Inflation: Its Causes, Effects, and Social Costs Chapter 5 of Macroeconomics, 8th edition, by N. Gregory Mankiw ECO62 Udayan Roy Nominal Variables In Ch. 3 we saw a long-run theory of several real variables (Y, C, S, I, and r) Real variables are inflation-adjusted variables In this chapter we will see a long-run theory of three nominal variables: The overall price level, P The rate of inflation, The nominal interest rate, i I will be discussing only sections 5-3 and

5-4. Nominal Variables and the Quantity of Money Well see that all of our three nominal variables are, in the long run, driven primarily by the quantity of money in the economy Recall that in Chapter 4 we discussed money, and the control of the quantity of money by the Fed The money supply and monetary policy definitions The quantity of money available in the economy (M) is also called the money supply Monetary policy is the control of the money supply. The growth rate of the money supply will be denoted Mg.

Both M and Mg will be assumed exogenous The Central Bank Monetary policy is conducted by a countrys central bank. In the U.S., the central bank is called the Federal Reserve (the Fed). The Federal Reserve Building Washington, DC Money Demand = Money Supply Although a countrys central bank can control the money supply, ultimately the people must want to hold the money that the central bank wants them to hold That is, the money demand of the people

must be equal to the money supply desired by the central bank So, we now need to discuss money demand RECAP: INTEREST RATES Interest Rates: Chapter 3 Recap Before getting into money demand, we need to revisit the discussion of interest rates in Chapter 3 The Real Interest Rate Imagine that lending and borrowing take place in our economy, but in commodities, not cash That is, you may borrow some amount of the final good, as long as you pay back the quantity you borrowed plus a little bit extra as interest The real interest rate (r) is the fraction of

every unit of the final good borrowed that the borrower will have to pay to the lender as interest The nominal interest rate The interest paid for cash loans is called the nominal interest rate (i) It is the fraction of every dollar borrowed that the lender must pay in interest The nominal interest rate is not adjusted for inflation The nominal interest rate Suppose you borrow $100 today and promise to pay back $110 a year from today Here i = 0.10 If prices are low a year from today, the

purchasing power of the $10 you pay in interest will be high. So, you will regret the loss If prices are high a year from today, the purchasing power of the $10 you pay in interest will be low. You will not regret the loss as much The Real Interest Rate In the case of cash loans, the real interest rate is the inflation-adjusted interest rate To adjust the nominal interest rate for inflation, you simply subtract the inflation rate from the nominal interest rate If the bank charges you 5% interest rate on a cash loan, thats the nominal interest rate (i = 0.05). If the inflation rate turns out to be 3% during the loan period ( = 0.03), then you paid the real interest rate of just 2% (r = i = 0.02) The Real Interest Rate

The problem is that when you are taking out a loan you dont quite know what the inflation rate will be over the loan period So, economists distinguish between the ex post real interest rate: r = i and the ex ante real interest rate: r = i E, where E is the expected inflation rate over the loan period The Real Interest Rate r In chapter 3, we also worked out the longrun theory of the (ex ante) real interest rate, which yielded several predictions

I = Y C(Y-T) G I = F(K, L) C(F(K, L) -T) G I(r) = Io Irr I Predictions Grid Y C S, I r + + +

Taxes, T + Co + +

+ K, L, Technology Govt, G Io + MONEY DEMAND Money demand and the interest rate We can keep our wealth (our assets) in two forms: Liquid (money = currency + demand deposits) Illiquid (stocks, bonds, real estate, a wine collection, etc.)

Our demand for money depends on whether money is as good a store of value as the illiquid assets Money demand and the interest rate Liquid assets are assumed to earn no interest Illiquid assets are assumed to earn the nominal interest rate i Therefore, an increase in i is assumed to reduce the demand for money Assumption: the quantity of money demanded (Md) is inversely related to the nominal interest rate (i) Money demand and economic activity We also hold some of our wealth in the form of moneyinstead of some illiquid asset because money is an excellent medium of

exchange Therefore, the greater the need for a medium of exchange, the stronger will be the demand for money Assumption: the quantity of money demanded is directly related to nominal GDP Money demand and economic activity Let P represent the overall level of prices, as measured by the GDP Deflator Assumption: the quantity of money demanded (Md) is directly related to nominal GDP (PYY) Money Demand So, Md is inversely related to i, and directly related to PYY

Here, L, the desire for liquidity, is inversely related to i, the nominal interest rate Money Demand = Money Supply Therefore, using the algebra of growth rates that we discussed in chapter 2, we get Inflation Recall that the rate of inflation is simply the growth rate of the overall level of prices That is, = Pg, where Pg denotes the growth rate of P = Mg Lg Yg Growth Rates of Money and Output Assumption: The growth rates of the quantity of money (Mg) and real GDP (Yg) are both

exogenous Nominal Interest Rate: Simplifying assumption The following is to simplify our analysis: Assumption: In the long run, the nominal interest rate (i) stays constant over time As a result, L(i) also stays constant over time Therefore, Lg = 0 Therefore, last slides = Mg Lg Yg becomes = Mg Yg. As both Mg and Yg are assumed exogenous, we now have a theory of inflation ()! Inflation in the Long Run In the long run, the inflation rate = the rate at which the money supply grows the rate at which real GDP grows Example: if real GDP grows at the annual rate of

3.5% and if the quantity of money grows at the annual rate of 4%, then the rate of inflation will be 0.5% Inflation in the Long Run Long-Run Predictions Grid (Ch. 3) Y C S, I r + + +

Taxes, T + Co + +

+ K, L, Technology Govt, G Io + Long-Run Predictions Grid Y C S, I r

+ + + Taxes, T + Co

+ + + K, L, Technology Govt, G Io Mg Yg , E +

+ Expected Inflation: Simplifying Assumption Assumption: In the long run, expected inflation equals actual inflation (E = ) Recall that Therefore, Nominal Interest Rate in the Long Run We have As we already have a theory of r from Chapter 3, and as both Mg and Yg are exogenous, we now have a theory of the nominal interest rate (i) Nominal Interest Rate in the Long Run We have

Long-Run Predictions Grid Y C S, I r + + +

Taxes, T + Co + + +

+ + + + K, L, Technology Govt, G Io Mg Yg , E

+ i + The Overall Price Level in the Long Run Recall that As we have already developed theories of the nominal interest rate (i) and real GDP (Y), and as the quantity of money (M) is exogenous, the above equation gives our theory of the overall price level (P) We now have long-run theories for all three of our nominal variables (, i, and P)! The Overall Price Level in the Long Run Lets be more specific about L(i), the desire for

liquidity We have seen that the desire for liquidity is inversely related to the nominal interest rate So, let Then This is a more specific version of the last slide Figure 5-5: Simultaneous links Solving it all, step by step! M, L(i) P = M/L(i)Y i=r+ K, L, F(K, L) Y

G I(r) S=I=YCG r C C(Y T), T Mg,Yg, = Mg Yg Whole chapter in one slide! Long-Run Predictions Grid Y

C S, I r + + + Taxes, T Co +

K, L, Technology Govt, G Io Mg Yg , E i P

+ + + + +

+ + + + + + + + M

+ L0 Long-Run Macroeconomics Long-Run Predictions Grid Y C S, I r + +

+ Taxes, T Co + K, L, Technology Govt, G Io Mg Y g , E

i P +

+ + + + + + + +

+ + + + M + L0 Note that the money supply and its growth rate have no effect on the real endogenous variables This result is called monetary neutrality

Monetary neutrality does not hold in short-run theories Long-Run Macroeconomics Long-Run Predictions Grid Y C S, I r + + + Taxes, T

Co + K, L, Technology Govt, G Io Mg Y g , E i P

+ + +

+ + + + + + + +

+ + M + L0 Recall that i = r + E = r + , assuming expected inflation = actual inflation This yields the Fisher Effect: whatever affects inflation also has an identical effect on the nominal interest rate EVIDENCE

Figure 5 1: US Inflation and Money Growth Figure 5 2: International Data on Inflation and Money Growth Figure 5 3: Fisher Effect in US Data Figure 5 4: Fisher Effect in International Data Figure 5 6: Money and Prices in Interwar Germany