Classical Inflation

• Classical Inflation
  • Inflation and Money
  • Money
  • The Quantity Theory of Money
  • Seigniorage
  • Adjusting Prices for Inflation
  • Real vs Nominal Interest Rates
  • Costs and Benefits to Inflation
  • The Classical Dichotomy

Classical Inflation

Inflation and Money

• Inflation: The percentage rate in prices, calculated using measures like CPI
• In the short run, doubling the quantity of money in an economy might cause more demand and more output, but in the long run, all the prices would double and everything would remain the same
• Inflation must be understood as a monetary phenomenon
• Inflation (or increase in price) is related to a change in the money supply

Money

• Money: The stock of assets that can be readily used to make transactions
  • C: Currency (cash and coin); narrowest measure of money supply
  • M1: C and demand deposits, travelers’ checks, other checkable deposits (i.e. checking accounts)
  • M2: M1 and small time deposits (i.e. 3 month CD), savings deposits, money market mutual funds, money market deposit accounts
• Functions of money
  • Medium of Exchange: Used to make purchases
  • Store of Value: Used to transfer purchasing power to the future
  • Unit of Account: Used to compare value of goods
• Commodity money: Money that has intrinsic value, such as gold or silver
• Fiat money: Money that is assigned value by a government but has no intrinsic value
  • Paper currency, coins
  • The transition from commodity to fiat money usually has allowed the conversion of paper money into a commodity; AKA gold standard
• Good monetary policy does not require commodity-backed policy

The Quantity Theory of Money

• Classical theory of money
• Velocity: The rate at which money circulates through an economy; i.e. the number of times a dollar bill is spent
  • V = PY / M, where P is average price per transaction, Y is the volume of transactions, and M is the quantity of money
    • Know nas the quantity equation or the equation of exchange
• The Quantity Theory assumes that velocity is a constant feature of the economy, meaning that people consistently spend money at the same rate

$$\text{Since velocity is constant, } V = \bar{V} \\ M \bar{V} = PY \\ \text{If output is also thought of as constant:} \\ M \bar{V} = P \bar{Y}$$

This equation implies the following: - Money supply determines the nominal GDP (PY) - If the quantity of M changes in the economy, then the nominal GDP must change - In the short run, Y and P will both go up as M increases - In the short run, Y will go back to normal and P would rise in exactly proportion to M - This means that Y is also thought of as fixed

• Changes in money will lead to changes in prices; money growth creates price growth, or inflation

Seigniorage

• Fiat money costs very little to produce
  • For example, a $100 bill costs 13 cents to make
• Seignorage is defined as the money that the government makes from printing money
  • Can be thought of as a tax; increases prices for people, but also increases the amount of money that the government have
• Because the economy (and output, Y) grows over time, banks must print more money to keep prices steady
• Responsible central banks earn seigniorage revenue by slowly increasing the currency, maintaining prices
• Some governments rely more on seigniorage which causes higher inflation

Adjusting Prices for Inflation

• p is used to denote prices and pi is used to denote inflation
• To adjust a price for inflation, multiply the price by (1 + pi/100)^n where n is the number of years

Real vs Nominal Interest Rates

• Nominal interest rates (denoted by i) do not account for inflation, while real interest rates (denoted by r) do account for it
• Fisher equation: (1 + r) = (1 + i) / (1 + pi)

• Can use r = i - pi when i and pi are small (<10%)

• Ex ante: Expected real interest rate based on forecasted inflation rate; represented by r^e, using i^e as expected inflation
• Ex post: Real interest rate based on inflation rate given data on a past period of time

Costs and Benefits to Inflation

• Classical view: Inflation doesn’t matter because, if it is expected, then prices and wages will be adjusted accordingly
  • “Money is a veil”, simply changing a unit of measure
• Costs of high inflation
  • Typically unexpected, leads to arbitrary redistributions of wealth
  • More uncertainty in the economy which makes conducting business more costly
• Benefits of inflation
  • Reducing nominal wages is difficult due to social norms, so to cut wages, businesses leave nominal wages the same which decreases real wages
  • Inflation at 2% per year allows the labor market to work well

The Classical Dichotomy

• Real variables are measured in quantities of physical units
  • Real GDP, wage, interest rate all measures in quantities of output, not money
• Nominal variables are measured in money units instead
• The Classical Dichotomy separates real and nominal variables, implying that nominal variables do not affect real variables
• Monetary Neutrality states that money is irrelevant to understanding real variables; approximately neutral in the long run