7.4 What causes inflation?

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By the end of this section, you will be able to:

• Explain the relationship between indexing and inflation
• Identify three ways the government can control inflation through macroeconomic policy

A preview of policy discussions of inflation

We will talk more about inflation in a later chapter. But the fundamental cause of inflation can be summed up in one sentence: Too many dollars chasing too few goods. The great surges of inflation early in the twentieth century came after wars, which are a time when government spending is very high, but consumers have little to buy, because production is going to the war effort. Governments also commonly impose price controls during wartime. After the war, the price controls end and pent-up buying power surges forth, driving up inflation. On the other hand, if too few dollars are chasing too many goods, then inflation will decline or even turn into deflation. Therefore, slowdowns in economic activity, as in major recessions and the Great Depression, are typically associated with a reduction in inflation or even outright deflation.

In a nutshell, if governments print and spend too much money, demand rises relative to supply. As we know, that will drive up prices. The policy implications are clear. If inflation is to be avoided, the amount of purchasing power in the economy must grow at roughly the same rate as the production of goods. Macroeconomic policies that the government can use to affect the amount of purchasing power—through taxes, spending, and regulation of interest rates and credit—can thus cause inflation to rise or reduce inflation to lower levels.

One way to think about inflation is with the quantity theory of money. The quantity theory says that there is an inverse relationship between the quantity of money and the value of money. Other things the same, the more money there is, the higher the price level will be. Higher prices mean that a given quantity of money can buy less, i.e. has less value.

Discussions of the quantity theory of money often begin with a definition of the velocity of money (V). The velocity of money is defined as nominal GDP divided by the money supply. For example, suppose nominal GDP is \$20 billion and the money supply is \$4 billion. That would mean that velocity is \$20/\$4 = 5. Velocity equal to 5 means that the average dollar is spent 5 times per year on final goods and services. That is how \$4 billion worth of money can support \$20 billion worth of spending; each dollar is spent, on average, five times. So velocity is the "speed" at which money circulates in the economy.

Recall from Chapter 4 that the GDP deflator is a price index. Also recall that the the GDP deflator equals nominal GDP divided by real GDP. Rearranging this definition, we can say that nominal GDP equals the GDP deflator times real GDP. If we abbreviate the GDP deflator with the letter P and real GDP with the letter Y, then nominal GDP equals P times Y. To sum up: GDP delator = Nominal GDP/Real GDP. That implies Nominal GDP = GDP deflator x Real GDP = PY.

Now let us abbreviate the money supply with the letter M. Recall that velocity (V) equals nominal GDP divided by the money supply. We can now write V = PY/M. If we multiply both sides by M, we get the oldest equation in economics, called the quantity equation: MV = PY. This equation provides us with a basic theory of inflation. In its dynamic form, the equation is: % change in M + % change in V = % change in P + % change in Y. Suppose real GDP (Y) grows by 3%, and that velocity stays the same. If the money supply grows by 3%, prices will be stable (3 + 0 = 0 + 3). If the money supply grows by 5%, prices will rise by 2% (5 + 0 = 2 + 3). If the money supply grows by 10%, prices will rise by 7% (10 + 0 = 7 + 3). The faster the money supply grows, the higher the inflation rate will be. Inflation is caused by a too-rapid rise in the money supply.

A \$550 million loaf of bread?

As we will learn in Money and Banking , the existence of money provides enormous benefits to an economy. In a real sense, money is the lubrication that enhances the workings of markets. Money makes transactions easier. It allows people to find employment producing one product, then use the money earned to purchase the other products they need to live on. However, too much money in circulation can lead to inflation. Extreme cases of governments recklessly printing money lead to hyperinflation. Inflation reduces the value of money. Hyperinflation, because money loses value so quickly, ultimately results in people no longer using money. The economy reverts to barter, or it adopts another country’s more stable currency, like U.S. dollars. In the meantime, the economy literally falls apart as people leave jobs and fend for themselves because it is not worth the time to work for money that will be worthless in a few days.

Only national governments have the power to cause hyperinflation. Hyperinflation typically happens when government faces extraordinary demands for spending, which it cannot finance by taxes or borrowing. The only option is to print money—more and more of it. With more money in circulation chasing the same amount (or even less) goods and services, the only result is higher and higher prices until the economy and/or the government collapses. This is why economists are generally wary of letting inflation get out of control.

Problems

Suppose the money supply grows by 7 percent and velocity does not change. If real GDP grows by 4 percent, what will be the inflation rate?

Suppose the money supply grows by 8 percent, velocity does not change, and the inflation rate is 6%. How much did real GDP grow?

References

Wines, Michael. “How Bad is Inflation in Zimbabwe?” The New York Times , May 2, 2006. http://www.nytimes.com/2006/05/02/world/africa/02zimbabwe.html?pagewanted=all&_r=0.

Hanke, Steve H. “R.I.P. Zimbabwe Dollar.” CATO Institute . Accessed December 31, 2013. http://www.cato.org/zimbabwe.

Massachusetts Institute of Technology. 2015. "Billion Prices Project." Accessed March 4, 2015. http://bpp.mit.edu/usa/.