Chapter 13

1. Chapter 13 Part 1 Inflation Equation of exchange

2. Laugher Curve Economics is the only field in which two people can share a Nobel Prize for saying opposing things. Specifically, Gunnar Myrdahland Friedrich S. Hayekshared one.

3. Some Basics about Inflation • Inflation is a continuous rise in the price level. • It is measured using a price index.

4. The Distributional Effects of Inflation • There are individual winners and losers in an inflation. • On average, winners and losers balance out.

5. The Distributional Effects of Inflation • The winners are those who can raise their prices or wages and still keep their jobs or sell their goods. • The losers in an inflation are those who cannot raise their wages or prices.

6. The Distributional Effects of Inflation • Unexpected inflation redistributes income from lenders to borrowers. • People who do not expect inflation and who are tied to fixed nominal contracts are likely lose in an inflation.

7. Expectations of Inflation • Expectations play a key role in the inflationary process. • Rational expectations are the expectations that the economists' model predicts. • Adaptive expectations are those based, in some way, on what has been in the past. • Extrapolative expectations are those that assume a trend will continue.

8. Productivity, Inflation, and Wages • Changes in productivity and changes in wages determine whether inflation may be coming. • There will be no inflationary pressures if wages and productivity increase at the same rate.

9. Productivity, Inflation, and Wages • The basic rule of thumb: Inflation = Nominal wage increases – Productivity growth

10. Deflation • Deflation is the opposite of inflation and is associated with a number of problems in the economy. • Deflation – a sustained fall in the price level.

11. Deflation • Deflation places a limit on how low the Fed can push the real interest rate. • Deflation is often associated with large falls in stock and real estate prices.

12. Theories of Inflation • The two theories of inflation are the quantity theory and the institutional theory. • The quantity theory emphasizes the connection between money and inflation. • The institutional theory emphasizes market structure and price-setting institutions and inflation.

13. The Quantity Theory of Money and Inflation • The quantity theory of money is summarized by the sentence: • Inflation is always and everywhere a monetary phenomenon.

14. The Equation of Exchange • Equation of exchange – the quantity of money times velocity of money equals price level times the quantity of real goods sold. MV = PQ • M = Quantity of money • V = velocity of money • P = price level • Q = real output • PQ = the economy’s nominal output

15. The Equation of Exchange • Velocity of money – the number of times per year, on average, a dollar goes around to generate a dollar’s worth of income.

16. Velocity Is Constant • The first assumption of the quantity theory is that velocity is constant. • Its rate is determined by the economy’s institutional structure.

17. Velocity Is Constant • If velocity remains constant, the quantity theory can be used to predict how much nominal GDP will grow. • Nominal GDP will grow by the same percent as the money supply grows.

18. Real Output Is Independent of the Money Supply • The second assumption of the quantity theory is that real output (Q) is independent of the money supply. • Q is autonomous – real output is determined by forces outside those in the quantity theory.

19. Real Output Is Independent of the Money Supply • The quantity theory of money says that the price level varies in response to changes in the quantity of money. • With both V and Q unaffected by changes in M, the only thing that can change is P. %M %P

20. Examples of Money's Role in Inflation • The quantity theory lost favor in the late 1980s and early 1990s. • The formerly stable relationships between measurements of money and inflation appeared to break down.

21. Examples of Money's Role in Inflation • The relationship between money and inflation broke down because: • Technological changes and changing regulations in financial institutions. • Increasing global interdependence of financial markets.

22. 6 5 4 Price level and money relative to real income (1960 = 1) 3 2 1 0 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 U.S. Price Level and Money Relative to Real Income Price level Money

23. Inflation and Money Growth • The empirical evidence that supports the quantity theory of money is most convincing in Brazil and Chile.

24. 100 90 80 70 60 50 40 30 20 10 0 0 30 40 50 60 70 80 90 100 Inflation and Money Growth Argentina Poland Annual percent change in inflation (%) Nicaragua Chile Zaire Indonesia U.S. 10 20 Annual percent change in the money supply (%)

25. The Inflation Tax • Central banks in nations such as Argentina and Chile are not a politically independent as in developed countries. • Their central banks sometimes increase the money supply to keep the economy running.

26. The Inflation Tax • The increase in money supply is caused by the government deficit. • The central bank must buy the government bonds or the government will default.

27. The Inflation Tax • Financing the deficit by expansionary monetary policy causes inflation.

28. The Inflation Tax • The inflation works as a kind of tax on individuals, and is often called an inflation tax. • It is an implicit tax on the holders of cash and the holders of any obligations specified in nominal terms.

29. The Inflation Tax • Central banks have to make a monetary policy choice: • Ignite inflation by bailing out their governments with an expansionary monetary policy. • Do nothing and risk recession or even a breakdown of the entire economy.

30. Policy Implications of the Quantity Theory • Supporters of the quantity theory oppose an activist monetary policy. • Monetary policy is powerful, but unpredictable in the short run. • Because of its unpredictability, monetary policy should not be used to control the level of output in an economy.

31. Policy Implications of the Quantity Theory • Quantity theorists favor a monetary policy set by rules not by discretionary monetary policy. • A monetary rule takes money supply decisions out of the hands of politicians.

32. Policy Implications of the Quantity Theory • Many central banks use monetary regimes or feedback rules. • New Zealand has a legally mandated monetary rule based on inflation. • The Fed does not have strict rules governing money supply, but it works hard to establish credibility that it is serious about fighting inflation.