Mankiw: Brief Principles of Macroeconomics, Second Edition (Harcourt, 2001)

1. Mankiw: Brief Principles of Macroeconomics, Second Edition (Harcourt, 2001) Ch. 11: Money Growth and Inflation

2. Quantity Theory of Money • It explains the price level in the long run. • Long run means when the economy is operating at full employment (at the natural rate of unemployment). • The theory has been around since the 18th century. • The theory is summarized as “Prices rise when too much money is printed.” Econ 202 Dr. Ugur Aker

3. Monetary Neutrality • In the long run, the real GDP will depend on available labor, capital and technology. • Doubling the amount of money in the system will not increase the output in the long run. • The impact of more money will be on the price level but real variables (real GDP, real saving, real investment, real interest rates, etc.) will not be affected. • Monetary neutrality means the amount of money in the system is not relevant to the amount of output. Econ 202 Dr. Ugur Aker

4. Monetary Neutrality and the Short Run • In the short run, prices take some time to adjust. • An increase in money supply, until price level increases and equates money demand to money supply, will have output response. • When there is excess money and prices are lower than they should be, more goods and services will be purchased, signaling to the producers to produce more. • In the short run, monetary policy will have impact on real variables. Econ 202 Dr. Ugur Aker

5. Income Velocity of Money • Given the amount of money stock in the system, how many times it has to turn over as the GDP is created. • If US nominal GDP is $9 trillion and M1 is $1 trillion, then the velocity of M1 is 9. • Y is used to denote real GDP and P is used to denote the price level. YP, then is nominal GDP. • V = (YP)/M Econ 202 Dr. Ugur Aker

6. Quantity Equation • MV = PY is called the quantity equation. • It says that the value of nominal GDP is equal to the money stock times its velocity. • If there is an increase in money stock (M), one or more of the following will happen to bring the equation into balance. • Velocity should decline. • Price level should rise. • Output should rise. Econ 202 Dr. Ugur Aker

7. Prediction with Quantity Equation • Velocity is relatively stable. • Increases in M, therefore, will be matched by increases in nominal GDP (PY). • In the long run, real GDP (Y) is determined by factor supplies and technology, i.e., money is neutral. • Therefore, the increase in money stock will be matched by an increase in the price level. • This reasoning is called Quantity Theory of Money. Econ 202 Dr. Ugur Aker

8. Measuring the Value of Money • Just like any price, the value of money should respond to supply of money and demand for money. • The value of money is the reciprocal of the price level, 1/P. • As the price level rises, the same $1 can purchase fewer commodities. • 1/P shows the value of $1 in terms of goods and services. Econ 202 Dr. Ugur Aker

9. Money Demand • Money demand means how much liquidity households desire to hold. • Liquidity here means currency and demand deposits. • There are many factors that affect the demand for money. • Income • Interest rates • Frequency of payments • Price level Econ 202 Dr. Ugur Aker

10. Price Level and Money Demand • As the price level rises, the value of money declines. • Just like any commodity, the lower the price of a commodity, the higher will be quantity demanded. • As the price level rises, the same basket of goods cost more. • In order to fulfill their shopping lists, households have to hold larger amounts of money. Econ 202 Dr. Ugur Aker

11. Money Demand Price Level Value of Money (1/P) As the price level rises, the value of money declines. The higher the price level, the more money is demanded, i.e., people need to hold higher balances of currency and demand deposits. 2 0.5 1.5 0.67 1 1 0.5 2 Quantity of Money Econ 202 Dr. Ugur Aker

12. Money Supply • Money supply is determined by the Fed and the banking system. • Assuming that banks always keep the required reserve ratio and households prefer to keep their money in checking accounts, the Fed will be able to control the amount of money in the economy. • Through open market operations, the Fed will manipulate the money supply. • Buying US securities will increase money supply. • Selling US securities will decrease money supply. Econ 202 Dr. Ugur Aker

13. Money Demand and Money Supply Price Level Value of Money (1/P) Ms In the long run, when the Fed keeps a certain amount of money available, price level will adjust to equate supply and demand. At P=0.67, there is excess supply. To increase the Md to the level of Ms, P has to rise up to P=2. 2 0.5 1.5 0.67 1 1 0.5 2 Md Quantity of Money Econ 202 Dr. Ugur Aker

14. Reducing Money Supply If the Fed targeted Ms’ there will be excess demand at P=2. In order to fulfill the demand, people will reduce purchases. The lower expenditures will reduce the price level, assuming the economy operates at full employment. Equilibrium will come at P=0.67. Price Level Value of Money (1/P) Ms’ Ms 2 0.5 1.5 0.67 1 1 0.5 2 Md Quantity of Money Econ 202 Dr. Ugur Aker

15. Inflation • Inflation is an economy-wide phenomenon. • Price increases in a few commodities do not portend inflation. • Inflation takes place when a basket of goods cost more to purchase. • Inflation lowers the value of money. • The same amount of money (currency+demand deposits) can buy a smaller amount of goods. Econ 202 Dr. Ugur Aker

16. Inflation Tax • When governments spend money, they raise the funds either from taxes or from borrowing or from printing money. • Governments that found taxing or borrowing difficult have turned to inflation to finance their activities. • Governments get goods and services through the printed money they spend. The larger stock of money and the smaller amount of goods and services left for the private sector force prices to rise. • The nominally valued assets lose value and owners of these assets are in fact taxed. Econ 202 Dr. Ugur Aker

17. Examples of Inflation Tax • Continental Congress in 1770s needed funds to pay for military. • Their limited ability to raise taxes or to borrow forced them to print money. • Prices rose more than a 100-fold over a few years. • After WWI, the Allies imposed war reparations on Germany. Not being able to make the payments, German government resorted to printing money. • Between 1921 and 1923 prices rose 100-fold. • Between 1923 and 1924 prices rose one-billion fold. Econ 202 Dr. Ugur Aker

18. Examples of Inflation Tax • To pay its creditors in 1998 Russia resorted to inflation tax. • Between Mar. 1998 and Mar. 1999, inflation in Russia was 130.5%. (The Economist, April 17, 1999, p. 112) • The latest inflation numbers from Russia are between Aug. 1999 and Aug. 2000: 18.8%. (The Economist, October 7, 2000, p. 124) Econ 202 Dr. Ugur Aker

19. The Fisher Effect • Lenders always lend funds above the expected inflation rate; otherwise, they would lose wealth. • Nominal interest rate is the interest rate the bank offers for deposits or charges for loans. • Real interest rate is nominal interest rate minus expected inflation rate. (Fisher equation) • Real interest rate is determined in the loanable funds market through the interaction of supply and demand. • Inflation is determined through the growth of money supply. Econ 202 Dr. Ugur Aker

20. Inflation Does Not Make Everyone Poorer • If everyone received a raise in their incomes equal to the inflation rate, their purchasing power will not change. • The society as a whole does increase its income in line with inflation; however, some gain and others lose. • Inflation is a tax on holders of money. It transfers income from them to the government. Econ 202 Dr. Ugur Aker

21. Costs of Inflation • Shoeleather costs • Menu costs • Increased variability of relative prices • Tax consequences • Confusion because of the change in unit of account • Arbitrary redistribution of wealth Econ 202 Dr. Ugur Aker

22. Shoeleather Costs • People change their behavior to avoid the inflation tax. • To get rid of money and other assets that have fixed values forces people to undertake efforts that use time and other resources that could have been devoted to productive use. • How could you beat inflation? • Keep lower money balances. (Demand for money low). • Exchange currency or other assets with fixed values to real assets or to currencies that are stable in value. Econ 202 Dr. Ugur Aker

23. Menu Costs • During high inflation the prices of goods and services will be adjusted upward frequently. • This takes time and effort and is a cost of business. • Catalogues, menus, price tags all need to be changed. Econ 202 Dr. Ugur Aker

24. Relative-price Variability • In an efficient market economy, prices reflect scarcity and allow efficient allocation of resources through the decisions of consumers and producers who respond to these prices. • During inflationary times, if prices aren’t updated as fast as the inflation, the relative price of an item will start being high and then will fall. • Consumers and producers will make their choices according to the changing relative prices, distorting efficient allocation of resources and, therefore, wasting resources. Econ 202 Dr. Ugur Aker

25. Inflation Induced Tax Distortions • Impact on capital gains. • You buy a house in 2000 for $100,000. In 2020 you sell the house for $200,000. • You have a capital gain of $100,000. • If the capital gain tax is 20%, you have to pay $20,000 in taxes. • Suppose during these twenty years CPI moved from 100 to 200. • In real terms, the value of your house stayed the same. • Yet you had to pay taxes on gains you did not have. Econ 202 Dr. Ugur Aker

26. Inflation Induced Tax Distortions • Impact on interest income. • You deposit $1000 in a certificate-of-deposit that pays 6% interest. • At the end of the year your interest earnings are $60. • You are in the income tax bracket of 30%. • You pay $18 in taxes. • Suppose inflation during this time was 4%. • The real rate of interest you earned is 2% (6-4=2). • Your real interest income was $20. • After paying the tax, your earnings were $2 or 0.2%. Econ 202 Dr. Ugur Aker

27. Inflation Induced Tax Distortions • In both cases, returns are much lower than they would have been if there were no inflation. • Lower returns will discourage saving. • Remember, saving is not-consuming. • Lower savings will have dampening effect on investments and future growth. • Indexing could solve this problem but would complicate calculations. Econ 202 Dr. Ugur Aker

28. Confusion and Inconvenience • In an inflationary environment, firms will show huge revenue gains. • They might even show huge profit gains. • Because these gains aren’t adjusted for inflation, evaluating the health and reliability of firms becomes more difficult. • It increases adverse selection problem and reduces the savings channeled into these firms. • If every accounting number were given in real terms, this problem wouldn’t have arisen. Econ 202 Dr. Ugur Aker

29. Arbitrary Redistribution of Wealth • Unexpected inflation redistributes wealth from creditors to debtors. • Today you borrow $10,000 at 8% interest rate. • The inflation rate people expect is 4%. • Suppose the inflation turns out to be 10%. • When you pay your loan back next year you pay less money in real terms than you borrowed. • You pay $10,800 but the real value of the $10,000 you borrowed is $11,000. Econ 202 Dr. Ugur Aker

30. Arbitrary Redistribution of Wealth • Unexpected inflation redistributes income away from fixed income earners to their employers. • You negotiate wages of $1000 per month hoping that there would be no inflation. • A monthly inflation of 1% takes place (over 12% annual inflation). • Your 12th payment is worth about $833 in real terms instead of the $1000 you expected to receive. • Your employer gained by paying less real wages each month. Econ 202 Dr. Ugur Aker

31. Arbitrary Redistribution of Wealth • Countries that have high inflation rates also have high variability in inflation rates. • High variability makes uncertainty arise. • Long term planning suffers. • Savings are reduced (adverse selection). • High variability makes unexpected inflation to become more of a force. • Winners and losers keep on changing creating social unrest. Econ 202 Dr. Ugur Aker

32. The Wizard of Oz • During unexpected inflation debtors win. • During unexpected deflation creditors win. • A unexpected decline in the price level between 1880 and 1896 hurt the farmers and workers because they were both heavily in debt. • Farmers borrowed from banks to plow and plant. • Workers borrowed from company stores. Econ 202 Dr. Ugur Aker

33. The Wizard of Oz • In accordance with the Quantity Theory of Money, an increase in price level could come through increasing money supply. • During this time US was under the gold standard. • The amount of money available in the system was determined by the amount of gold. • By allowing silver to be used along with gold to back money, the amount of money could be increased. • William Jennings Bryan Econ 202 Dr. Ugur Aker