Académique Documents
Professionnel Documents
Culture Documents
Chapter Four
Introduction
% p er year
12
10
8
6
4
2
0
1960
1965
1970
1975
1980
1985
inflation rate
1990
1995
2000
% p e r ye ar
12
10
8
6
4
2
0
1960
1965
1970
1975
1980
inflation rate
1985
1990
1995
2000
M quantity of money
V transactions velocity of money; measures the # of
times that a typical dollar bill changes hands per year
Example: 60 loaves of bread, $.50 per loaf
(M/P)d = k Y
k constant that tells how much money people want to hold
for every dollar of income
What does this equation tell us? What does higher income
lead to?
(M/P)d = M/P
M/P = k Y M (1/k) = P Y
If V = (1/k), then our money demand function is
equivalent to the quantity equation
1.
2.
3.
% M + % V = % P + % Y
= % P the variable we wish to explain
= % M under the control of the central bank
0 = % V we have assumed that velocity is constant
% Y depends on growth in f.o.p. and technological progress
= - % Y; it follows that the inflation rate depends on
the growth rate of the money supply
Inflation is always
and everywhere a
monetary
phenomenon
Milton Friedman
Empirical link
between inflation
and growth in the
quantity of money
Decades with high
money growth
tend to have high
inflation, and
decades with low
money growth
tend to have low
inflation.
International data
show the correlation
even more clearly.
Again, the link
between money
growth and inflation is
clear.
Countries with high
(low) money growth
tend to have high
(low) inflation.
This theory of inflation
works best in the long
run, notice we are
talking about 10 year
averages of money
growth and inflation.
% per year
12
10
8
6
4
2
0
1960
1965
1970
1975
1980
inflation rate
1985
1990
1995
2000
% per year
12
10
8
6
4
2
0
1960
1965
1970
inflation rate
1975
M2 growth rate
1980
1985
1990
1995
2000
Fisher effect 1
for 1 relation
between the
inflation rate and
the nominal
interest rate
Empirical validity
of the Fisher effect
When inflation is
high (low),
nominal interest
rates are typically
high (low)
When were real
interest rates
highest?
When were real
interest rates
lowest?
International data
demonstrates the
Fisher effect.
Countries with
high (low) inflation
tend to have high
(low) nominal
interest rates.
Why would the
empirical links
between inflation
and nominal
interest rates be
important for bond
traders?
Exercise:
Suppose V is constant, M is growing 5% per
year, Y is growing 2% per year, and r = 4.
a. Solve for i (the nominal interest rate).
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?
1)
2)
The higher the level of income (Y), the greater the demand for real
balances
The higher the nominal interest rate (i), the lower the demand for
real balances
adjusts to make S = I
Y F (K , L )
M
adjusts to make L(i ,Y )
P
How P responds to M
M
L(r e , 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.
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
Discussion Question
Why is inflation bad?
What costs does inflation impose on
society?
of.
A common misperception
Common misperception:
inflation reduces real wages
16
16
perhour
hour
$$per
14
14
12
12
66
44
22
Average
Average
hourly
hourly
earnings
earnings
200
200
175
175
150
150
125
125
10
10
88
250
250
225
225
Consumer
Consumer
Price
PriceIndex
Index
100
100
75
75
50
50
25
25
00
00
1964
1964 1968
1968 1972
1972 1976
1976 1980
1980 1984
1984 1988
1988 1992
1992 1996
1996 2000
2000
CPI(1983=100)
(1983=100)
CPI
18
18
Examples:
Hyperinflation
Recent episodes of
hyperinflation
Chapter summary
Money
1.
2.
Chapter summary
Nominal interest rate
3.
4.
Chapter summary
5.
Costs of inflation
Expected inflation
shoeleather 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
Hyperinflation
6.
Chapter summary
Classical dichotomy
7.