Lecture Notes: Money Growth and Inflation

Introduction

• Topic: Money Growth and Inflation (Chapter 30, Principles of Economics by Gregory Mankiw)
• Key Concepts:
  • Inflation: Increase in overall prices.
  • Calculated via percentage change in CPI (Consumer Price Index) or GDP deflator.

Inflation Overview

• US Inflation Rate:
  • Average increase: 3.6% per year.
  • Prices multiplied by 17 times over 80 years.
• Deflation: Rare periods of price decrease.
• Hyperinflation:
  • Defined as price increase > 50% per month.
  • Example: Zimbabwe with 24,000% increase.

Classical Theory of Inflation

• Price Level & Value of Money:
  • Developed in early 19th century.
  • Price levels can be seen through CPI or GDP deflator.
  • P (price level) represents the number of dollars needed to buy a basket of goods.
  • 1/P represents the value of money in terms of goods and services.

Supply and Demand for Money

• Money Supply Management: Controlled by the Federal Reserve through open market operations:
  • Selling bonds contracts money supply.
  • Buying bonds expands money supply.
• Demand for Money: Influenced by how much wealth people want to hold in liquid form.

Long Run vs. Short Run

• Long Run:
  • Money supply and demand are balanced by price levels.
  • Money is neutral and does not affect real variables.
• Short Run:
  • Changes in money supply can affect real variables.

Quantity Theory of Money

• Velocity of Money: How often money is used for transactions.
• Quantity Equation: V (velocity) = (P (price level) × Y (output))/(M (money))
  • Increase in money supply causes proportionate changes in nominal output.

Costs of Inflation

• Inflation Fallacy: Perception that inflation is bad, but if wages rise equally, it isn't necessarily negative.
• Shoe Leather Costs: Time and effort spent to minimize holding cash.
• Menu Costs: Costs associated with changing prices frequently.
• Tax Distortions: Inflation affects the real value of taxed income.
• Relative Price Variability: Misallocation of resources due to changing relative prices.

Fisher Effect

• Interest Rates: Real interest rate = Nominal interest rate - Inflation rate.
• Nominal vs. Real Interest Rate: Changes in inflation lead to changes in nominal interest rates.

Inflation and Deflation

• High Inflation Rates: Lead to uncertainty and misallocation of resources.
• Deflation Risks: Can be more damaging than inflation, leading to decreased GDP and unemployment.

Conclusion

• Main Takeaway: More money supply leads to more inflation.
• Long Run: Money is neutral and doesn't affect real aspects of the economy.
• Short Run: Impacts real economy and causes various costs.

• Recommendation: Explore real-world cases of inflation and hyperinflation for deeper understanding.