Economics 161
Fall 2003
STUDY QUESTIONS ON MONEY AND INFLATION
1. What is the relationship between the price level and the “value of money”? Explain your answer.
2. What is meant by the “demand for money”? Why is the primary benefit of holding money?
3. What variables affect the demand for money? Explain.
4. Using a graph of the money market, determine the impact on the price level of an increase in money supply. Explain the adjustment process.
5. Classical theory claims that money is neutral. What does this mean and why does classical theory make this claim? Use a graph of the labor market and production function to explain your answer.
6. What is velocity of money? What is the exchange of equation (also called the quantity exchange)? What is the quantity theory of money?
7. “The cost of inflation is that it reduces one’s purchasing power.” Do you agree? If not, explain what is wrong about this statement.
8. What are the costs of inflation? Explain.
ANSWERS
1. The value of money = 1/P where P is the price level. To understand this, imagine that there was one good in the economy, say, widgets. The price level would then simply be the money price of widgets. For example, suppose P = $0.50/ widget.
Then 1/P = 1/0.5 = 2. What does this number tell us? It tells us that ONE dollar can be used to purchase 2 widgets. In other words, it tells us the value of one dollar (the value of money). Suppose the price of widgets rises to $1/widget (i.e., P = $1/widget). Now
1/P = 1/1 = 1. Therefore one dollar can now only buy 1 widget. Our example indicates that as P rises (price level goes up) the value of money goes down (cannot buy as many goods with one dollar).
2. Demand for money: the desire to hold money as a store of value. The demand for money can be thought of as a portfolio decision—that is, how much of my wealth should I hold in the form of money? The primary benefit of holding money is that it is the most liquid (“flexible”, “convenient” )of all assets. So the demand for money is the demand for liquidity.
3. a. The price level (P). As the price level rises, people require more dollars to conduct a given level of transactions. Therefore, as P increases, the demand for money increases.
b. Real income (Y). As people’s real income rises, they desire to buy more goods and services. As desired transactions rises, the demand for money rises. In summary, as Y rises, the demand for money rises.
c. The real rate of interest (r). As the real rate of interest rises, the opportunity cost of holding money (in the form of forgone interest income) rises. As the cost of holding money rises, people will desire to hold less money. So as r rises, demand for money falls.
d. The expected inflation rate (π). As the expected inflation rate rises, the cost of holding money rises (in the form of expected lost purchasing power). As the cost of holding money rises, people will desire to hold less money. In summary, as π rises, the demand for money falls.
4.
Value of money (1/P)
MS1 MS2
(1/P1)
(1/P2)
Money Demand
Quantity of Money
Suppose the Fed increases the money supply from MS1 to MS2.
The adjustment process:
i.At the initial value of money of 1/P1, people are now holding more money than they desire to hold (that is, the supply of money exceeds the demand for money at 1/P1).
ii. The public attempts to reduce their excess holdings by either spending on goods and services or by lending it to someone else who uses it to buy goods and services. Either way, there is a general increase in demand for goods and services.
iii. With this general rise in demand for goods and services, prices will be bid up (the price level rises). As P rises, 1/P falls until money supply again equals money demand. Equilibrium is again established at 1/P2.
5. The claim that money is neutral means that a change in the money supply will NOT affect any real variables, rather it will only affect nominal variables. Classical theory makes that claim because it believes that markets clear rapidly. For example, suppose the labor market is initially in equilibrium at W1/P1 and L1 (see graph below)
Y Production Function Y= real output (real GDP)
PF = production function
PF L = labor
Y1
W= nominal wage rate
P= price level
W/P = real wage rate
L
W/P Labor Market
LS
W2/P2=W1/P1
LD
L1 L
Now suppose P rises due to an increase in the money supply. According to classical theory, the labor market clears rapidly (i.e., the labor market is nearly always in equilibrium). Therefore, W must rise in proportion to P to maintain equilibrium in the labor market. If W did not rise when P did, then W/P would fall. The fall in W/P lead to a shortage in the labor market (LD > LS). But the shortage would cause W to be quickly bid up so that W/P would end up at the same level as before the increase in M and P. The end result is that the real wage rate, employment, and real output are unchanged, although the nominal wage rate is higher—hence the claim that money is neutral.
6. Velocity of money is the average number of times a dollar is used to purchase final goods and services. More specifically, velocity of money (V) is:
V = (P*Y)/M
where P is the price level, Y is real output, and M is the money supply. P*Y is nominal output.
If we rearrange this equation, we get the Equation of Exchange (also called the quantity equation): M*V = P*Y.
The quantity theory of money (also called the classical theory of inflation) claims that:
i. V is stable (roughly constant) over time
ii. Y is determined by A, K, H and N. Printing up more money does not change these variables, and so we can treat Y as constant when M changes.
iii. Given that V and Y are constants, increasing M causes a proportionate increase in P.
7. Do not agree. When the money supply rises, ALL prices rise—including the average nominal wage rate. So the price of goods rise, but so do nominal incomes. In other words, the very thing (the rise in the money supply) that causes prices to rise also causes nominal incomes to rise.
8. Costs of inflation:
a. Shoeleather costs: People will not desire to hold as much money when inflation is high. One way to reduce your holdings of money is by making more trips to the bank Instead of withdrawing $1000 per month, you might withdraw $250 each week. Therefore, you can keep more of your wealth in interest-bearing accounts and less in you pocket. The costs of making more frequent trips to your bank are what are known as shoeleather costs.
b. Menu costs: Firms must reprint catalogs and menus much more frequently during inflationary times.
c. Inflation-induced Tax Distortions: Suppose you buy stock in 1993 for $100 and sell it in 2003 for $200. According to US tax law you had a $100 capital gain that will be taxed. Suppose that the price level doubled over this period. In real terms, you do not earn a capital gain ($100/1 = $200/2). Yet the government taxes you on your nominal gain of $100 (=$200 minus $100). Suppose the tax rate is 50%. Your tax is therefore $50. After tax, you end up with $200-$50 or $150. In real terms, you lose since $150/2 < $100/1. This implies that this tax distortion caused by inflation will create a disincentive to buy stock. In general, it creates a disincentive to save.
d. Confusion and Inconvenience.
Inflation does not tend to be steady. In countries that experience hyperinflation, inflation rates may vary from 30% to 50% on a monthly basis. This creates uncertainty about how much value money will lose. This makes planning difficult.
e. Redistribution of wealth
When there are unanticipated changes in the inflation rate, there is redistribution of wealth between lenders and borrowers. For example, suppose the nominal rate of interest is 10%, the actual inflation rate (π) is 4% and the expected inflation rate (at the time loans were made) was 2%. Lenders and borrowers expected a real rate of interest of 8% (recall that re = i – πe), but the realized real rate of interest turns out to be 6% (recall that rr = i-π)
Thus borrowers gain and lenders lose. The uncertainty generated by inflation creates uncertainty about the profitability of borrowing and lending. To avoid this uncertainty lenders may reduce the amount of lending.