Chapter 17

Inflation: Its Causes and Costs

Outline

What is inflation? Causes of inflation Arriving at the monetary equilibrium Quantity theory of money The classical dichotomy- Real versus

nominal Velocity of money The Fisher effect Costs of inflation

Inflation

Inflation is the overall increase in price level.

Inflation rate can be measured as the percent change in CPI, GDP deflator, or any overall price index.

Recall that prices rise when the government prints too much money (chap 1).

Causes of InflationLevel of prices and the value of money:

• P= Price level = # $ required to buy a basket of goods and services

• 1/P= quantity of goods that can be bought with $1 = value of money

• Therefore, price level and value of money are inversely related

Monetary EquilibriumDeterminants of money supply:• The banking system along with the Bank of Canada

can influence the supply of money

• Money supply is determined by the Bank of Canada and is treated as a policy variable

Determinants of money demand: • Quantity of money held by public (demand) is

determined by interest rate on bonds

• Demand for money also depends on the average price level in the economy

Monetary EquilibriumDeterminants of money demand: Higher the price level (lower value of money), more

money people choose to hold, and demand for money increases

Equilibrium • In the LR, the overall level of prices adjusts to the

level where demand equals supply of money

• At the point of equilibrium, price level and value of money have adjusted to balance supply and demand for money

Quantity Theory of Money

The theory states 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.

The Classical dichotomy and Monetary Neutrality

Classical dichotomy is the theoretical separation of nominal and real variables

Nominal variables are measured in monetary units

Real variables are measured in physical units

Relative prices are real variables Monetary neutrality states that changes in

the money supply affect nominal variables and do not affect real variables

Velocity and the quantity equation Velocity of money is the rate at which

money changes hands or the speed at which the $ travels around the economy

MV=PY is the quantity equation and relates the quantity of money and its velocity to the nominal value of output

Velocity of money is relatively stable over time in Canada

Therefore, when Bank of Canada increases money supply rapidly, it results in inflation.

Velocity of money

Inflation tax Hyperinflation is defined as inflation that

exceeds 50% per month. Inflation tax is the revenue the government

raises by creating money supply When the government prints money in

order to fund its expenditure, it increases the price level and thereby reduces the value of money.

Fisher Effect Money neutrality means that an increase in

the growth of money supply raises inflation rate but does not affect any real variables.

However, increase in money supply does affect (increase) nominal interest rate.

Recall real interest rate= nominal interest rate-inflation rate.

The one-for-one adjustment between the nominal interest rate to the inflation rate is the Fisher effect.

The Costs of Inflation Inflation fallacy Shoeleather costs Menu costs Relative price variability and misallocation

of resources Inflation-induced tax distortions Confusion and inconvenience Arbitrary redistribution of wealth

Inflation fallacy Inflation leads to fall in purchasing power of

money and hurts consumers. Suppliers on the other hand receive a

higher price for the same quantity sold. Factors of production receive higher

incomes

Inflation does not in itself reduce real purchasing power

Neutrality of money

Shoeleather costs Inflation is like a tax and creates

deadweight loss for the society. To reduce the burden of inflation tax,

people hold less money in hand and hold in interest bearing savings instead.

The resources wasted (time and inconvenience) in reducing money holdings is termed as shoeleather costs.

During hyperinflation, local currency’s store of value is vastly reduced.

Menu costs Menu costs are incurred when prices

change frequently and frequent changing of prices increases the costs of firms.

Relative-price variability and the misallocation of resources With no inflation, a firm’s relative prices

would be constant over a period of time ( a year).

With inflation, the relative prices of a firm will be high in the early months of the year and low in later months.

As market economies allocate resources based on relative prices, inflation distorts prices resulting in misallocation of resources by markets.

Inflation-induced tax distortions Inflation tends to raise the tax burden on

income from savings Tax treatment of capital gains discourages

savings All of the nominal interest earned on savings

is treated as income for purpose of taxation

Tax rate= 50% Economy 1 Economy 2

Real interest rate 6% 6%

Inflation rate 0 10%

Nominal interest rate

6% 16%

After-tax nominal interest rate

3% 4%

After-tax real interest rate

3% -6%

Save?

Confusion and Inconvenience Inflation erodes the real value of money as

a unit of account.

Cost of unexpected inflation: Arbitrary redistribution of wealth Hyperinflation enriches the borrower by

diminishing the real value of the debt. Deflation enriches the lender by increasing

the real value of the debt. Unexpected inflation prevents the Fisher

effect from taking place imposing a risk on the borrower and lender.

Inflation indexed bonds are a solution to protect long term savings.