Chapter 5. Inflation: Its Causes and Effects

Split off from Chapter 4 in the previous editions.

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Homework pp. 128-29, #2, 3

Link to syllabus

Equation of Exchange:

MV = P x Y

Y is output, or real income, rather than transactions (p. 103, 104). Note, V is defined as P x Y/M, so the equation is an identity – it has to be true. What is open to discussion is whether or not V and Y are constant.

« Inflation is always and everywhere a monetary phenomenon. » (m.f.)

From calculus, %ΔM + %ΔV = %ΔP + %ΔY (p. 106). where %Δ is ‘the percentage change;’ e.g. %ΔM is ΔM/M

This is the basis of Friedman’s proposed monetary growth rule.

Comparisons of Velocities of M

DifferentText.

Milton Friedman, 1912-2006

Leader of anti-government movement, which we see in rejection of discretionary policies, and preference for rules.

Monetarism Monetary Growth ruleConsumption function (Introduced expectations into macro)Flexible exchange rates

Paraphrase of Robert Solow – also a Brooklyn-born Nobel Prize Winner,and a prominent Keynesian:

“Milton is obsessed by the quantity of money, and always puts it into hispapers. I’m obsessed by sex, but I don’t put it into all my papers.”

Figure 5.1 p. 107 Historical Data on US Inflation and Monetary Growth

Viewed as being supportive of the Quantity Theory

Fig. 5-2 p. 108. International Data on Inflation and Money Growth

Also viewed as supportive of the Quantity Theory.

Monetary Growth Rule i

Monetary Growth Rule ii

Fig. 5-3 p. 111. Inflation and Nominal Interest Rates

Irving Fisher. 1867-1947 Irving Fisher was one of the earliest American neo- c classical economists, of unusual mathematical sophistication. ( 1) his contributions to the Walrasian theory of equilibrium price (he also invented the indifference curve device) in 1892; 2) His volumes on the theory of capital and I investment (1896, 1898, 1906, 1907, 1930) which brought the Austrian intertemporal theories into the English-speaking world, wherein he introduced the famous distinction between "stocks" and flows", the Fisher Separation Theorem and the loanable funds theory of interest rates. 3) his famous resurrection of the quantity theory of money (1911, 1932, 1935); (4) the theory of index numbers (1922). This Yale economist was an eccentric and colorful figure. When Irving Fisher wrote his 1892 dissertation, he constructed a remarkable machine equipped with pumps, wheels, levers and pipes in order to illustrate his price theory. Socially, he was an avid advocate of eugenics and health food diets. He made a fortune with his visible index card system - known today as the rolodex - and advocated the establishment of an 100% reserve requirement banking system His fortune was lost and his reputation was severely marred by the 1929 Wall Street Crash, when just days before the crash, he was reassuring investors that stock prices were not overinflated but, rather, had achieved a new, permanent plateau.

Irving Fisher, a bit earlier

Fig. 5-4 p. 112. Inflation and Nominal Interest Rates, different countries

Evidence that as inflation increases, so do nominal interest rates.

Fig. 5-5 p. 115. Linkages among Money, Prices, and Interest Rates

EYE ON THE PAST

P. 315(Bade/ParkinText)

Hyperinflation in Germany in the 1920s

Fig. 5-6 p.124. Money and

Prices in Interwar

Germany.

End of chapter problems.

Chapter 4 #1.1. Which functions of money do the following satisfy? a) credit card b) Rembrandt painting c) subway token

Chapter 5 #12. In the country of Wicknam, velocity of money is constant. If Real GDP grows by 5 percent per year, the money stock by 14% per year, and the nominal interest rate is 11%, what is the real interest rate?