Modern Principles of Economics PDF - Chapter 31

MODERN PRINCIPLES OF ECONOMICS Sixth Edition Chapter 31 Inflation and the Quantity...

MODERN PRINCIPLES OF ECONOMICS Sixth Edition Chapter 31 Inflation and the Quantity Theory of Money AI generated image provided by Alex Tabarrok © 2024 Worth Publishers. All Rights Reserved.  Outline Defining and Measuring Inflation The Quantity Theory of Money The Costs of Inflation Takeaway © 2024 Worth Publishers. All Rights Reserved.  Introduction Zimbabwe President Robert Mugabe's policy of seizing commercial farms drove away entrepreneurs and investors. To bribe his enemies and pay the army, he simply printed more money. The economy was flooded with money but could not produce more goods. Prices went up: The inflation rate increased from 50% per year to 50% per month to more than 50% per day. © 2024 Worth Publishers. All Rights Reserved.  Definition (1 of 8) Inflation: An increase in the average level of prices. © 2024 Worth Publishers. All Rights Reserved.  Inflation (1 of 4) Inflation is measured by changes in a price index. The inflation rate is the percentage change in a price index from one year to the next. P2  P1 Inflation rate  %  = ×100 P where P2 is the index value in year 2, and P1 is the index value in year 1. © 2024 Worth Publishers. All Rights Reserved. Inflation (2 of 4) © 2024 Worth Publishers. All Rights Reserved.  Self-Check (1 of 5) If the price index is 200 in year 1 and 210 in year 2, the rate of inflation is: a. 4.76%. b. 5%. c. 20%. © 2024 Worth Publishers. All Rights Reserved.  Self-Check (1 of 5) (Answer) If the price index is 200 in year 1 and 210 in year 2, the rate of inflation is: a. 4.76%. b. 5%. c. 20%. Answer: b. The rate of inflation is (210 – 200) / 200 × 100 = 5%. © 2024 Worth Publishers. All Rights Reserved.  Price Indexes 1. Consumer price index (CPI): Measures the average price for a basket of goods and services bought by a typical American consumer; covers 80,000 goods and services and is weighted so major items count more. 2. GDP deflator: The ratio of nominal to real GDP multiplied by 100; covers finished goods and services. 3. Producer price indexes (PPI): Measure the average price received by producers; includes intermediate and finished goods and services. © 2024 Worth Publishers. All Rights Reserved.  Relevance of CPI as a Price Index For Americans, CPI is the measure of inflation that corresponds most directly to their daily economic activity. The Bureau of Labor Statistics (BLS) computes the CPI. It tries to take both new goods and higher-quality goods into account when computing the CPI. © 2024 Worth Publishers. All Rights Reserved. Inflation (3 of 4) © 2024 Worth Publishers. All Rights Reserved.  Effect of Inflation on Price The effect of inflation on a large basket of goods © 2024 Worth Publishers. All Rights Reserved.  Definition (2 of 8) Real price: A price that has been corrected for inflation. Real prices are used to compare the prices of goods over time. © 2024 Worth Publishers. All Rights Reserved.  Real Prices The CPI is used to calculate real prices. 1982 2006 Gallon of gasoline $1.25 $2.50 CPI 100 202 202 $1.25   $2.53 100 The real price of gasoline (adjusted for inflation) was slightly lower in 2006 than it was in 1982. © 2024 Worth Publishers. All Rights Reserved.  Inflation (4 of 4) Inflation rate in selected countries In 2021, Venezuela had the highest inflation rate in the world at 2,700%. Greece and Japan had slight deflations. © 2024 Worth Publishers. All Rights Reserved.  Hyperinflation Hyperinflation occurs when price increases are so out of control that the concept of inflation is meaningless. Hungary's postwar hyperinflation is the largest on record. After World War II, 1945–1946, the cumulative inflation rate was 1.3 × 1024%. The maximum inflation rate on a monthly rate basis was 4.19 × 1016%. © 2024 Worth Publishers. All Rights Reserved.  Self-Check (2 of 5) A real price is a price that has been corrected for: a. population growth. b. foreign currency exchange rates. c. inflation. © 2024 Worth Publishers. All Rights Reserved.  Self-Check (2 of 5) (Answer) A real price is a price that has been corrected for: a. population growth. b. foreign currency exchange rates. c. inflation. Answer: c. A real price is a price that has been corrected for inflation. © 2024 Worth Publishers. All Rights Reserved.  Quantity Theory of Money (1 of 5) The quantity theory of money Sets out the general relationship between money, velocity, real output, and prices Helps to explain the critical role of the money supply in determining the inflation rate © 2024 Worth Publishers. All Rights Reserved.  Quantity Theory of Money (2 of 5) Mv = PYR where: M = Money supply P = Price level v = Velocity of money YR = Real GDP Since Mv is the total amount spent on finished goods and services, and PYR is the price level times real GDP, both sides of this equation are also equal to nominal GDP. © 2024 Worth Publishers. All Rights Reserved.  Definition (3 of 8) Velocity of money (v): The average number of times a dollar is spent on finished goods and services in a year. In short, it refers to how fast money passes from one holder to the next. © 2024 Worth Publishers. All Rights Reserved.  Quantity Theory of Money (3 of 5) We assume that both real GDP (YR) and velocity (v) are stable compared to the money supply (M). – Real GDP is fixed by the real factors of production: capital, labor, and technology. – The velocity of money is determined by factors that change only slowly, such as how often workers are paid, or how long it takes to clear a check. – In the United States, the velocity of money is about 7. © 2024 Worth Publishers. All Rights Reserved.  Quantity Theory of Money (4 of 5) The quantity theory of money in a nutshell When v and Y are fixed (indicated by the top bar), increases in M must cause increases in P. © 2024 Worth Publishers. All Rights Reserved.  Self-Check (3 of 5) The number of times a dollar is spent on final goods and services in a year is called the: a. quantity theory of money. b. velocity of money. c. currency turnover rate. © 2024 Worth Publishers. All Rights Reserved.  Self-Check (3 of 5) (Answer) The number of times a dollar is spent on final goods and services in a year is called the: a. quantity theory of money. b. velocity of money. c. currency turnover rate. Answer: b. The velocity of money is the number of times a dollar is spent on final goods and services in a year. © 2024 Worth Publishers. All Rights Reserved.  Quantity Theory of Money (5 of 5) If YR is fixed by the real factors of production and v is stable, then the only thing that can cause an increase in P is an increase in M. – In other words, inflation is caused by an increase in the supply of money. The quantity theory of money also says that the growth rate of the money supply will be approximately equal to the inflation rate. © 2024 Worth Publishers. All Rights Reserved.  The Cause of Inflation (1 of 3) "Inflation is always and everywhere a monetary phenomenon." Milton Friedman, 1912–2006 © 2024 Worth Publishers. All Rights Reserved.  The Cause of Inflation (2 of 3) Nations with rapidly (slowly) growing money supplies had high (low) inflation rates. As indicated by the red line, on average, the relationship is almost perfectly linear, with a 10% increase in the money growth rate leading to a 10% increase in the inflation rate. "Inflation is always and everywhere a monetary phenomenon." © 2024 Worth Publishers. All Rights Reserved.  Definition (4 of 8) Deflation: A decrease in the average level of prices (a negative inflation rate). Disinflation: A reduction in the inflation rate. © 2024 Worth Publishers. All Rights Reserved.  The Cause of Inflation (3 of 3) An unexpected increase in the money supply can boost the economy in the short run. As firms and workers come to expect and adjust to the new influx of money, output will not grow any faster than normal. In the long run, money is neutral. © 2024 Worth Publishers. All Rights Reserved.  The Costs of Inflation Four problems associated with inflation: 1. There is price confusion and money illusion. 2. Inflation redistributes wealth. 3. Inflation interacts with other taxes. 4. Inflation is painful to stop. © 2024 Worth Publishers. All Rights Reserved.  Price Confusion and Money Illusion Inflation makes price signals more difficult to interpret. It is not always clear whether prices are rising because of increased demand or because of an increase in the money supply. We sometimes mistake inflation for higher wages and prices in real terms. Resources are wasted in activities that appear profitable but are not, and resources flow more slowly to profitable uses. © 2024 Worth Publishers. All Rights Reserved.  Definition (5 of 8) Money illusion: When people mistake changes in nominal prices for changes in real prices. © 2024 Worth Publishers. All Rights Reserved.  Inflation Redistributes Wealth (1 of 6) Inflation is a type of tax that transfers real resources from citizens to the government. Inflation reduces the real return that lenders receive on loans, transferring wealth from lenders to borrowers. When inflation and interest rates fall unexpectedly, wealth is redistributed from borrowers (who are paying higher rates) to lenders. © 2024 Worth Publishers. All Rights Reserved.  Self-Check (4 of 5) A decrease in the average level of prices is called: a. deflation. b. disinflation. c. money illusion. © 2024 Worth Publishers. All Rights Reserved.  Self-Check (4 of 5) (Answer) A decrease in the average level of prices is called: a. deflation. b. disinflation. c. money illusion. Answer: a. A decrease in the average level of prices is called deflation. © 2024 Worth Publishers. All Rights Reserved.  Definition (6 of 8) Real rate of return: The nominal rate of return minus the inflation rate. Nominal rate of return: The rate of return that does not account for inflation. © 2024 Worth Publishers. All Rights Reserved.  Inflation Redistributes Wealth (2 of 6) The relationship between the lender's real rate of return, the nominal rate of return, and the inflation rate is: rReal = i − π where: rReal = Real interest rate i = Nominal rate of interest π = Rate of inflation The real rate of return is equal to the nominal rate of return minus the inflation rate. © 2024 Worth Publishers. All Rights Reserved.  Definition (7 of 8) Fisher effect: The tendency of nominal interest rates to rise with expected inflation rates. © 2024 Worth Publishers. All Rights Reserved.  Inflation Redistributes Wealth (3 of 6) When lenders expect inflation to increase, they will demand a higher nominal interest rate. The Fisher effect says that the nominal interest rate is equal to the expected inflation rate plus the equilibrium real interest rate. It also says the nominal rate will rise with expected inflation. © 2024 Worth Publishers. All Rights Reserved.  Inflation Redistributes Wealth (4 of 6) The Fisher effect: i = Eπ + rEquilibrium where: rEquilibrium = Equilibrium real rate of return i = Nominal rate of interest Eπ = Expected rate of inflation © 2024 Worth Publishers. All Rights Reserved.  The Fisher Effect Nominal interest rates tend to increase with inflation rates. © 2024 Worth Publishers. All Rights Reserved.  Inflation Redistributes Wealth (5 of 6) Unexpected Inflation Unexpected Disinflation Expected Inflation = Actual Inflation (Eπ < π) (Eπ > π) (Eπ = π) Real rate less than Real rate greater than Real rate equal to equilibrium rate equilibrium rate equilibrium rate Harms lenders Benefits lenders No redistribution of wealth Benefits borrowers Harms borrowers © 2024 Worth Publishers. All Rights Reserved.  Definition (8 of 8) Monetizing the debt: When the government pays off its debts by printing money. © 2024 Worth Publishers. All Rights Reserved.  Inflation Redistributes Wealth (6 of 6) A government with massive debts has an incentive to increase the money supply, since it benefits from unexpected inflation. The government doesn't always inflate its debt away for two reasons: – If lenders expect inflation, they will increase nominal rates. – Buyers of bonds are often also voters, who would be upset if real returns were shrunk. © 2024 Worth Publishers. All Rights Reserved.  Self-Check (5 of 5) A government monetizes its debt by: a. raising interest rates. b. lowering interest rates. c. printing money to pay off the debt. © 2024 Worth Publishers. All Rights Reserved.  Self-Check (5 of 5) (Answer) A government monetizes its debt by: a. raising interest rates. b. lowering interest rates. c. printing money to pay off the debt. Answer: c. A government monetizes its debt by printing money to pay off the debt. © 2024 Worth Publishers. All Rights Reserved.  Breakdown of Financial Intermediation (1 of 2) When nominal interest rates are not allowed to rise and the inflation rate is high, the real rate of return will be negative. People take their money out of the banking system. The supply of savings falls, and financial intermediation becomes less efficient. Negative real interest rates reduce financial intermediation and economic growth. © 2024 Worth Publishers. All Rights Reserved.  Breakdown of Financial Intermediation (2 of 2) When inflation is volatile and unpredictable, long-term loans become riskier. Few long-term contracts will be signed. Any contract involving future payments will be affected by inflation. © 2024 Worth Publishers. All Rights Reserved.  Inflation Interacts with Other Taxes Most tax systems define incomes, profits, and capital gains in nominal terms. Inflation will produce some tax burdens and liabilities that do not make economic sense. If asset prices rise due to inflation, people pay capital gains taxes when they should not. Inflation can push people into higher tax brackets. Corporations pay taxes on phantom profits. © 2024 Worth Publishers. All Rights Reserved.  Inflation Is Painful to Stop The government can reduce inflation by reducing the growth in the money supply. When inflation is expected, lower inflation may be misinterpreted as a reduction in demand. Firms reduce output and employment. Workers may become unemployed as the unexpected increase in their real wage makes them unaffordable. Expectations will eventually adjust in the long run. © 2024 Worth Publishers. All Rights Reserved.  Takeaway (1 of 2) Inflation is an increase in the average level of prices as measured by a price index. Sustained inflation is always and everywhere a monetary phenomenon. Although money is neutral in the long run, changes in the money supply can influence real GDP in the short run. Inflation makes price signals more difficult to interpret. © 2024 Worth Publishers. All Rights Reserved.  Takeaway (2 of 2) The tendency of the nominal interest rate to increase with expected inflation is called the Fisher effect. Arbitrary redistributions of wealth make lending and borrowing riskier and thus break down financial intermediation. Anything above a mild rate of inflation is generally bad for an economy. © 2024 Worth Publishers. All Rights Reserved.