Week 5: Inflation
(Chapter 8)
Aarti Singh
University of Sydney
ECOS2002 Intermediate Macroeconomics

Outline
ECOS2002 Survey
Question
The Quantity Theory of Money
Long-run relationship between nominal and real variables
Real and nominal interest rates
Cost of Inflation
Case study: Wage-Price Spiral
The Fiscal Causes of High Inflation
Next week
Outline
ECOS2002 Survey
Question
The Quantity Theory of Money
Long-run relationship between nominal and real variables
Real and nominal interest rates
Cost of Inflation
Case study: Wage-Price Spiral
The Fiscal Causes of High Inflation
Next week
Survey I
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grandparents
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Parents
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family
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you
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Outline
ECOS2002 Survey
Question
The Quantity Theory of Money
Long-run relationship between nominal and real variables
Real and nominal interest rates
Cost of Inflation
Case study: Wage-Price Spiral
The Fiscal Causes of High Inflation
Next week
Question I
I This lecture: What causes inflation?
I "Inflation is always and everywhere a monetary phenomenon."
Milton Friedman
I "Inflation is always and everywhere a fiscal phenomenon." Thomas
Sargent
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Inflation I
p =
!
Pt!Pt!1
Pt!1
"
100
US: currently 7.9%
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Inflation I
Australia: 3.5%
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Outline
ECOS2002 Survey
Question
The Quantity Theory of Money
Long-run relationship between nominal and real variables
Real and nominal interest rates
Cost of Inflation
Case study: Wage-Price Spiral
The Fiscal Causes of High Inflation
Next week
QTM I
I Connects money and inflation
I Quantity equation
MtVt = PtYt (1)
I M is money
I V is velocity (The average number of times per year that each piece
of paper currency is used in a transaction)
I P is price level
I Y is real GDP
I One equation with 4 unknowns!
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Second equation of QT: Classical dichotomy I
I The second equation of the Quantity theory (QT) is in fact an
assumption
I The assumption is called the classical dichotomy which says that
"In the long run, the real and nominal sides of the economy are
completely separate."
I Real GDP is assumed as exogenously given. Determined by real
forces such s TFP, capital, labour..(lectures 1-3) Yt = Y¯
I The third equation of QT is a simplification: Velocity is constant
Vt = V¯
I The fourth equation of QT determines money supply. Since not
modelling how RBA conducts monetary policy, we assume Mt = M¯
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QTM model I
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QTM model solution I
I Solve for the price level
P"t =
MtV¯
Y¯t
(2)
I Price level will rise as a result of: increase in the money supply;
decreases in real GDP
I Prediction of QTM: In the long run, the key determinant of the
price level is the money supply
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QTM model solution for inflation I
I Using growth rates and assuming gV = 0
p"t = gM ! gY (3)
I Prediction of the QTM: Changes in the growth rate of money lead
to one-for-one to changes in the inflation rate
I This result serves as the main basis for the assertion by Milton
Friedman
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Long-run relationship between nominal and real variables I
I Empirically, what are the long run relationships between... ?
I p inflation
I DM :growth in M0;M1; and M2 measures of money
I Dy output growth
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Outline
ECOS2002 Survey
Question
The Quantity Theory of Money
Long-run relationship between nominal and real variables
Real and nominal interest rates
Cost of Inflation
Case study: Wage-Price Spiral
The Fiscal Causes of High Inflation
Next week
McCandless and Weber I
I McCandless and Weber (1995) "Some Monetary Facts"
https://EconPapers.repec.org/RePEc:fip:fedmqr:y:1995:i:sum:p:2-
11:n:v.19no.3
I Document long-run relationship (correlations) between DM and p,
DM and Dy and p and Dy
I Methodology:
I 110 countries, 30-years of data (1960-1990)
I Also look at subsamples: 21 OECD countries and 14 Latin American
countries
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Their findings I
I Money Growth and Inflation: In the long run, there is a high (almost
unity) correlation between the rate of growth of the money supply
and the rate of inflation
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Their findings II
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Long-run I
I Linear relationship, with many values close to the 45 degree line
I However, since the line does not go through the origin suggests that
that a central bank cannot generate a particular long run rate of
inflation by choosing an equal long run growth rate for the money
supply. The long-run inflation rate is influenced by the growth rates
of real output and velocity as well as by the growth rate of money.
But the long run a higher growth rate of the money supply will
result in a proportionally higher inflation rate.
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Long-run II
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Money growth and output growth I
I Money Growth and Real Output Growth: In the long run, there is no
correlation between the growth rate of money and real output. The
correlation holds across all definitions of money, but not for the
subsample of OECD countries, where the correlation is positive.
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Money growth and output growth II
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Money growth and output growth I
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I Increases in money growth are associated with increases in real
output growth about one-tenth as large
I Correlation; not causation; might reflect similar policy rules in these
countries
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I Inflation and Real Output Growth: In the long run, there is no
correlation between inflation and real output growth. This holds
across both samples after removing the outlier (Nicaragua).
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I Inflation and Real Output Growth Caveats: They note that the
relationship is disputed. Many people estimate negative or positive
relationships between inflation and real output.
I Also, if the long-run e§ect of monetary policy on real economic
activity is truly zero, then any short-run successes in reducing
downturns can only come about at the expense of reducing upturns.
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Outline
ECOS2002 Survey
Question
The Quantity Theory of Money
Long-run relationship between nominal and real variables
Real and nominal interest rates
Cost of Inflation
Case study: Wage-Price Spiral
The Fiscal Causes of High Inflation
Next week
I The relationship between i and r is given by the Fisher Equation
(1+ i) = (1+ r)(1+ pe ) (4)
I Since p " r is very small, and ignoring errors in inflation
expectations, it simplifies to
i = r + p (5)
if r is independent of p , then is there a
I positive correlation between i and DM (due to the long relationship
between p and DM)?
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I Monnet and Weber (2001) "Money and Interest Rates" Federal
Reserve Bank of Minneapolis Quarterly Review Fall 2001, Vol. 25,
No. 4, pp. 2—13
I Document the relationship between i and DM ,
I Methodology
I 32 countries, 19 developed and 13 developing, 37-years of data
(1961-1998)
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I Slope=0.68. nominal interest rates increase about 50—70 basis
points for each one percentage point increase in the rate of growth
of money
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Long-run stylized facts I
I Corr(DM,p)' 1
I Corr(DM,Dy)'0 or Corr(DM,Dy) > 0 but small for OECD
I Corr(p,Dy)'0
I Corr(DM, i) > 0
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Outline
ECOS2002 Survey
Question
The Quantity Theory of Money
Long-run relationship between nominal and real variables
Real and nominal interest rates
Cost of Inflation
Case study: Wage-Price Spiral
The Fiscal Causes of High Inflation
Next week
Costs of expected inflation
I Shoeleather costs: The inconvenience of carrying less cash
I Menu costs: The cost of changing prices. Also, lost revenue when
prices are not changed
I Taxes: most taxes are not indexed to inflation
I Consumer Uncertainty: How can one shop smartly if prices are
constantly changing?
I An individual who has a pension that is not indexed to inflation
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Costs of large unexpected surprise inflations
I Can lead to large distributions in wealth
I People with debts can pay back their loans with new cheaper dollars
I Creditors wind up losers
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Outline
ECOS2002 Survey
Question
The Quantity Theory of Money
Long-run relationship between nominal and real variables
Real and nominal interest rates
Cost of Inflation
Case study: Wage-Price Spiral
The Fiscal Causes of High Inflation
Next week
Nixon wage-price spiral I
I Facing reelection in 1972, with unemployment and inflation around
5% and a view that rising inflation was a consequence of wage-price
spiral
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Nixon wage-price spiral II
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Nixon wage-price spiral I
I 1971: Freeze wage and prices at their current levels for 90 days
I Inflation slowed; unemployment remained high
I Nixon administration pursued expansionary policy
I Plus the oil price increase
I Inflation was back
I Reinstated price controls in 1973 but finally abandoned in 1974
I Why didnt they work?: Price controls led to rationing (e.g higher
costs because of imported oil, cant increase your own price, reduce
supply); empty supermakets. Pent up inflation will be released when
price controls are lifted
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Outline
ECOS2002 Survey
Question
The Quantity Theory of Money
Long-run relationship between nominal and real variables
Real and nominal interest rates
Cost of Inflation
Case study: Wage-Price Spiral
The Fiscal Causes of High Inflation
Next week
The Fiscal Causes of High Inflation I
I QTM: The main cause of inflation in the long run is that the central
bank prints too much money
I But why does it do that?
I Printing money is one way for the government to pay its bills
G = T + DB + DM
I where G is government spending
I T is tax revenue
I B is stock of government debt
I DM is the change in the stock of money
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The Fiscal Causes of High Inflation I
I Seigniorage and the inflation tax
I Names for the revenue that the government obtains from printing
more money (DM)
I The inflation tax
I Shows up as a rise in the price level
I Is paid by people holding currency
I Who would be those people? people who hold a large fraction of
ther savings in checking accounts
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The Fiscal Causes of High Inflation I
I When is this likely to occur?
I In well-functioning economy, government finances its expenditure via
taxes or by issuing debt
I However when debt becomes very large, lenders might worry that
the government might not be able to repay. They ask higher and
higher interest rates and stop lending altogether
I Eg. Hyperinflation in many countries (Argentina, Brasil, Russia..)
I Consistent with Thomas Sargent point of view
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Episodes of High Inflation in Argentina, Brazil and Russia I
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Episodes of High Inflation in Mexico, Nigeria and
Venezuela I
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How to these episodes end? I
Hyperinflation ends when
I The rate of money growth falls rapidly
I The government gets its finances in order through lower spending,
higher taxes, and new loans
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Outline
ECOS2002 Survey
Question
The Quantity Theory of Money
Long-run relationship between nominal and real variables
Real and nominal interest rates
Cost of Inflation
Case study: Wage-Price Spiral
The Fiscal Causes of High Inflation
Next week
Next week
I The introduction to the short-run
I Readings: CJ Chapter 9
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