Money, Inflation, and Interest Rates: An Analysis of Monetary Policy, Monografías, Ensayos de Macroeconomía

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Macroeconomics

Chapter 4 - Money and Inflation (III)

Chapter 10 - Aggregate Demand I: Building

the IS-LM Model (V)

Equilibrium

M L r Y P

E

The supply of real

money balances

Real money demand

How P Responds to  M

• 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.

M L r Y P

E

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: Fed announces it will increase M next year. People

will expect next year’s P to be higher, so E  rises

• This affects P now, even though M hasn’t changed yet

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

A Common Misperception

• Common misperception:

Inflation reduces real wages

• This is true only in the short run, when

nominal wages are fixed by contracts

• 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…

The Classical View of Inflation

• The classical view: A change in the price level is

merely a change in the units of measurement

Then, why is inflation

a social problem?

The Social Costs of Inflation

Fall into two categories:

1. Costs when inflation is expected

2. Costs when inflation is different than

people had expected

The Costs of Expected Inflation:

2. Menu Costs

• Def: The costs of changing prices
• Examples:
• cost of printing new menus
• cost of printing & mailing new catalogs
• The higher is inflation, the more frequently

firms must change their prices and incur these

costs.

The Costs of Expected Inflation:

3. Relative Price Distortions

• Firms facing menu costs change prices infrequently.
• Example:

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…

…causing microeconomic inefficiencies

in the allocation of resources.

The Costs of Expected Inflation:

5. General Inconvenience

• Inflation makes it harder to compare nominal

values from different time periods

• This complicates long-range financial planning

Additional Cost of Unexpected Inflation:

Arbitrary Redistribution 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

One Benefit of Inflation

• Nominal wages are rarely reduced, even when

the equilibrium real wage falls.

This hinders labor market clearing.

• Inflation allows the real wages to reach

equilibrium levels without nominal wage cuts.

• Therefore, moderate inflation improves the

functioning of labor markets.

Hyperinflation

• Common definition:   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.