Inflation 25092024 020001pm

5
CHAPTE
R
Inflation: Its Causes,

Effects, and Social Costs
MACROECONOMICS
N. GREGORY MANKIW
In this chapter, you will
learn…
 The classical theory of inflation
 causes
 effects
 social costs
 “Classical” – assumes prices are flexible &
markets clear
 Applies to the long run
CHAPTER 4 Money and Inflation slide 2

Money: Definition
Money is the stock

of assets that can be
readily used to make
transactions.

Money: Functions
 medium of exchange
we use it to buy stuff
 store of value
transfers purchasing power from the present to
the future
 unit of account
the common unit by which everyone measures
prices and values

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

Money supply measures, April
2006
amount
symbol assets included
($ billions)
C Currency $739
C + demand deposits,
M1 travelers’ checks, $1391
other checkable deposits
M1 + small time deposits,
savings deposits,
M2 $6799
money market mutual funds,
money market deposit accounts
The Quantity Theory of Money
 A simple theory linking the inflation rate

to the growth rate of the money supply.
 Begins with the concept of velocity…

Velocity, cont.
 This suggests the following definition:

T
V
M
where
V = velocity
T = value of all transactions
M = money supply

Velocity, cont.
 Use nominal GDP as a proxy for total
transactions.
Then, P Y
V
M
where
P = price of output (GDP deflator)
Y = quantity of output (real
GDP)
P Y = value of output (nominal GDP)

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.

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)

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).

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

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 economy’s
supplies of K and L and the production
function (Chap 3).
 The price level is
P = (nominal GDP)/(real GDP).

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
cont.
 (Greek letter “pi”) P

denotes the inflation rate:
 
P
The result from the M P Y
 
preceding slide was: M P Y
Solve this result M Y

for  to get   
M Y

cont.
M Y
  
M Y
 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.

cont.
M Y
  
M Y
Y/Y depends on growth in the factors of
production and on technological progress
(all of which we take as given, for now).
Hence,
Hence, the
the Quantity
Quantity Theory
Theory predicts
predicts
aa one-for-one
one-for-one relation
relation between
between
changes
changes inin the
the money
money growth
growth rate
rate and
and
changes
changes in in the
the inflation
inflation rate.
rate.
Seigniorage
 To spend more without raising taxes or selling

bonds, the govt can print money.
 The “revenue” raised from printing money
is called seigniorage
(pronounced SEEN-your-idge).
 The inflation tax:
Printing money to raise revenue causes inflation.
Inflation is like a tax on people who hold
money.
See Supplements 4-5 to 4-7 on Seigniorage.
Inflation and interest rates
 Nominal interest rate, i

not adjusted for inflation
 Real interest rate, r
adjusted for inflation:
r = i 

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.
See Supplements 4-8, Deriving the Fisher Effect
and 4-9, Using Interest Rates to Forecast .

Two Causes of Rising and
Falling Inflation
Cost-push inflation
Inflation resulting from shocks to aggregate
supply
Demand-pull inflation
Inflation resulting from shocks to aggregate
demand.

Cost-push inflation

Demand-pull inflation

The social costs of inflation
…fall into two categories:

1. costs when inflation is expected
2. costs when inflation is different than
people had expected

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 does not
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.
See Supplement 4-11 for Welfare Theoretic Approach.

2. Menu costs
 def: The costs of changing prices.

 Examples:
 cost of printing new menus
 cost of printing & mailing new catalogs
 The higher is inflation, the more frequently
firms must change their prices and incur
these costs.

4. Unfair tax treatment
Some taxes are not adjusted to account for
inflation, such as the capital gains tax.
Example:
 Jan 1: you buy $10,000 worth of IBM stock
 Dec 31: you sell the stock for $11,000,
so your nominal capital gain is $1000 (10%).
 Suppose  = 10% during the year.
Your real capital gain is $0.
 But the govt requires you to pay taxes on your
$1000 nominal gain!!
One benefit of inflation
 Nominal wages are rarely reduced, even when

the equilibrium real wage falls.
This hinders labor market clearing.
 Inflation allows the real wages to reach
equilibrium levels without nominal wage cuts.
 Therefore, moderate inflation improves the
functioning of labor markets.

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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5

Inflation: Its Causes,

CHAPTER 4 Money and Inflation slide 2

Money is the stock

CHAPTER 4 Money and Inflation slide 3

CHAPTER 4 Money and Inflation slide 4

CHAPTER 4 Money and Inflation slide 5

 A simple theory linking the inflation rate

CHAPTER 4 Money and Inflation slide 7

 This suggests the following definition:

CHAPTER 4 Money and Inflation slide 9

CHAPTER 4 Money and Inflation slide 10

 The quantity equation

CHAPTER 4 Money and Inflation slide 11

CHAPTER 4 Money and Inflation slide 12

CHAPTER 4 Money and Inflation slide 13

CHAPTER 4 Money and Inflation slide 14

CHAPTER 4 Money and Inflation slide 15

The quantity theory of money assumes

 (Greek letter “pi”) P

Solve this result M Y

CHAPTER 4 Money and Inflation slide 17

CHAPTER 4 Money and Inflation slide 18

 To spend more without raising taxes or selling

 Nominal interest rate, i

CHAPTER 4 Money and Inflation slide 21

 The Fisher equation: i = r + 

CHAPTER 4 Money and Inflation slide 22

CHAPTER 4 Money and Inflation slide 23

CHAPTER 4 Money and Inflation slide 24

CHAPTER 4 Money and Inflation slide 25

…fall into two categories:

CHAPTER 4 Money and Inflation slide 26

CHAPTER 4 Money and Inflation slide 27

 def: The costs of changing prices.

CHAPTER 4 Money and Inflation slide 28

 Nominal wages are rarely reduced, even when

CHAPTER 4 Money and Inflation slide 30

 def:   50% per month

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