Inflation and the Quantity Theory of Money

Transcription

1 DYNAMIC POWERPOINT SLIDES BY SOLINA LINDAHL CHAPTER 29 Inflation and the Quantity Theory of Money

2 CHAPTER OUTLINE Defining and Measuring Inflation The Quantity Theory of Money The Costs of Inflation For applications, click here To Try it! questions To Video

3 Food for Thought. Some good blogs and other sites to get the juices flowing:

4 Introduction In this chapter: How is inflation defined and measured? What causes inflation? The costs and benefits of inflation? Why do governments sometimes resort to inflation?

5 Defining and Measuring Inflation Inflation: an increase in the average level of prices. Measured using the following formula: Where P2 is the index value in year 2 and P1 is theall index value in year 1 of prices. Inflation is the average change Some prices go up and some go down. Think of an elevator containing many prices that change relative to each other. As the elevator rises, all of the prices rise.

6 Try it! Year CPI Value What was the approximate inflation rate over the period 2007 to 2008? a)6.6% b)8% c)21% To next Try it! d)7.1%

7 Try it! Year CPI Value In which year was the inflation rate the highest? a)2006 b)2007 c)2008 d)2009 To next Try it!

8 Defining and Measuring Inflation Price Indexes are used to measure inflation. An index is a number that compares the price level in one period relative to the prices in some base year. An index is only a number; it is not expressed in dollars. There are several price indexes: Consumer price index (CPI) GDP deflator Producer price index (PPI)

9 Defining and Measuring Inflation 1.CPI: The average price of goods bought by a typical American consumer. Covers 80,000 goods. Weighted so that major items (housing) count more. 2.GDP deflator: Measures the average price of all final goods and services. 3.Producer price indexes (PPI): The average price received by producers. Includes intermediate goods as well as final goods. PPI s exist for different industries.

10 The Inflation Rate in the United States,

11 The Effect of Inflation on the Price of a Basket of Goods

12 Defining and Measuring Inflation Inflation in the U.S. and Around the World Using the CPI to calculate real prices Real price is the price of a good that has been corrected for inflation. Example: 1982 price of gasoline was $1.25/gal it was double that at $2.50/gal. CPI was 100 in 1982 and 202 in Conclusion: The real price of gasoline was about the same in 2006 as it was in 1982.

13 Defining and Measuring Inflation Inflation in the United States and Around the World Hyperinflation: extremely high rates of inflation Many governments have fallen into the trap of inflating their currency in order to pay debts.

14 Defining and Measuring Inflation

15 Defining and Measuring Inflation Inflation in the United States and Around the The worthless Hungarian Pengo, 1946 World Hungary s hyperinflation is the highest on record. What cost 1 Hungarian pengo in 1945 cost 1.3 septillion pengos at the end of Prices doubled every 15 hours! 100,000,000,000,000,000,000 Pengo World's highest denomination banknote: Hungary (1946) 100 Quintillion pengo

16 Causes of Inflation

17 Take a look.. Commanding Heights (PBS) looks at prices. The first few minutes of the clip focus on Germany s hyperinflation, the second half of the 8-minute clip focuses on the U.S. Great Depression

18 The Quantity Theory of Money The quantity theory of money does two things: 1. Sets out the general relationship between inflation, money, real output, and prices. 2. Presents the critical role of the money supply in regulating the level of prices. For the nation as a whole M x v = P x YR Where M = Money supply, v = Velocity of money, P = Price level and YR = Real GDP

19 The Quantity Theory of Money Velocity (v): average number of times that a dollar is spent on goods and services in a year.

20 The Quantity Theory of Money The quantity theory of money depends on two assumptions 1. Real GDP is stable compared to the money supply. Real GDP is fixed by the real factors of production capital, labor, and technology. The growth rate of real GDP is limited by how fast these factors can increase.

21 The Quantity Theory of Money 2. The velocity of money, v, is stable compared to the money supply. It is determined by various factors such as: Whether workers are paid monthly or biweekly. How long it takes to clear a check or electronic transaction. How easy it is to find an ATM. Factors like these may change, but slowly.

22 The Quantity Theory of Money The Cause of Inflation The quantity theory: a theory of inflation. If YR is fixed by real factors of production and v is stable, then it follows that inflation is caused by an increase in the supply of money. The quantity theory of money can also be written in terms of growth rates: Which translates as: Growth rate of money + growth rate of v equals the rate of inflation + growth rate of real GDP.

23 The Quantity Theory of Money Important implication: If the growth rates of v and YR are small compared to the growth rate of M, the rate of inflation will be approximately equal to the increase in money supply. Or more generally:

24 SEE THE INVISIBLE HAND Source: Inflation is always and everywhere a monetary phenomenon. Milton Friedman ( ), Nobel Prize Winner the Chicago school of economics, Leader of

25 The Quantity Theory of Money How well does the theory hold up? In Peru, very well.

26 The Quantity Theory of Money More money means more inflation.

27 The Quantity Theory of Money Some Important Caveats: 1. If M and v grow more slowly than YR, prices will fall; this is called deflation. 2. Changes in velocity will affect prices. Hyperinflation: People will spend their money faster (increase v) even faster increase in prices. Great Depression: Fear spending (decreased v) deflation worse depression. 3. In the long run, money is neutral.

28 Deflation and Disinflation Don t be confused: Deflation: a decrease in the average level of prices (negative inflation) E.g. if the CPI falls from 100 to 95, the inflation rate is negative. Disinflation: a reduction in the inflation rate E.g. if the CPI rose from 100 to 110, and the next year to 112, the inflation rate is positive but slowing down.

29 Try it! Year Inflation Rate (Annual Percent Change) % % % % % This table shows actual inflation data for different periods of Polish history. Which year can you identify as deflationary? a)1990 b)1999 c)2003 To next Try it! d)no year was deflationary.

30 The Quantity Theory of Money An Inflation Parable Under some circumstances, changes in M can temporarily change YR. Let s see how Consider a mini-economy consisting of a baker, tailor, and carpenter who buy and sell products among themselves. Government prints money to pay army Soldiers buy from baker, tailor, and carpenter When the baker, tailor, and carpenter go to buy from each other, they find they are no better off than before because of higher prices All three work harder to increase output and raise their prices. Eventually they catch on and stop working harder to produce more output. Conclusion: Increase in M can boost the economy in the short run but as firms and workers come to expect and adjust to the influx of new money, output (real GDP) will not grow any faster than normal.

31 The Costs of Inflation If all prices (including wages) are going up, then why is inflation a problem? Four problems with inflation: 1. Inflation causes price confusion and money illusion. 2. Inflation redistributes wealth. 3. Inflation interacts with other taxes. 4. Inflation is painful to stop.

32 The Costs of Inflation: Price Confusion and Money Illusion 1. Price Confusion and Money Illusion Price confusion: Inflation makes price signals more difficult to interpret. A consumer may not know if the price of a product is increasing Because of increased demand? or As a result of all prices going up with inflation. Making sense of prices

33 The Costs of Inflation: Price Confusion and Money Illusion Money Illusion: when people mistake changes in nominal prices for changes in real prices. Example: Mary receives a 10% increase in salary and takes on a higher mortgage payment. The rate of inflation is 10%: she is no better off in terms of real salary. She now has a higher house payment and is in danger of losing her home. Result: resources are wasted in unprofitable activities.

34 The Costs of Inflation: Wealth Redistribution 2. Inflation Redistributes Wealth Inflation is type of tax. It transfers wealth to the government. Even tax cheats can t avoid this tax! Governments that print money to pay their bills are using this type of tax. Inflation redistributes wealth among the public. The real rate of return for a lender is given by: ractual = i p where ractual = actual rate of return, i = nominal interest rate and p = inflation rate

35 The Costs of Inflation: Wealth Redistribution Example: Suppose a bank makes a 30-year home loan at an interest rate of 7%. If inflation is 3% over that period: bank s actual rate of return = 7% - 3% = + 4% If inflation rises unexpectedly to 13% (as it did in late 1970s), the actual rate of return = 7% - 13% = -6%! The lender is now losing money on the loan. The borrower gains.

36 The Costs of Inflation: Wealth Redistribution What happens if people expect inflation to go up? Lenders will increase nominal rates of interest. Fisher effect: the tendency for nominal interest rates to rise with expected inflation. The nominal rate of interest will be equal to expected inflation rate plus the equilibrium rate of return.

37 The Costs of Inflation: Wealth Redistribution Nominal Interest Rates Tend to Increase with Inflation Rates

38 The Costs of Inflation: Wealth Redistribution The actual rate of return: determined in large part by the difference between expected inflation and actual inflation. From earlier equations we have: Substituting i from equation (2) into equation (1) we get:

39 Try it! Using the inflation data in the table above, assume that all loan contracts matured after one year, and that they all had fixed nominal interest rates of 10%. In which of the years given below did lenders gain relative to borrowers? a)2000 b)2002 c)2003 To next d)2004 Try it!

40 The Costs of Inflation: Wealth Redistribution

41 The Costs of Inflation: Wealth Redistribution Monetizing the debt: when the government pays off its debts by printing money. Why don t they always inflate their debt away? Two reasons: 1. The Fisher effect: if banks know the government is doing this, they will simply raise interest rates. 2. Political cost: People who buy government bonds usually vote.

42 The Costs of Inflation: Wealth Redistribution Workers and firms are affected by inflation. Wage agreements are often made several years in advance. Underestimating inflation wages are too low supply of labor: too low. Overestimating inflation wages are too high demand for labor: too low. Conclusion: errors in estimating the rate of inflation a misallocation of resources lower economic growth.

43 The Costs of Inflation: Wealth Redistribution Hyperinflation and the Breakdown of Financial Intermediation If inflation is moderate and stable: Lenders and borrowers can forecast well. Loans can be signed with rough certainty regarding the value of future payment. If inflation is high and volatile: Long-term risk becomes high and loans may not be signed at all. Financial intermediation breaks down.

44 The Costs of Inflation: Wealth Redistribution Peru ( ) Private loans virtually disappeared. Investment fell and the economy collapsed. Mexico 1980s: Inflation rate at times exceeded 100%. Long-term loans were hard to get. As recently as 2002, 90% of debt matured within one year. Since the 1990s: inflation has been tamed. Result: rapidly growing capital markets and increased investment: Economic growth

45 The Costs of Inflation Conclusions: 1. Unexpected inflation redistributes wealth throughout society in arbitrary ways. 2. When inflation is high and volatile Unexpected inflation is difficult to avoid. Long-term contracting grinds to a halt. Result: economic growth suffers.

46 Try it! Unanticipated high inflation always means: a)a loss in purchasing power for lenders. b)a decrease in the amount of real taxes paid by citizens and firms. c)a redistribution of wealth from the rich to the poor. d)all of the answers are correct. To next Try it!

47 The Costs of Inflation 3. Inflation Interacts with Other Taxes Inflation will produce tax burdens and tax liabilities that do not make economic sense. People pay taxes on illusory capital gains. Example: Taxes are collected on nominal capital gains (e.g. not real gains) Results: Longer-run effect is to discourage investment in the first place. Inflation increases the costs of complying with the tax system.

48 The Costs of Inflation 4. Inflation is Painful to Stop Slowing down the money supply can create a recession. A good lesson: Inflation in 1980 was 13.5%. Tough monetary policy reduced the rate of inflation to 3%, but the consequence was The worst recession since the Great Depression. Unemployment rate over 10%. The unemployment rate didn t return to near 5.5% until 1988.

49 Try it! The average number of times a dollar is spent on final goods and services during a year is: a)the velocity of money. b)the consumption rate. c)the money supply. d)the quantity theory of money.