Chapter 11: Inflation Chapter 11: Inflation

Inflation

A continuous rise of the general price level

General price level is measured by the Consumer Price Index (CPI): The weighted average price of 400 goods & services sold in urban areas around the nation.

Inflation RatePercentage change of the CPI over the previous period

Inflation stayed under 5% during the 1960s

It averaged 7.7% in the first half and 10.6% in the second half of the 1970s

Since the early 1980s, inflation rate has declined to as low as 3% in the late 1990s

Demand-Pull Inflation

Inflation caused by an increase in the level of Aggregate Demand (1960s)

At full employment, expansion of the Aggregate Demand is inflationary with no additional output

Price Level

Output of Goods & Services

105

110

200 400

S

S

D1

D1

Full employment output

120D2

D2

D3

D3

Demand-Pull Inflation

Cost-Push InflationCost-Push Inflation

Inflation caused by an decrease in the level of Aggregate Supply (1970s & early 1980s)

Higher general price level and falling output of goods & services result in stagflation, inflation plus stagnation

Cost-Push InflationPrice Level

Output of Goods & Services

105

110

200 400

S1

S

D

D

Full employment outputS2

115

50

S3

Effects of Inflation

Equity effect: changing the pattern of income distribution from wage-earners to profit-makers

Efficiency effect: requiring greater investment in hedging against inflation in labor & business contracts

Output effect: recession resulting from cost-push inflation

Functions of Money

Medium of ExchangeMeasure of ValueStore of Value

Characteristics of Money

Limited in supplyWidely acceptedPortableDivisibleUniformDurable

Money Supply

Narrow definition: M1

– Currency: coins & bills (25%)– Demand Deposits: checking account

deposits (75%)

Money Supply

Broad definition: M2

– M1– Time Deposits: savings account deposits

(less than $100,000)

Money Supply Line

The quantity of money in circulation is controlled by the central bank

Quantity of Money

Interest Rate (%)

S

S

80

5

10

Money Demand

The amount of money demanded for transaction and speculative purposes depends: personal income and interest rate

At any level of personal income, quantity demanded of money is a negative function of interest rate

Money Demand Line

Quantity of Money

Interest Rate (%)

D

D

10

5

10080

Money Market Equilibrium

Quantity of Money

Interest Rate (%)

D

D

5

80

S

S

Federal Reserve System, FED

The central bank of the U.S.

Independent decision making unit with regional banks

In charge of money supply management and economic stabilization

Tools of Monetary Policy

Legal reserve ratio: ratio of cash reserves to deposits that banks are required to maintain

By lowering the ratio, banks will have more reserves to lend and invest, increasing the money supply

Tools of Monetary Policy

Discount rate: rate of interest the FED charges on loans to banks

By lowering the rate, banks encourage borrowing from the FED and lending to the public, increasing the money supply

Tools of Monetary Policy

Open Market Operations: FED’s purchases and sales of government bonds

By purchasing bonds and paying the sellers, the FED increases the money supply

Expansionary Monetary Policy

Increase the money supply by any one or combination of the above tools

Reduce the interest rate to encourage investment

Increase Aggregate Demand, creating employment & income

Expansionary Monetary Policy

Quantity of Money

Interest Rate (%)

D

D

5

80

S

S

S’

S’

4

85

Quantity Theory of Money

Equation of Exchange: MV = PQ

– M = money supply– V = income velocity of money: the rate of turn over of

money– P = general price level– Q = output of goods & services

Quantity Theory of Money

Write: P = (V/Q) M

Assuming V, Q, and V/Q constant, an increase in M causes a proportional increase in P

Inflation is caused by a rapid growth of the money supply

Money Supply Growth & Inflation

In 1960s, inflation was low and money supply growth constant at about 7%

In the 1970s, inflation rose as the money supply grew at an increasing arte to reach 10%

In the 1980s and 1990s, inflation fell as money supply grew at a declining rate to reach about 6%