Chapter 5. Inflation
Chapter 5. Inflation: Its Causes and Effects
Split off from Chapter 4 in the previous editions.
Mention classical dichotomy
Skip appendix
Homework: p. 128-29 # 2, 3
Skip Appendix
Homework pp. 128-29, #2, 3
Link to syllabus
Quantity Equation: MV = P x T (transactions) or MV = P x Y
(Y is output, or real income) (p. 103, 104). [is an identity]
Look at demand for money, esp. real money balances: M/P.
Relate this to the simplest money demand function, (M/P)d = kY. So
V = 1/k. Friedman thought money demand was stable, so V bar.
MV = P x T (transactions) or MV = P x
Y
Equation of Exchange:
MV = P x Y
Y is output, or real income, rather than transactions (p. 103, 104).
Note, V is defined as P x Y/M, so the equation is an identity – it has
to be true. What is open to discussion is whether or not V and Y are
constant.
From calculus, %ΔM + %ΔV = %ΔP + %ΔY (p. 106).
where %Δ is ‘the percentage change;’ %ΔM is ΔM/M
This is the basis of Friedman’s proposed monetary growth rule.
Comparisons of
Velocities of M
%ΔM + %ΔV = %ΔP + %ΔY (p. 106).
Is velocity constant?
Comparisons of velocities.
Different
Text.
Milton Friedman, 1912-2006
Leader of anti-government movement,
which we see in rejection of discretionary
policies, and preference for rules.
Monetarism
Monetary Growth rule
Consumption function
(Introduced expectations into macro)
Flexible exchange rates
Paraphrase of Robert Solow – also a Brooklyn-born Nobel Prize Winner,
and a prominent Keynesian:
“Milton is obsessed by the quantity of money, and always puts it into his
papers. I’m obsessed by sex, but I don’t put it into all my papers.”
Friedman: resurgence of free market
economics. Monetarism
2
Quantity theory: M determines nominal GDP.
If Y=Ybar, then we have the classical dichotomy: changes in M
don’t affect output nor employment or real interest rates, but
only affect prices.
Mentions seigniorage: revenue received through printing money.
Small: in U.S., ~ 3% of gov’t revenue. Higher elsewhere.
Perhaps was important in American Revolution, when deficits
led to inflation. Stopped by adoption of gold standard
Fig. 4-1 p. 86. Historical Data on U.S.
Inflation and Money Growth
Fig. 5-1 p. 107. Historical Data on U.S.
Inflation and Money Growth
Good support for quantity theory in %Δ
form
Fig. 4-2 p. 87. International Comparisons of
Inflation and Money Growth
Fig. 5-2 p. 108. International
Comparisons of Inflation and Money
Growth
Stronger support for quantity theory.
Also comments that quantity theory is
better as a long run theory.
Monetary Growth Rule (see page 532 of text):
Monetary
Growth Rule i
Monet
ary
Growt
h Rule
i
Monetary Growth Rule ii
Real interest rate = nominal interest rate – inflation (r = i -Π). Vision
of r being determined by real factors, and inflation by money
growth.
3
Fisher effect: i = r + Π. Point is one for one, between inflation and
interest rates.
Fig. 4-3 p. 90. Inflation and Nominal Interest Rates
Irving Fisher. 1867-1947
Irving Fisher was one of the earliest American neoclassicals of unusual mathematical sophistication.
(1) his contributions to the Walrasian theory of
equilibrium price (he also invented the indifference
curve device) in 1892; 2) his volumes on the theory
of capital and investment (1896, 1898, 1906, 1907, 1930) which
brought the Austrian intertemporal theories into the English-speaking
world, wherein he introduced the famous distinction between "stocks"
and flows", the Fisher Separation Theorem and the loanable funds
theory of interest rates. 3) his famous resurrection of the quantity theory
of money (1911, 1932, 1935); (4) the theory of index numbers (1922);
This Yale economist was an eccentric and colorful figure. When Irving
Fisher wrote his 1892 dissertation, he constructed a remarkable machine
equipped with pumps, wheels, levers and pipes in order to illustrate his
price theory - see here for pictures of his draft and his first and second
prototypes. Socially, he was an avid advocate of eugenics and health
Fig.He4-4
p.a91.
Inflation
and Interest
food diets.
made
fortune
with his visible
index cardRates,
system known today as the rolodex
- and advocated
the establishment of an
different
countries
100% reserve requirement banking system His fortune was lost and his
reputation was severely marred by the 1929 Wall Street Crash, when
just days before the crash, he was reassuring investors that stock prices
were not overinflated but, rather, had achieved a new, permanent
plateau.
Fig. 5-3 p. 111. Inflation and Nominal
Interest Rates.
Mankiw is more positive than I about
empirical support.
Irving Fisher 1867-1947
Fig. 5-4 p. 112. Inflation and Interest
Rates, different countries
Describes this as evidence for the Fisher
effect.
Discussion of linkages, focusing on actual and expected inflation.
Fig. 4-5 p. 94. Linkages among Money,
Prices, and Interest Rates
Fig. 5-5 p. 124. Linkages among Money,
Prices, and Interest Rates.
Md=L(i, Y) =Ms=M/P
But i = r + Πe
And Πe can be affected by several
factors, so classical dichotomy is too
simple.
Social costs of inflation.
Incorrect to say that inflation always reduces real wage or income.
Distinguish:
4
Expected inflation: all prices, wages, profits will go up same rate
Shoe leather costs of going to bank might increase
Menu costs of adjusting prices
Distortionary effect of taxes
Cost of information rises
Unexpected inflation
Helps debtors, hurts creditors
One benefit is alleged effect of inflation greasing the wheels of
the labor market.
Hyperinflation in Bolivia, Germany, Zimbabwe. What causes it?
Too much money. Caused by deficits, caused by weak tax
structures (caused by weak governments). Notes that solution to
hyperinflations is usually accompanied by fiscal reform
(political change)
Fig. 4-6 p.
106. Money
and Prices in
Interwar
Germany.
Fig. 4-6 p. 110. Money and Prices in Interwar
Germany.
Inflation lowering real money balances.
Summary: classical dichotomy characterized by monetary neutralitymoney supply doesn’t affect real variables. Nominal variables
are wages, prices, nominal interest rates (exchange rates). Real
variables.
For long run stories, money neutrality is a good story, but not so good
for short run economic fluctuations.
2. In the country of Wicknam, velocity of money is constant. If
Real GDP grows by 5 percent per year, the money stock by 14%
per year, and the nominal interest rate is 11%, what is the real interest
rate? Note also:
#4. During WWII, both England and Germany had printed up each
other’s money, to use as a weapon
5
#5 Inflation as reputation. (demand for money)
#8 If consumption depends on real money balances… (wealth
effect—Mundell/Tobin)