Inflation is a sustained increase in the general price level within an economy.

If the price level falls, then we have Deflation.

The price level going up is not the same thing as one or two prices rising.

• For example, the gasoline price rising is not evidence of inflation.
• Inflation is when the price of all (or most) things rise.

Inflation also implies a decrease in the purchasing power of money.

A Price Index is used to measure inflation.

An index is only a number, it is not measured in dollars.

It is the ratio of the average prices in one year relative to the prices in a base year.

There are many price indexes that economists use:

• Consumer Price Index (CPI)
• Producer Price Index (PPI)
• GDP Deflator

The Consumer Price index is the most commonly used measure.

The CPI is the average price of goods bought by a typical American consumer

• Includes roughly 80,000 goods
• Is a weighted average and heavily weights goods that consumers consume more of

Inflation is measured using the equation:

\(Inflation\: Rate = \pi = \dot{P} = \frac{P_{t} - P_{t-1}}{P_{t-1}}\)

Where \(P_{t}\) is the average price level (i.e. value of a price index) in year \(t\).

Recall that CPI in June, 2021 is 271.7. The CPI in June, 2020 was 257.8.

Therefore, inflation between those two dates was \(\frac{271.7 - 257.8}{257.8} = 5.4\%\).

CPI is also useful for converting prices between time periods.

A nominal price is a price denominated in the dollar terms of the era the price appeared.

A real price is a price that has been converted into a different time period’s dollars for purposes of comparison

The conversion is simple: \(Real\; Price=Nominal\;Price \frac{CPI_{Target Year}}{CPI_{Original Year}}\)

For example, imagine a product cost $100 in 1972 and $400 today.

While the price of this product has clearly increased in nominal terms, has it increased in real terms? The CPI in 1972 was 41.1.

\(Real\;Price=Nominal\;Price\frac{CPI_{2021}}{CPI_{1972}}=\$100\frac{271.7}{41.1}=\$661.06\)

Therefore, this product has actually become cheaper in real terms: the real price, in current dollars, is \(\$661.06\)!

If low inflation rates are beneficial for the economy, why do some countries have higher inflation rates?

Many governments inflate their currency to fund government deficits or pay off debts.

While this may solve short term budgetary problems, this typically creates far worse long run issues.

Left unchecked, this often leads to hyperinflation. Hyperinflation refers to very high rates of inflation; a common defitition is that hyperinflation is when inflation exceeds 50% per month.

Some historical examples of hyperinflation (Hanke and Krus):

The worst hyperinflation on record: Hungarian pengo, 1945 - 1946.

An item that would have cost 1 pengo in 1945 would cost 1.3 septillion pengo by the end of the hyperinflation!

• A septillion is a big number: 1,300,000,000,000,000,000,000,000

Dubious distinction: the largest denomination banknote ever was the 100 quintillion pengo note.

The Quantity Theory of Money sets forth the general relationship between inflation, money, real GDP, and the price level

The general form of the quantity theory is \(M \cdot V=P \cdot Y\), where

• \(M =\) Money supply
• \(V =\) Velocity of Money
• \(P =\) Price level
• \(Y =\) real GDP

Velocity (\(V\)) is the average number of times that a dollar is used to purchase goods/services in a year.

It is often more useful to think of the quantity theory in terms of growth rates, \(\dot{M}+\dot{V}=\dot{P}+\dot{Y}\), where

• \(\dot{M}\) is the growth rate of the money supply
• \(\dot{V}\) is the growth rate of velocity
• \(\dot{P}\) is inflation
• \(\dot{Y}\) is real GDP growth.

With this formulation, we can rewrite this as a theory of inflation:

\(\dot{P}=\dot{M}+\dot{V}-\dot{Y}\)

If \(\dot{P}=\dot{M}+\dot{V}-\dot{Y}\), what has to happen for \(\dot{P}\) to be a huge number, as in a hyperinflating economy?

Generally speaking, \(\dot{V}\) and \(\dot{Y}\) tend to be very small numbers.

Real GDP growth, \(\dot{Y}\), is limited by an economy’s factors of production–capital, human capital, technology. In most economies, \(\dot{Y}\) is a number like 1 or 2 percent.

\(\dot{V}\) is also generally a very small number. Intuitively, it measures increases or decreases in spending. The factors that move \(\dot{V}\) change slowly.

Deflation is when price levels fall. Based on the quantity theory, this would imply that \(\dot{M}+\dot{V}<\dot{Y}\).

Economists are mixed on whether or not deflation is bad for an economy

• Is deflation a cause or symptom of economic slowdown?

The stability of \(\dot{V}\) doesn’t always hold up under extreme economic conditions.

• Recessions and depressions reduce spending, meaning that falling \(\dot{Y}\) causes \(\dot{V}\) to fall. - In periods of hyperinflation, \(\dot{V}\) tends to spike because money is losing its value so quickly.

Why is inflation a problem?

• Inflation creates “noisy” prices
• Inflation distorts taxes
• Inflation leads to “shoe-leather” and “menu” costs
• Inflation redistributes wealth
• Inflation undermines financial markets
• Inflation is painful to stop

Prices generated within the supply and demand framework do two very important things in an economy:

• Transmit information about the scarcity of resources, and
• Incentivize people to economize on their use of scarce resources.

Inflation messes with prices, and thus reduces the ability of a market to function.

Price confusion exists when people in the economy cannot determine whether or not price changes are due to inflation or changes in supply and demand.

If a small business owner finds that she can raise her prices, is this because:

• demand for her products has increased? If so, she should expand her output!
• inflation is happening? If so, she should not expand.

Inflation increases the likelihood that decision makers will make the wrong economic decisions.

Money Illusion is the notion that pepole think in nominal terms, not real terms.

If a person gets a raise, what has happened to their real purchasing power?

• If there is no inflation, their purchasing power has gone up by the amount of their raise. They can consume more if they choose.
• If there is inflation, then their purchasing power has changed by the amount of their raise less the rate of inflation.
  • If their raise is perfectly offset by inflation, a person suffering from money illusion will consume more, even though their purchasing power has not changed.

Inflation is inherently a form of tax called seigniorage.

If the government prints more money, some of the purchasing power in your money gets transferred into the newly printed money.

Moreover, inflation produces tax burdens and liabilities that typically harm taxpayers. For example:

• capital gains taxes are paid on nominal gains.
  
• Depreciation is based on initial purchase price.

In either case, taxpayers will pay more in tax if there is inflation.

When inflation is high, the value of money falls.

This encourages people to spend their money faster than they otherwise would.

Shoe-Leather Costs refers to the extent this inflation makes people waste their time and energy trying to avoid the costs of inflation.

Similarly, Menu Costs are the costs to businesses of changing their prices through such means as printing new menus, new catalogs, reprogramming POS systems, changing advertising, etc.

Inflation redistributes wealth in a number of ways.

As seen before, seigniorage redistributes wealth from private citizens to the government.

Inflation also redistributes wealth between borrowers and lenders.

To see this, let’s look at the Fisher Equation: \(r=i-\pi\)

Where:

• \(r\) is the real rate of return (or real interest rate)
• \(i\) is the nominal rate of return (or nominal interest rate)
• \(\pi\) is \(\dot{P}\) or the inflation rate.

The intuition of the Fisher Equation is as follows:

Say you borrow $100 at 10% interest for one year, so you will pay back $10 in a year’s time.

If there is no inflation, the $110 you pay back has 10% more purchasing power than the $100 you borrowed, so he lender is earning a real rate of return of 10%.

What if there is \(\pi=\dot{P}=10\%\) instead? When you pay back your loan of $110 in a year, that $110 has the same purchasing power as the $100 you borrowed initially. The lender gets a 0% real rate of return!

Lenders aren’t dumb. They know that inflation will erode their rate of return.

Nominal interest rates, \(i\), have expected inflation \(\pi^{e}\) built in to them: this is called the Fisher effect.

If actual inflation is higher than unexpected inflation \((\pi>\pi^{e})\) then inflation transfers wealth from lenders to borrowers.

If actual inflation is lower than unexpected inflation \((\pi<\pi^{e})\) then inflation transfers wealth from borrowers to lenders.

The Fisher effect leads into the next problem with inflation: inflation is very detrimental to financial markets.

This is because inflation volatility increases with inflation rates.

Recall the Fisher equation, \(r=i-\pi^{e}\), and assume \(\pi^{e}\) is accurate within 25%.

if \(\pi^{e}\) is 2%, then \(\pi\) will lie between 1.5% and 2.5%; lenders are willing to take on inflation risk.

But if \(\pi^{e}\) is 20%, and thus \(\pi\) will be something between 15% and 25%, lenders are likely to be scared off.

For example, during the Venezuelan hyperinflation, private lending fell by 95%.

If Financial institutions cannot operate, markets that rely on lending are disrupted, greatly hampering the economy.

A final reason to avoid inflation is that ending inflation has the potential to create a recession.

The Volcker Disinflation provides a good exmaple.

US inflation in the 70s hovered around 10%. The Volcker Disinflation reduced inflation to around 3%.

Cutting inflation was necessary, however the short term effect was that this caused the US to go into a recession.

The Federal Reserve is the Central Bank of the United States and is broken into 12 districts.

You many not be aware of this, but you have been seeing references to this system your whole life.

Each piece of paper currency is marked with the Federal Reserve branch that issued it!

• Small notes (especially $1s) and older notes have the seal of the reserve bank just to the left of the portrait.
• Most modern notes have an identifier (A1, B2, … , L12) beneath the serial number on the top left. The number is a reference to the issuing reserve bank.

The Federal Reserve performs anumber of functions. They:

• Issue and create money
• Have two sets of customers
  • US federal government
  • Banks
• Regulate the financial sector (especially banks)
• Manage the clearinghouse payment system

Money is anything that is generally accepted as a medium of exchange.

Today, most monies are created by a government body, but they needn’t be (e.g. cryptocurrency, bank issued money)

Money can emerge spontaneously without central design.

In the US, the three most important definitions of the money supply are:

• The Monetary Base (MB): currency outstanding plus total reserves at the Fed.
• M1: MB plus checkable deposits.
• M2: M1 plus savings deposits, money-market deposits, and short-term CDs.

Liquidity refers to how quickly an asset can be converted into cash.

MB is perfectly liquid since it is cash, M1 is very liquid since it incldues immediately accessible deposits, and M2 is pretty liquid as well since it is money that people could access very quickly if they chose.

The Federal Reserve wants to control M1 and M2, however they only have direct control over MB

• M1 and M2 are influenced by the actions of private citizens and banks.

M1 and M2 are created by banks due to Fractional reserve banking.

Fractional Reserve Banking refers to a system in which banks only keep a fraction of their deposits on reserve.

Fractional reserve banking allows banks to simply create money.

How much money the create depends on the reserve ratio–the fraction of deposits banks keep as reserve.

\(Reserve\;Ratio=\frac{Value\;of\;Reserves}{Value\;of\;Deposits}\)

While the Fed sets a minimum Reserve ratio, if banks want to be more liquid they can set their reserve ratio higher.

If the Fed doesn’t control the reserve ratio, then they cannot control the money multiplier.

The money multiplier is the amount by which the money supply expands for every dollar increase in reserves.

\(Money\;Multiplier=\frac{1}{Reserve\;Ratio}\)

Assume that banks have a reserve ratio of 10%

• the money multiplier is then \(\frac{1}{10\%}=10\)

Also, assume and that the Fed creates $10,000 in new money that they simply put in your account.

• Thus, M goes up by $10,000.

Because the reserve ratio is 10%, the bank keeps $1,000 on reserve and loans out $9,000.

Assume I borrow that $9,000. Either I put it in my bank, or buy something and it winds up in someone else’s bank.

• M goes up by an additional $9,000, and the bank lends out $8,100.

This process continues ad infinitum until \(\$10,000(\frac{1}{10\%})=\$100,000\) new money has been created.

The Fed uses three primary means by which to control the money supply

• Open market operations: buying and selling US government bonds on the open market
• Discount rate lending: lending various financial institutions, especially banks
• Changing bank reserves: adjusting the required reserve ratio, or paying interest on reserves held at the Fed

Open Market Operations refers to the Federal Reserve buying and selling US treasury bonds.

If the Fed buys bonds, they are trying to stimulate the economy

• Buying bonds is the same as lending to the private sector, so they are adding money to the economy.
• Buying bonds reduces interest rates, encouraging private borrowing.

If the Fed sells bonds, they are trying to control inflation

• Selling bonds is the same thing as borrowing from the private sector, so they are taking money out of the economy.
• Selling bonds increases interest rates, discouraging private borrowing.

Typically, the Fed communicates their intentions through announcements regarding the interest rate.

If the Fed announces an increase in interest rates, they are selling bonds and reducing the money supply.

if the Fed announces a decrease in interest rates, they are buying bonds and increasing the money supply.

The Fed has the greatest influence over the Federal Funds rate - the interest rate banks charge each other for overnight loans.

The Fed also controls the Discount Rate - the rate the fed charges banks on loans.

Banks typically only borrow from the Fed as a last resort in a crisis. The two major crises that banks might face are solvency crises and liquidity crises.

A Solvency crisis is when the value of a bank’s liabilities exceeds the value of its assets.

• This tends to happen when a lot of a bank’s loans default at once.
• To ensure against this, banks hold “capital” - safe assets like government bonds.
• To help prevent solvency crises, the Fed imposes capital requirements.

A Liquidity crisis is when a lot of a bank’s depositors want to get their money at the same time

• This can impact even healthy banks
• The danger here is contagion effects and bank runs
• The FDIC is designed to avoid liquidity crises.

What happens if a bank is insolvent?

• Typically, the FDIC steps in and pays depositors and the bank is closed.
• In 2008, so many banks were insolvent at the same time that the fed many of them out instead.
  • The Fed lent an estimated $9 trillion in overnight loans between March 2008 and May 2009 to try to stave off a full-blown depression.

The Fed can adjust the required reserve ratio (recall that the money multiplier is a function of the reserve ratio).

• Increasing the reserve requirement decreases the money supply, decreasing the requirement increases the money supply
• But, the required reserve ratio is a minimum, and cautious banks can choose to keep their ratio higher.

Starting in 2008, the Fed offered interest rates on the deposits banks held at the fed.

• Higher interest rates will encourage banks to sit on their money, reducing the money supply.
• Lower rates encourage banks to lend more, increasing the money supply