ECO1102 Macroeconomics - Money Growth and Inflation PDF

Chapter 11 Money growth and inflation ECO1102 Macroeconomics 1 l’Univeristé d’Ottawa / University of Ottawa 13:26 1 Mot...

Chapter 11 Money growth and inflation ECO1102 Macroeconomics 1 l’Univeristé d’Ottawa / University of Ottawa 13:26 1 Motivation Until mid-2021, Canada had experienced a quarter century of approximately 2 % annual inflation – Now running at about 3 %, but had risen to 8 % So until recently we were not covering it that much in this course It does vary a great deal historically, however – I lived through the inflationary 1970s myself – There was deflation (negative inflation) in the 1930s caused by the Great Depression – There was hyperinflation in central Europe in the 1920s 2 It also varies across countries – Over 1000 % these days in Argentina What are its causes? What can macroeconomic theory tell us? What are the macroeconomic consequences? 3 13:26 3  Miscellaneous points My presentation will be somewhat different from that found in the textbook – Parts of this chapter should be avoided The climate of low and stable inflation is thought to be ideal for economic prosperity Ordinary folk HATE inflation over 3 % or so, and so the issue is politically sensitive – Keeps Joe Biden’s approval rates lower than what would otherwise be the case ECO1102 Macroeconomics 4 Université d’Ottawa / University of Ottawa 13:26 4 – This direct effect of ‘getting squeezed’, or losing purchasing power, depends on the growth of incomes for households and the growth of revenues for firms In the 1970s price and wage controls were attempted to no avail The leader of the official opposition, MP Pierre Poilievre, has said that people can opt out of inflation by investing in Bitcoin – Total nonsense Later on we will cover monetary policy to combat inflation 5 Types of inflation Demand-pull, or overheating, inflation – Too many $ chasing too few goods and services pushes prices up Cost-push, or supply chain, inflation – Constraints on the supply side raise the costs of production Demand-shift inflation – Major shifts in the composition of aggregate expenditure can lead to production capacity constraints in some industries, causing shortages 6 13:26 6  ALL of these factors raised their ugly heads from 2021 to 2023 ECO1102 Macroeconomics Université d’Ottawa / University of Ottawa 7 The Classical Theory of Inflation Analogous to demand-pull inflation Applies in the long-run time horizon only Very orthodox view 8 Consider the variable of the composite price level P The growth rate of P is the inflation rate that we studied previously ∆𝑷 𝒅 𝒍𝒏 𝑷 – 𝒊𝒏 𝒅𝒊𝒔𝒄𝒓𝒆𝒕𝒆 𝒕𝒊𝒎𝒆 𝒐𝒓 in 𝑷 𝒅𝑷 continuous time There is an inverse relation between P and the value of money, also called purchasing power Value of money in terms of goods and services that can be purchased = 1 / P 9  Punchline: the quantity of money circulating in the economy determines its value = 1 / P – Provided that output is fixed Implies that the growth in the money supply (Ms) determines the inflation rate – Persistent positive growth in Ms causes inflation – Persistent negative growth in Ms causes deflation 10 The quantity equation M*V = P*Y – M = the nominal supply of money – P = the composite price level – Y = real GDP – V = the velocity of money = the speed at which $ 1 changes hands per year ECO1102 Macroeconomics 11 Université d’Ottawa / University of Ottawa 13:26 11 M*V = P*Y – P * Y = nominal GDP – Nominal GDP is a flow quantity (units: $ per year) – M is a stock quantity (units: $) – V is a frequency measure (units: # of hits per year) – Therefore, we have flow quantities on each side, and the units for each side are consistent with each other ECO1102 Macroeconomics 12 Université d’Ottawa / University of Ottawa 13:26 12  Implication of the quantity equation M*V = P*Y HOLD V and Y constant – According to the classicals, real GDP depends on strictly REAL, PHYSICAL factors: factor endowments and productivity, as depicted in chapter 7 13 13:26 13 The % change in the money supply = % change in the price level – In other words, the changes in P and are totally proportionate to each other – Can be either positive or negative in theory – page 228 ECO1102 Macroeconomics 14 Université d’Ottawa / University of Ottawa 13:26 14 Figure 11.3 – nominal GDP, money supply, velocity of money Copyright © 2020 by Nelson Education Ltd. 15  Figure 11.4 – hyperinflations 13:26 16 The Fisher Effect Real interest rate = nominal interest rate – inflation rate – By definition In the market for loanable funds, as far as savers and borrowers are concerned, what matters is the real interest rate Nominal interest rate = real interest rate + the inflation rate – That is just simple algebra ECO1102 Macroeconomics 17 Université d’Ottawa / University of Ottawa 13:26 17 Implication: when inflation rises, or when inflationary expectations rise, interest rates tend to rise in tandem This is not controversial, and this is what is occurring right now – Interest rates over the past year and a half have increased in lock-step with inflation ECO1102 Macroeconomics 18 Université d’Ottawa / University of Ottawa 13:26 18  Figure 11.5 FIGURE 11.5 The Nominal Interest Rate and the Inflation Rate ECO1102 Macroeconomics Université d’Ottawa / University of Ottawa 19 The Costs of Inflation 1. Shoe-leather costs 2. Menu costs 3. Relative-price variability and the misallocation of resources 4. Inflation-Induced Tax Distortions 5. Confusion and Inconvenience 6. Arbitrary Redistributions of Wealth ECO1102 Macroeconomics 20 Université d’Ottawa / University of Ottawa 13:26 20 What theme do they have in common? If inflation is low and stable, its effect on economic activity should be neutral – It is not economically desirable for economic actors (consumers, workers, investors, firms, land-owners) to base their choices on inflation rather than on economic fundamentals. – Inflation distorts such choices. 21 13:26 21  Shoe-leather costs – When inflation is fairly high or worse, money loses its function as a store of value. The value of savings and money held erodes very rapidly. – People have an incentive to either spend everything they have now or try to hedge their balances by converting the balances to some hard currency. – They waste a lot of time and effort doing so. ECO1102 Macroeconomics 22 Université d’Ottawa / University of Ottawa 13:26 22 Inflation-Induced Tax Distortions – Think of the loanable funds market – Unless inflation is pretty low, savers are SUCKERS even abstracting from taxes Unless the Fisher effect applies immediately – Interest and investment income (such as capital gains) are typically taxed in nominal terms as opposed to in real terms – This reduces the rate of return even further, and we are likely to see under-investment – Possible remedy: indexation of capital gains and interest income to inflation as far as tax liability is concerned 23 13:26 23 Arbitrary Redistributions of wealth when inflation is unexpected – Occurs between borrowers and savings – If inflation turns out to be higher than expected, borrowers who took out loans on long-term contracts get a windfall, as they are paying their loans back in DEFLATED $ – If inflation turns out to lower than expected, borrowers who took out loans on long-term contracts lose big time, as they are paying their loans back in INFLATED $ – No good economic reason for these gains and losses 24 13:26 24  It really distorts investment behaviour Related to point 3 Inflation can be really dangerous when people invest in speculative assets and ventures as opposed to more productive ones – E.g. gold and junk-bonds as opposed to more staid but tested and true productive investments ECO1102 Macroeconomics 25 Université d’Ottawa / University of Ottawa 13:26 25