Lecture 8 - Money Growth and Inflation

1. Inflation and the Value of Money

1.1 Core Definitions

Definition

Inflation: An increase in the overall price level in the economy.
Deflation: A decrease in the overall price level.
Hyperinflation: An extraordinarily high rate of inflation.

Inflation is an economy-wide phenomenon. It is measured using indices such as:

  • The Consumer Price Index (CPI)
  • The GDP deflator

Hyperinflation episodes such as Germany in the 1930s, Yugoslavia in the 1990s, and Zimbabwe in the late 2000s illustrate how extreme monetary instability can destroy economic functioning.

1.2 Inflation and the Value of Money

Inflation concerns the value of the economy’s medium of exchange.

If the price level is denoted by , then:

  • Inflation means rises.
  • The value of money is .
  • When increases, falls.
Economic Intuition

If prices double, each pound buys half as much as before. Inflation is therefore not just about “high prices”, but about the purchasing power of money.

Thus:

  • A rise in → fall in purchasing power.
  • Inflation is a monetary phenomenon affecting all nominal prices.

2. What Determines the Value of Money?

The value of money is determined by:

  • Money supply
  • Money demand

However, we must distinguish between:

  • The long run
  • The short run

In the long run:

  • The price level adjusts to equate money supply and money demand.

In the short run:

  • The interest rate plays a central role.

This lecture focuses on the long run.

3. The Classical Theory of Inflation

3.1 Historical Foundations

The classical theory of money:

  • Dates back to David Hume
  • Revived by Milton Friedman and monetarism in the 1970s
  • Represents the overwhelming consensus on long-run inflation
Theoretical Interpretation

The classical theory assumes that in the long run, real variables are determined by real factors such as technology , capital , and labour . Money affects only nominal variables.

3.2 Money Supply

Money supply is determined by:

  • The Central Bank (e.g. via Open Market Operations)
  • The banking system (money multiplier)

In the classical model:

  • The money supply curve is vertical
  • It is treated as a policy variable

3.3 Money Demand

Money demand reflects:

  • The wealth people wish to hold in liquid form
  • The need to conduct transactions

Money demand depends positively on .

Higher :

  • Reduces value of money
  • Requires people to hold more nominal balances

Thus money demand is:

  • Decreasing in
  • Increasing in

3.4 Long-Run Equilibrium

In the long run:

  • The price level adjusts so that

If money supply increases:

  • There is excess supply of money
  • People increase spending
  • Prices rise
  • Money demand increases
  • New equilibrium is reached at higher

4. Monetary Injection and Price Adjustment

Suppose the Central Bank doubles the money supply.

Mechanisms:

  • Purchases government bonds
  • Purchases private bonds
  • Reduces reserve requirements

Long-run effects:

  • Excess money → higher demand for goods
  • Output unchanged in long run
  • Prices rise proportionally
Summary
  • Money supply does not affect real GDP in the long run
  • It determines the price level
  • Doubling → doubling

This is the essence of monetary neutrality.

5. The Money Stock

5.1 Definitions

Definition

M1 = Currency + Demand deposits + Checkable deposits
M2 = M1 + Savings deposits + Money market mutual funds

The money stock is the total amount of fiat money in the economy.

Monitoring aggregates such as M2 helps track monetary expansion.

6. The Quantity Theory of Money

6.1 The Quantity Equation

The quantity equation:

Where:

  • = money supply
  • = velocity of money
  • = price level
  • = real output

equals nominal GDP.

Velocity is defined as:

This is an identity.

6.2 Long-Run Implications

Assume:

  • is stable
  • determined by real factors

Then:

  • Increase in must increase .
Theoretical Interpretation

If real output is pinned down by technology and factor endowments, and is stable, then changes in cannot affect real production. Adjustment must occur through prices.

This implies:

  • Growth in money supply determines inflation.

Milton Friedman summarised this as:

“Inflation is always and everywhere a monetary phenomenon.”

6.3 Empirical Regularity

Over long periods:

  • Nominal GDP and M2 grow dramatically.
  • Velocity remains relatively stable.

This empirical stability supports the quantity theory in the long run.

7. Classical Dichotomy and Monetary Neutrality

Definition

Nominal variables: Measured in monetary units.
Real variables: Measured in physical units.

Definition

Classical dichotomy: Separation between nominal and real variables.

Definition

Monetary neutrality: Changes in money supply do not affect real variables in the long run.

Real interest rates, real wages, employment, and output are unaffected by money growth in the long run.

Exam Insight

If asked: “Explain monetary neutrality”, state clearly that in the long run money growth affects only inflation, not real GDP or employment.

8. The Fisher Effect

8.1 Real vs Nominal Interest Rates

Rearranged:

Where:

  • = nominal interest rate
  • = real interest rate
  • = inflation

8.2 The Fisher Effect

Definition

Fisher Effect: A one-for-one adjustment of nominal interest rates to changes in inflation.

If money growth increases inflation:

  • Real interest rate unchanged
  • Nominal rate rises one-for-one

This holds in the long run when inflation is expected.

Common Mistake

Do not assume the Fisher effect holds in the short run. Unexpected inflation can temporarily affect real rates.

9. Why Inflation Matters

Even if inflation does not reduce real purchasing power directly, it has costs.

9.1 The Inflation Tax

Definition

Inflation tax: Revenue raised by printing money.

Mechanism:

  • Government prints money
  • Prices rise
  • Real value of money holdings falls

This is effectively a tax on money holders.

9.2 Shoeleather Costs

Inflation encourages:

  • Lower money holdings
  • More frequent bank visits
  • Higher transaction costs

Modern equivalent:

  • Financial management costs
  • Increased transaction complexity

9.3 Menu Costs

Firms must:

  • Change prices
  • Update systems
  • Adjust contracts

These are real resource costs.

9.4 Distortion of Relative Prices

Inflation interferes with the price system.

Theoretical Interpretation

Markets rely on relative prices to allocate resources efficiently. Inflation introduces noise, making it harder to distinguish real changes from nominal changes.

This leads to:

  • Misallocation of savings
  • Poor investment decisions
  • Reduced efficiency

9.5 Arbitrary Redistribution

Unexpected inflation:

  • Transfers wealth from creditors to debtors.
  • Reduces real value of fixed nominal debts.

This redistribution:

  • Is not merit-based.
  • Is not based on need.
  • Undermines contract stability.

10. Deflation

Deflation also creates problems:

  • Incentive to postpone spending
  • Reduced investment
  • Downward spiral

Debt deflation:

  • Real burden of debt rises
  • Financial instability

Central banks respond by lowering interest rates, but they face the lower bound constraint.

Japan provides a historical example of prolonged low inflation and stagnation.

11. Overall Summary

Summary
  • In the long run, money supply determines inflation.
  • The quantity equation provides a formal explanation.
  • Monetary neutrality holds in the long run.
  • The Fisher effect links inflation and nominal interest rates.
  • Inflation imposes real economic costs.
  • Both high inflation and deflation are problematic.

The key message:

In the long run, sustained inflation is caused by sustained growth in the money supply.

Short-run complications will be studied later in the module.

Bibliography

Fisher, I. (1930) The Theory of Interest. New York: Macmillan.

Friedman, M. (1963) Inflation: Causes and Consequences. New York: Asia Publishing House.

Hume, D. (1752) ‘Of Money’, in Political Discourses. Edinburgh.

Mankiw, N.G. and Taylor, M.P. (2023) Macroeconomics. 6th edn. Andover: Cengage Learning.

Jensen, M.K. (2026) ECON1002: Money Growth and Inflation, Week 5 Set 1 Lecture Slides. University of Nottingham. oai_citation:1‡Week_5_set1.pptx