The Classical theory of money and inflation

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The Classical theory of money and inflation

• Chap 17, Mankiw

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• Chap 17 discusses
• The classical theory of the price level
• Money growth and inflation
• Monetary neutrality
• Costs of inflation

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I. Classical theory of the price level

• Some definitions
• Inflationa period of persistent rise in the
  price level (average of all prices)
• Deflationa period of persistent decline in the
  price level
• Hyperinflation a period of extremely high
  inflation rate exceeding 50 per month
• Inflation is measured by,
• ? (Pt Pt-1)/ Pt-1
• Where ? rate of inflation, P the price level
  and the subscripts denote previous and current
  periods.
• Most economists agree nowadays that inflation is
  a monetary phenomenon inflation is caused by
  increase in money supply.

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I. Classical theory of the price level

• Some definitions (contd.)
• What is money?
• Briefly, any object that can serve as a medium
  of exchange, unit of account or store of
  value.
• Note People in daily life misuse the word for
  income or wealth.
• Example I want to get an MBA from Drake so that
  I can make a lot of money or My uncle has a lot
  of money.
• In most modern economies there are many objects
  besides paper currency and coins which can serve
  these three functions. There are therefore more
  than one measure of money supply two standard
  ones being M1 and M2, where M1 lt M2.
• The narrowest measure of total money supply M1 is
  greater than the total amount of paper currency
  and coins in circulation

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• The classical theory of the price level
• Assume the price level P to be measured by either
  the GDP Deflator or the Consumer Price Index.
• Then P measures the number of dollars (currency)
  needed to buy a basket of good.
• Example the CPI in 2000 (base year) is 100 and
  in 2006 is 110 (say). A basket of goods which
  used to cost 1in 2000 costs 1.10 in 2006.
• Equivalently this can also be described as the
  quantity of goods that can be bought with 1 in
  2006 is 1/1.10.
• In symbols, if P is the price level, 1/P is the
  purchasing power of money or value of money in
  units of goods.
• According to the classical theory, 1/P (or P) is
  determined by demand for and supply of money
  (paper currency coins).

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• Demand for and supply of money
• Many variables affect the demand for money. Two
  most important ones are the average rate of
  interest and the average price level. We will
  focus on the second variable only in this
  chapter.
• People hold money because it is a medium of
  exchange. Higher the price level, higher the
  amount of cash needed to carry out transactions.
• Demand for money is positively related to P, that
  is inversely related to 1/P.
• Supply of money is controlled by the FED
  assumed to be a constant for this chapter.
• Equilibrium price level is determined at the
  level at which quantity demanded quantity
  supplied

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• II. Money growth and inflation

Value of money1/P
Price level P
M1
M2
An increase in the money supply increases the
price level. The classical theory of the price
level is also known as the quantity theory of
money. An important implication of this is that
inflation is more often than not a monetary
phenomenon.
P1
P2
Quantity of money
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III. Monetary neutrality The most important of
the classical theory of the price level and
inflation is that money does not have real
effects. Why? What may happen if increase in
money supply can in fact change aggregate output
(GDP)? The proposition that money growth does not
have real effects is known as monetary
neutrality/neutrality of money. The classical
theory implies that money is neutral. Alternative
way of describing the classical view of an
economy is that there is a separation or
dichotomy between real and nominal variables.
Examples of real variables real GDP, real
interest rate, employment Examples of nominal
variables price level, nominal GDP, nominal
interest rate. Money supply affects only nominal
variables, not real variables.
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IV. Costs of inflation Is the classical view of
the neutrality of money realistic? Most
economists agree that it is true in the long run
but not in the short run. In other words money
growth may have some temporary real effects but
only nominal permanent effects. Since there are
no long run real effects of inflation, why is
commonly regarded with concern by policymakers.
In other words are there any welfare costs of
inflation that we have not been able to capture
with our simplistic view of the economy. The
following are some ill effects of
hyperinflation, shoeleather costs menu costs