chapter 13 part 1 inflation equation of exchange

Chapter 13Chapter 13

Part 1

Inflation

Equation of exchange

Laugher CurveLaugher Curve

Economics is the only field in which two people can share a Nobel Prize for saying opposing things.

Specifically, Gunnar Myrdahl and Friedrich S. Hayek shared one.

Some Basics about InflationSome Basics about Inflation

• Inflation is a continuous rise in the price level.

• It is measured using a price index.

The Distributional Effects of The Distributional Effects of InflationInflation

• There are individual winners and losers in an inflation.

• On average, winners and losers balance out.


• The winners are those who can raise their prices or wages and still keep their jobs or sell their goods.

• The losers in an inflation are those who cannot raise their wages or prices.


• Unexpected inflation redistributes income from lenders to borrowers.

• People who do not expect inflation and who are tied to fixed nominal contracts are likely lose in an inflation.

Expectations of InflationExpectations of Inflation

• Expectations play a key role in the inflationary process.– Rational expectations are the expectations that

the economists' model predicts.– Adaptive expectations are those based, in some

way, on what has been in the past.– Extrapolative expectations are those that

assume a trend will continue.

Productivity, Inflation, and Productivity, Inflation, and WagesWages

• Changes in productivity and changes in wages determine whether inflation may be coming.

• There will be no inflationary pressures if wages and productivity increase at the same rate.

Productivity, Inflation, and Productivity, Inflation, and WagesWages

• The basic rule of thumb:

Inflation = Nominal wage increases – Productivity growth

DeflationDeflation

• Deflation is the opposite of inflation and is associated with a number of problems in the economy.

• Deflation – a sustained fall in the price level.

DeflationDeflation

• Deflation places a limit on how low the Fed can push the real interest rate.

• Deflation is often associated with large falls in stock and real estate prices.

Theories of InflationTheories of Inflation

• The two theories of inflation are the quantity theory and the institutional theory.– The quantity theory emphasizes the connection

between money and inflation.– The institutional theory emphasizes market

structure and price-setting institutions and inflation.

The Quantity Theory of Money The Quantity Theory of Money and Inflationand Inflation

• The quantity theory of money is summarized by the sentence:

• Inflation is always and everywhere a monetary phenomenon.

The Equation of ExchangeThe Equation of Exchange

• Equation of exchange – the quantity of money times velocity of money equals price level times the quantity of real goods sold.

MV = PQ M = Quantity of money V = velocity of money P = price level

Q = real output PQ = the economy’s nominal

output

The Equation of ExchangeThe Equation of Exchange

• Velocity of money – the number of times per year, on average, a dollar goes around to generate a dollar’s worth of income.

supply Money

GDP NominalVelocity

Velocity Is ConstantVelocity Is Constant

• The first assumption of the quantity theory is that velocity is constant.

• Its rate is determined by the economy’s institutional structure.

Velocity Is ConstantVelocity Is Constant

• If velocity remains constant, the quantity theory can be used to predict how much nominal GDP will grow.

• Nominal GDP will grow by the same percent as the money supply grows.

Real Output Is Independent of the Real Output Is Independent of the Money SupplyMoney Supply

• The second assumption of the quantity theory is that real output (Q) is independent of the money supply.

• Q is autonomous – real output is determined by forces outside those in the quantity theory.

Real Output Is Independent of the Real Output Is Independent of the Money SupplyMoney Supply

• The quantity theory of money says that the price level varies in response to changes in the quantity of money.

• With both V and Q unaffected by changes in M, the only thing that can change is P.

%M %P

Examples of Money's Role in Examples of Money's Role in InflationInflation

• The quantity theory lost favor in the late 1980s and early 1990s.

• The formerly stable relationships between measurements of money and inflation appeared to break down.

Examples of Money's Role in Examples of Money's Role in InflationInflation

• The relationship between money and inflation broke down because:

– Technological changes and changing regulations in financial institutions.

– Increasing global interdependence of financial markets.

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U.S. Price Level and Money U.S. Price Level and Money Relative to Real IncomeRelative to Real Income

Money

Price level

Inflation and Money GrowthInflation and Money Growth

• The empirical evidence that supports the quantity theory of money is most convincing in Brazil and Chile.

Inflation and Money GrowthInflation and Money Growth

10 20Annual percent change in the money supply (%)

30 40 50 60 70 80 90 1000

1009080706050403020100

Annu

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Indonesia

Chile

Poland

Argentina

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U.S.

The Inflation TaxThe Inflation Tax

• Central banks in nations such as Argentina and Chile are not a politically independent as in developed countries.

• Their central banks sometimes increase the money supply to keep the economy running.


• The increase in money supply is caused by the government deficit.

• The central bank must buy the government bonds or the government will default.


• Financing the deficit by expansionary monetary policy causes inflation.


• The inflation works as a kind of tax on individuals, and is often called an inflation tax.

• It is an implicit tax on the holders of cash and the holders of any obligations specified in nominal terms.


• Central banks have to make a monetary policy choice:

– Ignite inflation by bailing out their governments with an expansionary monetary policy.

– Do nothing and risk recession or even a breakdown of the entire economy.

Policy Implications of the Policy Implications of the Quantity TheoryQuantity Theory

• Supporters of the quantity theory oppose an activist monetary policy.– Monetary policy is powerful, but unpredictable

in the short run.– Because of its unpredictability, monetary policy

should not be used to control the level of output in an economy.


• Quantity theorists favor a monetary policy set by rules not by discretionary monetary policy.

• A monetary rule takes money supply decisions out of the hands of politicians.


• Many central banks use monetary regimes or feedback rules.

– New Zealand has a legally mandated monetary rule based on inflation.

– The Fed does not have strict rules governing money supply, but it works hard to establish credibility that it is serious about fighting inflation.

chapter 13 part 1 inflation equation of exchange

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