESS
From graph: Increasing MS causes P to rise.
How does this work? Short version:
 At the initial P, an increase in MS causes an
excess supply of money.
 People get rid of their excess money by spending
it on goods and services or by loaning it to others,
who spend it. Result: increased demand for goods.
 But supply of goods does not increase, so prices
must rise. 13
REAL VS. NOMINAL VARIABLES
Nominal variables
 Are measured in monetary units.
 Examples: nominal GDP, nominal interest rate (rate
of return measured in $), nominal wage ($ per hour
worked)
Real variables
 Are measured in physical units.
 Examples: real GDP, real interest rate (measured
in output), real wage (measured in output)
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REAL VS. NOMINAL VARIABLES
Prices are normally measured in terms of money:
 Price of a CD: $15/cd
 Price of a pizza: $10/pizza
A relative price
 Is the price of one good relative to (divided by)
another
 Relative price of CDs in terms of pizza:
15
price of cd
price of pizza
$15/cd
$10/pizza
= = 1.5 pizzas per cd
REAL VS. NOMINAL WAGE
An important relative price is the real wage:
 W = nominal wage = price of labor, e.g.,
$15/hour
 P = price level = price of goods and services, e.g.,
$5/unit of output
Real wage
 Is the price of labor relative to the price of output:
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W
P
= 3 units output per hour
$15/hour
$5/unit of output
=
THE CLASSICAL DICHOTOMY
Classical dichotomy:
 Theoretical separation of nominal and real variables
 Hume and the classical economists: monetary
developments affect nominal variables but not real
variables:
 If central bank doubles the money supply:
 Then all nominal variables – including prices – will
double
 But all real variables – including relative prices – will
remain unchanged.
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THE NEUTRALITY OF MONEY
Monetary neutrality:
 The proposition that changes in the money
supply do not affect real variables
Doubling money supply
 Causes all nominal prices to double
 What happens to relative prices?
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Initially, relative price of cd in terms of pizza is
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After nominal prices double,
price of cd
price of pizza
= 1.5 pizzas per cd
$15/cd
$10/pizza
=
price of cd
price of pizza
= 1.5 pizzas per cd
$30/cd
$20/pizza
=
The relative price
is unchanged.
THE NEUTRALITY OF MONEY
THE NEUTRALITY OF MONEY
Similarly, the real wage W/P remains unchanged, so
 Quantity of labor supplied does not change
 Quantity of labor demanded does not change
 Total employment of labor does not change
The same applies to employment of capital and other
resources.
 Since employment of all resources is unchanged,
total output is also unchanged by the money supply.
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THE NEUTRALITY OF MONEY
Most economists believe
 The classical dichotomy and neutrality of
money describe the economy in the long run.
In later chapters
 We will see that monetary changes can
have important short-run effects on real
variables.
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THE VELOCITY OF MONEY
Velocity of money:
 The rate at which money changes hands
Notation:
P x Y= nominal GDP = (price level) x (real GDP)
M = money supply
V = velocity
Velocity formula:
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V =
P x Y
M
THE VELOCITY OF MONEY
Velocity formula V = P x Y / M
Example with one good: pizza. In 2020:
Y = real GDP = 3000 pizzas
P = price level = price of pizza = $10
P x Y= nominal GDP = value of pizzas = $30,000
M = money supply = $10,000
V = velocity = $30,000/$10,000 = 3
The average dollar was used in 3 transactions. 23
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ACTIVE LEARNING 1 VELOCITY OF MONEY
One good: corn.
The economy has enough labor, capital, and land to
produce Y = 800 bushels of corn.
V is constant.
In 2019, MS = $2000, P = $5/bushel.
Compute nominal GDP and velocity in 2019.
Answers
Nominal GDP = P x Y = $5 x 800 = $4000
velocity V = P x Y / M = $4000 / $2000 = 2
U.S. NOMINAL GDP, M2, AND VELOCITY 1960–2020
Velocity is fairly stable
over the long run.
25
1960=100
Nominal GDP
M2
Velocity
THE QUANTITY THEORY
The quantity equation: M x V = P x Y
1. V is stable.
2. A change in M causes nominal GDP (P x Y) to
change by the same percentage.
3. A change in M does not affect Y: money is neutral,
Y is determined by technology & resources
4. So, P changes by same percentage as
P x Y and M.
5. Rapid money supply growth causes rapid inflation.
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ACTIVE LEARNING 2 QUANTITY THEORY OF MONEY
One good: corn. The economy has enough labor,
capital, and land to produce Y = 800 bushels of corn.
V is constant. In 2019, MS = $2000, P = $5/bushel.
For 2020, the Fed increases MS by 5%, to $2100.
a. Compute the 2020 values of nominal GDP and P.
Compute the inflation rate for 2019–2020.
b. Suppose tech. progress causes Y to increase to 824 in
2020. Compute 2019–2020 inflation rate.
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ACTIVE LEARNING 2 ANSWERS
Y = 800, V is constant.
In 2019, MS = $2000, P = $5/bushel.
For 2020, the Fed increases MS by 5%, to $2100.
a. Compute the 2020 values of nominal GDP and P.
Compute the inflation rate for 2019–2020.
 2019: P x Y = M x V, so V= 2
 2020: nominal GDP = P x Y = M x V = 2100 x 2
= $4200
 2020: P = M x V / Y = 4200/800 = $5.25
 Inflation rate 2019-2020 = (5.25 – 5.00)/5.00 =
5% (same as MS!)
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ACTIVE LEARNING 2 ANSWERS
Y = 800, V is constant.
In 2019, MS = $2000, P = $5/bushel.
For 2020, the Fed increases MS by 5%, to $2100.
b. Suppose tech. progress causes Y to increase to
824 in 2020. Compute 2019–2020 inflation
rate.
 2020: P = M x V / Y = 4200/824 = $5.10
 Inflation rate 2019-2020 =
= (5.10 – 5.00)/5.00 = 2%
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LESSONS ABOUT THE QUANTITY THEORY OF MONEY
If real GDP is constant,
 Then inflation rate = money growth rate.
If real GDP is growing,
 Then inflation rate < money growth rate.
The bottom line:
 Economic growth increases # of transactions.
 Some money growth is needed for these extra
transactions.
 Excessive money growth causes inflation.
HYPERINFLATION
Hyperinflation
 Inflation exceeding 50% per month.
Prices rise when the government prints too much
money.
 Excessive growth in the money supply always
causes hyperinflation.
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THE INFLATION TAX
The inflation tax
 Revenue the government raises by creating
(printing) money
 Like a tax on everyone who holds money
➢ When the government prints money
➢ The price level rises
➢ And the dollars in your wallet are less valuable
 In the U.S., the inflation tax today accounts for less
than 3% of total revenue
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THE FISHER EFFECT
Principle of monetary neutrality
 An increase in the rate of money growth raises
the rate of inflation but does not affect any real
variable
Because
Real interest rate = Nominal interest rate –
Inflation rate
We get
Nominal interest rate = Real interest rate +
Inflation rate 35
THE FISHER EFFECT
Fisher effect
 One-for-one adjustment of nominal interest rate to
inflation rate
 When the Fed increases the rate of money growth
 Long-run result
➢ Higher inflation rate
➢ Higher nominal interest rate
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U.S. NOMINAL INTEREST & INFLATION RATES, 1960–2021
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Inflation rate
Nominal
interest rate
The close relation between
these variables is evidence
for the Fisher effect.
THE COSTS OF INFLATION
Inflation fallacy
 “Inflation robs people of the purchasing power
of his hard-earned dollars”
When prices rise
 Buyers pay more
 Sellers get more
Inflation does not in itself reduce people’s real
purchasing power
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U.S. AVERAGE HOURLY EARNINGS & THE CPI 1965 - 2020
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CPI
Nominal wage
Inflation causes the CPI
and nominal wages to rise
together over the long run.
THE COSTS OF INFLATION
Shoeleather costs
 Resources wasted when inflation encourages
people to reduce their money holdings
 Time and transaction cost of more frequent bank
withdrawals
Menu costs
 Costs of changing prices
 Inflation – increases menu costs that firms must bear
 Take time and resources from productive activity
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THE COSTS OF INFLATION
Misallocation of resources from relative-price
variability
 Firms don’t all raise prices at the same time, so
relative prices can vary
➢ Distorts the allocation of resources
Confusion and inconvenience
 Inflation changes the yardstick we use to
measure transactions
➢ Complicates long-range planning and the
comparison of dollar amounts over time
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THE COSTS OF INFLATION
Tax distortions
 Inflation makes nominal income grow faster than
real income.
 Taxes are based on nominal income,
and some are not adjusted for inflation.
 So, inflation causes people to pay more taxes
even when their real incomes don’t increase.
 After-tax real interest rate falls, making saving
less attractive
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ACTIVE LEARNING 3 TAX DISTORTIONS
You deposit $1000 in the bank for one year.
CASE 1: inflation = 0%, nom. interest rate = 10%
CASE 2: inflation = 10%, nom. interest rate = 20%
a. In which case does the real value of your deposit
grow the most?
Assume the tax rate is 25%.
b. In which case do you pay the most taxes?
c. Compute the after-tax nominal interest rate,
then subtract inflation to get the after-tax real
interest rate for both cases.
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ACTIVE LEARNING 3 ANSWERS
Deposit $1000.
CASE 1: inflation = 0%, nom. interest rate = 10%
CASE 2: inflation = 10%, nom. interest rate = 20%
a. In which case does the real value of your deposit
grow the most?
In both cases, the real interest rate is 10%,
so the real value of the deposit grows 10%
(before taxes).
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ACTIVE LEARNING 3 ANSWERS
Deposit $1000. Tax rate =25%.
CASE 1: inflation = 0%, nom. interest rate = 10%
CASE 2: inflation = 10%, nom. interest rate = 20%
b. In which case do you pay the most taxes?
CASE 1: interest income = $100,
so you pay $25 in taxes.
CASE 2: interest income = $200,
so you pay $50 in taxes.
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ACTIVE LEARNING 3 ANSWERS
Deposit $1000. Tax rate =25%.
CASE 1: inflation = 0%, nom. interest rate = 10%
CASE 2: inflation = 10%, nom. interest rate = 20%
c. Compute the after-tax nominal interest rate,
then subtract inflation to get the after-tax real
interest rate for both cases.
CASE 1: nominal = 0.75 x 10% = 7.5%
real = 7.5% – 0% = 7.5%
CASE 2: nominal = 0.75 x 20% = 15%
real =15% – 10% = 5%
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ACTIVE LEARNING 3 SUMMARY AND LESSONS
Deposit $1000. Tax rate =25%.
CASE 1: inflation = 0%, nom. interest rate = 10%
CASE 2: inflation = 10%, nom. interest rate = 20%
Inflation…
• raises nominal interest rates (Fisher effect) but not real
interest rates
• increases savers’ tax burdens
• lowers the after-tax real interest rate
↑ Inflation - ↓ the incentive to save − ↓ future productivity
ARBITRARY REDISTRIBUTIONS OF WEALTH
Unexpected inflation
 Redistributes wealth among the population
➢ Not by merit
➢ Not by need
 Redistribute wealth among debtors and creditors
Inflation: volatile and uncertain
 When the average rate of inflation is high
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THE COSTS OF INFLATION
All these costs
 Are quite high for economies experiencing
hyperinflation.
For economies with low inflation (< 10% per year),
 These costs are probably much smaller,
though their exact size is open to debate.
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CONCLUSION
Prices rise when the government prints too much
money.
 We saw that money is neutral in the long run,
affecting only nominal variables
In later chapters
 Money has important effects in the short run on
real variables like output and employment
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SUMMARY
• To explain inflation in the long run, economists use the
quantity theory of money.
➢ The price level depends on the quantity of money, and
the inflation rate depends on the money growth rate.
• The classical dichotomy is the division of variables into
real and nominal.
• The neutrality of money is the idea that changes in the
money supply affect nominal variables but not real ones
(in the long-run).
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SUMMARY
• The inflation tax is the loss in the real value of
people’s money holdings when the government causes
inflation by printing money.
• The Fisher effect is the one-for-one relation between
changes in the inflation rate and changes in the
nominal interest rate.
• The costs of inflation include menu costs, shoeleather
costs, confusion and inconvenience, distortions in
relative prices and the allocation of resources, tax
distortions, and arbitrary redistributions of wealth.
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