Inflation

Equilibrium in the money market

Rate of interest MS

re

Md

0 Me Quantity of money
 Inflation
 Inflation is a rise in the general level of prices
of goods and services.
 The rate of inflation is the rate at which
prices are increasing
 Inflation is measured by the changes in the
consumer price index (CPI).
Enough for a hamburger
 Introduction
 We introduces the quantity theory of money to
explain:
Prices rise when the govt prints
too much money.
 Most economists believe the quantity theory
is a good explanation of the long run behavior
of inflation.

5 MONEY GROWTH AND INFLATION

 The Value of Money
 P = the price level
(e.g., the CPI or GDP deflator)
P is the price of a basket of goods, measured in
money.
 1/P is the value of $1, measured in goods.
 Example: basket contains one candy bar.
 If P = $2, value of $1 is 1/2 candy bar
 If P = $3, value of $1 is 1/3 candy bar
 Inflation drives up prices and drives down the value
of money.
6 MONEY GROWTH AND INFLATION
 The Quantity Theory of Money
 Developed by 18th century philosopher
David Hume and the classical economists
 Advocated more recently by Nobel Prize
Laureate Milton Friedman
 Asserts that the quantity of money determines
the value of money
 We study this theory using two approaches:
1. A supply-demand diagram
2. An equation

7 MONEY GROWTH AND INFLATION

 Money Supply (MS)
 In real world, determined by RBI, the banking system,
consumers.
 In this model, we assume the RBI precisely controls
MS and sets it at some fixed amount.

8 MONEY GROWTH AND INFLATION

 Money Demand (MD)
 Refers to how much wealth people want to hold in
liquid form.
 Depends on P:
An increase in P reduces the value of money,
so more money is required to buy g&s.
 Thus, quantity of money demanded
is negatively related to the value of money
and positively related to P, other things equal.
(These “other things” include real income, interest
rates, availability of ATMs.)

9 MONEY GROWTH AND INFLATION

 Inflation
 The causes of inflation
 demand-pull inflation – rises in AD
 cost-push inflation – wage, profit, import price (AS)
 Inflation
Before we examine inflation let’s examine AD
and AS again
 Aggregate demand

 The aggregate demand curve

 AD = C + I + G + X – M

12
 Aggregate demand
Price level

AD1

0 GDP
 The aggregate supply curve

● Relates the aggregate supply of goods and services to

the general price level.

14
 Aggregate supply
Price level AS1

0
GDP
15
 Equilibrium price and GDP
Price level
AS
At price level P1 ,
aggregate supply exceeds
aggregate demand. Both
contract towards
equilbrium point.

P1

At price level P2,

Pe aggregate demand
exceeds aggregate supply.
P2 Both contract towards
equilbrium point.
AD

0
GDPe GDP
16
 Demand-pull inflation
Price level AS

How will an increase

in demand impact?
What responds first – AD or
AS?
P1

AD1

0 GDP1 GDP
 Demand-pull inflation
Price level AS

What is the
impact on
price?

AD2

AD1

0 GDP
 Demand-pull inflation
Price level
Prices rise from
AS
P1 to P2 due to
output rises GDP1
to GDP2
Increase in
price will
P2 depend on
steepness in AS
P1
curve
AD2

AD1

0 GDP1 GDP2 GDP

 Demand-pull inflation
Price level AS

A consequence of price
rise is falling real wages –
therefore workers will
P2 want to negotiate wage
increase. How will this be
P1 shown?
AD2

AD1

0 GDP1 GDP2 GDP

 Cost-push inflation

Price level
AS2
AS1

As a result of wage
increase prices will
P2 rise further
P1

AD

0 GDP2 GDP1 GDP

 Cost-push inflation
 Cost-push inflation is associated with leftward (upward)
shifts in the aggregate supply curve.
● Single shifts in the aggregate supply curve (known as ‘supply
shocks’) and continuing shifts.
● Rises in costs may originate from a number of different sources,
such as trade unions pushing up wages, firms with monopoly
power raising prices in order to increase their profits, or
increases in international commodity prices.
● Higher taxes on producers, leads to high price
● Higher import costs (eg: exchange rate deprecation)
 Cost-push inflation

 Expectations and inflation

● The higher people expect inflation to be, the higher it will be
 Cost-push inflation

Price level
AS2
AS1

As a result of
wage increase
P2
prices will rise
P1
further

AD

0 GDP2 GDP1 GDP

 Interaction: demand-pull and cost-push inflation

Price level
STAGE I: If the
economy is already
AS1 at full employment,
GDP1, an increase
in demand to AD2,
will “pull” prices
higher, from P1 to
P2. Notional GDP
temporarily expands
P2 E2 from GDP1 to GDP2
and equilibrium from
P1 E1 E1 to E2.

AD2

AD1

0 GDP
GDP1 GDP2
Interaction: demand-pull and cost-push inflation

Price level
AS2
STAGE II: Firms
are unable to
AS1 expand real supply
because the
economy is already
E3 at full employment,
GDP1. In response
P3 to shortage of
E2 supply, prices
P2 increase further,
from P2 to P3. GDP
P1 returns to its
original, real level,
GDP1.
AD2

AD1

0 GDP
GDP1 GDP2
 Interaction: demand-pullASand
3
cost-push inflation
Price level
AS2 STAGE III: The
E5 interaction of
AS1 excessive demand
P4 and shortage of
E4 supply continues,
pushing prices
even higher but
P3 E3
without inducing
any real growth in
P2 GDP.

P1
AD3

AD2

AD1

0 GDP
GDP1 GDP2
 Long run AS
ASlong run

Price level
AS2
AS1

E3
P3
E2
P2

P1

AD2

AD1

0 GDP
GDP1 GDP2
 The Costs of Inflation
 The inflation fallacy: most people think inflation
erodes real incomes.
 But inflation is a general increase in prices
of the things people buy and the things they sell (e.g.,
their labor).
 In the long run, real incomes are determined by real
variables, not the inflation rate.

29 MONEY GROWTH AND INFLATION

 Costs of Inflation
 Redistribution of income – away from those
on fixed incomes
 Uncertainty and lack of investment
 Balance of payments
 Reallocation of resources to cope with
effects of inflation
 The Costs of Inflation
 The resources wasted when inflation encourages people to
reduce their money holdings
 Includes the time and transactions costs of more frequent bank
withdrawals
 Menu costs: the costs of changing prices
 Printing new menus, mailing new catalogs, etc.

 Lender Suffers and Borrower benefits

 When inflation occurs, lender gets back less valued money,
(as value of money decline) whereas the borrower payback
low valued money. His money is not worth that much
31
presently… (Why?) MONEY GROWTH AND INFLATION
 The Costs of Inflation
 Misallocation of resources from relative-price
variability: Firms don’t all raise prices at the same
time, so relative prices can vary…
which distorts the allocation of resources.
 Confusion & inconvenience: Inflation changes the
yardstick we use to measure transactions.
Complicates long-range planning and the comparison
of dollar amounts over time.

32 MONEY GROWTH AND INFLATION

 The Costs of Inflation
 Tax distortions:
Inflation makes nominal income grow faster than real
income.
Taxes are based on nominal income,
and some are not adjusted for inflation.
So, inflation causes people to pay more taxes even
when their real incomes don’t increase.

33 MONEY GROWTH AND INFLATION