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Econ 202 Macroeconomic

Theory 1
Lecture Note Chapter 4
Money and Inflation
University of Waterloo
Department of Economics
Spring 2015

Introduction
Inflation is always and everywhere a
monetary phenomenon.
.. Milton
Friedman
Inflation is always and everywhere a
fiscal phenomenon.
.. Thomas
Sargent
CHAPTER 4 Money and Inflation

Introduction
This chapter explains the classical
theory of money and inflation.
The chapter has three main goals:
(1). To explain the economic meaning
of money and introduce money
supply and money demand.
(2). To examine the effects of
monetary policy when prices are
flexible.
(3). To discuss the costs of inflation.
CHAPTER 4 Money and Inflation

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

U.S. inflation and its trend,


19602014
14%
12% from 12 mos. earlier
% change
10%

% change in
GDP deflator

8%
6%
4%
2%
0%
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

U.S. inflation and its trend,


19602014
14%
12% from 12 mos. earlier
% change
10%
8%
6%
4%
2%
0%
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

The connection between


money and prices
Inflation rate = the percentage increase
in the average 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.
CHAPTER 4 Money and Inflation

What is inflation?
Here is a great illustration of the power of inflation:
In 1970, the New York Times cost 15 cents, the median
price of a single-family home was $23,400, and the
average wage in manufacturing was $3.36 per hour.
In 2008, the Times cost $1.50, the price of a home was
$183,300, and the average wage was $19.85 per hour.

1950

1970
2008

Money: Definition
Money is the stock
of assets that can be
readily used to make
transactions.

CHAPTER 4 Money and Inflation

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.
The ease with which money is converted into other
things such as goods and services--is sometimes called
moneys liquidity.
CHAPTER 4 Money and Inflation

10

Monetization increases efficiency!!!

Money is the yardstick with which we


measure economic transactions. Without
it, we would be forced to barter.
However, barter requires the
double coincidence of wantsthe unlikely
situation of two people, each having a
good that the other wants at the right time
and place to make an exchange.

Money: Types
1. fiat money is money by declaration.
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
3. When people use gold as money, the
economy is said to be on a gold standard.
CHAPTER 4 Money and Inflation

12

Discussion Question
Which of these are money?
a. Currency
b. Checks
c. Deposits in checking accounts
(demand deposits)
d. Credit cards
e. Certificates of deposit
(time deposits)
CHAPTER 4 Money and Inflation

13

The money supply and


monetary policy definitions
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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14

The central bank


Monetary policy is conducted by a countrys
central bank.
In Canada,
the central bank
is called the
The Bank of Canada.
The official website : www.bankofcanada.ca

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15

Open-Market Operations
purchase and sale of U.S. Treasury B
To expand the money supply:
BOC buys Canadian Government Bonds and
pays for them with new money.
To reduce the money supply:
BOC sells Canadian Government Bonds and
receives the existing dollars and then
destroys them.

The Federal Reserve


controls
the money supply in 3
Conducting Open
Market Operations
ways:

(buying and selling Treasury bonds).


Changing the Reserve requirements (never really
used).
Changing the Discount rate which member banks
(not meeting the reserve requirements) pay to
borrow from BOC.

Money Supply Measures in


Canada, December 2005

CHAPTER 4 Money and Inflation

18

Money supply measures, June 2014 (US)


symbol assets included
C

amount
($ billions)

Currency

1,214

M1

C + demand deposits,
travelers checks,
other checkable deposits

2,270

M2

M1 + small time deposits,


savings deposits,
money market mutual funds,
money market deposit accounts

9,952

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

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20

Velocity
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 2009,
$500 billion in transactions
money supply = $100 billion
The average dollar is used in five
transactions in 2009
So, velocity = 5
CHAPTER 4 Money and Inflation

21

Velocity, cont.
This suggests the following
definition:
T
V

where
V = velocity
T = value of all
transactions
M = money supply
CHAPTER 4 Money and Inflation

22

Velocity, cont.
Use nominal GDP as a proxy for total
transactions.
P Y
Then,
V
M

where
P

= price of output

(GDP

deflator)
Y

= quantity of output

GDP)
P Y = value of output
CHAPTER 4 Money and Inflation

23

(real

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.

CHAPTER 4 Money and Inflation

24

The quantity equation


Transactions and output are related,
because the more the economy produces,
the more goods are bought and sold.
If Y denotes the amount of output and P
denotes the price of one unit of output,
then the dollar value of output is PY.
We encountered measures for these
variables when we discussed the national
income accounts.
CHAPTER 4 Money and Inflation

25

The quantity equation


This version of the quantity equation is
called the income velocity of money, which
tells us the number of times a dollar bill
enters someones income in a given time.

CHAPTER 4 Money and Inflation

26

Money demand and the


quantity equation
When we analyze how money affects the
real economy, it is often useful to express
the quantity of money in terms of the
goods and services it can buy. This
amount M/P, is called the real money
balances.
Real money balances measure the
purchasing power of the stock of money.
M/P = real money balances, the
purchasing power of the money supply.
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27

Money demand and the


quantity equation
A money demand function an equation
that shows the determinants of the
quantity of real balances people wish to
hold. 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)
CHAPTER 4 Money and Inflation

28

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) and
vice versa.

CHAPTER 4 Money and Inflation

29

Back to the quantity theory


of money
starts with quantity equation
V V
assumes V is constant & exogenous:

With this assumption, the quantity


equation can be written as

M V P Y

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30

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

31

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
CHAPTER 4 Money and Inflation

32

The quantity theory of


money, cont.
(Greek letter pi)
denotes the inflation
rate:
The result from
the
preceding
Solve this slide
was:
result
for to get

P

P
M
P Y

M
P
Y

M Y

M
Y

CHAPTER 4 Money and Inflation

33

The quantity theory of


money, 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.
CHAPTER 4 Money and Inflation

34

The quantity theory of


money, 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 in
in the
the money
money growth
growth rate
rate and
and
changes
changes in
in the
the inflation
inflation rate.
rate.
CHAPTER 4 Money and Inflation

35

The quantity theory of


money, cont.
Note: the theory doesnt predict that the
inflation rate will equal the money growth
rate.
It does predict that a change in the money
growth rate will cause an equal change in
the inflation rate.

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36

Confronting the quantity


theory with data
The quantity theory of money implies
1. countries with higher money growth
rates
should have higher inflation rates.
2. the long-run trend behavior of a
countrys inflation should be similar to
the long-run trend in the countrys
money growth rate.
Are the data consistent with these
CHAPTER 4 Money and Inflation

37

(percent, logarithmic scale)

Inflation rate

International data on inflation and


money
growth
100.0
Indonesia
Ecuador

Belarus

Turkey
Argentina

10.0

Euro Area
U.S.

1.0

0.1

Switzerland

Singapore

China

10

Money supply growth


38
(percent, logarithmic scale)

CHAPTER 4 Money and Inflation

100

Historical data on U.S.


Inflation and money growth

CHAPTER 4 Money and Inflation

39

Confronting the quantity


theory with data
Data for the U.S. economy since 1870
provide broad support for the link between
money growth and inflation implied by the
quantity theory.
Decadal averages over this period reveal
a positive relationship between the GDP
deflator and the growth of M2.
International data show the correlation
even more clearly.
CHAPTER 4 Money and Inflation

40

U.S. inflation and money growth,


19602014
14%
12% from 12 mos. earlier
% change

M2 growth rate

10%
8%
6%
4%
2%

inflation
rate

0%
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

U.S. inflation and money growth,


19602014

Inflation and money growth


have the same long-run trends,
12% from 12 mos. earlier as the quantity theory predicts.
% change
14%

10%
8%
6%
4%
2%
0%
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

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.
CHAPTER 4 Money and Inflation

43

Seigniorage
While the government can print money
and use that money to purchase goods
and services, it obviously does not get
these goods and services for free.
Someone is paying for them. In effect,
when the government prints new money, it
levies an inflation tax. As more money is
introduced into the economy, we now
know that there will be inflation.
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44

Seigniorage
An increase in the money supply
increases the general price level.
This makes existing money in the
economy worth less; existing money
holdings decline in real value. Inflation
serves as a tax on real balances.

CHAPTER 4 Money and Inflation

45

Seigniorage
Seigniorage is not an important source of
revenue in North America, but it has been
used to finance a significant fraction of
government spending in some other
countries.

CHAPTER 4 Money and Inflation

46

Inflation and interest rates


We now turn to the distinction between
nominal and real interest rates.
The interest rate quoted in the
newspapers is a nominal interest rate.
It gives the number of dollars that will be
paid next year for a dollar deposited today.

CHAPTER 4 Money and Inflation

47

Inflation and interest rates


For example, a 10 percent interest rate
implies that $100 deposited today earns
$110 next year.
But suppose that prices also rise at 10
percent per year.
Then, $100 deposited in the bank has
exactly the same purchasing power in
terms of real goods next year as this year.
CHAPTER 4 Money and Inflation

48

Inflation and interest rates


The dollar price of goods is not ultimately
important to people making economic
decisions; rather, they care about real
tradeoffs.
An individual deciding whether to
consume today or to save for consumption
next year needs to know how much she
can get in terms of goods next year if she
gives up goods today.
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49

Inflation and interest rates


In other words, she cares about the real
interest rate.
The real interest rate corrects for inflation.
In the preceding example, the real interest
rate was zero, even though the nominal
rate was 10 percent.

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50

Inflation and interest rates


Nominal interest rate, i
not adjusted for inflation
Real interest rate, r
adjusted for inflation:
r = i
Remember that the real interest rate is the
interest rate that matters for investment.

CHAPTER 4 Money and Inflation

51

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

52

The Fisher effect


Note that S and I are real variables.
In chapter 3, we learned about the factors
that determine S and I.
These factors did not include the money
supply, velocity, inflation, or other nominal
variables.

CHAPTER 4 Money and Inflation

53

The Fisher effect


Hence, in the classical (long-run) theory
we are learning, changes in money growth
or inflation do not affect the real interest
rate.
This is why theres a one-for-one
relationship between changes in the
inflation rate and changes in the nominal
interest rate.
CHAPTER 4 Money and Inflation

54

Deriving the Fisher Equation

CHAPTER 4 Money and Inflation

55

The Fisher effect


Again, the Fisher effect does not imply
that the nominal interest rate EQUALS the
inflation rate.
It implies that CHANGES in the nominal
interest rate equal CHANGES in the
inflation rate, given a constant value of the
real interest rate.

CHAPTER 4 Money and Inflation

56

The Fisher effect


Notice that we now have two implications
of an increase in the money growth rate.
First, our theory predicts that an increase
in the money growth rate of, say, 1 percent
should increase the inflation rate by 1
percent.
In turn, this should imply a 1 percent
increase in the nominal interest rate. This
link between the inflation rate and the
nominal interest rate is known as the
CHAPTER 4 Money and Inflation

57

Inflation and nominal


interest rate over time in
Canada

CHAPTER 4 Money and Inflation

58

U.S. inflation and nominal interest rates,


18%

1960-2009

nominal
interest rate

14%

10%

6%

2%

inflation rate
-2%
1960

1965

1970

1975
1980
1985
1990
CHAPTER
4 Money
and Inflation

1995

59

2000

2005

2010

Inflation and nominal interest


rates across countries
Nominal
interest rate 100

Georgia

(percent,
logarithmic
scale)

Romania
Turkey

Brazil

10

Zimbabwe

Israel
Kenya
U.S.

Ethiopia
Germany
1

10

100

Inflation rate
60
(percent, logarithmic scale)

CHAPTER 4 Money and Inflation

1000

The Fisher Effect


The data for the U.S. and other
economies clearly reveal the connection
between the inflation rate and the nominal
interest rate suggested by the Fisher
effect.
They also reveal that the real interest rate
changes over time.

CHAPTER 4 Money and Inflation

61

NOW YOU TRY:

Applying the theory


Suppose V is constant, M is growing 5% per year,
Y is growing 2% per year, and r = 4.

a. Solve for i.
b. If the Fed increases the money growth rate by
2 percentage points per year, find i.
c. Suppose the growth rate of Y falls to 1% per
year.
What will happen to ?
What must the Fed do if it wishes to
keep constant?
CHAPTER 4 Money and Inflation

62

NOW YOU TRY:

Answers
V is constant, M grows 5% per year,
Y grows 2% per year, r = 4.
a. First, find = 5 2 = 3.
Then, find i = r + = 4 + 3 = 7.
b. i = 2, same as the increase in the money
growth rate.
c. If the Fed does nothing, = 1.
To prevent inflation from rising,
Fed must reduce the money growth rate by
1 percentage point per year.
CHAPTER 4 Money and Inflation

63

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 actually realized.
CHAPTER 4 Money and Inflation

64

Two real interest rates


When people make inter-temporal
economic decisions, they dont know for
sure what the inflation rate will be.
This means that, rather than the actual
inflation rate, we should use the expected
inflation rate.

CHAPTER 4 Money and Inflation

65

Two real interest rates


The relevant real interest rate for, say,
investors decisions is defined as
r = i e.
The Fisher effect is modified:
i = r + e.

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66

Money demand and


the nominal interest rate
In the quantity theory of money,
the demand for real money balances
depends only on real income Y.
Another determinant of money demand:
the nominal interest rate, i.
the opportunity cost of holding money
(instead of bonds or other interestearning assets).
Hence, i in money demand.
CHAPTER 4 Money and Inflation

67

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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68

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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69

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

Real money
demand

CHAPTER 4 Money and Inflation

70

What determines what


M
e
L(r , Y )
P
variable how determined (in the long run)
M exogenous (the Bank of Canada)
r adjusts to make S = I
Y

Y F (K , L )
P adjusts to make

CHAPTER 4 Money and Inflation

M
L( i , Y )
P
71

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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72

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: Fed announces it will increase M next
year. People will expect next years P to be
higher,
so e rises.
This affects P now, even though M hasnt
CHAPTER 4 Money and Inflation

73

How P responds to

M
L(r e , 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

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74

The linkages among money,


prices and interest rates

CHAPTER 4 Money and Inflation

75

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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76

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

77

The CPI and Average Hourly Earnings,


19652014
900

$20

1965 = 100

700
600

$15

500

Nominal average
hourly earnings,
(1965 = 100)

400
300
200
100

$10

$5

CPI (1965 = 100)

0
$0
1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

Hourly wage in 2014 dollars

800

Real average hourly earnings


in 2014 dollars, right scale

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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79

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.

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80

The costs of expected inflation:


1. Shoe leather 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.
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81

The costs of expected inflation:


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.

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82

The costs of expected inflation:


3. Relative price distortions
Firms facing menu costs change prices infrequently.
Example:
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
causing microeconomic inefficiencies
in the allocation of resources.

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83

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 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!!
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84

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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85

Additional cost of unexpected inflation:


Arbitrary redistribution 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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86

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,
making risk averse people worse off.
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87

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.
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88

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.
CHAPTER 4 Money and Inflation
89

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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90

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.

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91

A few examples of hyperinflation


country

period

CPI Inflation
% per year

M2 Growth
% per year

Israel

1983-85

338%

305%

Brazil

1987-94

1256%

1451%

Bolivia

1983-86

1818%

1727%

Ukraine

1992-94

2089%

1029%

Argentina

1988-90

2671%

1583%

Dem. Republic
of Congo / Zaire

1990-96

3039%

2373%

Angola

1995-96

4145%

4106%

Peru

1988-90

5050%

3517%

Zimbabwe

2005-07

5316%

9914%

The Classical Dichotomy


Note: Real variables were explained in Chap
3, nominal ones in Chapter 4.
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.
CHAPTER 4 Money and Inflation

93

Useful websites

http://minneapolisfed.org/pubs/region/int.cfm
http://www.dictionaryofeconomics.com/dictionary
www.federalreserve.gov
www.bankofcanada.ca
Textbooks on Monetary economics (Monetary economics is a
sub discipline of economics that is very closely related to
macroeconomics but that pays particular attention to financial
institutions):
-Gary Smith, Money, Banking, and Financial Intermediation
(Lexington, Mass.: D.C. Heath, 1991)
-Laurence Ball, Money, Banking, and Financial Markets (New
York: Worth Publishers, 2008)
CHAPTER 4 Money and Inflation

94

Assignment
Questions 3, 4 & 8 from the textbook.

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Chapter Summary
Costs of inflation
Expected inflation

shoe leather 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

CHAPTER 4 Money and Inflation

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Chapter Summary
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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Chapter Summary
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, money market equilibrium determines price
level and all nominal variables.
Most economists believe the economy works this
way in the long run.

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