16.1 Money Growth, Inflation, and Interest Rates

Inflation in a Steady State

• Nominal Wages: Wages expressed in current dollars.

• Real Wage: The wage rate paid to employees is adjusted for changes in the price level.

• Money illusion: Confusion of real and nominal magnitudes.

• Expectations of inflation: The beliefs held by the public about the likely path of inflation in the future.

• Inflation Expectations and Interest Rates

  • Nominal rates of interest do depend on monetary policy because whether the Fed expands or contracts the money supply affects the rate of inflation, which in the long run is determined by the growth of the money supply.

• Inflation Expectations and Money Demand

  • Since, money demand and supply are both growing at the same rate, real interest rates, and nominal interest rates will not change.

How Changes in the Growth Rate of Money Affect the Steady State

• In the short run, a policy of tight money leads to slower money growth, higher interest rates, and lower output.

• In the long run, reduced money growth results in lower interest rates, lower inflation, and no effect on the level of output.

16.2 Understanding the Expectations Phillips Curve: The relationship between Unemployment and Inflation

• Expectations Phillip curve: The relationship between unemployment and inflation when taking into account expectations of inflation.

• The expectations Phillip curve included the notion that unemployment varies with anticipated inflation.

• After workers recognize that the inflation rate is higher, though, they will incorporate this higher inflation rate into their expectations of inflation.

• A decrease in the inflation rate is likely to be associated with temporary increases in unemployment.

Are the Public’s Expectations about Inflation Rational?

• Two broad classes of theories attempt to explain how the public forms its expectations of inflation

  • Some believe the public uses simple rules of thumb to predict future inflation. One such rule of thumb might be to assume next year’s inflation rate will be the same as this year’s.

  • Rational expectations: The economic theory analyzes how the public forms expectations in such a manner that, on average, it forecasts the future correctly.

• The theory predicts the public will anticipate the consequences of these policies and change its expectations about inflation.

• With long-term contracts, workers and firms must make forecasts far into the future.

U.S. Inflation and Unemployment in the 1980s

• By 1980, inflation had risen to 9.4 percent for two reasons:

  • Utilizing expansionary policy, the Carter administration had steadily reduced unemployment to under 6 percent by 1979.

  • There was an oil shock in 1979, which also contributed to higher inflation.

• By the time President George H. W. Bush took office in 1989, actual unemployment was below the natural rate of unemployment, inflation had been rising, and the Fed started slowing down the economy.

• The rate of inflation was eventually reduced, but the recovery back to full employment in 1992–1993 came too late in Bush’s term for the voters to fully appreciate, and he lost his bid for reelection.

Shifts in the Natural Rate of Unemployment in the 1900s

• Economics has identified a number of factors that can shift the natural rate of unemployment:

  • Demographics: The composition of the workforce can change, decreasing the natural rate.

  • Institutional changes: Changes in laws, regulations, and economic institutions can influence the natural rate of unemployment.

  • The recent history of the economy: Some economists believe the economic performance of the economy itself may influence the natural rate of unemployment.

  • Changes in growth of labor productivity: If the growth rate in labor productivity falls, wages must also rise more slowly because they are tied to productivity increases in the long run.

16.3 How the Credibility of a Nation’s Central Bank Affects Inflation

• The heads of central banks are conservative, preferring to risk increasing unemployment rather than inflation.

• Since 1989, the central bank in New Zealand has been operating under a law that specifies its only goal is to attempt to maintain stable prices, which, in practice, requires it to keep inflation between 0 and 2 percent a year. This policy sharply limits the central bank’s ability to stabilize real GDP, but it does signal to the private sector that the central bank will not be increasing the money supply, regardless of the actions taken by wage setters or unions.

• Some political scientists and economists have suggested that central banks that have true independence from the rest of the government and are therefore less subject to political influence, will be more credible in their commitment to fighting inflation.

16.4 Inflation and the Velocity of Money

• The velocity of money is defined as the ratio of nominal GDP to the money supply.

  • Velocity of money = nominal GDP/money supply

  • Money supply x velocity = nominal GDP

  • M * V = P * y

• Quantity Equation: The equation links money, velocity, prices, and real output.

• Growth Version of the quantity Equation: An equation that links the growth rates of money, velocity, prices, and real output.

  • Growth rate of money = growth rate of velocity = growth rate of prices = growth rate of real output

• The formula allows for real economic growth and for growth in velocity.

16.5 Hyperinflation

• Hyperinflation: An inflation rate exceeding 50 percent per month.

• The value of money deteriorates sharply during hyperinflations and no longer serves as a good store of value.

• The velocity of money should increase sharply during hyperinflations.

• During hyperinflations, money doesn’t facilitate exchange well.

• Hyperinflation also means people have less time to produce goods and services.

How Budget Deficits Lead to Hyperinflation

• Seignorage: Revenue raised from money creation.

• Governments do a combination of both selling bonds and printing money, as long as the deficit is covered.

• Government deficit = new borrowing from the public + new money created

• Hyperinflation also means people have less time to produce goods and services.

Monetarists: Economists who emphasize the role that the supply of money plays in determining nominal income and inflation.