Inflation: Its Causes, Effects, and Social Costs PDF

5 Inflation: Its Causes, Effects, and Social Costs MACROECONOMICS N. Gregory Mankiw Fall 2014 PowerPoint Slides by Ron Cronovich ® update © 2015 Wo...

5 Inflation: Its Causes, Effects, and Social Costs MACROECONOMICS N. Gregory Mankiw Fall 2014 PowerPoint Slides by Ron Cronovich ® update © 2015 Worth Publishers, all rights reserved  Introduction  In most modern economies, most prices tend to rise over time. This increase in the overall level of prices is called inflation.  Earlier in the chapter 2, we examined how economists measure the inflation rate as the percentage change in the consumer price index (CPI) and the GDP deflator. CHAPTER 5 Inflation 2  Introduction  Inflation may seem natural and inevitable to a person who grew up in the United States during recent decades, but in fact, it is not inevitable at all.  There were long periods in the 19th century during which most prices fell—a phenomenon called deflation. The average level of prices in the U.S. economy was 23 percent lower in 1896 than in 1880, and this deflation was a major issue in the presidential election of 1896. Farmers, who had accumulated large debts, suffered when declines in crop prices reduced their incomes and thus their ability to pay off their debts. They advocated government policies to reverse the deflation. CHAPTER 5 Inflation 3  Introduction  The public often views such high rates of inflation as a major economic problem  An extraordinarily high rate of inflation such as this is called hyperinflation  A classic example is Germany in 1923, when prices increased an average of 500 percent per month. More recently, similar examples of extraordinary inflation gripped the nations of Zimbabwe in 2008 and Venezuela in 2017 CHAPTER 5 Inflation 4  Introduction  In this chapter we examine the classical theory of the causes and effects of inflation.  The theory is “classical” in the sense that it assumes that prices are flexible. As discussed in Chapter 2, most economists believe this assumption describes the behavior of the economy in the long run.  For now, we ignore short-run price stickiness. As we will see, the classical theory of inflation provides a good description of the long run and a useful foundation for the short-run CHAPTER 5 Inflation 5  IN THIS CHAPTER, YOU WILL LEARN:  The classical theory of inflation  causes  effects  “Classical” – assumes prices are flexible & markets clear  Applies to the long run 6  The quantity theory of money CHAPTER 5 Inflation 7  The quantity theory of money  In Chapter 4 we defined what money is and learned that the quantity of money available in the economy is called the money supply.  With that foundation, we can now start to examine the macroeconomic effects of monetary policy. policy To do this, we need a theory that tells us how the quantity of money is related to other economic variables, such as prices and incomes.  The theory we develop in this section, called the quantity theory of money, has its roots in the work of the early monetary theorists, including the philosopher and economist David Hume (1711–1776) CHAPTER 5 Inflation 8  The quantity theory of money  The starting point of the quantity theory of money is the insight that people hold money to buy goods and services. The more money they need for such transactions, the more money they hold.  Thus, the quantity of money in the economy is related to the number of dollars exchanged in transactions. CHAPTER 5 Inflation 9  The quantity theory of money  The link between transactions and money is expressed in the following equation, called the quantity equation: Money × Velocity = Price × Transactions M × V = P × T Let’s examine each of the four variables in this equation CHAPTER 5 Inflation 10  The quantity theory of money P×T The right-hand side of the quantity equation tells us about transactions. T represents the total number of transactions during some period of time, say, a year. T is the number of times in a year that goods or services are exchanged for money. P is the price of a typical transaction—the number of dollars exchanged. The product of the price of a transaction and the number of transactions, P × T, equals the number of dollars exchanged in a year CHAPTER 5 Inflation 11  The quantity theory of money M × V The left-hand side of the quantity equation tells us about the money used to make the transactions. M is the quantity of money. V, called the transactions velocity of money, measures the rate at which money circulates in the economy. In other words, velocity tells us the number of times a dollar bill changes hands in a given period of time. CHAPTER 5 Inflation 12  The quantity theory of money  For example, suppose that 50 loaves of bread are sold in a given year at $2 per loaf. Then T equals 50 loaves per year, and P equals $2 per loaf. The total number of dollars exchanged is P × T= $2/loaf × 50 loaves/year=$100/year The right-hand side of the quantity equation equals $100 per year, the dollar value of all transactions. Suppose further that the quantity of money in the economy is $20. By rearranging the quantity equation, we can compute velocity a That is, for $100 of transactions per year to take place with $20 of money, each dollar must change hands 5 times per year. CHAPTER 5 Inflation 13  Velocity  basic concept: the rate at which money circulates  definition: the number of times the average dollar bill changes hands in a given time period  example: In 2015,  $500 billion in transactions  money supply = $100 billion  The average dollar is used in five transactions in 2015  So, velocity = 5 CHAPTER 5 Inflation 14  From Transactions to Income  When studying the role of money in the economy, economists usually use a slightly different version of the quantity equation than the one just introduced.  The problem with the first equation is that the number of transactions is difficult to measure. To solve this problem, the number of transactions T is replaced by the total output of the economy Y CHAPTER 5 Inflation 15  From Transactions to Income.  Use nominal GDP as a proxy for total transactions. Then, V × M= P × Y P Y V where M P = price of output (GDP deflator) Y = quantity of output (real GDP) P×Y = value of output (nominal GDP) CHAPTER 5 Inflation 16  The Money Demand Function and the Quantity Equation CHAPTER 5 Inflation 17  Money demand and the quantity equation  When we analyze how money affects the economy, it is often useful to express the quantity of money in terms of the quantity of goods and services it can buy. This amount, M/P, is called real money balances.  Real money balances measure the purchasing power of the stock of money.  For example, consider an economy that produces only bread. If the quantity of money is $20, and the price of a loaf is $2, then real money balances are 10 loaves of bread. That is, at current prices, the stock of money in the economy can buy 10 loaves. CHAPTER 5 Inflation 18  Money demand and the quantity equation  M/P = real money balances, the purchasing power of the money supply.  A simple money demand function: (M/P )d = k Y where k = how much money people wish to hold for each dollar of income. (k is exogenous) This equation states that the quantity of real money balances demanded is proportional to real income. CHAPTER 5 Inflation 19  Money demand and the quantity equation  M/P = real money balances, the purchasing power of the money supply.  A money demand function is an equation that shows the determinants of the quantity of real money balances people wish to hold.  A simple money demand function: (M/P )d = k Y where k = how much money people wish to hold for each dollar of income. (k is exogenous) This equation states that the quantity of real money balances demanded is proportional to real income. CHAPTER 5 Inflation 20  Money demand and the quantity equation  Just as owning an automobile makes it easier for a person to travel, holding money makes it easier to make transactions.  Therefore, just as higher income leads to a greater demand for automobiles, higher income also leads to a greater demand for real money balances GDP (constant ), GDP per capita (constant M$, 2023 2015 US$), 2023 USA 21 776 284 65 020 China 17 173 989 12 174 Japan 4 616 966 37 079 Germany 3 622 499 42 878 Tunisia 48 611 3 901 Burndi 3 470 262 CHAPTER 5 Inflation 21  Money demand and the quantity equation  money demand: (M/P )d = k Y M/P = K × Y M ×1/K= P ×Y  quantity equation: M×V = P×Y  The connection between them: V = 1/K CHAPTER 5 Inflation 22  Money demand and the quantity equation  The connection between them: V = 1/K  These connection show the link between the demand for money and the velocity of money. – When people want to hold a lot of money for each dollar of income (k is large), money changes hands infrequently (V is small). – Conversely, when people want to hold only a little money (k is small), money changes hands frequently (V is large) In other words, the money demand parameter k and the velocity of money V are opposite sides of the same coin. . CHAPTER 5 Inflation 23  The Assumption of Constant Velocity CHAPTER 5 Inflation 24  Back to the quantity theory of money  The quantity equation can be viewed as a definition: it defines velocity V as the ratio of nominal GDP, PY, to the quantity of money M. Yet if we make the additional assumption that the velocity of money is constant, then the quantity equation becomes a useful theory about the effects of money, called the quantity theory of money.  Like many of the assumptions in economics, the assumption of constant velocity is only a simplification of reality.  Nonetheless, experience shows that the assumption of constant velocity is useful in many situations. Let’s therefore assume that velocity is constant and see what this assumption implies about the effects of the money supply on the economy CHAPTER 5 Inflation 25  Back to the quantity theory of money  starts with quantity equation  assumes V is constant & exogenous: V  V Then, quantity equation becomes: M  V  P Y CHAPTER 5 Inflation 26  The quantity theory of money, cont. M  V  P Y How the price level is determined:  With V constant, the money supply determines nominal GDP (P × Y ). That is, if velocity is fixed, the quantity of money determines the dollar value of the economy’s output.  Real GDP is determined by the economy’s supplies of K and L and the production function (Chap. 3).  The price level is P = (nominal GDP)/(real GDP). CHAPTER 5 Inflation 27  The quantity theory of money, cont. M  V  P Y This theory explains what happens when the central bank changes the supply of money. Because velocity V is fixed, any change in the money supply M must lead to a proportionate change in the nominal value of output P × Y. Because the factors of production and the production function have already determined output Y, the nominal value of output P × Y can adjust only if the price level P changes. Hence, the quantity theory implies that the price level is proportional to the money supply. CHAPTER 5 Inflation 28  The quantity theory of money, cont.  Recall from Chapter 2: The growth rate of a product equals the sum of the growth rates. M  V % Change in M + % Change in V = % Change in P + % Change in Y  P  Y The quantity equation in growth rates: M V P Y    M V P Y The quantity theory of money assumes V CHAPTER 5 Inflation V is constant, so = 0. 29 V  The quantity theory of money, cont. M V P Y    M V P Y Consider each of these four terms. First, the percentage change in the quantity of money, %ΔM, is under the control of the central bank. Second, the percentage change in velocity, %ΔV is constant Third, the percentage change in the price level, %ΔP, is the rate of inflation; Fourth, the percentage change in output, %ΔY, depends on growth in the factors of production and on technological progress, which for our present purposes we are taking as given. CHAPTER 5 Inflation 30  The quantity theory of money, cont. π (Greek letter pi ) P   denotes the inflation rate: P The result from the M P Y   preceding slide: M P Y Solve this result for π: CHAPTER 5 Inflation 31  The quantity theory of money, cont.  Normal economic growth requires a certain amount of money supply growth to facilitate the growth in transactions.  Money growth in excess of this amount leads to inflation. CHAPTER 5 Inflation 32  The quantity theory of money, cont. ΔY/Y depends on growth in the factors of production and on technological progress (all of which we take as given, for now). Hence, the quantity theory predicts a one-for-one relation between changes in the money growth rate and changes in the inflation rate. CHAPTER 5 Inflation 33  The quantity theory of money, cont.  Normal economic growth requires a certain amount of money supply growth to facilitate the growth in transactions.  Money growth in excess of this amount leads to inflation.  Example : Suppose real GDP is growing by 3% per year over the long run. Thus, production, income, and spending are all growing by 3%. This means that the volume of transactions will be growing as well.  The central bank can achieve zero inflation (on average over the long run) simply by setting the growth rate of the money supply at 3%, in which case exactly enough new money is being supplied to facilitate the growth in transactions. CHAPTER 5 Inflation 34  The quantity theory of money, cont.  Note: the theory doesn’t predict that the inflation rate will equal the money growth rate. It predicts that a change in the money growth rate will cause an equal change in the inflation rate. CHAPTER 5 Inflation 35  The quantity theory of money, cont. ΔY/Y depends on growth in the factors of production and on technological progress (all of which we take as given, for now) Thus, the quantity theory of money states that the central bank, which controls the money supply, has ultimate control over the rate of inflation. If the central bank keeps the money supply stable, the price level will be stable. If the central bank increases the money Inflation supply CHAPTER 5 rapidly, the price level will rise rapidly 36  Confronting the quantity theory with data The quantity theory of money implies: 1. Countries with higher money growth rates should have higher inflation rates. 2. The long-run trend in a country’s inflation rate should be similar to the long-run trend in the country’s money growth rate. Are the data consistent with these implications? CHAPTER 5 Inflation 37  Confronting the quantity theory with data “Inflation is always and everywhere a monetary phenomenon.” So wrote Milton Friedman, the great economist who won the Nobel Prize in economics in 1976. The quantity theory of money leads us to agree that the growth in the quantity of money is the primary determinant of the inflation rate. Friedman, together with fellow economist Anna Schwartz, wrote two treatises on monetary history that documented the sources and effects of changes in the quantity of money over the past century CHAPTER 5 Inflation 38 CHAPTER 5 Inflation 39  Confronting the quantity theory with data As you may have learned in a statistics class, one way to quantify a relationship between two variables is with a measure called correlation. A correlation is +1 if the two variables move exactly in tandem, 0 if they are unrelated, and –1 if they move exactly opposite each other. Precedent Figure, the correlation is 0.79, indicating that the two variables move closely together CHAPTER 5 Inflation 40  Confronting the quantity theory with data  Next Figure examines the same question using international data. It shows the average rate of inflation and the average rate of money growth in 123 countries during the period from 2007 to 2016.  Again, the link between money growth and inflation is clear.  Countries with high money growth (such as Ghana and Mozambique) tend to have high inflation, and countries with low money growth (such as Japan and the United States) tend to have low inflation.  The correlation here is 0.70. CHAPTER 5 Inflation 41 CHAPTER 5 Inflation 42  Seigniorage: The Revenue from Printing Money CHAPTER 5 Inflation 43  Seigniorage  So far, we have seen how growth in the money supply causes inflation.  With inflation as a consequence, what would ever induce a central bank to increase the money supply substantially? CHAPTER 5 Inflation 44 Seigniorage  Some of this spending is to buy goods and services (and some is to provide transfer payments)  A government can finance its spending in three ways.  First, it can raise revenue through taxes, such as personal and corporate income taxes.  Second, it can borrow from the public by selling government bonds.  Third, it can print money. The revenue raised by the printing of money is called seigniorage. CHAPTER 5 Inflation 45  Seigniorage  The “revenue” raised from printing money is called seigniorage (pronounced SEEN-your-idge).  When the government prints money to finance expenditure, it increases the money supply. The increase in the money supply, in turn, causes inflation.  Printing money to raise revenue is like imposing an inflation tax CHAPTER 5 Inflation 46  Seigniorage  The inflation tax: Printing money to raise revenue causes inflation. Inflation is like a tax on people who hold money.  At first, inflation might not look like a tax. After all, no one receives a bill for it—the government just prints the money it needs.  Who, then, pays the inflation tax? The answer is the holders of money. As prices rise, the real value of the money in your wallet falls. Therefore, when the government prints new money for its use, it makes the old money in the hands of the public less valuable. In essence, inflation is a tax on holding money CHAPTER 5 Inflation 47  Seigniorage  The amount of revenue raised by printing money varies from country to country. In the United States, the amount has been small: seigniorage has usually accounted for less than 3 percent of government revenue.  In Italy and Greece, seigniorage has often been more than 10 percent of government revenue.  In countries experiencing hyperinflation, seigniorage is often the government’s chief source of revenue CHAPTER 5 Inflation 48  Inflation and interest rates CHAPTER 5 Inflation 49  Inflation and interest rates  As we first discussed in Chapter 3, interest rates are among the most important macroeconomic variables  The interest rate that the bank pays is the nominal interest rate, and the increase in your purchasing power is the real interest rate  Nominal interest rate, i not adjusted for inflation  Real interest rate, r adjusted for inflation: r = i − π CHAPTER 5 Inflation 50  The Fisher effect  Rearranging terms in our equation for the real interest rate, we can show that the nominal interest rate is the sum of the real interest rate and the inflation rate: i =r +π  The equation written in this way is called the Fisher equation, after economist Irving Fisher (1867–1947).  It shows that the nominal interest rate can change for two reasons: because the real interest rate changes or because the inflation rate changes CHAPTER 5 Inflation 51  The Fisher effect  The Fisher equation: i = r + π  Once we separate the nominal interest rate into these two parts, we can use this equation to develop a theory that explains the nominal interest rate. 1. Chap. 3: S = I determines r. 2. The quantity theory of money shows that the rate of money growth determines the rate of inflation. 3. The Fisher equation then tells us to add the real interest rate and the inflation rate together to determine the nominal interest rate, CHAPTER 5 Inflation 52  The Fisher effect  The quantity theory and the Fisher equation together tell us how money growth affects the nominal interest rate.  According to the quantity theory, an increase in the rate of money growth of 1 percent causes a 1 percent increase in the rate of inflation.  According to the Fisher equation, a 1 percent increase in the rate of inflation in turn causes a 1 percent increase in the nominal interest rate.  The one-for-one relation between the inflation rate and the nominal interest rate is called the Fisher effect. This one-for-one relationship is called the Fisher effect. CHAPTER 5 Inflation 53 U.S. inflation and nominal interest rates, 1960–2014 nominal interest rate inflation rate   Precedent Figure shows the variation over time in the nominal interest rate and the inflation rate in the United States from 1960 to 2015.  You can see that the Fisher effect has done a good job of explaining fluctuations in the nominal interest rate during this period. When inflation is high, nominal interest rates are typically high, and when inflation is low, nominal interest rates are typically low as well.  The correlation between the inflation rate and the nominal interest rate is 0.76 CHAPTER 5 Inflation 55  Inflation and nominal interest rates in 96 countries Nominal Correlation=0,75 Turkey interest rate (percent) Georgia Malawi Ghana Mexico Brazil Poland Iraq U.S. Japan Kazakhstan Inflation rate (percent)   Similar support for the Fisher effect comes from examining the variation across countries.  As Precedent Figure shows, a nation’s inflation rate and its nominal interest rate are related. Countries with high inflation tend to have high nominal interest rates as well, and countries with low inflation tend to have low nominal interest rates.  The correlation between these two variables is 0.75. CHAPTER 5 Inflation 57 NOW YOU TRY Applying the theory Suppose V is constant, M is growing 5% per year, Y is growing 2% per year, and r = 4. a. Solve for i. b. If the Fed increases the money growth rate by 2 percentage points per year, find Δi. c. Suppose the growth rate of Y falls to 1% per year.  What will happen to π?  What must the Fed do if it wishes to keep π constant? 58 ANSWERS Applying the theory V is constant, M grows 5% per year, Y grows 2% per year, r = 4. a. First, find π = 5 − 2 = 3. Then, find i = r + π = 4 + 3 = 7. b. Δi = 2, same as the increase in the money growth rate. c. If the Fed does nothing, Δπ = 1. To prevent inflation from rising, Fed must reduce the money growth rate by 1 percentage point per year. 59  Two Real Interest Rates: Ex Ante and Ex Post CHAPTER 1 The Science of Macroeconomics 60  Two real interest rates When a borrower and lender agree on a nominal interest rate, they do not know what the inflation rate over the term of the loan will be. Therefore, we must distinguish between two concepts of the real interest rate: The real interest rate that the borrower and lender expect when the loan is made, called the ex ante real interest rate. The real interest rate that is actually realized, called the ex post real interest rate. CHAPTER 5 Inflation 61  Two real interest rates Notation:  π = actual future inflation rate (not known until after it has occurred)  Eπ = expected future inflation rate Two real interest rates:  Ex ante real interest rate = i – Eπ : the real interest rate people expect at the time they buy a bond or take out a loan  Ex post real interest rate = i – π : the real interest rate actually realized The two real interest rates differ when actual inflation π differs from expected inflation Eπ CHAPTER 5 Inflation 62  Money demand and the nominal interest rate CHAPTER 5 Inflation 63  Money demand and the nominal interest rate  In the quantity theory of money, the demand for real money balances depends only on real income Y.  Another determinant of money demand— the nominal interest rate CHAPTER 5 Inflation 64  Money demand and the nominal interest rate  The Cost of Holding Money The money you hold in your wallet does not earn interest. If, instead of holding that money, you used it to buy government bonds or deposited it in a savings account, you would earn the nominal interest rate. Therefore, the nominal interest rate is the opportunity cost of holding money: it is what you give up by holding money rather than bonds. CHAPTER 5 Inflation 65  Money demand and the nominal interest rate Another way to see that the cost of holding money equals the nominal interest rate is by comparing the real returns on alternative assets. Assets other than money, such as government bonds, earn the real return r. Holding money: money earns an expected real return of −Eπ, because its real value declines at the rate of inflation. When you hold money, you give up the difference between these two returns. Thus, the cost of holding money is r−(−Eπ) = r + Eπ = i, which the Fisher equation tells us is the nominal interest rate. CHAPTER 5 Inflation 66  The money demand function (M P )  L(i , Y ) d (M/P )d = real money demand, depends  negatively on i i is the opp. cost of holding money  positively on Y higher Y increases spending on g & s, so increases need for money (“L” is used for the money demand function because money is the most liquid asset.) CHAPTER 5 Inflation 67  The money demand function (M P )  L(i , Y ) d  L(r  E  , Y ) When people are deciding whether to hold money or bonds, they don’t know what inflation will turn out to be. Hence, the nominal interest rate relevant for money demand is r + Eπ. CHAPTER 5 Inflation 68  Equilibrium M  L(r  E  , Y ) P The supply of real money balances Real money demand CHAPTER 5 Inflation 69  What determines what M  L(r  E  , Y ) P variable how determined (in the long run) M exogenous (the Fed) r adjusts to ensure S = I Y Y F ( K , L ) M P adjusts to ensure P L(i ,Y ) CHAPTER 5 Inflation 70  What determines what M  L(r  E  , Y ) P The last equation tells a more sophisticated story about the determination of the price level than does the quantity theory. The quantity theory of money says that today’s money supply determines today’s price level. This conclusion remains partly true: if the nominal interest rate and output are held constant, the price level moves proportionately with the money supply. Yet the nominal interest rate is not constant; it depends on expected inflation, which in turn depends on growth in the money supply. CHAPTER 5 Inflation 71  What determines what The presence of the nominal interest rate in the money demand function yields an additional channel through which money supply affects the price level. This general money demand equation implies that the price level depends not only on today’s money supply but also on the money supply expected in the future CHAPTER 5 Inflation 72  What determines what To see why: 1.Suppose the Fed announces that it will increase the money supply in the future, but it does not change the money supply today. 2.This announcement causes people to expect higher money growth and higher inflation. 3.Through the Fisher effect, this increase in expected inflation raises the nominal interest rate. 4.The higher nominal interest rate increases the cost of holding money and therefore reduces the demand for real money balances. 5.Because the Fed has not changed the quantity of money available today, the reduced demand for real money balances leads to a higher price level. Hence, expectations of higher money growth in the future lead to a higher price level today. CHAPTER 5 Inflation 73  How P responds to ΔM M  L(r  E  , Y ) P  For given values of r, Y, and Eπ , a change in M causes P to change by the same percentage—just like in the quantity theory of money. CHAPTER 5 Inflation 74  What about expected inflation?  Over the long run, people don’t consistently over- or under-forecast inflation, so Eπ = π on average.  In the short run, Eπ may change when people get new information.  EX: Fed announces it will increase M next year. People will expect next year’s P to be higher, so Eπ rises.  This affects P now, even though M hasn’t changed yet…. CHAPTER 5 Inflation 75  How P responds to ΔE π M  L(r  E  , Y ) P  For given values of r, Y, and M ,  E   i (the Fisher effect)  M P  d    P to make M P  fall to re-establish eq'm CHAPTER 5 Inflation 76  The Classical Dichotomy  Neutrality of money: Changes in the money supply do not affect real variables. In the real world, money is approximately neutral in the long run. CHAPTER 5 Inflation 77