Inflation

Quantity Theory of Money

Let the price level according to CPI be $\text{P}$ in an economy. This means that a standard basket of goods and services can be bought using an amount $\text{P}$. From this, we can say that the value of an individual unit of money in terms of the standard basket is $1/\text{P}$. This is the value of money in this economy.

We draw a demand-supply graph. The supply is the money supplied by the central bank, and the demand is the liquid cash that people wish to have. The demand depends significantly on the price level, as people would need more money the higher prices are. X-axis is the quantity of money supplied, and left Y-axis is the value of money in the economy.

From this, we can see that inflation occurs when the quantity of money in the economy is increased. That is, when people have larger quantities of money, they will offer more than competitors to get services first.

Classical Dichotomy

Every quantity is divided into two types, real and nominal. Real variables measure quantities and physical stuff whereas nominal variables measure made-up stuff like money. For example, price of a CD and nominal GDP are nominal variables and number of cds is a real variable.

Relative prices are real variables as well. “One copy of Titanfall is worth fifty CoD copies” is an example of relative prices. In the long run, price changes affect only nominal variables leaving real variables almost unchanged. This is called as the Monetary Neutrality of real variables.

Quantity Equation

We define the velocity of money in an economy to be the number of times it changes hands on average over a given period of time. It is calculated as the ratio of nominal GDP with money supply. Let the price index of the economy (GDP Deflator) be $\text{P}$, real GDP be $\text{R}$, the velocity be $\text{V}$ and the money supply be $\text{M}$. Then: \(\begin{align*} \text{V} &= \frac{P\times R}{M}\\ \implies \text{V}\times\text{M} &= \text{P}\times\text{R} \end{align*}\) The below equation is called the quantity equation. It has been observed that velocity is nearly constant when money supply changes, and it is clear that money supply cannot change the value of real GDP (real variable). Therefore, an increase in money supply is cancelled by an increase in price index, leading to inflation.

Inflation Tax: The “tax” levied on every person with money (as its value has dropped) due to the government increasing its supply is called as the inflation tax. Seigniorage is the income that is generated by printing money.

Fischer Effect

\[\text{Nominal Interest} = \text{Real Interest} + \text{Inflation}\]

From monetary neutrality, we can say that inflation and nominal interest are closely tied together.

Costs of Inflation

1. Inflation Fallacy: The idea that inflation erodes the income which people have. Real income doesn’t depend on inflation, although nominal income does.
2. Shoeleather Costs: During high inflation, we would want to exchange money for goods and services as quickly as possible; or store it in banks. The costs incurred for this effort come under this category.
3. Menu Costs: The costs for changing menus frequently during periods of high price instability.
4. Taxes: Taxes are based upon nominal incomes, and inflation causes more percentage of the real income to be given away than usual.

Hyper-Inflation

Inflation of over $1\%$ per day. When the govt doesn’t have enough money to pay debts, and buyers do not have confidence in its bonds (due to socio-economic reasons); the govt has no option other than seigniorage to get the money required.