University of California Los Angeles

Summer 2017 Session A

Economics 102 Macroeconomic Theory
Instructor: Konstantin Platonov
kplatonov@ucla.edu

Lecture 4: Money, Price Level, and Inflation

Now we know how to solve for the equilibrium in the economy. Factor markets determine the
equilibrium quantities of inputs, and the equilibrium GDP is determined by the production func-
tion. Then, given the level of GDP, households determine how much they would like to consume
and save, and the equilibrium on the loanable funds market determines the equilibrium interest
rate, investment and savings. All the variables we have discussed were real, that is, in terms of
goods. For instance, we would say: The real wage is equal to 50 pounds apples, rather than
The real wage is equal to $100. We have said nothing about nominal variablesthe variables
measured in units of money (dollars). This lecture fills this gap.

1 The Definition of Money

Money is anything that satisfies the following three properties:
Medium of exchange: money helps transact. In the absence of money, when goods and
services are directly traded for other goods and services, trade is called barter trade. This
is very inconvenient and results in big transaction costs.
Unit of account: money is a common unit to measure the value of any good or service, as
well as time, risks, etc.
Store of value: money is a way to transfer wealth in the future.
During early stages of the development of our society, people used commodity money. This is a
good that has the functions of money, in addition to its own use. This money has intrinsic value.
Examples include precious metals, grain, cigarettes, alcohol, and even food. Commodity money
seems riskless because there is no fear that this money will depreciate: it can always be used for
its direct purpose. However, the use of commodity money is inconvenient: transportation and
storage of commodity money are usually costly, and such money is not perfectly divisible. Finally,
there is no control over the quantity of money, which makes the value of money (the purchasing
power of money) unstable.
A particular example of the commodity money is gold. During the 19-20th centuries, many
countries adhered to the gold standard. A gold standard is a monetary system in which the

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value of money is pegged to gold. Namely, government issues banknotes and backs them with
gold. Every person who held a banknote was able to convert it back to gold on demand. The
gold standard would significantly reduce transaction costs without casting doubt on the value
of money: people would accept paper money because they knew every dollar could be easily
exchanged for gold. However, it would also make government keep huge gold reserves. More
importantly, government could not still perfectly control the quantity of money in the economy.
It could keep part of its gold reserves and not give it away, but if government was to increase the
quantity of money in the economy, it would need to find new goldmines.
The disadvantages of commodity money led to the creation of fiat moneymoney that has no
intrinsic value. Fiat money must be legal tender and every economic agent must believe in the
value of fiat money. Workers will accept fiat money if and only if they believe a cashier at a
store will accept them. A store will accept them if and only if it believes that this money will be
accepted for other payments. Introducing fiat money helps governments to take control over the
quantity of money in the economy, but this is where the credibility of money matters a lot.
Nowadays, nearly all countries use fiat money, the value of which is backed by nothing except
the reputation of the central bank and its promise that it will keep the value of money stable.
Moreover, now the share of cash in the total quantity of money is very small as more and more
transactions are made with electronic money using plastic cards and cashless payments. We
barely see the money we use.

2 Supply of Money
The quantity of money in the economy is determined by the central bank. Every country that
uses national currency has its own central bank. In the United States, it is the Federal Reserve
System (or simply the Fed). In the eurozone, it is the European Central Bank. In England, this
is the Bank of England. In China, this is the Bank of China. At every point in time, the supply of
money is predetermined by the policy of the central bank. It can be changed only by the central
bank.

3 The Quantity Theory of Money

3.1 Velocity of Money and the Quantity Equation

Let M denote the quantity of money in the economy, or the money supply. Define the velocity of
money:
PY
V = . (1)
M
The velocity of money is a ratio of nominal GDP P Y and the quantity of money M . It shows
how much of nominal GDP one dollar can buy. Intuitively, the velocity shows, how fast money

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changes hands. If V is a large number, then the same amount of money M generates a bigger
value of nominal GDP P Y .
The Quantity Theory of Money states: if V is a constant number, the quantity equation holds:

M V = P Y. (2)

This equation says that nominal GDP is proportional to the stock of money. Given the values
for M (determined by the Central bank), V (this is a behavioral parameter), and Y (determined
by the production function), the price level adjusts to satisfy the quantity equation. Moreover,
the price level moves one-to-one with the money supply.
The Quantity Theory provides the theory of the price level. It says that the central bank deter-
mines the money supply, and the money supply determines the price level.

3.2 From Price Level to Inflation

Rewrite equation (2) in terms of percentage increases:

M V P Y
+ = + . (3)
M V P Y
Here, M/M is the growth rate of money, P/P = is the inflation rate, and Y /Y = g
is the rate of economic growth. The Quantity Theory of Money assumes V is constant, so
V /V = 0.
What happens if the supply of money increases by 5%? We know that the rate of economic growth
depends only on technology, capital and labor. If they do not change, the rate of economic growth
is zero. Plugging zeros for V /V and Y /Y in equation (3), we obtain

M
= = 5%. (4)
M
Therefore, an increase in the money supply causes inflation of the same rate. Note that all real
prices (real wage, real interest rate, real price of capital) remain unchanged, whereas all nominal
prices (P , W and R) increase by 5%.
The result that real variables are determined independently from nominal variables is called the
classical dichotomy. It says that all the real variables do not depend on the money supply, and the
money supply determines only the nominal variables. The other result is the money neutrality.
It says that shifts in the money supply do not affect real variables.
The value $1/P is called the purchasing power of a dollar. It shows how much of goods and services
one dollar buys. For instance, if a person has $100 and the price of apples if $4 per pound, the
purchasing power of her money is 100/4 = 25 pounds of apples. When there is inflation and P
rises over time, the purchasing power of the same amount of dollars depreciates.

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4 What Determines the Velocity of Money?
The assumption of a constant velocity of money may seem too strict. Indeed, the velocity can
change from day to day depending on the moods and needs of economic agents. What determines
the velocity of money?

4.1 Interest Rates: Real and Nominal

The interest rate we considered in Lecture 3 was real: it showed the price of a loan in terms
of goods. However, when it comes to money, we need to look at the nominal interest rate
denoted i.
The nominal interest rate is the interest rate paid on money. For instance, a deposit in a bank
of $100 may pay 4%. This means that, at the beginning of next year, the account holder will
receive $100 + 0.04 $100 = $104. Does it mean that the account holder is 4% richer? Not really.
If there is inflation of 3% over that year, the real interest rate is only 4% 3% = 1%. Instead,
if the rate of inflation was 5%, that person would even lose purchasing power because her real
interest rate would be 1%. When r = 1%, in a year from now, she will be able to buy 1% less
of goods than now (even though nominally her wealth went up).
Most of the contracts and agreements are made at the beginning of the year when nobody knows
what inflation will be. Therefore, economic agents base their decision on the expected rate of
inflation e . The superscript e stand for expected. If a person lends money, believes the
inflation would be e and would like to receive the real rate r at the end of the year, she would
set the nominal interest rate equal to
i = r + e. (5)
This equation is called the Fisher equation, after a famous economist Irving Fisher who con-
tributed to the theory of inflation and interest rates in the fist half of the 20th century.

4.2 Demand for Money

Households keep money. They need money for purchasing goods and services. However, what
households really need is purchasing power. Therefore, the correct statement is: households
demand purchasing power, or real money balances, M/P . This demand function is called the
liquidity function and depends on two arguments: real GDP Y and nominal interest rate i.
 D
M
= L(Y, i). (6)
P

Do not confuse the liquidity function L with labor L. Both notations are conventional and may
indeed be confusing.

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The liquidity function has the following properties:
L L
> 0, < 0. (7)
Y i

The first property is called the transaction motive for holding money: the bigger real income Y ,
the more real money balances M/P households need to make the desired purchases. The second
property is called the speculative motive against holding money: the bigger the nominal interest
rate i, the bigger the opportunity cost of holding money, and the less money households would
like to hold (and the more money will be held in a saving account).
Example 1 shows how the demand for money determines the velocity of money.
Example 1. Let the liquidity function be L(Y, i) = Y /(2i). Find the velocity of money.
At equilibrium, the real balances demanded are equal to the real supply of money:
 D
M M M M Y
= = = L(Y, i) = = . (8)
P P P P 2i

Use the definition of the velocity of money (1):

PY Y Y
V = = = = 2i. (9)
M M/P Y /(2i)

End of Example 1.
The velocity of money is an increasing function of the nominal interest rate. Indeed, if the nominal
interest rate goes up, the opportunity costs of holding money are bigger, and households would
not like to hold money for a long period of time. They would prefer to purchase goods or deposit
money in a bank account. Money will change hands faster when the (nominal) interest rate is
high.
We remember that the real interest rate comes from the equilibrium on the loanable funds market.
The expected inflation is determined by the expectations about the future. If we consider the
expected inflation as a given parameter, the velocity of money is pinned down by the condition
that V = V (i) and i = r + e .

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5 Inflation and Hyperinflation

5.1 Costs of Inflation

The model we have discussed so far does not explain, why inflation is bad. Indeed, from our
assumptions, inflation does not affect real GDP, employment, or real consumption. Inflation
is merely a change in the units of measurement. Why are we concerned so much about infla-
tion?
Inflation generates costs. When inflation is small and predictable, these costs are of small impor-
tance. High and volatile inflation, however, amplifies these costs. In extreme cases of hyperinfla-
tion the monetary system may completely break down as money will be absolutely worthless.
Costs of expected inflation:
Shoeleather costs: If expected inflation e is high, given the real interest rate r, the nominal
interest rate i is also high. People would hold less money ((M/P )D goes down) and would
need to make more frequent trips to the ATM to withdraw money. Putting this literally,
making more trips to the bank wears out ones shoes. The shoeleather costs are basically
zero in advanced economies but are still relevant for some developing countries.
Menu costs: The costs to firms of updating posted prices. When prices change frequently,
firms need to print and distribute new catalogs. With the spread of online shopping, how-
ever, the menu cost are very small.
Relative price distortions: Remember that inflation is only average growth in prices. Not all
the prices increase simultaneously which causes relative prices to be distorted. As economic
agents respond to prices, relative price distortions lead to sub-optimal decisions made by
agents and misallocation of resources.
Unfair tax treatment: Some taxes do not take into account inflation; government levies taxes
on nominal income, not on real income. Therefore, even if a person had no real income over
a year, she may still have to pay.
Example: Unfair tax treatment of capital gains. Capital gain is the income earned on the
difference is stock prices. At the beginning of the year, a person buys $100 worth of Apple
stock. Suppose she sells this stock at the end of the year for $105. The capital gain would
be (105 100)/100 100% = 5%. If inflation was equal to 5% as well, she made no real
profit: the 5% of capital gain are depreciated by 5% inflation. Her real capital gain would
be equal to 5% 5% = 0%. Yet, she has to pay taxes on her nominal capital gain of 5%,
making her effectively lose money.
General inconvenience: When one dollar is worth different amounts of goods in different
years, it is hard to compare the purchasing powers of money. This complicates long-term
planning a lot and leads to overall uncertainty about the future.

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Additional costs of unexpected inflation:
Redistribution of purchasing power: When economic agents contract at the beginning of the
year, they set the nominal interest i is based on their desired interest rate r and expected
inflation e . This interest rate i is set in contracts and agreements. At the end of the year,
the realized real interest rate may differ from the desired one if actual inflation is not equal
to expected inflation.
For example, Mr. X borrows $100 from Mrs. Y. Both persons agree on the real interest
rate to be r = 2% and expect inflation of e = 3%. They thus contract on the nominal
interest rate of i = r + e = 2 + 3 = 5%. At the end of the year, the actual inflation rate
turns out to be = 5%. The realized real interest rate is rrealized = i = 5 5 = 0%.
The borrower has to pay zero in real terms! The borrower gains, the lender loses.
Increased uncertainty: when there are big differences between expected inflation e and
actual inflation , economic risks increase due to arbitrary redistribution of wealth be-
tween lenders and borrowers. This makes it harder to plan the future in such uncertain
environment.

5.2 Inflation as a Self-Fulfilling Prophecy

From the Quantity Theory of Money it follows: in order to keep inflation low and predictable,
the central bank should keep the growth of money low and predictable. Does this rule work? Not
always. The problem about inflation is that it may arise as a self-fulfilling prophecy.
Suppose there appear totally unreasonable rumors that inflation will increase in the future. Eco-
nomic agents revise their expectations, and expected inflation e goes up. Then they would set
higher nominal interest rates to cover up higher inflation and, at the same time, would hold less
money. People would avoid money by exchanging it for goods and services faster. The money
velocity would increase. According to the quantity equation (2), if money supply and output are
constant, higher velocity V leads to higher price level P and, therefore, inflation. In this exam-
ple, inflation occurs only because economic agents expected inflation. Hadnt economic agents
expected inflation, would there have been no inflation at all!

e = i = (M/P )D and V = P =

5.3 Hyperinflation

Hyperinflation is very BIG inflation. We can speak about hyperinflation if the inflation rate
exceeds 50% per month. [Question: if the inflation rate is 50% per month, how big is the
inflation rate per annum?]
Many countries experienced spells of hyperinflation. The main source of hyperinflation is printing
new money. Usually, it is the government that has big debt and starts to print new money

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to finance its debt. The bigger the debt, the more money needs the government. Here come
inflation expectations in play: rational economic agents know that the government is going to
print money, so they expect high inflation in advance. As we have just seen, increased inflation
expectations raise the actual inflation even if the money supply has not increased yet. The
inflation expectations are usually persistent: once people believe in high inflation, it is hard to
reduce their expectations.
When inflation accelerates, it is very hard to stop it. Not only the price level grows, the rate
of inflation grows. That is, the price level grows at faster and faster rate. People start to avoid
money: it makes no sense to keep money because it will be worth almost nothing in a small period
of time.
What should government do to stop a hyperinflation or a very high inflation? We see that the core
problem is high inflationary expectations. To reduce them and bring trust back to the financial
system, besides big changes in policy, government may need to resort to drastic measures:
Create a new currency (Germany 1923, USSR 1924, Hungary 1946, China 1955, Poland
1990, among other countries)
Fixing exchange rate: fixing exchange rate means that government will have to keep up
with the amount of dollars in the world. This puts discipline on the monetary authorities
and will not allow them to engage in inflationary policy. Such policy, however, wont work
if population does not trust the government (Bolivia 1985, Argentina 1991 and many other
countries)
Dollarization: abandon the local currency and start using the U.S. dollar or any other stable
currency. This solves the problem of inlfationary expectations because the local authorities
cannot print dollars, hence they cannot expand the money supply indefinitely (a recent
example is Zimbabwe 2011)

6 Putting Pieces Together: The Neoclassical Model of the

Economy
The chart below shows how different concepts studied in this class are connected with each
other.

Further Reading
Mankiw Ch. 4, ch. 5

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