Inflation and Deflation
Money and Inflayion in the Long Run
Velocity and Quantity Equation
.Deriving the Inflation Rate
Velocity of money If spending is $500 and the money supply is $100, then velocity is
500/100 5.
Quantity equation of maney relationship among the maney suppl velocity and nominal GDP: MV = PY
This quantity equation of money says that total spending in the economy (PY) equals the money supply (M ) times the number of times each
dollar is spent (V ). If M is $100 and V is 5, then total spending is $500
% change in (MV) = % change in (PY )
(% change in M) = (% change in V) = (% change in P) = (% change in Y)
Inflation = (% change in M ) = (% change in V ) = (% change in Y) )
Output growth depends on factors that affect the economy’s productivity, such as new technologies. Long-run neutrality means that
monetary policy is irrelevant.
Long-run changes in velocity are driven primarily by changes in transaction technologies—the methods people use to acquire and spend
money.
The Data
The great economist Milton Friedman said that “inflation is always and everywhere a monetary phenomenon.”
The Phillips Curve Again
The Phillips curve is part of the mechanism by which mnoey growth produces inflation.
Instead, higher money growth sets off a chain of
events that involves the Phillips curve
What Detrmines Money Growth?
Commodity Money
Such as gold coins or paper money exchageable for gold, has intrinsic value, With commodity money, the money supply is datermined by much of the commodity is produced
The slow money growth of the early gold-standard period led to deflation: the inflation rate averaged 1 percent from 1879 to 1897
CASE STUDY The Free Silver Movement,
Supporters of higher inflation pushed for a monetary system called Bimetallism (literally, two metals). In this system, the government would issue money backed by silver as well as by gold.
Fiat Money and Inflation
Today, economies use fiat money—pieces of paper that are not exchangeable for any commodity. The supply of fiat money is controlled by an economy’s central bank, not its mining industry.
The central bank has tools, suchas open-market operations, which allow it to increase the money supply at whatever rate it chooses.
The Output-Inflation Trade-Off
A central bank also allows inflation to rise if it accommodates an adverse supply shock, such as a rise in oil prices. Here the aim of policymakers is not to raise output but merely to keep it from falling below potential. With an adverse supply shock, however, stable output requires an increase in money growth and inflation.
Seigniorage and Very High Inflation
Printing money financing government budget deficits by selling bonds to the central bank
Seigniorage revenue revenue the government receives from printing money
What explains inflation in the hundreds or thousands of percent? The short answer is government budget deficits. Governments frequently spend more than they raise in taxes, creating deficits.
Sometimes, however, governments with deficits have trouble selling bonds. When private savers refuse to buy government bonds, the government turns to another buyer: the central bank.
So when the government sells bonds to the central bank, it does not really create a debt to an outside entity. In effect, the central bank just creates money and gives it to the government
The Cots Of Inflation
The Inflation Fallacy
Economists don’t see a necessary connection between inflation and changes in living standards
The reason is that inflation increases all the economy’s prices—including
wages and salaries.
Vary High Inflation
This does not mean that economists consider inflation harmless. Although inflation does not directly reduce living standards, it can hurt the economy in subtler ways.
Shoe Leather Costs
If people lack bank accounts, as is common in developing countries, they rush to buy goods as soon as they receive their pay. They buy things they don’t really want just to get rid of cash.
Distracted Firms
Relative-Price Variability
When inflation is high, all firms raise their prices
by large amounts. But they do so at different times.
Income Inequality
High inflation hurts the overall economy, but the biggest
problem may be the unevenness of its effects.
Moderate Inflation
Inflation Uncertainty
Uncertainty about inflation creates risk in loan markets. When inflation changes unpredictably, the ex post real interest rate differs from the ex ante rate
Inflation and Taxes
The final inflation cost we’ll discuss involves taxation. When inflation rises, people pay higher taxes on the income they earn from savings.
The After-Tax real Interest Rate, interest rate adjusted for both taxes and inflation
Deflation And The Liquidity Trap
Money Growth Again
Historically, this principle has explained negative as well as positive inflation.
Deflation arises when money growth is low.
The Liquidity Trap
Situation in which output is below potential at a nominal interest rate of zero (a real interest rate of -inflation), eliminating the central bank’s usual ability to raise output and inflation; also, zero-bound problem
Lower Bounds on Interest Rates
Zero bound limit on the nominal interest rate; a central bank cannot reduce i below zero, which limits its ability to stimulate the economy
The Role of Deflation
Although deflation raises the risk of a liquidity trap, danger also exists if the inflation rate is positive but low. Inflation of 1 percent, for example, means the lower bound on the real interest rate is 1 percent. That level is usually low enough to boost output to potential, but it may not be during an unusually deep recession
The Irrelevance of Money Growth
Any Escaping a Liquidity Trap?
Reducing Long-Term Interest Rates
. The central bank can reduce long-term rates by reducing
either expected short rates or term premiums.
Raising Expected Inflation
Using Fiscal Policy