Lecture 19: Inflation in the Business Cycle Model

1. Lecture 19: Inflation in the Business Cycle Model L11200 Introduction to Macroeconomics 2009/10 Reading: Barro Ch.11 16 March 2010

2. Introduction • Before the Mid-Term Exam: • Considered role of money demand and supply in determining the price level • Introduced concept and measurement of inflation • Today • Incorporate inflation into decisions of agents in the Equilibrium Business Cycle Model

3. Real Effects of Inflation • In previous version of the model, inflation rate was zero • Does positive inflation affect choices? • Channel through which it might is effect on real interest rate Real interest rate = nominal interest rate – inflation rate

4. Bonds rate and Interest Rates • Rate of return on capital / bonds • Written in real terms, so no change if inflation is positive • Households make investment decisions based on real return, so changes in inflation rate push up nominal return and leave real return unchanged

5. Money Demand • Does inflation impact on money demand? • Money demand was a trade-off between cash (lower transaction costs) or assets (which earn a return) • Interest rate on assets: • Return on holding money is -π • So net of these is i : money demand still driven by nominal interest rate

6. Labour and Capital Markets • So positive inflation rate has no impact of asset holding / money demand decision • What about capital and labour markets? • No effect on MPK (capital demand), or κK (labour supply) as R/P unchanged • No effect on MPL (labour demand) of W/P* as wage bargained in real terms • Overall: positive inflation doesn’t impact output, capital/labour mix, consumption/saving or labour supply, money demand or asset holding

7. Money Growth and Inflation • Understanding Dynamics of Inflation Growth of money supply = money at time t+1 – money at time t Rate money supply growth = growth of money supply between t and t+1 / money at time t Rate of inflation= growth of money prices between t and t+1 / price level at time t

8. Money Growth and Inflation • Equilibrium in the money market given by • So price level determined by: • Hence (for fixed L(Y,i)) money growth determines price growth Inflation rate = money growth rate

9. Money Demand and Money Growth • Demand for money also changes over time • Increase in output (Y) raises money demand. With constant growth is Y • is (constant) rate of growth of money demand

10. Inflation Dynamics • Dynamics of inflation driven by: • Money growth: constant rate μ • Money demand growth: constant rate Price level = level of money supply / level of money demand Inflation rate = rate of money supply growth – rate of money demand growth

11. Changes in Money Growth • What is the impact of a change in the growth of money? • Assume Y is constant (money demand constant) • Prices growing in line with money growth • Then government undertakes one-off increase in money supply • What is the impact on prices?

12. Changes in Money Growth • Prices now grow at new (higher) rate of money growth • Nominal interest rate increases in line with one-off increase in prices • Real interest rate unchanged • Higher nominal interest rate induces effect on money demand: money demand falls as households offset higher opportunity cost of holding money by reducing money holding

13. Effect on Money Demand • Household offload excess money holding • Now holding too much cash relative to assets at the new nominal interest rate • (Transactions costs are unchanged) • So off-load cash onto asset purchases • Increases demand investment (bought of out current output) • Raises price level in the economy

14. Jump in Price Level • So increasing money supply growth has two effects • Increases steady-state inflation rate 1:1 • Induces one-off jump in price level via impact on money demand • So prices jump (high inflation) followed by fall in inflation down to new steady-state level

15. Printing Money • Q: Can governments benefit from ‘printing money’ (i.e. print new money and spend it) • A: Maybe, if money demand is slow to adjust • Government prints money for itself • Nominal value of new money: • Real value of new money: • Real revenue from printing money:

16. Printing Money • So return to government depends on how quickly M/P responds • If households lower money demand quickly, prices rise and M/P falls equivalent to increase in supply • So real revenue from printing money = 0 • If money demand is slow to adjust, government makes real return from printing money

17. Real Money Balance Adjustment • Money Printing vs Money off-loading • So government is in a ‘race’ against households • Government prints cash (and begins spending) • Causes price inflation, increases nominal interest rate • Households lower money demand and real money balances • Price rise (decreasing value of printed money) • Real return to government falls

18. Hyperinflation • Evidence suggests that when governments try to print money, households respond quickly • E.g. German government 1920-23 tried to repay war debts by printing money • Households figured this, and lowered money demand • So inflation rate exceeded money growth rate (as households offloaded excess money holding) • Government printed more and more money, but couldn’t outstrip growth in inflation rate (caused by household response)

19. Summary • Inflation caused by growth in money supply • Has no effect on real variables, so leaves key economic outcomes unchanged • But can distort price dynamics and be mis-used by governments • Evidence suggests cannot be used on large-scale • Next time: more orthodox spending policy! • Government taxation and spending