Inflation: Its Causes and Costs

1
Chapter 17

• Inflation Its Causes and Costs

2
Outline

• What is inflation?
• Causes of inflation
• Arriving at the monetary equilibrium
• Quantity theory of money
• The classical dichotomy- Real versus nominal
• Velocity of money
• The Fisher effect
• Costs of inflation

3
Inflation

• Inflation is the overall increase in price level.
  
• Inflation rate can be measured as the percent
  change in CPI, GDP deflator, or any overall price
  index.
• Recall that prices rise when the government
  prints too much money (chap 1).

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Causes of Inflation

• Level of prices and the value of money
• P Price level required to buy a basket of
  goods and services
• 1/P quantity of goods that can be bought with 1
  value of money
• Therefore, price level and value of money are
  inversely related

5
Monetary Equilibrium

• Determinants of money supply
• The banking system along with the Bank of Canada
  can influence the supply of money
• Money supply is determined by the Bank of Canada
  and is treated as a policy variable
• Determinants of money demand
• Quantity of money held by public (demand) is
  determined by interest rate on bonds
• Demand for money also depends on the average
  price level in the economy

6
Monetary Equilibrium

• Determinants of money demand
• Higher the price level (lower value of money),
  more money people choose to hold, and demand for
  money increases
• Equilibrium
• In the LR, the overall level of prices adjusts to
  the level where demand equals supply of money
• At the point of equilibrium, price level and
  value of money have adjusted to balance supply
  and demand for money

7
Quantity Theory of Money

• The theory states that the quantity of money
  available determines the price level and that the
  growth rate in the quantity of money available
  determines the inflation rate.

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The Classical dichotomy and Monetary Neutrality

• Classical dichotomy is the theoretical separation
  of nominal and real variables
• Nominal variables are measured in monetary units
• Real variables are measured in physical units
• Relative prices are real variables
• Monetary neutrality states that changes in the
  money supply affect nominal variables and do not
  affect real variables

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Velocity and the quantity equation

• Velocity of money is the rate at which money
  changes hands or the speed at which the travels
  around the economy
• MVPY is the quantity equation and relates the
  quantity of money and its velocity to the nominal
  value of output
• Velocity of money is relatively stable over time
  in Canada
• Therefore, when Bank of Canada increases money
  supply rapidly, it results in inflation.

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Velocity of money
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Inflation tax

• Hyperinflation is defined as inflation that
  exceeds 50 per month.
• Inflation tax is the revenue the government
  raises by creating money supply
• When the government prints money in order to fund
  its expenditure, it increases the price level and
  thereby reduces the value of money.

12
Fisher Effect

• Money neutrality means that an increase in the
  growth of money supply raises inflation rate but
  does not affect any real variables.
• However, increase in money supply does affect
  (increase) nominal interest rate.
• Recall real interest rate nominal interest
  rate-inflation rate.
• The one-for-one adjustment between the nominal
  interest rate to the inflation rate is the Fisher
  effect.

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The Costs of Inflation

• Inflation fallacy
• Shoeleather costs
• Menu costs
• Relative price variability and misallocation of
  resources
• Inflation-induced tax distortions
• Confusion and inconvenience
• Arbitrary redistribution of wealth

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Inflation fallacy

• Inflation leads to fall in purchasing power of
  money and hurts consumers.
• Suppliers on the other hand receive a higher
  price for the same quantity sold.
• Factors of production receive higher incomes

Inflation does not in itself reduce real
purchasing power
Neutrality of money
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Shoeleather costs

• Inflation is like a tax and creates deadweight
  loss for the society.
• To reduce the burden of inflation tax, people
  hold less money in hand and hold in interest
  bearing savings instead.
• The resources wasted (time and inconvenience) in
  reducing money holdings is termed as shoeleather
  costs.
• During hyperinflation, local currencys store of
  value is vastly reduced.

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Menu costs

• Menu costs are incurred when prices change
  frequently and frequent changing of prices
  increases the costs of firms.

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Relative-price variability and the
misallocation of resources

• With no inflation, a firms relative prices would
  be constant over a period of time ( a year).
• With inflation, the relative prices of a firm
  will be high in the early months of the year and
  low in later months.
• As market economies allocate resources based on
  relative prices, inflation distorts prices
  resulting in misallocation of resources by
  markets.

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Inflation-induced tax distortions

• Inflation tends to raise the tax burden on income
  from savings
• Tax treatment of capital gains discourages
  savings
• All of the nominal interest earned on savings is
  treated as income for purpose of taxation

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Save?
20
Confusion and Inconvenience

• Inflation erodes the real value of money as a
  unit of account.

21
Cost of unexpected inflation Arbitrary
redistribution of wealth

• Hyperinflation enriches the borrower by
  diminishing the real value of the debt.
• Deflation enriches the lender by increasing the
  real value of the debt.
• Unexpected inflation prevents the Fisher effect
  from taking place imposing a risk on the borrower
  and lender.
• Inflation indexed bonds are a solution to protect
  long term savings.