Mankiw Chapter 5: Money and

Inflation

Worth Publishers, all rights reserved

CHAPTER 4

Money and Inflation

In this chapter you will learn

What is money and who creates it.
The classical theory of inflation
causes
effects
social costs

Classical -- assumes prices are

flexible & markets clear.

Applies to the long run.

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Money and Inflation

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U.S. inflation & its trend, 1960-2003

14%
12%
10%
8%
6%
4%
2%
0%
1960

1965

1970

1975
Inflation rate

CHAPTER 4

1980

1985

1990

1995

2000

Inflation rate trend

Money and Inflation

slide 3

The connection between

money and prices
Inflation rate = the percentage
increase in the overall 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.

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Money and Inflation

slide 4

Money: definition

Money is the stock

of assets that can be readily used to
make transactions.

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Money and Inflation

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Money: functions
1. medium of exchange

we use it to buy stuf

2. store of value

transfers purchasing power from

the present to the future
3. unit of account

the common unit by which

everyone measures prices and
values
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Money and Inflation

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Money: types
1. fiat money
has no intrinsic value
example: the paper currency we

use
2. commodity money
has intrinsic value
examples: gold coins,

cigarettes in P.O.W. camps

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Money and Inflation

slide 7

The central bank

Monetary policy is conducted by a
countrys central bank.

The central bank of the Euro Area is the

European Central Bank (often referred
to as the ECB).

In the U.K., the central bank is the Bank

of England.

In the U.S., the central bank is called the

Federal Reserve
(the Fed).
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Money and Inflation

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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.

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Money and Inflation

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The Quantity Theory of Money

One goal of this chapter is how
the quantity of money affects
the economy.

To do that we need a theory

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Money and Inflation

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The Quantity Theory of Money

A simple theory linking the inflation
rate to the growth rate of the
money supply.

M x V= P x T
where
V

= velocity

PT = value of all transactions

M = money supply

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Money and Inflation

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The Transaction Velocity (V )

basic concept: the rate at which money
circulates

definition: the number of times the

average dollar bill changes hands in a

given time period

example: In 2003,
$500 billion in transactions (PT )
money supply (M )= $100 billion
On average, each dollar was used in

five transactions in 2003

So, velocity V = 5
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Money and Inflation

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The Income Velocity

Use nominal GDP as a proxy for total
transactions.
Then,
where

P Y
V
M

P = price of output
Y = quantity of output

(GDP deflator)
(real GDP)

P Y = value of output (nominal GDP)

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Money and Inflation

slide 13

The quantity equation

The quantity equation
M V = P Y
follows from the preceding definition
of velocity.

It is an identity:
it holds by definition of the variables.

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Money and Inflation

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Money demand and the quantity equation

M/P = real money balances, the
purchasing power of the money supply.

A simple money demand function:

(M/P )d = k Y
where
k = how much money people wish to
hold for each dollar of income.
(k is exogenous)

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Money and Inflation

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Money demand and the quantity equation

money demand:

(M/P )d = k Y

quantity equation: M V = P Y
The connection between them: k = 1/V
When people hold lots of money
relative to their incomes (k is high),
money changes hands infrequently (V
is low).

CHAPTER 4

Money and Inflation

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back to the Quantity Theory of Money

starts with quantity equation
assumes V is constant & exogenous:

V V
With this assumption, the quantity
equation can be written as

M V P Y
CHAPTER 4

Money and Inflation

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The Quantity Theory of Money, cont.

M V P Y
How the price level is determined:

With V constant, the money supply

determines nominal GDP (P Y )

Real GDP is determined by the

economys supplies of K and L and the
production function (chap 3)

The price level is

P = (nominal GDP)/(real GDP)
CHAPTER 4

Money and Inflation

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The Quantity Theory of Money, cont.

Recall from Chapter 2:
The growth rate of a product equals
the sum of the growth rates.

The quantity equation in growth rates:

M V
P Y

M
V
P
Y
The quantity theory of money assumes
V
V is constant, so
= 0.
V
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Money and Inflation

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The Quantity Theory of Money, cont.

Let (Greek letter pi)
denote the inflation rate:

The result from the

preceding slide was:

P

P
M
P Y

M
P
Y

Solve this result

for to get

CHAPTER 4

Money and Inflation

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The Quantity Theory of Money, cont.

Normal 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.

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Money and Inflation

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The Quantity Theory of Money, cont.

Y/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.
CHAPTER 4

Money and Inflation

slide 22

U.S. Inflation & Money Growth, 1960-2003

14%
12%
10%
8%
6%
4%
2%
0%
1960

1965

1970

Inflation rate
CHAPTER 4

1975

M2 growth rate

1980

1985

1990

Inflation rate trend

Money and Inflation

1995

2000

M2 growth rate trend

slide 24

International data on
inflation and money growth
Inflation rate
10,000
(perc ent,
logarithmic
sc ale)
1,000

Democratic Repub
Nicaragua of Congo
Angola
Brazil

Georgia

100

Bulgaria

10
Germany

Kuwait
1

USA
Oman

0.1
0.1

CHAPTER 4

Japan
10

Canada

100
1,000
10,000
Money supply growth (perc ent, logarithmic

Money and Inflation

slide 25

Inflation and interest rates

Nominal interest rate, i
not adjusted for inflation

Real interest rate, r

adjusted for inflation:
r = i

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Money and Inflation

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The Fisher Effect

The Fisher equation:

i =r +

Chap 3: S = I determines r .
Hence, an increase in
causes an equal increase in i.

This one-for-one relationship

is called the Fisher effect.

CHAPTER 4

Money and Inflation

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U.S. inflation and nominal interest rates,

since 1954

Nominal
interest rate

Inflation rate

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Money and Inflation

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Inflation and nominal interest rates

across countries

100
Nominal
interest rate
(perc ent,
logarithmic
sc ale)

Kazakhstan
Kenya
Uruguay

Armenia

Italy
France
10
Nigeria
United Kingdom
United States
Japan

Germany
Singapore

CHAPTER 4

10

100
1000
Inflation rate (perc ent, logarithmic s

Money and Inflation

slide 29

Old exam question

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Money and Inflation

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Two real interest rates

= actual inflation rate

(not known until after it has occurred)

e = expected inflation rate

i e = ex ante real interest rate:

the real interest rate people expect

at the time they buy a bond or take out a
loan

i = ex post real interest rate:

the real interest rate people actually end up

earning on their bond or paying on their loan

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Money and Inflation

slide 31

Money demand and

the nominal interest rate
The Quantity Theory of Money assumes
that the demand for real money balances
depends only on real income Y.

We now consider another determinant of

money demand: the nominal interest rate.

The nominal interest rate i is the

opportunity cost of holding money (instead
of bonds or other interest-earning assets).

Hence, i in money demand.

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Money and Inflation

slide 32

The money demand function

(M P ) L(i , Y )
d

(M/P )d = real money demand, depends

negatively on i
i is the opp. cost of holding money

positively on Y
higher Y more spending
so, need more money

(L is used for the money demand function

because money is the most liquid asset.)
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Money and Inflation

slide 33

The money demand function

(M P ) L(i , Y )
d

L(r , Y )
e

When people are deciding whether to

hold money or bonds, they dont know
what inflation will turn out to be.
Hence, the nominal interest rate
relevant for money demand is r + e.

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Money and Inflation

slide 34

Equilibrium
M
e
L(r , Y )
P
The supply of
real money
balances

CHAPTER 4

Money and Inflation

Real money
demand

slide 35

What determines what

M
e
L(r , Y )
P
variable

how determined (in the long run)

exogenous (the ECB)

adjusts to make S = I

Y
P

CHAPTER 4

Y F (K , L )
adjusts to make

Money and Inflation

M
L(i ,Y )
P
slide 36

How P responds to M
M
e
L(r , Y )
P
For given values of r, Y, and e,
a change in M causes P to change
by the same percentage --- just like
in the Quantity Theory of Money.

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Money and Inflation

slide 37

What about expected inflation?

Over the long run, people dont consistently
over- or under-forecast inflation,
so e = on average.

In the short run, e may change when people

get new information.

EX: Suppose Fed announces it will increase

M next year. People will expect next years
P to be higher, so e rises.

This will affect P now, even though M hasnt

changed yet.
(continued)
CHAPTER 4

Money and Inflation

slide 38

How P responds to e
M
e
L(r , Y )
P
For given values of r, Y, and M ,

e i (the Fisher effect)

M P

P to make M P fall
to re-establish eq'm

CHAPTER 4

Money and Inflation

slide 39

The Classical Dichotomy

Real variables are measured in physical units:
quantities and relative prices, e.g.
quantity of output produced
real wage: output earned per hour of work
real interest rate: output earned in the future
by lending one unit of output today
Nominal variables: measured in money units,
e.g.
nominal wage: dollars per hour of work
nominal interest rate: dollars earned in future
by lending one dollar today
the price level: the amount of dollars needed
to buy a representative basket of goods
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Money and Inflation

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The Classical Dichotomy

Note: Real variables were explained in Chap
3,
nominal ones in Chap 5.

Classical Dichotomy : the theoretical

separation of real and nominal variables in
the classical model, which implies nominal
variables do not affect real variables.

Neutrality of Money : Changes in the

money supply do not affect real variables.
In the real world, money is approximately
neutral in the long run.
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Money and Inflation

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Old exam question

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Money and Inflation

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Discussion Question

Why is inflation bad?

What costs does inflation impose on
society? List all the ones you can think
of.

Focus on the long run.

Think like an economist.

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Money and Inflation

slide 43

A common misperception
Common misperception:
inflation reduces real wages

This is true only in the short run, when

nominal wages are fixed by contracts.

(Chap 3) In the long run,

the real wage is determined by labor
supply and the marginal product of labor,
not the price level or inflation rate.

Consider the data

CHAPTER 4

Money and Inflation

slide 44

Average hourly earnings & the CPI

Hourly earnings
in 2004 dollars
Average hourly
earnings (nominal)

Consumer
Price Index

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Money and Inflation

slide 45

The classical view of inflation

The classical view:
A change in the price level is merely a
change in the units of measurement.

So why, then, is
inflation a social
problem?

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Money and Inflation

slide 46

The social costs of inflation

fall into two categories:
1. costs when inflation is expected
2. additional costs when inflation is

different than people had

expected.

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Money and Inflation

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The costs of expected inflation:

1. shoeleather cost
def: the costs and inconveniences of
reducing money balances to avoid the
inflation tax.

i real money balances

Remember: In long run, inflation doesnt
affect real income or real spending.

So, same monthly spending but lower

average money holdings means more
frequent trips to the bank to withdraw
smaller amounts of cash.
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Money and Inflation

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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.

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Money and Inflation

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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 firms 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.
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Money and Inflation

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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:
Jan 1: you bought $10,000 worth of

Starbucks stock
Dec 31: you sold the stock for $11,000,

so your nominal capital gain was $1000

(10%).
= 10% during the year.
Your real capital gain is $0.

Suppose

But the govt requires you to pay taxes on

your $1000 nominal gain!!

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Money and Inflation

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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.

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Money and Inflation

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Additional cost of unexpected inflation:

arbitrary redistributions of purchasing
power
Many long-term contracts not indexed,
but based on e.
If turns out different from e,
then some gain at others expense.
Example: borrowers & lenders
If > e, then (i ) < (i e)

and purchasing power is transferred

from lenders to borrowers.
If < e, then purchasing power is

transferred from borrowers to lenders.

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Money and Inflation

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Additional cost of high inflation:

increased uncertainty
When inflation is high, its more
variable and unpredictable:
turns out different from 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.
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Money and Inflation

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One benefit of inflation

Nominal
Nominalwages
wagesare
arerarely
rarelyreduced,
reduced,even
even
when
whenthe
theequilibrium
equilibriumreal
realwage
wagefalls.
falls.

Inflation
Inflationallows
allowsthe
thereal
realwages
wagesto
toreach
reach

equilibrium
equilibriumlevels
levelswithout
withoutnominal
nominalwage
wage
cuts.
cuts.

Therefore,
Therefore,moderate
moderateinflation
inflationimproves
improves
the
thefunctioning
functioningof
oflabor
labormarkets.
markets.

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Money and Inflation

slide 55

Seigniorage
To spend more without raising taxes or
selling bonds, the govt can print money.

The revenue raised from printing

money
is called seigniorage

The inflation tax:

Printing money to raise revenue causes
inflation. Inflation is like a tax on
people who hold money.
CHAPTER 4

Money and Inflation

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Hyperinflation
def: 50% per month
All the costs of moderate inflation described
above become

HUGE

under hyperinflation.

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.

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Money and Inflation

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What causes hyperinflation?

Hyperinflation is caused by excessive
money supply growth:

When the central bank prints money,

the price level rises.

If it prints money rapidly enough, the

result is hyperinflation.

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Money and Inflation

slide 58

Recent episodes of hyperinflation

slide 59

The most recent episode

Zimbabwe
Year Inflation rate

CHAPTER 4

2000

55%

2001

112%

2002

199%

2003

599%

2004

133%

2005

586%

2006

1281%

2007

66,212%

2008

231,150,889%

Money and Inflation

slide 60

Why governments create hyperinflation

When a government cannot raise taxes or
sell bonds,

it must finance spending increases by

printing money.

In theory, the solution to hyperinflation is

simple: stop printing money.

In the real world, this requires drastic and

painful fiscal restraint.

Alternatively, start using another currency.

CHAPTER 4

Money and Inflation

slide 61

Chapter summary
1. Money
the stock of assets used for transactions
serves as a medium of exchange, store
of value, and unit of account.
Commodity money has intrinsic value,
fiat money does not.
Central bank controls money supply.
2. Quantity theory of money
assumption: velocity is stable
conclusion: the money growth rate
determines the inflation rate.
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Money and Inflation

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Chapter summary
3. Nominal interest rate
equals real interest rate + inflation rate.
Fisher effect: nominal interest rate moves
one-for-one w/ expected inflation.
is the opp. cost of holding money
4. Money demand
depends on income in the Quantity Theory
more generally, it also depends on the
nominal interest rate;
if so, then changes in expected inflation
affect the current price level.
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Money and Inflation

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Chapter summary
5. Costs of inflation
Expected inflation
shoeleather costs, menu costs,
tax & relative price distortions,
inconvenience of correcting figures for
inflation
Unexpected inflation
all of the above plus arbitrary
redistributions of wealth between
debtors and creditors

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Money and Inflation

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Chapter summary
6. Hyperinflation
caused by rapid money supply
growth when money printed to
finance
govt budget deficits
stopping it requires fiscal reforms to
eliminate govts need for printing
money

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Money and Inflation

slide 65

Chapter summary
7. Classical dichotomy
In classical theory, money is neutral-does not affect real variables.
So, we can study how real variables are
determined w/o reference to nominal
ones.
Then, eqm in money market determines
price level and all nominal variables.
Most economists believe the economy
works this way in the long run.

CHAPTER 4

Money and Inflation

slide 66