PrinciplesofEconomicsII:

MacroeconomicsMoneyGrowthandInflationTheEconomyintheLongRunEconomicGrowthHumanandPhysical,FinancialCapitalFormationMoneyandPricesTopicsHowdoesthemoneysupplyaffectinflationand

nominalinterestrates?DoesthemoneysupplyaffectrealvariableslikerealGDPortherealinterestrate?Howisinflationlikeatax?Whatarethecostsofinflation?Howseriousare

they?0IntroductionThischapterintroducesthequantitytheoryof

money

toexplainoneoftheTenPrinciplesofEconomicsfromChapter1:

Pricesrisewhenthegovtprints

toomuchmoney.Mosteconomistsbelievethequantitytheory

isagoodexplanationofthelongrunbehavior

ofinflation.0TheValueofMoneyP=thepricelevel

(e.g.,theCPIorGDPdeflator) Pisthepriceofabasketofgoods,measuredinmoney.1/Pisthevalueof$1,measuredingoods.Example:basketcontainsonecandybar.IfP=$2,valueof$1is1/2candybarIfP=$3,valueof$1is1/3candybarInflationdrivesuppricesanddrivesdownthevalueofmoney.0TheQuantityTheoryofMoneyDevelopedby18thcenturyphilosopher

DavidHumeandtheclassicaleconomistsAdvocatedmorerecently

byNobelPrizeLaureateMiltonFriedmanAssertsthatthequantityofmoneydeterminesthe

valueofmoneyWestudythistheoryusingtwoapproaches:Asupply-demanddiagramAnequation0MoneySupply(MS)Inrealworld,determinedbyFederalReserve,

thebankingsystem,consumers.Inthismodel,weassumetheFedpreciselycontrolsMSandsetsitatsomefixedamount.0MoneyDemand(MD)Referstohowmuchwealthpeoplewanttohold

inliquidform.DependsonP:

AnincreaseinPreducesthevalueofmoney,

somoremoneyisrequiredtobuyg&s.Thus,quantityofmoneydemanded

isnegativelyrelatedtothevalueofmoney

andpositivelyrelatedtoP,otherthingsequal. (These“otherthings”includerealincome,interest

rates,availabilityofATMs.)0TheMoneySupply-DemandDiagramValueof

Money,1/PPrice

Level,PQuantityofMoney11?1.33?2?4Asthevalueofmoneyrises,thepricelevelfalls.0TheMoneySupply-DemandDiagramValueof

Money,1/PPrice

Level,PQuantityofMoney1???11.3324MS1$1000TheFedsetsMS

atsomefixedvalue,

regardlessofP.0TheMoneySupply-DemandDiagramValueof

Money,1/PPrice

Level,PQuantityofMoney1???11.3324MD1Afallinvalueofmoney

(orincreaseinP)

increasesthequantityofmoneydemanded:0MS1$1000Valueof

Money,1/PPrice

Level,PQuantityofMoney1???11.3324TheMoneySupply-DemandDiagramMD1Padjuststoequate

quantityofmoney

demandedwith

moneysupply.eq’m

price

leveleq’m

value

of

moneyA0MS1$1000TheEffectsofaMonetaryInjectionValueof

Money,1/PPrice

Level,PQuantityofMoney1???11.3324MD1eq’m

price

leveleq’m

value

of

moneyAMS2$2000BThenthevalue

ofmoneyfalls,

andPrises.SupposetheFedincreasesthemoneysupply.0ABriefLookattheAdjustmentProcessHowdoesthiswork?Shortversion:AttheinitialP,anincreaseinMScauses

excesssupplyofmoney.Peoplegetridoftheirexcessmoneybyspendingit

ongoodsandservicesorbyloaningittoothers,whospendit.

Result:increaseddemandforgoods.Butsupplyofgoodsdoesnotincrease,

sopricesmustrise.(Otherthingshappenintheshortrun,whichwewill

studyinlaterchapters.)Resultfromgraph:IncreasingMScausesPtorise.0Realvs.NominalVariablesNominalvariablesaremeasuredinmonetaryunits.Examples:nominalGDP,

nominalinterestrate(rateofreturnmeasuredin$)

nominalwage($perhourworked)Realvariablesaremeasuredinphysicalunits.Examples:realGDP,

realinterestrate(measuredinoutput)

realwage(measuredinoutput)0Realvs.NominalVariablesPricesarenormallymeasuredintermsofmoney.Priceofacompactdisc: $15/cdPriceofapepperonipizza: $10/pizzaArelativepriceisthepriceofonegoodrelativeto

(dividedby)another:RelativepriceofCDsintermsofpizza:priceofcdpriceofpizza$15/cd$10/pizza=Relativepricesaremeasuredinphysicalunits,

sotheyarerealvariables.=1.5pizzaspercd0Realvs.NominalWageAnimportantrelativepriceistherealwage:W=nominalwage=priceoflabor,e.g.,$15/hourP=pricelevel=priceofg&s,e.g.,$5/unitofoutputRealwageisthepriceoflaborrelativetotheprice

ofoutput:WP=3unitsoutputperhour$15/hour$5/unitofoutput=0TheClassicalDichotomyClassicaldichotomy:

thetheoreticalseparationofnominalandrealvariablesHumeandtheclassicaleconomists

suggestedthatmonetarydevelopments

affectnominalvariablesbutnotrealvariables.Ifcentralbankdoublesthemoneysupply,

Hume&classicalthinkerscontendallnominalvariables–includingprices–

willdouble.allrealvariables–includingrelativeprices–

willremainunchanged.0TheNeutralityofMoneyMonetaryneutrality:thepropositionthatchanges

inthemoneysupplydonotaffectrealvariablesDoublingmoneysupplycausesallnominalprices

todouble;whathappenstorelativeprices?Initially,relativepriceofcdintermsofpizzaispriceofcdpriceofpizza=1.5pizzaspercd$15/cd$10/pizza=Afternominalpricesdouble,priceofcdpriceofpizza=1.5pizzaspercd$30/cd$20/pizza=Therelativepriceisunchanged.0TheNeutralityofMoneySimilarly,therealwageW/Premainsunchanged,soquantityoflaborsupplieddoesnotchangequantityoflabordemandeddoesnotchangetotalemploymentoflabordoesnotchangeThesameappliestoemploymentofcapitaland

otherresources.Sinceemploymentofallresourcesisunchanged,

totaloutputisalsounchangedbythemoneysupply.Monetaryneutrality:thepropositionthatchanges

inthemoneysupplydonotaffectrealvariables0TheNeutralityofMoneyMosteconomistsbelievetheclassicaldichotomyandneutralityofmoneydescribetheeconomyinthelongrun.Inlaterchapters,wewillseethatmonetarychanges

canhaveimportantshort-runeffects

onrealvariables.0TheVelocityofMoneyVelocityofmoney:therateatwhichmoneychangeshandsNotation:

PxY =nominalGDP

=(pricelevel)x(realGDP)

M =moneysupply

V =velocityVelocityformula:V=PxYM0TheVelocityofMoneyExamplewithonegood:pizza.

In2008,

Y =realGDP=3000pizzas

P =pricelevel=priceofpizza=$10

PxY =nominalGDP=valueofpizzas=$30,000

M =moneysupply=$10,000 V =velocity=$30,000/$10,000=3

Theaveragedollarwasusedin3transactions.Velocityformula:V=PxYM0Onegood:corn.Theeconomyhasenoughlabor,capital,andland

toproduceY=800bushelsofcorn.Visconstant.In2008,MS=$2000,P=$5/bushel.ComputenominalGDPandvelocityin2008.ACTIVELEARNING1

ExerciseU.S.NominalGDP,M2,andVelocity(1960=100)

1960-2007NominalGDPM2VelocityVelocityisfairly

stableovertime.0TheQuantityEquationMultiplybothsidesofformulabyM:

MxV=PxYCalledthequantityequationVelocityformula:V=PxYM0TheQuantityTheoryin5Steps1. Visstable.2.

So,achangeinMcausesnominalGDP(PxY)

tochangebythesamepercentage.3. AchangeinMdoesnotaffectY:

moneyisneutral,

Yisdeterminedbytechnology&resources4. So,Pchangesbysamepercentageas

PxYandM.5. Rapidmoneysupplygrowthcausesrapidinflation.Startwithquantityequation:MxV=PxY0ACTIVELEARNING2

ExerciseOnegood:corn.Theeconomyhasenoughlabor,capital,

andlandtoproduceY=800bushelsofcorn.Visconstant.In2008,MS=$2000,P=$5/bushel.For2009,theFedincreasesMSby5%,to$2100.a. Computethe2009valuesofnominalGDPandP.

Computetheinflationratefor2008-2009.b. Supposetech.progresscausesYtoincreaseto824

in2009.Compute2008-2009inflationrate.IfrealGDPisconstant,then

inflationrate=moneygrowthrate.IfrealGDPisgrowing,then

inflationrate<moneygrowthrate.Thebottomline:Economicgrowthincreases#oftransactions.Somemoneygrowthisneededfortheseextra

transactions.Excessivemoneygrowthcausesinflation.ACTIVELEARNING2

SummaryandLessonsaboutthe

QuantityTheoryofMoneyHyperinflationHyperinflationisgenerallydefinedasinflation

exceeding50%permonth.RecalloneoftheTenPrinciplesfromChapter1:

Pricesrisewhenthegovernment

printstoomuchmoney.

Excessivegrowthinthemoneysupplyalwayscauseshyperinflation.0TheInflationTaxWhentaxrevenueisinadequateandabilitytoborrowislimited,govtmayprintmoneytopayforits

spending.Almostallhyperinflationsstartthisway.Therevenuefromprintingmoneyisthe

inflationtax:printingmoneycausesinflation,whichislikeataxoneveryonewhoholdsmoney.IntheU.S.,theinflationtaxtodayaccountsfor

lessthan3%oftotalrevenue.0TheFisherEffectRearrangethedefinitionoftherealinterestrate:Therealinterestrateisdeterminedbysaving&

investmentintheloanablefundsmarket.Moneysupplygrowthdeterminesinflationrate.So,thisequationshowshowthenominalinterestrateisdetermined.Real

interestrateNominal

interestrateInflationrate+=0TheFisherEffectInthelongrun,moneyisneutral,

soachangeinthemoneygrowthrateaffects

theinflationratebutnottherealinterestrate.So,thenominalinterestrateadjustsone-for-onewith

changesintheinflationrate.ThisrelationshipiscalledtheFishereffect

afterIrvingFisher,whostudiedit.Real

interestrateNominal

interestrateInflationrate+=0U.S.NominalInterest&InflationRates,1960-2007Thecloserelation

betweenthesevariablesisevidencefor

theFishereffect.0TheFisherEffect&theInflationTaxTheinflationtaxappliestopeople’sholdingsofmoney,

nottheirholdingsofwealth.TheFishereffect:anincreaseininflationcauses

anequalincreaseinthenominalinterestrate,

sotherealinterestrate(onwealth)isunchanged.Real

interestrateNominal

interestrateInflationrate+=0TheCostsofInflationTheinflationfallacy:mostpeoplethinkinflation

erodesrealincomes.Butinflationisageneralincreaseinprices

ofthethingspeoplebuyandthethingstheysell

(e.g.,theirlabor).Inthelongrun,realincomesaredetermined

byrealvariables,nottheinflationrate.0U.S.AverageHourlyEarnings&theCPICPI

(leftscale)Nominalwage

(rightscale)Inflationcauses

theCPIand

nominalwages

torisetogetheroverthelongrun.0TheCostsofInflationShoeleathercosts:theresourceswasted

wheninflationencouragespeopletoreducetheir

moneyholdingsIncludesthetimeandtransactionscostsofmore

frequentbankwithdrawalsMenucosts:thecostsofchangingpricesPrintingnewmenus,mailingnewcatalogs,etc.0TheCostsofInflationMisallocationofresourcesfromrelative-price

variability:Firmsdon’tallraisepricesatthesame

time,sorelativepricescanvary… whichdistortstheallocationofresources.Confusion&inconvenience:Inflationchanges

theyardstickweusetomeasuretransactions. Complicateslong-rangeplanningandthecomparisonofdollaramountsovertime.0TheCostsofInflationTaxdistortions: Inflationmakesnominalincomegrowfasterthanrealincome. Taxesarebasedonnominalincome,

andsomearenotadjustedforinflation. So,inflationcausespeopletopaymoretaxes

evenwhentheirrealincomesdon’tincrease.0ACTIVELEARNING3

TaxdistortionsYoudeposit$1000inthebankforoneyear.CASE1:inflation=0%,nom.interestrate=10%CASE2:inflation=10%,nom.interestrate=20%a. Inwhichcasedoestherealvalueofyourdepositgrow

themost?Assumethetaxrateis25%.b. Inwhichcasedoyoupaythemosttaxes?c. Computetheafter-taxnominalinterestrate,

thensubtractoffinflationtogettheafter-taxreal

interestrateforbothcases.0ACTIVELEARNING3

SummaryandlessonsInflation…raisesnominalinterestrates(Fishereffect)

butnotrealinterestratesincreasessavers’taxburdenslowerstheafter-taxrealinterestrateDeposit=$1000.Taxrate=25%.CASE1:inflation=0%,nom.interestrate=10%CASE2:inflation=10%,nom.interestrate=20%ASpecialCostofUnexpectedInflationArbitraryredistributionsofwealth

-Higher-than-expectedinflationtransferspurchasing

powerfromcreditorstodebtors:Debtorsgettorepaytheirdebtwithdollarsthataren’tworthasmuch.

-Lower-than-expectedinflationtransferspurchasing

powerfromdebtorstocreditors.

-Highinflationismorevariableandlesspredictable

thanlowinflation.

-So,thesearbitraryredistributionsarefrequent

wheninflationishigh.0TheCostsofInflationAllthesecostsarequitehighforeconomies

experien