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Lesson 9

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5 views

Lesson 9

Uploaded by

Maurice Agbayani
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Lesson 9

Money Growth and Inflation


The Meaning of Money
 Money is the set of assets in an economy that people regularly use to
buy goods and services from other people.

The Classical Theory of Inflation


 Inflation is an increase in the overall level of prices.
 Hyperinflation is an extraordinarily high rate of inflation.
 The quantity theory of money is used to explain the long-run
determinants of the price level and the inflation rate.
 Inflation is an economy-wide phenomenon that concerns the value of the
economy’s medium of exchange.
 When the overall price level rises, the value of money falls.

Money Supply, Money Demand, and Monetary Equilibrium


 The money supply is a policy variable that is controlled by the
central bank. Through instruments such as open-market operations, the
central bank directly controls the quantity of money supplied.
 Money demand has several determinants, including interest rates and
the average level of prices in the economy.
 People hold money because it is the medium of exchange.
 The amount of money people chooses to hold depends on the prices of
goods and services.
 In the long run, the overall level of prices adjusts to the level at
which the demand for money equals the supply.

The Classical Theory of Inflation


 The Quantity Theory of Money
o The quantity of money available in the economy determines the
value of money.
o The primary cause of inflation is the growth in the quantity of
money.

The Classical Dichotomy and Monetary Neutrality


 Nominal variables are variables measured in monetary units.
 Real variables are variables measured in physical units.
 According to Hume and others, real economic variables do not change
with changes in the money supply
 Changes in the money supply affect nominal variables but not real
variables.
 The irrelevance of monetary changes for real variables is called
monetary neutrality.

Velocity and the Quantity Equation


 The velocity of money refers to the speed at which the money changes
hands, travelling around the economy from wallet to wallet.
 V = (P x Y)/M
o Where: V = velocity
o P = the price level
o Y = the quantity of output
o M = the quantity of money
o Rewriting the equation gives the quantity equation:
 M x V = P x Y
o The quantity equation relates the quantity of money (M) to the
nominal value of output (P x Y).

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Lesson 9
Money Growth and Inflation
 The Equilibrium Price Level, Inflation Rate, and the Quantity Theory
of Money
o The velocity of money is relatively stable over time.
o When the central bank changes the quantity of money, it causes
proportionate changes in the nominal value of output (P x Y).
o Because money is neutral, money does not affect output.

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.

The Fisher Effect


 The Fisher effect refers to a one-to-one adjustment of the nominal
interest rate to the inflation rate.
 According to the Fisher effect, when the rate of inflation rises, the
nominal interest rate rises by the same amount.
 The real interest rate stays the same.

The Costs of Inflation


 A Fall in Purchasing Power?
o Inflation does not in itself reduce people’s real purchasing
power.
 Shoe leather costs
 Menu costs
 Relative price variability
 Tax distortions
 Confusion and inconvenience
 Arbitrary redistribution of wealth

Shoe leather Costs


 Shoe leather costs are the resources wasted when inflation encourages
people to reduce their money holdings.
 Inflation reduces the real value of money, so people have an incentive
to minimize their cash holdings.
 Less cash requires more frequent trips to the bank to withdraw money
from interest-bearing accounts.
 The actual cost of reducing your money holdings is the time and
convenience you must sacrifice to keep less money on hand.
 Also, extra trips to the bank take time away from productive
activities.

Menu Costs
 Menu costs are the costs of adjusting prices.
 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.

Relative-Price Variability and the Misallocation of Resources


 Inflation distorts relative prices.

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Lesson 9
Money Growth and Inflation
 Consumer decisions are distorted, and markets are less able to
allocate resources to their best use.

Inflation-Induced Tax Distortion


 Inflation exaggerates the size of capital gains and increases the tax
burden on this type of income.
 With progressive taxation, capital gains are taxed more heavily.
 The nominal interest earned on savings is treated as income for income
tax purposes, even though part of the nominal interest rate merely
compensates for inflation.
 The after-tax real interest rate falls when inflation rises, making
saving less attractive.

Confusion and Inconvenience


 When the central bank increases the money supply and creates
inflation, it erodes the real value of the unit of account.
 Inflation causes money at different times to have different real
values.
 Therefore, with rising prices, it is more difficult to compare real
revenues, costs, and profits over time.

A Special Cost of Unexpected Inflation: Arbitrary Redistribution of


Wealth
 Unexpected inflation redistributes wealth among the population in a
way that has nothing to do with either merit or need.
 These redistributions occur because many loans in the economy are
specified in terms of the unit of account—money.

Summary
 The overall level of prices in an economy adjusts to bring money supply
and money demand into balance.
 When the central bank increases the supply of money, it causes the price
level to rise.
 Persistent growth in the quantity of money supplied leads to continuing
inflation.
 The principle of money neutrality asserts that changes in the quantity
of money influence nominal variables but not real variables.
 A government can pay for its spending simply by printing more money.
 This can result in an “inflation tax” and hyperinflation.
 According to the Fisher effect, when the inflation rate rises, the
nominal interest rate rises by the same amount, and the real interest
rate stays the same.
 Many people think that inflation makes them poorer because it raises the
cost of what they buy.
 This view is a fallacy because inflation also raises nominal incomes.
 Economists have identified six costs of inflation:
o Shoe leather costs
o Menu costs
o Increased variability of relative prices
o Unintended tax liability changes
o Confusion and inconvenience
o Arbitrary redistributions of wealth
 When banks loan out their deposits, they increase the quantity of money
in the economy.

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Lesson 9
Money Growth and Inflation
 Because the central bank cannot control the amount bankers choose to
lend or the amount households choose to deposit in banks, the central
bank’s control of the money supply is imperfect.

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