CHAPTER 4: MONEY AND

INFLATION
OVERVIEW
 The classical theory of inflation
 causes
 effects
 social costs
 Classical theory assumes prices are flexible and markets
clear.
 Applies to the long run.
THE CONNECTION BETWEEN MONEY
AND PRICES
 Inflation rate = percentage change in the overall price
level.
 Price = amount of money required to buy a good.

 Because prices are defined in terms of money, we need

to consider the nature of money, the supply of money,
and how it is controlled.
MONEY: DEFINITION

Money is the stock

of assets that can be
readily used to make
transactions.
MONEY: FUNCTIONS
 Medium of exchange: we use it to buy stuff.
 Store of value: transfers purchasing power from the
present to the future.
 Unit of account: the common unit by which everyone
measures prices and values.
MONEY: TYPES
 Fiat money
 hasno intrinsic value
 example: currency including notes and coins

 Commodity money
 hasintrinsic value
 examples: gold, silver, precious metal …
MONEY SUPPLY AND MONETARY
POLICY
 The money supply is the quantity of money available in
the economy.
 Monetary policy is the control over the money supply.
 Monetary policy is conducted by a country’s Central Bank.
 In the U.S., the central bank is called the Federal Reserve
System (“the Fed”).
 In Vietnam, the central bank is the Sate Bank of Vietnam.
THE QUANTITY THEORY OF MONEY
 A simple theory linking the inflation rate to the growth
rate of the money supply.
 Begins with a concept called “velocity”…

 Velocity is the rate at which money circulates.

 It is the number of times that average dollar bill changes hand
in a given time period.
 Example: In 2021, an economy records
 $500 billion in transactions
 Money supply = $100 billion
 The average dollar is used in five transactions in 2021

 So, velocity = 5
THE QUANTITY THEORY OF MONEY
 This suggests the following definition:
V=T/M
 where
V = velocity
T = value of all transactions
M = money supply
THE QUANTITY THEORY OF MONEY
 Use nominal GDP as a proxy for total transactions.
Then,
P Y
V 
where
M
P = price of output (GDP deflator)
Y = quantity of output (real GDP)
P ×Y = value of output (nominal GDP)
M = quantity of money
 The quantity equation is

M×V=Y×P
MONEY DEMAND AND THE QUANTITY
EQUATION
 M/P = the real money balance, the purchasing power of
the money supply.
 A simple money demand function:

                       (M/P )d = kY
where
k = how much money people wish to hold for
       each dollar of income.
      (k  is exogenous) 0< k <1
Y = real income
MONEY DEMAND AND THE QUANTITY
EQUATION

Money demand: (M/P )d = k Y (1)

Quantity equation: M  V = P  Y

M/P=Y/V (2)
 The connection between them: k = 1 / V

 When people hold lots of money relative to their

incomes (k is large), money changes hands infrequently
(V is small).
THE QUANTITY THEORY OF MONEY
 Back to the quantity equation and assume V is constant
then

M V  P Y
 From the equation we have
%∆M + %∆V = %∆P + %∆Y
 Since V is constant then %∆V = 0 and
%∆P = %∆M – %∆Y
 %∆P is the inflation rate which called π.
THE QUANTITY THEORY OF MONEY
 The inflation rate equals
π = %∆M – %∆Y
Where
 %∆M is the growth rate of money supply
 %∆Y is the growth rate of real GDP which depends on
growth in the factors of production and on technological
progress (all of which we take as given), so %∆Y = 0. Y =
F(K,L) = Ybar
 Thus, π = %∆M
 Hence, the Quantity Theory predicts a one-for-one
relation between changes in the money growth rate and
changes in the inflation rate.
INFLATION AND INTEREST RATES
 Nominal interest rate, i
not adjusted for inflation.
 Real interest rate, r
adjusted for inflation.
r = i 
THE FISHER EFFECT
 The Fisher equation: i = r + π
 In Topic 2 shows that the equilibrium in the loanable
funds market (S = I) determines r .
 Hence, an increase in π causes an equal increase in i.
 This one-for-one relationship is called the Fisher effect.
 INFLATION AND NOMINAL INTEREST RATES
ACROSS COUNTRIES

100
Nominal
interest rate Kazakhstan
(percent, Kenya
logarithmic Armenia
scale) Uruguay

Italy
France
10
Nigeria
United Kingdom

United States
Japan
Germany

Singapore
1
1 10 100 1000
Inflation rate (percent, logarithmic scale)
EXERCISE:
 Suppose V is constant, M is growing 5% per year, Y is
growing 2% per year, and r = 4.
a. Solve for i (the nominal interest rate).
b. If the Fed increases the money growth rate by
2 percentage points per year, find i .
c. Suppose the growth rate of Y falls to 1% per year.
 What will happen to ?
 What must the Fed do if it wishes to keep  constant?
TWO REAL INTEREST RATES
 Notation
π = actual inflation rate
(not known until after it has occurred)
e = expected inflation rate
 Two real interest rate
i – e = ex ante real interest rate: the real interest rate
people expect at the time they buy a bond or take out a
loan.
 i – π = ex post real interest rate: the real interest rate
actually realized.
MONEY DEMAND AND THE NOMINAL
INTEREST RATE
 The quantity theory of money assumes that the demand
for real money balances depends only on real income Y.
 We now consider another determinant of money demand:
the nominal interest rate.
 The nominal interest rate i is the opportunity cost of
holding money (instead of bonds or other interest-earning
assets).
 Hence, i↑ → money demand↓.
THE MONEY DEMAND FUNCTION

(M/P )d = L (i, Y)
(M/P )d = real money demand, depends
 negatively on interest rate (i is the opportunity cost of
holding money).
 positively on income (higher Y → more spending → need
more money).
 Note: “L” is used for the money demand function
because money is the most liquid asset.
THE MONEY DEMAND FUNCTION

(M/P )d = L (i, Y)
= L (r + e, Y)
 When people are deciding whether to hold money or
bonds, they don’t know what inflation will turn out to be.

 Hence, the nominal interest rate relevant for money

demand is r + e.
EQUILIBRIUM IN MONEY MARKET

M e
 L (r   , Y )
P

Real money supply

Real money
demand
WHAT DETERMINES WHAT?

𝑴 𝒆
= 𝑳 (𝒓 + 𝝅 ,𝒀 )
𝑷
 Variable How is determined (in the long run)
M exogenous (the Fed) →
r adjusts to ensure S = I →
Y
P adjusts to ensure M / P = L(i,Y)

¿
CAUSES OF INFLATION: INCREASE IN
MONEY SUPPLY

M
 L (r   e , Y )
P
 For given values of r, Y, and e (the right-hand side of the
equation is constant), a change in M causes P to change by
the same percentage (as to keep the left-hand side of the
equation to be constant in order to hold the equation).
%∆M = %∆P = π
just like in the quantity theory of money.
 Increase in money supply causes the price level to increase
→ inflation.
CAUSES OF INFLATION: CHANGE IN
EXPECTED INFLATION
 Expected inflation e may change when people
get new information.
 Example:
 Suppose Fed announces it will increase M next year.
People will expect next year P to be higher, so e rises.
 This will affect P now, even though M has not changed
yet.
CAUSES OF INFLATION: CHANGE IN
EXPECTED INFLATION
𝑴 𝒆
= 𝑳 (𝒓 + 𝝅 ,𝒀 )
𝑷
 For given value of r, Y, and M :
↑e → ↑i (the Fisher effect : ↑)
→ ↓ (M/P )d : the right-hand side of equation decreases.
→ to hold the equation the left-hand side of
equation must decrease → ↑P
 Increase in expected inflation causes the price level to
increase → inflation.
THE CLASSICAL VIEW ON COSTS OF
INFLATION
 The social cost of inflation fall into two categories:
1. Costs when inflation is expected.
2. Additional costs when inflation is different than what
people had expected.
THE COSTS OF EXPECTED INFLATION:
1. SHOE LEATHER COSTS
 The costs and inconveniences of reducing money
balances to avoid the inflation tax.
  i  ↓real money balances
 Remember: In long run, inflation does not affect real
income or real spending.
 So, same monthly spending but lower average money
holdings means more frequent trips to the bank to
withdraw smaller amounts of cash.
THE COSTS OF EXPECTED INFLATION:
2. MENU COSTS
 The costs of changing prices.
 Examples:
 print new menus
 print and mail new catalogs
 The higher is inflation, the more frequently firms must
change their prices and incur these costs.
THE COSTS OF EXPECTED INFLATION:
3. RELATIVE PRICE DISTORTIONS
 Firms facing menu costs change prices infrequently.
 Example:
 Suppose a firm issues new catalog each January. As the
general price level rises throughout the year, the firm’s
relative price will fall.
 Different firms change their prices at different times,
leading to relative price distortions…
 …which cause microeconomic inefficiencies
in the allocation of resources.
THE COSTS OF EXPECTED INFLATION:
4. UNFAIR TAX TREATMENT
 Some taxes are not adjusted to account for inflation, such
as the capital gains tax.
 Example:
 1/1/2021: you bought $10,000 worth of Starbucks stock
 12/31/2021: you sold the stock for $11,000,
so your nominal capital gain was $1000 (10%).
 Suppose  = 10% in 2021 → Your real capital gain is $0.
 But the government requires you to pay taxes on your $1000
nominal gain.
THE COSTS OF EXPECTED INFLATION:
5. GENERAL INCONVENIENCE
 Inflation makes it harder to compare nominal values
from different time periods.
 This complicates long-range financial planning.
THE COSTS OF UNEXPECTED INFLATION: ARBITRARY
REDISTRIBUTION OF PURCHASING POWER

 Many long term contracts are based on e.

 If  turns out different from e, then someone gains at
others’ expense. 
 r = i - expected inflation rate

 r = i - actual inflation rate

 Example:  borrowers and lenders 

 If  > e, then (i ) < (i  e) and purchasing power is
transferred from lenders to borrowers.
 If  < e, then (i ) > (i  e) and purchasing power is
transferred from borrowers to lenders.
ADDITIONAL COST OF HIGH INFLATION:
INCREASED UNCERTAINTY
 When inflation is high, it’s more variable and unpredictable:

 turns out different from e more often, and the differences

tend to be larger (though not systematically positive or
negative).
 Arbitrary redistributions of wealth become more likely.

 This creates higher uncertainty, which makes risk averse

people worse off.
THE CLASSICAL DICHOTOMY
 Real variables are measured in physical units –quantities
and relative prices. Examples:
 Quantity of output produced
 Real wage: output earned per hour of work
 Real interest rate: output earned in the future by lending one unit
of output today
 Nominal variables are measured in money unit. Examples:
 Nominal wage: dollars per hour of work
 Nominal interest rate: dollars earned in future by lending one
dollar today
 Price level: the amount of dollars needed to buy a representative
basket of goods
THE CLASSICAL DICHOTOMY
 Classical dichotomy: the theoretical separation of real
and nominal variables in the classical model, which
implies nominal variables do not affect real variables.
 Neutrality of money: Changes in the money supply do
not affect real variables.
 In the real world, money is approximately neutral in the
long run.