Lecture 7 money growth and inflation

Macroeconomics
Lecture 7

.


Money Growth &
Inflation
Chapter 28

.


In this chapter, you will study:
The definition and measures of inflation
 Two types of inflation.
 The causes of inflation and the quantity
theory of money.
 The relationship between inflation and
interest rates.
 The costs of inflation.


.


Inflation
 Inflation

An increase in the overall level of prices in
the economy

 Inflation rate

The percentage change in the price level
from the previous period

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Inflation & Its Historical Aspects
Inflation
 Deflation
A decrease in the overall level of prices in the
economy (the U.S. 1818-1821)
 Disinflation
A reduction in the rate of inflation (Vietnam
2011-2013)
 Hyperinflation
An extraordinary high rate of inflation
(Germany after World War I)


.


Hyperinflation in Venezuela


Replacing toilet paper with
cash would seem an
extremely affluent action in

most countries. But in
Venezuela, it's now the
financially prudent thing to
do.

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Types of Inflation
Demand-pull inflation
 Cost-push inflation


.


Demand-Pull Inflation
Occurs when Aggregate Demand grows up
quickly and runs ahead of Aggregate Supply
for goods and services
 Supply cannot increase accordingly because
it is constrained by factor supplies (labor,
technology, natural resources and capital)
 Excess demand enables suppliers to increase
the prices of their limited products


.

Demand-Pull Inflation

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Cost-push Inflation
Occurs when there is a rise in production
costs (wage and salary, raw material and
components, government taxes, ect)
 Profit margin decrease: a rationale for
reducing supply (the law of diminishing
marginal returns)
 Suppliers increase prices to compensate
partly for deacrease in profit margin,
passing a part of their loss on to consumers


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Cost-push Inflation

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The level of prices and the
value of money
Price level (P): number of dollars needed
to buy a basket of goods and services
 Value of money (1/P): number of goods

and services bought by each dollar
=> P  => 1/P 
=> When the price level rises, the value of
money falls.


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Money Supply, Money Demand,
and Monetary Equilibrium
 Money

Supply (MS)
• Determined by the Central Bank and the
banking system
• Assumptions: The quantity of money
supplied is a policy variable that the
Central Bank controls directly and
completely

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Money Supply, Money Demand,
and Monetary Equilibrium
Money Demand (MD)
 Determined by many factors: the level of
reliability on credit cards, whether an
ATM is easy to find, the interest rate, the

overall price level in the economy
 In the long-run, the overall price level
turns out to be the most important
determinants


.


Money Supply, Money Demand,
and Monetary Equilibrium


Monetary Equilibrium: The point at
which the quantity of money demanded
balances the quantity of money supplied

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Money Supply, Money Demand, and
the Equilibrium Price Level
Value of
Money (1/P)

Price
Level (P)

Money supply

(High) 1

1 (Low)
1.33
A

1/2
1/4

(Low) 0

2

Money
demand
Quantity fixed
by the Central Bank
.

4

Quantity of
Money

Equilibriu
m price
level

Equilibrium
value of money

3/4

(High)


The Effects of Monetary Injection
Value of
Money (1/P)

MS1

2

(High) 1

1. An increase
in the money
supply...

3/4
A

1/2

Money
demand

(Low) 0

M1
.

1.33
2

B

1/4

1 (Low)

M2

4

Quantity of
Money

3. …and
increases the
price level

2. ...decreases the
value of money ...

Price
Level (P)

MS

(High)


The Quantity Theory of Money
 Quantity

theory of money: explains how
the price level is determined and why it
might change over time




The quantity of money available in the
economy determines the price level.
The primary cause of inflation is the growth
in the quantity of money.

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Classical Dichotomy and
Monetary Neutrality
Classical Dichotomy: the separation of
economic variables into two groups:
• Nominal variables: variables measured in
monetary units
• Real variables: measured in physical units
 Monetary neutrality: changes in the

money supply affect nominal variables but
not real variables.


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Velocity and the Quantity Equation


Velocity of money: the speed at which the typical
dollar bill travels around the economy from wallet
to wallet.

MxV=PxY
Where:
V = velocity
P = the price level
Y = the quantity of output
M = the quantity of money
·
P x Y = nominal value of output
.


The Quantity Theory of Money

M = (P x Y)/V
 An

increase in the quantity of money (M)
 Changes in other three variables

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Indexes

(1960 = 100)

Quantity of Money and the
Velocity of Money in USA

1,500

Nominal GDP
M2

1,000

500
Velocity
0
1960

1965
.

1970

1975 1980

1985

1990

1995

2000


The Quantity Theory of Money
•
•
•

V: relatively stable.
M  (P x Y).
Money is neutral  does not affect Y

M  P
=> Rapid increase in money supply causes
high inflation rate
•

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Case Study: Money and prices
during four hyperinflations

(a) Austria

(b) Hungary

Index
(Jan. 1921 = 100)

Index
(July 1921 = 100)

100,000

100,000
Price level

Price level

10,000

10,000

Money supply

1,000
100

Money supply

1,000

1921

1922

.

1923

1924

1925

100

1921

1922

1923

1924

Copyright © 2004 South-Western

1925


Case Study: Money and prices
during four hyperinflations
(c) Germany

(d) Poland

Index
(Jan. 1921 = 100)
100,000,000,000,000
1,000,000,000,000
10,000,000,000
100,000,000
1,000,000
10,000
100
1

Index
(Jan. 1921 = 100)
10,000,000

Price level
Money
supply

Price level

1,000,000

Money
supply

100,000

10,000
1,000

1921

1922

.

1923

1924

1925

100

1921

1922

1923

1924

Copyright © 2004 South-Western

1925