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.

 Itis 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 
M
where
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 sc
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
Real money
supply
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.
 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.