Chapter 11: Inflation

1
Chapter 11 Inflation
2
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.

3
Inflation Rate

• Percentage 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

4
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

5
Demand-Pull Inflation
Price Level
D3
S
D2
120
D1
110
D3
105
Full employment output
D2
S
D1
200
400
Output of Goods Services
6
Cost-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

7
Cost-Push Inflation
Price Level
S
S3
115
D
110
105
S2
Full employment output
S1
D
50
200
400
Output of Goods Services
8
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

9
Functions of Money

• Medium of Exchange
• Measure of Value
• Store of Value

10
Characteristics of Money

• Limited in supply
• Widely accepted
• Portable
• Divisible
• Uniform
• Durable

11
Money Supply

• Narrow definition M1
• Currency coins bills (25)
• Demand Deposits checking account deposits (75)

12
Money Supply

• Broad definition M2
• M1
• Time Deposits savings account deposits (less
  than 100,000)

13
Money Supply Line

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

Interest Rate ()
S
10
5
S
80
Quantity of Money
14
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

15
Money Demand Line
Interest Rate ()
D
10
5
D
100
80
Quantity of Money
16
Money Market Equilibrium
Interest Rate ()
S
D
5
D
S
80
Quantity of Money
17
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

18
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

19
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

20
Tools of Monetary Policy

• Open Market Operations FEDs purchases and sales
  of government bonds
• By purchasing bonds and paying the sellers, the
  FED increases the money supply

21
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

22
Expansionary Monetary Policy
Interest Rate ()
S
S
D
5
4
D
S
S
85
80
Quantity of Money
23
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

24
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

25
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