Lecture 7 money growth and inflation

Macroeconomics Lecture Money Growth & Inflation Chapter 28 In this chapter, you will study: The definition and measures of inflation  Two types of inflation  The causes of inflation and the quantity theory of money  The relationship between inflation and interest rates  The costs of inflation  Inflation  Inflation An increase in the overall level of prices in the economy  Inflation rate The percentage change in the price level from the previous period Inflation & Its Historical Aspects Inflation  Deflation A decrease in the overall level of prices in the economy (the U.S 1818-1821)  Disinflation A reduction in the rate of inflation (Vietnam 2011-2013)  Hyperinflation An extraordinary high rate of inflation (Germany after World War I)  Hyperinflation in Venezuela  Replacing toilet paper with cash would seem an extremely affluent action in most countries But in Venezuela, it's now the financially prudent thing to Types of Inflation Demand-pull inflation  Cost-push inflation  Demand-Pull Inflation Occurs when Aggregate Demand grows up quickly and runs ahead of Aggregate Supply for goods and services  Supply cannot increase accordingly because it is constrained by factor supplies (labor, technology, natural resources and capital)  Excess demand enables suppliers to increase the prices of their limited products  Demand-Pull Inflation Cost-push Inflation Occurs when there is a rise in production costs (wage and salary, raw material and components, government taxes, ect)  Profit margin decrease: a rationale for reducing supply (the law of diminishing marginal returns)  Suppliers increase prices to compensate partly for deacrease in profit margin, passing a part of their loss on to consumers  The Fisher Effect  Fisher effect: when the rate of inflation rises, the nominal interest rate rises by the same amount and the real interest rate stays the same Nominal Interest Rate = Real Interest Rate + Inflation Discussion Techcombank doubles the deposit interest rate from 7% to 14% per year  Meanwhile, the inflation rate rockets from 3% to 20%  Should you put your money at the bank? If not, what would you instead?  The nominal interest rate and the inflation rate The Costs of Inflation: A Fall in Purchasing Power? Increasing overall price level erodes the value of money  People earn income by selling their services  • Pay more for what they buy • Get more for what they sell => Nominal income tends to keep pace with rising prices => Inflation does not itself reduce people’s real purchasing power The Costs of Inflation       Shoeleather costs Menu costs Relative price variability and the misallocation of resources Inflation-induced tax distortions Confusion and inconvenience Arbitrary redistribution of wealth – a special cost of unexpected inflation Self-study Shoeleather Costs The resources wasted when inflation encourages people to reduce their money holdings Shoeleather Costs Inflation erodes the real value of money People try to minimize their cash holdings More frequent trips to the bank to withdraw money from interestbearing accounts  Costs of reducing money holdings:    time and convenience sacrificed to keep less money on hand less productive activities Menu Costs Menu costs: costs of price adjustment (Eg: the cost of deciding on and printing new price lists and catalogs)  Inflation increases menu costs as firms must change their price more frequently to keep up with other prices in the economy => a resource-consuming process that takes away from other productive activities  Relative-Price Variability and the Misallocation of Resources Relative price: the price of one good compared to the price of others in the economy  Inflation distorts relative prices  Distort consumer decisions  less able for markets to allocate resources to their best use  Inflation-Induced Tax Distortion Inflation blows up the size of capital gains  Tax law does not take account of inflation and compute income tax based on nominal income => Increase the tax burden on capital gains  Inflation-Induced Tax Distortion The income tax treats the nominal interest earned on savings as income  Part of the nominal interest rate merely compensates for inflation =>The after-tax real interest rate is reduced, making saving less attractive, depressing economic growth in the longrun  How Inflation Raises the Tax Burden On Saving Economy (price stability) Economy (inflation) 4% 4% Inflation rate Nominal interest rate (Real interest rate + inflation rate) 12 Reduced interest due to 25 percent tax After-tax nominal interest rate Real interest rate (.25 x nominal interest rate) (.75 x nominal interest rate) After-tax real interest rate (after-tax nominal interest rate - inflation rate) Confusion and Inconvenience Money is used to measure economic transactions, to quote prices and record debts  Inflation causes dollars to have different real values at different times  Difficult to compare real revenues, costs, and profits over time  Impede investors’ making right decisions  Arbitrary Redistribution of Wealth    • • Unexpected changes in prices redistributes wealth among debtors and creditors Inflation is taken into account when setting nominal interest rate for loans If inflation is not up to expectation: Unexpected hyperinflation enriches at the expense of creditors Unexpected deflation enriches creditors at the expense of debtors Lecture Review Definition and measures of inflation  Types of inflation  Causes of inflation and the quantity theory of money  Inflation and interest rates  Costs of inflation  ... of debtors Lecture Review Definition and measures of inflation  Types of inflation  Causes of inflation and the quantity theory of money  Inflation and interest rates  Costs of inflation ... Types of Inflation Demand-pull inflation  Cost-push inflation  Demand-Pull Inflation Occurs when Aggregate Demand grows up quickly and runs ahead of Aggregate Supply for goods and services... determinants  Money Supply, Money Demand, and Monetary Equilibrium  Monetary Equilibrium: The point at which the quantity of money demanded balances the quantity of money supplied Money Supply, Money