• Inflation: the increase in the overall level of prices

• Deflation: the decrease in the overall level prices

• Hyperinflation: an extremely high rate of inflation

30-1 The Classical Theory of Inflation

The Level of Prices and the Value of Money

• Thinking of the price of a basket of goods and services, people have to pay more for the goods and services they buy.

• However, you can assume the price level as a measure of the value of money: a rise in the price level means a lower value of money. The opposite is true

Money Supply, Money Demand, and Monetary Equilibrium

• The demand for money reflects how much people value liquidity

  • Reliance on credit cards, etc

• The average level of prices in the economy affects the demand for money

• In the long run, money supply and money demand are brought into equilibrium by the overall level of prices

• At the equilibrium price level, the quantity of money wanted to be held = the quantity of money supplied by the Fed

• This equilibrium of money supply and money demand determines the value of money and the price level

The Effects of a Monetary Injection

• Quantity theory of money: a theory asserting that the quantity of money available determines the price level and that the growth rate in the quantity of money available determines the inflation rate

• The main cause of inflation is money being printed (a growth in quantity)

A Brief Look at the Adjustment Process

• A monetary injection creates an excess supply of money

• The supply of money is decreased by the buying of goods, services, or loaning of money. More money increases the demand for goods and services

• The overall price level for goods and services adjusts to bring money supply and money demand into balance

The Classical Dichotomy and Monetary Neutrality

• Nominal variables: variables measured in monetary units

• Real variables: variables measured in physical units

• Classical dichotomy: the theoretical separation of nominal variables and real variables

  • A dichotomy is a division into two groups

• A relative price is the price of one thing in terms of another

• Monetary neutrality: the proposition that changes in the money supply do not affect real variables

  • Money neutrality is not realistic in the short run, but, it will be realistic in the long run

Velocity and the Quantity Equation

• Velocity of money: the rate at which money changes hands

• To calculate the velocity of money, follow the equation: V = (P*Y)/M

  • P=price level (GDP deflator)

  • Y=quantity of output (real GDP)

  • M=quantity of money

  • V=Velocity

• This can also be written as: MV = PY

  • Quantity equation: MV = PY which relates the quantity of money, the velocity of money, and the dollar value of the economy’s output of goods and services

• 5 main points:

  • The velocity of money is stable in the long run

  • The quantity of M is proportionate to (P*Y) (the nominal value of output)

  • Y (goods & service output) are determined by factor supplies.

  • When the central bank alters M and is proportionate to (P*Y), there is a change in P

  • When the central bank increases the money supply rapidly, there is a high rate of inflation

The Inflation Tax

• Inflation tax: the revenue the government raises by creating money

• The inflation tax is like a tax on everyone who holds money

• Hyperinflation ends when the government institutes fiscal reforms that eliminate the need for inflation tax

The Fisher Effect

• The nominal interest rate is a typical bank interest rate.

• The real interest rate corrects the nominal interest rate for inflation. It refers to the purchasing power

• Real interest rate = Nominal interest rate - Inflation rate

• Nominal interest rate = Real interest rate + Inflation rate

• When the Fed increases the rate of money growth, the long-run result is both a higher inflation rate and a higher nominal interest rate

• Fisher effect: the one-for-one adjustment of the nominal interest rate to the inflation rate. This doesn’t hold in the short run because inflation does not follow a typical pattern in the short run, but it does in the long run

30-2 The Costs of Inflation

A Fall in Purchasing Power? The Inflation Fallacy

• Inflation does not in itself reduce people’s real purchasing power

Shoeleather Costs

• Tax is not a cost to society, it only transfers resources from households to the government

• Shoeleather costs: the resources wasted when inflation encourages people to reduce their money holdings

• Shoeleather costs can be large and can be considered wasted resources

Menu Costs

• Menu costs: the costs of changing prices

• This includes deciding, changing in distribution, and advertising new prices

• Inflation increases menu costs, especially during hyperinflations

Relative-Price Variability and the Misallocation of Resources

• Market companies rely on relative prices to allocate scare reasons

• Consumers use relative prices

• When inflation distorts relative prices, consumers are more mislead and markets adjust slowly

Inflation-Induced Tax Distortions

• Capital gains are the profits made by selling an asset for more than its purchase price

• The income tax treats the nominal interest earned on savings as income

Confusion and Inconvenience

• Both tax code and accountants incorrectly measure real incomes with inflation

• Inflation makes investors less able at differentiating successful with less successful firms

A Special Cost of Unexpected Inflation: Arbitrary Redistributions of Wealth

• Unexpected changes in price redistribute wealth among debtors and creditors

• Low average inflation is more stable than high average inflation

• There are redistributions of wealth when unexpected inflation occurs

Inflation Is Bad, but Deflation May Be Worse

• Deflation lowers the nominal interest rate, which reduces the cost of holding money

• Deflation is rarely steady and predictable and comes as a surprise

• Deflation is often a symptom