mankiw-chapter-4-money-and-inflation.ppt

Makroekonomi mankiw

1. macroeconomics
fifth edition
N. Gregory Mankiw
PowerPoint
®
Slides
by Ron Cronovich
m
a
c
r
o


© 2003 Worth Publishers, all rights reserved
CHAPTER FOUR
Money and Inflation

2. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
No 5 : 4,
No 6: 9,
No 7 :2, # 8: 1
slide 2

3. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 3
In this chapter you will learnIn this chapter you will learn
The classical theory of inflation
–causes
–effects
–social costs
“Classical” -- assumes prices are flexible
& markets clear.
Applies to the long run.

4. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 4
U.S. inflation & its trend, 1960-2003U.S. inflation & its trend, 1960-2003
0%
2%
4%
6%
8%
10%
12%
14%
196019651970197519801985199019952000
Inflation rate

5. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 5
U.S. inflation & its trend, 1960-2003U.S. inflation & its trend, 1960-2003
0%
2%
4%
6%
8%
10%
12%
14%
196019651970197519801985199019952000
Inflation rate Inflation rate trend

6. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 6
The connection between The connection between
money and pricesmoney and prices
Inflation rate = the percentage increase
in the average level of prices.
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.

7. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 7
Money: definitionMoney: definition
MoneyMoney is the stock is the stock
of assets that can be of assets that can be
readily used to make readily used to make
transactions.transactions.

8. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 8
Money: functionsMoney: functions
1.medium of exchange
we use it to buy stuff
2.store of value
transfers purchasing power from the
present to the future
3.unit of account
the common unit by which everyone
measures prices and values

9. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 9
Money: typesMoney: types
1.fiat money
•has no intrinsic value
•example: the paper currency we use
2.commodity money
•has intrinsic value
•examples: gold coins,
cigarettes in P.O.W. camps

10. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 10
Discussion QuestionDiscussion Question
Which of these are money?
a.Currency
b.Checks
c.Deposits in checking accounts
(called demand deposits)
d.Credit cards
e.Certificates of deposit
(called time deposits)

11. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 11
The money supply & monetary policyThe money supply & monetary policy
The money supply is the quantity of
money available in the economy.
Monetary policy is the control over
the money supply.

12. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 12
The central bankThe central bank
Monetary policy is conducted by a country’s
central bank.
In the U.S.,
the central
bank is
called the
Federal
Reserve
(“the Fed”).
The Federal Reserve Building
Washington, DC

13. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 13
Money supply measures, Money supply measures, April 2002April 2002
_SymbolAssets included Amount (billions)_
C Currency $598.7
M1 C + demand deposits,1174.0
travelers’ checks,
other checkable deposits
M2 M1 + small time deposits,
5480.1
savings deposits,
money market mutual funds,
money market deposit accounts
M3 M2 + large time deposits,8054.4
repurchase agreements,
institutional money market
mutual fund balances

14. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 14
The Quantity Theory of MoneyThe 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”…

15. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 15
VelocityVelocity
basic concept: the rate at which money
circulates
definition: the number of times the average
dollar bill changes hands in a given time
period
example: In 2003,
•$500 billion in transactions
•money supply = $100 billion
•The average dollar is used in five
transactions in 2003
•So, velocity = 5

16. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 16
Velocity, Velocity, cont.cont.
This suggests the following definition:

T
V
M
where
V = velocity
T = value of all transactions
M = money supply

17. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 17
Velocity, Velocity, cont.cont.
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)

18. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 18
The quantity equationThe quantity equation
The quantity equation
M V = P Y
follows from the preceding definition of
velocity.
It is an identity:
it holds by definition of the variables.

19. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 19
Money demand and the quantity equationMoney demand and the quantity equation
M/P = real money balances, the
purchasing power of the money supply.
A simple money demand function:
(M/P )
d
= k Y
where
k = how much money people wish to hold
for each dollar of income.
(k is exogenous)

20. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 20
Money demand and the quantity equationMoney demand and the quantity equation
money demand: (M/P )
d
= k Y
quantity equation: M V = P Y
The connection between them: k = 1/V
When people hold lots of money relative
to their incomes (k is high), money
changes hands infrequently (V is low).

21. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 21
back to the Quantity Theory of Moneyback to the Quantity Theory of Money
starts with quantity equation
assumes V is constant & exogenous:
V V
With this assumption, the quantity
equation can be written as
  M V P Y

22. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 22
The Quantity Theory of MoneyThe Quantity Theory of Money, cont., cont.
How the price level is determined:
With V constant, the money supply
determines nominal GDP (P Y )
Real GDP is determined by the economy’s
supplies of K and L and the production
function (chap 3)
The price level is
P = (nominal GDP)/(real GDP)
  M V P Y

23. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 23
The Quantity Theory of MoneyThe Quantity Theory of Money, cont., cont.
Recall from Chapter 2:
The growth rate of a product equals
the sum of the growth rates.
The quantity equation in growth rates:
M V P Y
M V P Y
   
  
The quantity theory of money assumes
is constant, so = 0.
V
V
V


24. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 24
The Quantity Theory of MoneyThe Quantity Theory of Money, cont., cont.
Let  (Greek letter “pi”)
denote the inflation rate:
M P Y
M P Y
  
 
P
P


The result from the
preceding slide was:
Solve this result
for  to get

25. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 25
The Quantity Theory of MoneyThe Quantity Theory of Money, cont., cont.
Normal economic growth requires a
certain amount of money supply growth
to facilitate the growth in transactions.
Money growth in excess of this amount
leads to inflation.

26. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 26
The Quantity Theory of MoneyThe Quantity Theory of Money, cont., cont.
Y/Y depends on growth in the factors of
production and on technological progress
(all of which we take as given, for now).
Hence, the Quantity Theory of Money predicts a one-
for-one relation between changes in the money
growth rate and changes in the inflation rate.

27. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 27
International data on International data on
inflation and money growthinflation and money growth
Inflation rate
(percent,
logarithmic
scale)
1,000
10,000
100
10
1
0.1
Money supply growth (percent, logarithmic scale)
0.1 1 10 100 1,000 10,000
Nicaragua
Angola
Brazil
Bulgaria
Georgia
Kuwait
USA
Japan
Canada
Germany
Oman
Democratic Republic
of Congo

28. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 29
U.S. Inflation & Money Growth, 1960-2003U.S. Inflation & Money Growth, 1960-2003
0%
2%
4%
6%
8%
10%
12%
14%
196019651970197519801985199019952000
Inflation rate Inflation rate trend

29. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 30
U.S. Inflation & Money Growth, 1960-2003U.S. Inflation & Money Growth, 1960-2003
0%
2%
4%
6%
8%
10%
12%
14%
196019651970197519801985199019952000
Inflation rate Inflation rate trend

30. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 31
U.S. Inflation & Money Growth, 1960-2003U.S. Inflation & Money Growth, 1960-2003
0%
2%
4%
6%
8%
10%
12%
14%
196019651970197519801985199019952000
Inflation rate M2 growth rate Inflation rate trend M2 growth rate trend

31. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 32
U.S. Inflation & Money Growth, 1960-2003U.S. Inflation & Money Growth, 1960-2003
0%
2%
4%
6%
8%
10%
12%
14%
196019651970197519801985199019952000
Inflation rate M2 growth rate Inflation rate trend M2 growth rate trend

32. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 33
SeigniorageSeigniorage
To spend more without raising taxes or
selling bonds, the govt can print money.
The “revenue” raised from printing money
is called seigniorage
(pronounced SEEN-your-ige)
The inflation tax:
Printing money to raise revenue causes
inflation. Inflation is like a tax on people
who hold money.

33. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 34
Inflation and interest ratesInflation and interest rates
Nominal interest rate, i
not adjusted for inflation
Real interest rate, r
adjusted for inflation:
r = i  
Fisher equation: i = r + 

34. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
Inflation and interest ratesInflation and interest rates
The quantity theory and the Fisher equation
together tell us how money growth affects the
nominal interest rate.
According to the quantity theory, an increase in the
rate of money growth of 1 percent causes a 1
percent increase in the rate of inflation.
According to the Fisher equation, a 1 percent
increase in the rate of inflation in turn causes a 1
percent increase in the nominal interest rate.
The one-for-one relation between the inflation rate
and the nominal interest rate is called the Fisher
effect.
slide 35

35. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 36
The Fisher EffectThe Fisher Effect
The Fisher equation: i = r + 
Chap 3: S = I determines r .
Hence, an increase in 
causes an equal increase in i.
This one-for-one relationship
is called the Fisher effect.

36. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 37
U.S. inflation and nominal interest rates, U.S. inflation and nominal interest rates,
since 1954since 1954
Percent
16
14
12
10
8
6
4
2
0
-2
Nominal
interest rate
Inflation
rate
19501955196019651970
Year
1975198019851990 20001995

37. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 38
Inflation and nominal interest rates Inflation and nominal interest rates
across countriesacross countries
Inflation rate (percent, logarithmic scale)
Nominal
interest rate
(percent,
logarithmic
scale)
100
10
1
1 10 100 1000
Kenya
Kazakhstan
Armenia
Nigeria
Uruguay
United Kingdom
United States
Singapore
Germany
Japan
France
Italy

38. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 39
Exercise: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?

39. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 40
Answers:Answers:
a.First, find  = 5  2 = 3.
Then, find i = r +  = 4 + 3 = 7.
b. i = 2, same as the increase in the money
growth rate.
c.If the Fed does nothing,  = 1.
To prevent inflation from rising, Fed must
reduce the money growth rate by 1
percentage point per year.
Suppose V is constant, M is growing 5% per
year, Y is growing 2% per year, and r = 4.

40. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 41
Two real interest ratesTwo real interest rates
 = actual inflation rate
(not known until after it has occurred)

e
= expected inflation 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 –  = ex post real interest rate:
the real interest rate people actually end up
earning on their bond or paying on their loan

41. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 42
Money demand and Money demand and
the nominal interest ratethe 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   in money demand.

42. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 43
The money demand functionThe money demand function
(M/P )
d
= real money demand, depends
negatively on i
i is the opp. cost of holding money
positively on Y
higher Y  more spending
 so, need more money
(L is used for the money demand function
because money is the most liquid asset.)
( ) ( , )
d
M P Li Y

43. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 44
The money demand functionThe money demand function
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
.
( ) ( , )
d
M P Li Y
( , )
e
Lr Y 

44. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 45
EquilibriumEquilibrium
( , )
eM
L r Y
P
 
The supply of real
money balances
Real money
demand

45. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 46
What determines whatWhat determines what
variablehow determined (in the long run)
M exogenous (the Fed)
r adjusts to make S = I
Y
( , )
eM
L r Y
P
 
( , )Y F K L
P adjusts to
make
( , )
M
L i Y
P


46. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 47
How How PP responds to responds to MM
For given values of r, Y, and 
e
,
a change in M causes P to change by
the same percentage --- just like in the
Quantity Theory of Money.
( , )
eM
L r Y
P
 

47. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 48
What about expected inflation?What about expected inflation?
Over the long run, people don’t consistently
over- or under-forecast inflation,
so 
e
=  on average.
In the short run, 
e
may change when people
get new information.
EX: Suppose Fed announces it will increase
M next year. People will expect next year’s P
to be higher, so 
e
rises.
This will affect P now, even though M hasn’t
changed yet.
(continued…)

48. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 49
How How PP responds to responds to 
ee
( , )
eM
L r Y
P
 
(the Fisher effect)
e
i  
 
d
M P 
  to make fall
to re-establish eq'm
P M P 
For given values of r, Y, and M ,

49. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 50

50. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 51
Discussion Question Discussion Question
Why is inflation bad?
What costs does inflation impose on
society? List all the ones you can think of.
Focus on the long run.
Think like an economist.

51. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 52
A common misperceptionA common misperception
Common misperception:
inflation reduces real wages
This is true only in the short run, when
nominal wages are fixed by contracts.
(Chap 3) In the long run,
the real wage is determined by labor
supply and the marginal product of labor,
not the price level or inflation rate.
Consider the data…

52. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 53
Average hourly earnings & the CPIAverage hourly earnings & the CPI
0
2
4
6
8
10
12
14
16
18
1964196819721976198019841988199219962000
$

p
e
r

h
o
u
r
0
25
50
75
100
125
150
175
200
225
250
C
P
I

(
1
9
8
3
=
1
0
0
)
Average
hourly
earnings
Hourly earnings
in 2001 dollars
Consumer
Price Index
0
2
4
6
8
10
12
14
16
18
1964196819721976198019841988199219962000
$

p
e
r

h
o
u
r
0
25
50
75
100
125
150
175
200
225
250
C
P
I

(
1
9
8
3
=
1
0
0
)
Average
hourly
earnings
Hourly earnings
in 2001 dollars
Consumer
Price Index

53. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 54
The classical view of inflationThe classical view of inflation
The classical view:
A change in the price level is merely a
change in the units of measurement.
So why, then, is inflation a So why, then, is inflation a
social problem?social problem?

54. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 55
The social costs of inflationThe social costs of inflation
…fall into two categories:
1. costs when inflation is expected
2. additional costs when inflation is
different than people had
expected.

55. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 56
The costs of expected inflation: The costs of expected inflation:
11.. shoeleather cost (p.102)shoeleather cost (p.102)
def: the costs and inconveniences of reducing
money balances to avoid the inflation tax.
  i
  real money balances
Remember: In long run, inflation doesn’t
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.

56. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 57
The costs of expected inflation: The costs of expected inflation:
22.. menu costsmenu costs
def: The costs of changing prices.
Examples:
–print new menus
–print & mail new catalogs
The higher is inflation, the more
frequently firms must change their
prices and incur these costs.

57. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 58
The costs of expected inflation: The costs of expected inflation:
33.. relative price distortionsrelative 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.

58. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 59
The costs of expected inflation: The costs of expected inflation:
44.. unfair tax treatmentunfair tax treatment
Some taxes are not adjusted to account for
inflation, such as the capital gains tax.
Example:
Jan 1: you bought $10,000 worth of Starbucks
stock
Dec 31: you sold the stock for $11,000,
so your nominal capital gain was $1000 (10%).
Suppose  = 10% during the year.
Your real capital gain is $0.
But the govt requires you to pay taxes on your
$1000 nominal gain!!

59. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 60
The costs of expected inflation: The costs of expected inflation:
55.. General inconvenienceGeneral inconvenience
Inflation makes it harder to compare
nominal values from different time
periods.
This complicates long-range financial
planning.

60. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 61
Additional cost of Additional cost of unexpectedunexpected inflation: inflation:
arbitrary redistributions of purchasing powerarbitrary redistributions of purchasing power
Many long-term contracts not indexed,
but based on 
e
.
If  turns out different from 
e
,
then some gain at others’ expense.
Example: borrowers & lenders
•If  > 
e
, then (i  ) < (i  
e
)
and purchasing power is transferred from
lenders to borrowers.
•If  < 
e
, then purchasing power is
transferred from borrowers to lenders.

61. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 62
Additional cost of high inflation: Additional cost of high inflation:
increased uncertaintyincreased 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.

62. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 63
One benefit of inflationOne benefit of inflation
Nominal wages are rarely reduced, even Nominal wages are rarely reduced, even
when the equilibrium real wage falls. when the equilibrium real wage falls.
Inflation allows the real wages to reach Inflation allows the real wages to reach
equilibrium levels without nominal equilibrium levels without nominal
wage cuts.wage cuts.
Therefore, moderate inflation improves Therefore, moderate inflation improves
the functioning of labor markets. the functioning of labor markets.

63. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 64
HyperinflationHyperinflation
def:   50% per month
All the costs of moderate inflation described
above become HUGE under hyperinflation.
Money ceases to function as a store of value,
and may not serve its other functions (unit of
account, medium of exchange).
People may conduct transactions with barter
or a stable foreign currency.

64. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 65
What causes hyperinflation?What causes hyperinflation?
Hyperinflation is caused by excessive
money supply growth:
When the central bank prints money,
the price level rises.
If it prints money rapidly enough, the
result is hyperinflation.

65. Recent episodes of hyperinflation Recent episodes of hyperinflation
slide 66

66. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 67
Why governments create hyperinflationWhy governments create hyperinflation
When a government cannot raise taxes
or sell bonds,
it must finance spending increases by
printing money.
In theory, the solution to hyperinflation
is simple: stop printing money.
In the real world, this requires drastic
and painful fiscal restraint.

67. The Classical DichotomyThe Classical Dichotomy
Real variables are measured in physical units:
quantities and relative prices, e.g.
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: measured in money units, e.g.
nominal wage: dollars per hour of work
nominal interest rate: dollars earned in future
by lending one dollar today
the price level: the amount of dollars needed
to buy a representative basket of goods
slide 68

68. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 69
The Classical DichotomyThe Classical Dichotomy
Note: Real variables were explained in Chap 3,
nominal ones in Chap 4.
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.

69. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 70
Chapter summaryChapter summary
1.Money
the stock of assets used for transactions
serves as a medium of exchange, store of
value, and unit of account.
Commodity money has intrinsic value, fiat
money does not.
Central bank controls money supply.
2.Quantity theory of money
assumption: velocity is stable
conclusion: the money growth rate
determines the inflation rate.

70. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 71
Chapter summaryChapter summary
3.Nominal interest rate
equals real interest rate + inflation rate.
Fisher effect: nominal interest rate moves
one-for-one w/ expected inflation.
is the opp. cost of holding money
4.Money demand
depends on income in the Quantity Theory
more generally, it also depends on the
nominal interest rate;
if so, then changes in expected inflation
affect the current price level.

71. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 72
Chapter summaryChapter summary
5.Costs of inflation
Expected inflation
shoeleather costs, menu costs,
tax & relative price distortions,
inconvenience of correcting figures for
inflation
Unexpected inflation
all of the above plus arbitrary
redistributions of wealth between debtors
and creditors

72. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 73
Chapter summaryChapter summary
6.Hyperinflation
caused by rapid money supply growth
when money printed to finance
govt budget deficits
stopping it requires fiscal reforms to
eliminate govt’s need for printing
money

73. CHAPTER 4CHAPTER 4 Money and Inflation Money and Inflation
slide 74
Chapter summaryChapter summary
7.Classical dichotomy
In classical theory, money is neutral--does
not affect real variables.
So, we can study how real variables are
determined w/o reference to nominal ones.
Then, eq’m in money market determines
price level and all nominal variables.
Most economists believe the economy
works this way in the long run.