Chapter 4

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.
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.
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%
% 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.
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.
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.
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.
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)
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.
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
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
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
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
21
Velocity, cont.
This suggests the following
definition:
T
V
where
V = velocity
T = value of all
transactions
M = money supply
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
23
(real
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.
24

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.
25

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.
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.
27

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)
28

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.
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
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).
31

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
32

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
33

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.
34

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.
35

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.
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
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
100
Historical data on U.S.

Inflation and money growth
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.
40
U.S. inflation and money growth,

19602014
14%
% 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.
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.
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.
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.
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.
47

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.
48

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.
49

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.
50

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.
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.
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.
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.
54
Deriving the Fisher Equation
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.
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
57
Inflation and nominal

interest rate over time in
Canada
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
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.
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?
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.
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.
64

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.
65

The relevant real interest rate for, say,
investors decisions is defined as
r = i e.
The Fisher effect is modified:
i = r + e.
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.
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.)
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.
69
Equilibrium
M
e
L(r , Y )
P
The supply of
real money
balances
Real money
demand
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
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.
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
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
74
The linkages among money,

prices and interest rates
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.
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
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?
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.
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.
81

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.
82

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.
83

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!!
84

5. General inconvenience
Inflation makes it harder to compare
nominal values from different time periods.
This complicates long-range financial
planning.
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.
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.
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.
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.
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.
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.
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.
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)
94
Assignment
Questions 3, 4 & 8 from the textbook.
95
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
96
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
97
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.
98

Chapter 4

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Chapter 4

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Econ 202 Macroeconomic

In this chapter, you will learn

U.S. inflation and its trend,

U.S. inflation and its trend,

The connection between

CHAPTER 4 Money and Inflation

Monetization increases efficiency!!!

Money is the yardstick with which we

The money supply and

CHAPTER 4 Money and Inflation

The central bank

CHAPTER 4 Money and Inflation

The Federal Reserve

(buying and selling Treasury bonds).

Money Supply Measures in

CHAPTER 4 Money and Inflation

Money supply measures, June 2014 (US)

M1 + small time deposits,

The Quantity Theory of Money

CHAPTER 4 Money and Inflation

The quantity equation

CHAPTER 4 Money and Inflation

The quantity equation

The quantity equation

CHAPTER 4 Money and Inflation

Money demand and the

Money demand and the

Money demand and the

money demand: (M/P )d = k Y

CHAPTER 4 Money and Inflation

Back to the quantity theory

With this assumption, the quantity

CHAPTER 4 Money and Inflation

The quantity theory of

How the price level is determined:

With V constant, the money supply

Real GDP is determined by the economys

The price level is

The quantity theory of

The quantity theory of

CHAPTER 4 Money and Inflation

The quantity theory of

Normal economic growth requires a

The quantity theory of

Y/Y depends on growth in the factors of

The quantity theory of

CHAPTER 4 Money and Inflation

Confronting the quantity

(percent, logarithmic scale)

International data on inflation and

Money supply growth

CHAPTER 4 Money and Inflation

Historical data on U.S.

CHAPTER 4 Money and Inflation

Confronting the quantity

U.S. inflation and money growth,

U.S. inflation and money growth,

Inflation and money growth

CHAPTER 4 Money and Inflation

CHAPTER 4 Money and Inflation

Inflation and interest rates

CHAPTER 4 Money and Inflation

Inflation and interest rates

Inflation and interest rates