C H A P T E R
Money and Inflation
Notes to the Instructor
This chapter explains the classical theory of money. It is important both because the topics covered are central to an understanding of the economy and because many of the concepts introduced are used elsewhere in the book. The chapter has three main goals: 1. To explain the economic meaning of “money” and to introduce money supply and money demand. 2. To examine the effects of monetary policy when prices are flexible. 3. To discuss the costs of inflation.
This chapter can probably be covered in two lectures, although the material on hyperinflation is quite hard and so may require a little extra time. Since hyperinflations are both fascinating and instructive, this part of the chapter is ultimately very rewarding for the students. The Fisher equation and the distinction between nominal and real rates of interest are among the most important topics in the chapter. I emphasize this as an occasion where macroeconomics provides an important insight that many noneconomists do not understand. I like to tell students that if they understand the Fisher equation, then they know more economics than former President Bush knows (or pretends to know?); see Supplement 14-10, “Distrust of Policymakers.”
Use of the Web Site
This is a good time to use the data to explain and illustrate the Fisher equation.
This chapter includes the following supplements: 4-1 4-2 4-3 4-4 4-5 4-6 4-7 4-8 4-9 4-10 4-11 If You Think the Island of Yap Has Problems… (Case Study p. 80) Credit Cards The Velocity of Money in Poetry and Song Data on Money Growth and Inflation (Case Study p. 87) Seigniorage as an Inflation Tax Seigniorage: How to Create Your Own—Part I Seigniorage: How to Create Your Own—Part II Deriving the Fisher Equation Using Interest Rates to Forecast Inflation (Case Study p. 92) Inflation and Economic Growth The Welfare Costs of Inflation and the Optimum Quantity of Money
Money and Inflation
4-12 4-13 4-14 4-15 4-16 4-17 4-18
Indexation U.S. Treasury Issues Indexed Bonds A Guide to Oz (Case Study p. 101) Are Monetary Allegories in the Eye of the Beholder? The Case of Mary Poppins (Case Study p. 101) How to Stop a Hyperinflation The Israeli Hyperinflation Additional Readings
So far, our entire analysis has been in real terms, since economists think that people ultimately care about goods and services, not about the dollar value of those goods and services. Because of this emphasis, we have so far left aside one of the main issues of macroeconomics—inflation—and we have also not yet been able to discuss monetary policy. Over at least the last 40 years in the United States, prices have tended to rise. This does not mean that the price of every single good has risen; personal computers, for example, are much cheaper now than they were a few years ago. But by and large, and on average, goods cost more now than they did in the past. This general increase in the price of goods and services is known as inflation. As discussed in Chapter 2, economists measure increases in the prices of goods and services by constructing price indexes, which are simply weighted averages of the prices of different goods. The weights are based upon the relative importance of the goods in consumption. The recent U.S. experience has been one of moderate but positive inflation. In recent years, prices have been rising by around 3 percent per year on average, while the average rate of inflation was somewhat higher in the 1970s and early 1980s and slightly lower in the 1950s and 1960s. But this is not the experience of all countries at all times. Earlier in this century, the United States experienced periods of deflation—falling prices. Other countries have experienced hyperinflations—very rapidly rising prices (hundreds of percent per month). People apparently...
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