Unit 7: Money Growth and

Inflation

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The Classical Theory of Inflation

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 Inflation

• Inflation
• Increase in the overall level of prices
• Deflation
• Decrease in the overall level of prices
• Hyperinflation
• Extraordinarily high rate of inflation

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Classical Theory of Inflation

• Quantity theory of money*

• Theory asserting that the quantity of money available determines
the price level and that the growth rate in the quantity of money
available determines the inflation rate
• Developed by some of the earliest economic thinkers

*Words accompanied by an asterisk are key terms from the chapter.

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 The Level of Prices and the Value of Money

• Inflation
• Economy-wide phenomenon
• Concerns the value of economy’s medium of exchange
• Inflation: Rise in the price level
• Lower value of money
• Each dollar buys a smaller quantity of goods and services

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Money Supply, Money Demand, and

Monetary Equilibrium (1 of 2)
• Money demand
• 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 goods and services
• Quantity of money demanded
• Is negatively related to the value of money
• Is positively related to P, other things equal

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 Money Supply, Money Demand, and
Monetary Equilibrium (2 of 2)
• Money supply
• Influenced by the Fed, the banking system, and consumers
• We assume the Fed precisely controls MS and sets it at some fixed
amount
• Supply curve is vertical
• In the long run
• Money supply and money demand are brought into equilibrium by
the overall level of prices

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The Effects of a Monetary Injection

• Economy starts in equilibrium

• If Fed doubles the supply of money
• Supply curve shifts right
• Value of money decreases
• Price level increases
• New equilibrium

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 Figure 1 How the Supply and Demand for Money
Determine the Equilibrium Price Level
The horizontal axis shows the quantity of
money. The left vertical axis shows the
value of money, and the right vertical axis
shows the price level. The supply curve for
money is vertical because the quantity of
money supplied is fixed by the Fed. The
demand curve for money slopes downward
because people want to hold a larger
quantity of money when each dollar buys
less. At the equilibrium, point A, the value of
money (on the left axis) and the price level
(on the right axis) have adjusted to bring the
quantity of money supplied and the quantity
of money demanded into balance.
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A Brief Look at the Adjustment Process

• Increasing money supply causes P to rise

• At the initial P, an increase in money supply causes an excess
supply of money
• People get rid of their excess money: spend it on goods and services
or by loan it to others, who spend it
• Result: Increased demand for goods and services
• But supply of goods does not increase, so prices must rise, so the
quantity of money demanded increases because people are using
more dollars for every transaction

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 Figure 2 An Increase in the Money Supply
When the Fed increases the supply of money, the money supply curve shifts from MS1 to MS2.
The value of money (on the left axis) and the price level (on the right axis) adjust to bring supply
and demand back into balance. The equilibrium moves from point A to point B. Thus, when an
increase in the money supply makes dollars more plentiful, the price level increases, making each
dollar less valuable.

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The Classical Dichotomy and Monetary

Neutrality (1 of 2)
• Nominal variables*
• Variables measured in monetary units (dollar prices)
• Dollar prices
• Real variables*
• Variables measured in physical units (relative prices, real wages, real
interest rate)
• Classical dichotomy*
• Theoretical separation of nominal and real variables
*Words accompanied by an asterisk are key terms from the chapter.

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 The Classical Dichotomy and Monetary
Neutrality (2 of 2)
• Monetary developments
• Influence nominal variables
• Irrelevant for explaining real variables
• Monetary neutrality*
• Proposition that changes in the money supply do not affect real
variables
• Not completely realistic in short-run
• Correct in the long run
*Words accompanied by an asterisk are key terms from the chapter.

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Active Learning 1: The Neutrality of Money

• If the central bank doubles the money supply, what happens with the
real wage and total employment?

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 Velocity and the Quantity Equation

• Velocity of money* (V)

• Rate at which money changes hands
• V = (P × Y) / M
P: Price level (GDP deflator)
Y: Real GDP
M: Quantity of money

*Words accompanied by an asterisk are key terms from the chapter.

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Quantity Equation (1 of 2)

• Quantity equation*
•M×V=P×Y
• Quantity of money (M)
• Velocity of money (V)
• Dollar value of the economy’s output of goods and services (P × Y)

*Words accompanied by an asterisk are key terms from the chapter.

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 Quantity Equation (2 of 2)

•M×V=P×Y
• An increase in quantity of money must be reflected in
• Price level (must rise)
• Quantity of output (must rise)
• Velocity of money (must fall)

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Active Learning 2: Velocity of Money

• Assume there is only one good in the economy, corn. The economy has
enough labor, capital, and land to produce 1,800 bushels of corn. V is
constant. In 2023, money supply is $3,600 and the price of corn is
$8/bushel.
• Compute nominal GDP and velocity in 2023

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 Equilibrium Price Level and Inflation Rate
(1 of 2)
1. Velocity of money
• Relatively stable over time
2. Changes in quantity of money (M)
• Proportionate changes in nominal value of output (P × Y)
3. Economy’s output of goods & services (Y)
• Primarily determined by factor supplies and production technology
• Money does not affect output

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Equilibrium Price Level and Inflation Rate

(2 of 2)
4. Change in money supply (M)
• Induces proportional changes in the nominal value of output (P × Y)
• Reflected in changes in the price level (P)
5. When the central bank increases the money supply rapidly
• High rate of inflation

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 Figure 4 Money and Prices during Four
Hyperinflations
This figure shows the quantity of money
and the price level during four
hyperinflations. (Note that because these
variables are graphed on logarithmic
scales, equal vertical distances on the
graph represent equal percentage changes
in the variable.) In each case, the quantity
of money and the price level move closely
together. The strong association between
these two variables is consistent with the
quantity theory of money, which states Source: Adapted from Thomas J. Sargent, “The End of
that growth in the money supply is the Four Big Inflations,” in Robert Hall, ed., Inflation (Chicago:
primary cause of inflation. University of Chicago Press, 1983), pp. 41–93. Each series
is normalized to equal 100 for the initial observation.

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Active Learning 3: Quantity Theory of

Money
• Assume there is only one good in the economy, corn. The economy has
enough labor, capital, and land to produce 1,800 bushels of corn. V is
constant. In 2023, money supply was $3,600 and the price of corn was
$8/bushel. For 2024, the Fed increases money supply, money supply by
10%.
A. Compute the 2024 values of nominal GDP and P
B. Compute the inflation rate for 2023–2024

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 The Inflation Tax

• Inflation tax*
• Revenue the government raises by creating (printing) money
• Like a tax on everyone who holds money
• When the government prints money
• The price level rises
• And the dollars in your wallet are less valuable

• In the U.S., the inflation tax today accounts for less than 3% of federal
receipts
*Words accompanied by an asterisk are key terms from the chapter.

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The Fisher Effect (1 of 2)

• Principle of monetary neutrality

• An increase in the rate of money growth raises the rate of inflation
but does not affect any real variable
• Because
• Real interest rate = Nominal interest rate – Inflation rate
• We get
• Nominal interest rate = Real interest rate + Inflation rate

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 The Fisher Effect (2 of 2)

• Fisher effect*
• One-for-one adjustment of nominal interest rate to inflation rate
• When the Fed increases the rate of money growth, long-run result is
• Higher inflation rate
• Higher nominal interest rate

*Words accompanied by an asterisk are key terms from the chapter.

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Figure 5 The Nominal Interest Rate and the

Inflation Rate
This figure uses annual data since 1960 to show the nominal interest rate on three-month
Treasury bills and the inflation rate as measured by the consumer price index. The close
association between these two variables provides evidence for the Fisher effect: When the
inflation rate rises, so does the nominal interest rate.

Source: U.S. Department of Treasury; U.S. Department of Labor.

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 2
The Costs of Inflation

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A Fall in Purchasing Power? The Inflation

Fallacy
• Inflation fallacy
• “Inflation robs people of the purchasing power of his hard-earned
dollars”
• When prices rise
• Buyers pay more
• Sellers get more
• Inflation does not in itself reduce people’s real purchasing power

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 Shoeleather Costs

• Inflation is like a tax on the holders of money

• Avoid the inflation tax
• By holding less money (and go to the bank more often)
• Shoeleather costs*
• Resources wasted when inflation encourages people to reduce their
money holdings
• Can be substantial in countries with hyperinflation

*Words accompanied by an asterisk are key terms from the chapter.

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Menu Costs

• Menu costs*
• Costs of changing prices
• Inflation increases menu costs that firms must bear
• Deciding on new prices
• Printing new price lists and catalogs
• Advertising the new prices
• Dealing with customer annoyance over price changes

*Words accompanied by an asterisk are key terms from the chapter.

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 Relative-Price Variability and the
Misallocation of Resources
• Misallocation of resources from relative-price variability
• Firms don’t all raise prices at the same time, so relative prices can
vary
• The higher the inflation rate, the greater this swing in relative prices
will be
• Inflation distorts relative prices
• Consumer decisions are distorted
• Markets are less able to allocate resources to their best use

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Inflation-Induced Tax Distortions (1 of 2)

• 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

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 Inflation-Induced Tax Distortions (2 of 2)

• Tax treatment of capital gains

• Capital gains are profits
• Inflation exaggerates the size of capital gains
• Increases the tax burden
• Tax treatment of interest income
• Treated as income
• Inflation tends to discourage people from saving

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Table 1 How Inflation Raises the Tax

Burden on Saving
• In the presence of zero Economy A Economy B
inflation, a 25 percent tax (zero inflation) (high inflation)
Real interest rate 4% 4%
on interest income reduces
Inflation rate 0 8
the real interest rate from
Nominal interest rate 4 12
4 percent to 3 percent. (real interest rate + inflation rate)
Reduced interest due to 25 1 3
• In the presence of 8 percent tax (0.25 x nominal
percent inflation, the same interest rate)
After-tax nominal interest rate 3 9
tax reduces the real (0.75 x nominal interest rate)
interest rate from 4 After-tax real interest rate 3 1
percent to 1 percent. (after-tax nominal interest rate -
inflation rate)

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 Confusion and Inconvenience

• Inflation changes the yardstick we use to measure transactions

• Complicates long-range planning and the comparison of dollar
amounts over time
• Difficult to judge the costs of the confusion and inconvenience that
arise from inflation

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A Special Cost of Unexpected Inflation:

Arbitrary Redistributions of Wealth
• Unexpected inflation
• Redistributes wealth among the population
• Not by merit
• Not by need
• Redistribute wealth among debtors and creditors
• Inflation is volatile and uncertain
• When the average rate of inflation is high

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 Inflation Is Bad, but Deflation May Be
Worse (1 of 2)
• The Friedman rule
• Prescription for moderate inflation
• Small and predictable amount of deflation may be desirable
• In practice, deflation is rarely steady and predictable
• Redistribution of wealth away from debtors (who are often poorer)
• Deflation often arises from broader macroeconomic difficulties

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Inflation Is Bad, but Deflation May Be

Worse (2 of 2)
• Costs of deflation
• Menu costs
• Relative-price variability
• If not steady and predictable
• Redistribution of wealth toward creditors and away from debtors
• Arises because of broader macroeconomic difficulties
• Symptom of deeper economic problems

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 Think-Pair-Share Activity

Suppose you explain the concept of an “inflation tax” to a friend. You correctly tell
them, “When a government prints money to cover its expenditures instead of taxing or
borrowing, it causes inflation. An inflation tax is simply the erosion of the value of
money from this inflation. Therefore, the burden of the tax lands on those who hold
money.” Your friend responds, “What’s so bad about that? Rich people have all the
money, so an inflation tax seems fair to me. Maybe the government should finance all
of its expenditures by printing money.”
A. Is it true that rich people hold more money than poor people do?
B. Do rich people hold a higher percent of their income as money than poor people?
C. Compared to an income tax, does an inflation tax place a greater or lesser burden
on the poor? Explain.
D. Are there any other reasons why engaging in an inflation tax is not good policy?

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