Money Growth & Inflation

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THE CLASSICAL THEORY OF INFLATION

Inflation is an increase in the overall level of prices. Hyperinflation is an extraordinarily high rate of inflation.

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THE CLASSICAL THEORY OF INFLATION

The classical theory of inflation is also known by the name of quantity theory of money. The quantity theory of money is used to explain the long-run determinants of the price level and the inflation rate.

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The level of prices & value of money

Inflation is an economy-wide phenomenon that concerns the value of the economys medium of exchange (i.e. money).

Value of money is expressed in terms of what amount of goods and services it can by.
Value of money is thus nothing but purchasing power of money.
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The level of prices & value of money

When the overall price level rises, the value of money falls. This is because with the rise in prices, each dollar/rupee in your wallet buys less amount of goods & services than before.

Thus we can conclude that the general price level and the value of money share a inverse relationship.
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The level of prices & value of money

Thus, if P is the general price level in the economy and V is the value of money, it can be expressed as V=1 P

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Money Supply, Money Demand, and Monetary Equilibrium

The value of money is determined by the demand and supply of money. The supply of money is largely controlled by the RBI through bank rates, CRR, SLR and open market securities. Thus money supply is a variable controlled by the policy adopted by RBI.
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Money Supply, Money Demand, and Monetary Equilibrium

Money demand has several determinants, the major being price levels. As price level rises, people need more money to buy the same goods and services and hence demand more money. To a certain extent the demand for money also depends on the interest rate that an individual would earn by buying an interest bearing security.
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Money Supply, Money Demand, and Monetary Equilibrium

In the long run, the overall level of prices adjusts to the level at which the demand for money equals the supply.

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Figure 1 Money Supply, Money Demand, and the Equilibrium Price Level
Value of Money, 1 /P (High) 1 Money supply Price Level, P 1 (Low)

/4

1.33

12

Equilibrium value of money

Equilibrium price level

14

4 Money demand

(Low)

0 Quantity fixed by the RBI

Quantity of Money

(High)

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Figure 2 The Effects of Monetary Injection

Value of Money, 1 /P (High) 1

MS1

MS2

Price Level, P

1
1. An increase in the money supply . . . A

(Low)

2. . . . decreases the value of money . . .

/4

1.33 3. . . . and increases the price level.

12

14

B Money demand

(Low) 0
M1 M2

(High)

Quantity of Money

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THE CLASSICAL THEORY OF INFLATION

The Quantity Theory of Money
How the price level is determined and why it might change over time is called the quantity theory of money.
The quantity of money available in the economy determines the value of money.

The primary cause of inflation is the growth in the quantity of money.

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The Classical Dichotomy and Monetary Neutrality

Nominal variables are variables measured in monetary units.
E.g.: nominal GDP measures the dollar value of output of goods and services & hence is affected by change in price of those goods and services.

Real variables are variables measured in physical units.

E.g.: real GDP measures quantity of goods and services produced & is not influenced by price of those goods & services.
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The Classical Dichotomy and Monetary Neutrality

The separation of real and nominal variables is known as classical dichotomy. According to the classical dichotomy, different forces influence real and nominal variables.

Changes in the money supply affect nominal variables but not real variables.
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The Classical Dichotomy and Monetary Neutrality

For e.g.: Real GDP depends on productivity and factors supplies. Real interest rates balances the demand and supply of loanable funds

Thus real variables are not affected by the money supply.

The irrelevance of monetary changes for real variables is called monetary neutrality. Thus when supply of money increases it rises the price levels but real variables like production, employment, real wages and real interest rate remain unchanged.
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Velocity and the Quantity Equation

The velocity of money means the number of times each unit of money is spent in a given period or the number of times each unit changes hands. It reflects how many times the total quantity of money circulates in the economy.

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Velocity and the Quantity Equation

V = (P Y)/M
Where: V = velocity
P = the price level Y = the quantity of output M = the quantity of money

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Velocity and the Quantity Equation

Rewriting the equation gives the quantity equation: MV=PY This equation states that quantity of money (M) times the velocity of money (V) equals the price of output (P) times the amount of output (Y). The quantity equation relates the quantity of money (M) to the nominal value of output (P Y).
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Velocity and the Quantity Equation

MV=PY
The quantity equation shows that an increase in the quantity of money in an economy must be reflected in one of three other variables:
the price level must rise, the quantity of output must rise, or the velocity of money must fall.

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Velocity and the Quantity Equation

The Equilibrium Price Level, Inflation Rate, and the Quantity Theory of Money
The velocity of money is relatively stable over time. When the RBI changes the quantity of money, it causes proportionate changes in the nominal value of output (P Y). Because output is neutral, money does not affect output. Thus the proportionate increase in nominal value of output as a result of increase in money supply is reflected in high prices.
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The Inflation Tax

At times governments of countries print new currency so that they can pay for the spending done by government. This increases money supply in the economy making the value of money low and rising the prices. Thus, when the government raises revenue by printing money, it is said to levy an inflation tax.

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The Inflation Tax

The value of money held by all decreases. Thus, an inflation tax is like a tax on everyone who holds money. The inflation ends when the government institutes fiscal reforms such as cuts in government spending.
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The Fisher Effect

The Fisher effect studies how money supply and inflation affect interest rates. Real interest rate = Nominal interest rate Inflation rate

Thus, Nominal interest rate = real interest rate + inflation rate. The real interest rate is determined by demand and supply of loanable funds.
And money supply determines the inflation rate.
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The Fisher Effect

With increase in supply of money, inflation rate would rise and real interest rate being a real variable is not affected by the money supply. According to the Fisher effect, thus when the rate of inflation rises, the nominal interest rate rises. The Fisher effect refers to a one-to-one adjustment of the nominal interest rate to the inflation rate.

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THE COSTS OF INFLATION

A Fall in Purchasing Power
It is easy to say that inflation reduces the purchasing power in the hands of the people. It should however be remembered that an increase in inflation is most of the times joined by increase in income as well.

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THE COSTS OF INFLATION

A Fall in Purchasing Power
But the increase in income with rise in inflation takes certain amount of time. An even then if the rise in prices is still higher than rise in income, it indeed reduces the purchasing power in the hands of the people

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THE COSTS OF INFLATION

Shoeleather costs Menu costs Relative price variability Tax distortions Confusion and inconvenience Arbitrary redistribution of wealth
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Shoeleather Costs
Shoeleather costs are the resources wasted when inflation encourages people to reduce their money holdings. Inflation reduces the real value of money, so people have an incentive to minimize their cash holdings. Thus your money is better if you keep in your interestbearing savings account than in your wallet.

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Shoeleather Costs
Less cash requires more frequent trips to the bank to withdraw money. The actual cost of reducing your money holdings is the time and convenience you must sacrifice to keep less money on hand. Also, extra trips to the bank take time away from productive activities.
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Menu Costs
Menu costs are the costs of adjusting prices. During inflationary times, it is necessary to update price lists and other posted prices.

This increases other costs like:

time and energy spent in deciding new prices printing new catalogs & price lists cost of sending these new price list to dealers and customers advertising cost to inform price change cost of dealing with customer annoyance over price rise.

This is a resource-consuming process that takes away from other productive activities.
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Relative-Price Variability and the Misallocation of Resources

Inflation distorts relative prices. People decide what to buy by comparing price and quality of different goods. But during inflation prices of different goods & services change in a distorted fashion. Thus, consumer decisions are distorted, and markets are less able to allocate resources to their best use.
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Inflation-Induced Tax Distortion

Tax laws charge tax on the income without considering the effect of inflation. One example is, suppose you used your savings to purchase land worth 10000 in 1990 and sold it in 2010 for 50000, the tax will be calculated on your capital gain of 40000. But if the prices have doubled since then means your investment in terms of purchasing power today is 20000, making your real gain only of 30000.
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Inflation-Induced Tax Distortion

Another example is of interest income. The income tax treats the nominal interest earned on savings as income, even though part of the nominal interest rate merely compensates for inflation.

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Table 1 How Inflation Raises the Tax Burden on Saving

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Inflation-Induced Tax Distortion

The after-tax real interest rate falls, making saving less attractive. Thus people tend to save less in times of inflation. If savings in the economy reduce so does the supply of money needed for investments. This leads to less efficient use of economic recourses.
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Confusion and Inconvenience

Money acts as a measuring rod and hence it itself should remain stable. When price stability is distorted due to inflation, measuring various things in terms of money becomes difficult. It becomes difficult to measure the revenues, costs, prices, interest rates, etc. in terms of money. This leads to confusion and inconvenience economy. in the

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A Special Cost of Unexpected Inflation: Arbitrary Redistribution of Wealth

Unexpected inflation redistributes wealth among the population in a way that has nothing to do with either merit or need.

They redistribute wealth among debtors and creditors, fixed income and variable income earners, and between return on shares and other assets with fixed returns.

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