Money Growth and

Inflation

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 The Meaning of Money
• Money is the set of assets in an economy that
people regularly use to buy goods and services
from other people.

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 THE CLASSICAL THEORY OF
INFLATION
• Inflation is an increase in the overall level of
prices. A rise in price level means your value of
money has fallen.
Example: A cone of ice cream has risen over a
period from TK 5 to Tk 15? Why?
Over time the money used to buy ice cream
has become less valuable.
• Hyperinflation is an extraordinarily high rate of
inflation.
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 THE CLASSICAL THEORY OF
INFLATION
• Inflation: Historical Aspects
• Over the past 60 years, prices have risen on average
about 5 percent per year.
• Deflation, meaning decreasing average prices,
occurred in the U.S. in the nineteenth century.
• Hyperinflation refers to high rates of inflation such
as Germany experienced in the 1920s.

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 THE CLASSICAL THEORY OF
INFLATION
• Inflation: Historical Aspects
• In the 1970s prices rose by 7 percent per year.
• During the 1990s, prices rose at an average rate of 2
percent per year.

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 THE CLASSICAL THEORY OF
INFLATION
• The quantity theory of money developed by
David Hume in the 18th century and is used to
explain the long-run determinants of the price
level and the inflation rate.
• Inflation is an economy-wide phenomenon that
concerns the value of the economy’s medium of
exchange.
• When the overall price level rises, the value of
money falls.
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 Value of Money explained by
Mathematics
• Let us assume that P is the price of an ice cream cone.
• When price of a cone is 2 then the value of $ is 1/P = ½ cone.
Value of $ means how many cone you can buy with 1 $.
• When price rises to $3 the value if dollar falls to 1/3 of a cone.

So logically we see that if the price of a good increases the value

of money falls.

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What determines the value of money?
Money Supply, Money Demand, and
Monetary Equilibrium
What determines the value of money ?
Just like the supply and demand determines the
value of cone, the supply and demand for
money determines the value of money.
• The money supply is a policy variable that is
controlled by the Fed.
• Through instruments such as open-market
operations such as buying and selling bonds, the
Fed together with the banking system controls the
quantity of money supplied.
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Money Supply, Money Demand, and
Monetary Equilibrium
• Money demand reflects how much wealth
people want to hold in liquid form. The several
determinants of money demand include interest
rates and the average level of prices in the
economy.

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Money Supply, Money Demand, and
Monetary Equilibrium
• People hold money because it is the medium of
exchange.
• The amount of money people choose to hold
depends on the prices of goods and services.
• The higher prices are , more money is required to
carry out a typical transaction.
• So higher price level (lower value of money)
increases the quantity of money demanded.

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Money Supply, Money Demand, and
Monetary Equilibrium
• In the long run, the overall level of prices
adjusts to the level at which the demand for
money equals the supply.

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 …continued
• The ideas of money supply and demand can be explained using
a Fig 1. The horizontal axis of the graph shows the quantity of
money. The vertical axis on the left shows value of money and
the vertical axis on the right shows the price level. One is the
opposite image of the other.
• The two curves are the supply and demand curves.
• The supply curve of money is vertical because the quantity of
money supplied by the Fed is fixed.
• The demand curve is downward sloping because people want to
hold a larger quantity of money when each dollar buys less.
• The equilibrium is point A where the value of money and price
level have adjusted to bring the quantity of money supplied and
money demanded into balance.
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 Figure 1 Money Supply, Money Demand, and the
Equilibrium Price Level

Value of Price
Money, 1/P Money supply Level, P

(High) 1 1 (Low)

3
/4 1.33

A
/
12 2

Equilibrium Equilibrium
value of price level
money
14
/ 4
Money
demand
(Low) 0 (High)
Quantity fixed Quantity of
by the Fed Money

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 Figure 2 The Effects of Monetary Injection

Value of Price
Money, 1/P MS1 MS2 Level, P

(High) 1 1 (Low)

1. An increase
3
/4 in the money 1.33
2. . . . decreases supply . . .
the value of
3. . . . and
money . . . A
12
/ 2 increases
the price
level.
B
14
/ 4
Money
demand
(Low) (High)
0 M1 M2 Quantity of
Money

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 The effects of monetary injection
• What happens when the FED doubles its money
supply by printing money or open market
operations?
• The monetary injection shifts the supply curve from
MS1 to MS2 as shown in Fig 2.
• The equilibrium moves from point A to point B. Value
of money falls, price level increases.

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 The Classical Theory of Inflation
• The Quantity Theory of Money
• How the price level is determined and why it might
change over time is called the quantity theory of
money.
• The quantity of money available in the economy
determines the value of money.
• The primary cause of inflation is the growth in the
quantity of money.

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The Classical (early economic
thinkers)Dichotomy (division)and Monetary
Neutrality
• Nominal variables are variables measured in monetary units.
• Real variables are variables measured in physical units.
Example:
• The income of farmers is a nominal variable but the quantity of
bushel (how much they produce) is a real variable.
• Nominal GDP is nominal because it measures the $ value of
economy’s output of goods and services. Real GDP is real
variable because it determines the total output produced and is
not influenced by the current prices of those goods and services.
This separation is called the monetary dichotomy.

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The Classical Dichotomy and Monetary
Neutrality
• According to Hume and others, real economic
variables do not change with changes in the
money supply.
• According to the classical dichotomy, different
forces influence real and nominal variables. Real
variables such as production, employment, real
wages and real interest rates are unchanged. Nominal
variables on the other hand such as price level, dollar
wage and other dollar value change.
• Changes in the money supply affect nominal
variables but not real variables.
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The Classical Dichotomy and Monetary
Neutrality
• The irrelevance of monetary changes for real
variables is called monetary neutrality.

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Velocity and the Quantity Equation

• The velocity of money refers to the speed at

which the typical dollar bill travels around the
economy from wallet to wallet. It is the rate at
which money changes hand.

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Velocity and the Quantity Equation

V = Nominal GDP/Qty of money

V=(P  Y)/M

• Where: V = velocity
P = the price level
Y = the quantity of output
M = the quantity of money
Example: Price of Pizza=$10, Qty of pizza is 100, qty of
money =$50
So V=(10*100)/50
= 20
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Velocity and the Quantity Equation

• Rewriting the equation gives the quantity

equation:
MV=PY

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Velocity and the Quantity Equation

• The quantity equation relates the quantity of

money (M) to the nominal value of output
(P  Y).

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Velocity and the Quantity Equation

• The quantity equation shows that an increase in

the quantity of money in an economy must be
reflected in one of three other variables:
• the price level must rise,
• the quantity of output must rise, or
• the velocity of money must fall.

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Velocity and the Quantity Equation and the
essence of Qty Theory of Money.
• The elements that explain the equilibrium price level and inflation rate are:
1. The velocity of money is relatively stable over time.
2. Because V is stable when Fed changes M, it causes proportionate
changes in the nominal value of output(PxY)
3. The economy’s output of goods and services is primarily determined
by factor supplies( labour, physical capital, human capital , natural
resources) and technology that is available. Money does not effect
output as money is neutral.
4. With output Y determined by factor supplies and technology,when
Central Bank changes Money Supply M and induces proportional
changes in nominal value of output (PxY), the changes are reflected in
changes in Price Level P.
5. When Central Bank changes Money supply rapidly, the result sis high
rate of inflation.

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 CASE STUDY: Money and Prices during
Four Hyperinflations
• Hyperinflation is inflation that exceeds 50
percent per month.
• Hyperinflation occurs in some countries
because the government prints too much money
to pay for its spending.

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The Inflation Tax

• When the government raises revenue by

printing money, it is said to levy an inflation
tax.
• An inflation tax is like a tax on everyone who
holds money because the $ in our wallet is less
valuable just like when traditional tax by govt.
is imposed.
• The inflation ends when the government
institutes fiscal reforms such as cuts in
government spending.
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The Fisher Effect

• The Fisher effect refers to a one-to-one

adjustment of the nominal interest rate (the
interest rate you hear about in your bank)to the
inflation rate.
• According to the Fisher effect, when the rate of
inflation rises, the nominal interest rate rises by
the same amount.
• The real interest rate stays the same. The real
interest rate corrects the nominal interest rate
for inflation.
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 The Fisher Effect
• Real interest rate= Nominal interest rate –
inflation rate.
• Nominal interest rate= Real interest rate +
inflation.

If nominal interest rate = 7%

Inflation Rate= 3%

What is the real interest rate?

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 Figure 5 The Nominal Interest Rate and the
Inflation Rate

Percent
(per year)

15

12
Nominal interest rate

Inflation
3

0
1960 1965 1970 1975 1980 1985 1990 1995 2000

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 THE COSTS OF INFLATION
• A Fall in Purchasing Power?
• Inflation does not in itself reduce people’s real
purchasing power. When prices rise, buyers of
goods and services pay more for what they buy. But
sellers of goods and services also get more for what
they sell including labour. So inflation in incomes
go hand in hand with inflation in prices.
• People believe in inflation fallacy because they do
not appreciate the monetary neutrality.

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 THE COSTS OF INFLATION
• Shoeleather costs
• Menu costs
• Relative price variability
• Tax distortions
• Confusion and inconvenience
• Arbitrary redistribution of wealth

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Shoeleather Costs

• Shoeleather costs are the resources wasted when

inflation encourages people to reduce their money
holdings.
• Inflation reduces the real value of money, so people
have an incentive to minimize their cash holdings.
Inflation is like a tax. To avoid it, the idea is to hold
less money in wallet and keep more in the bank.
Instead of drawing $200 every month, you might want
to withdraw $50 once a week and visit the bank more
often keeping more of your wealth in the interest
bearing savings account and less on your wallet.
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Shoeleather Costs

• Less cash requires more frequent trips to the

bank to withdraw money from interest-bearing
accounts.
• The actual cost of reducing your money
holdings is the time and convenience you must
sacrifice to keep less money on hand.
• Also, extra trips to the bank take time away
from productive activities.

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Menu Costs

• Menu costs are the costs of adjusting prices.

• During inflationary times, it is necessary to
update price lists and other posted prices.
• This is a resource-consuming process that takes
away from other productive activities.

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