Money

In 1970 the New York Times cost 15 cents, the median price of a single-family

home was $23,400, and the average wage in manufacturing was $3.36 per hour.

In 2000 the Times cost 75 cents, the price of a home was $166,000, and the average

wage was $14.26 per hour.This overall increase in prices is called inflation,

and it is the subject of this chapter.

The rate of inflation—the percentage change in the overall level of prices—

varies greatly over time and across countries. In the United States, according to

the consumer price index, prices rose an average of 2.4 percent per year in the

1960s, 7.1 percent per year in the 1970s, 5.5 percent per year in the 1980s, and

3.0 percent in the 1990s. Even when the U.S inflation problem became severe

during the 1970s, it was nothing compared to the episodes of extraordinarily

high inflation, called hyperinflation, that other countries have experienced

from time to time.A classic example is Germany in 1923, when prices rose an

average of 500 percent per month.

In this chapter we examine the classical theory of the causes, effects, and social

costs of inflation.The theory is “classical” in the sense that it assumes that prices

are flexible. As we first discussed in Chapter 1, most economists believe this assumption

describes the behavior of the economy in the long run. By contrast,

many prices are thought to be sticky in the short run, and beginning in Chapter

9, we incorporate this fact into our analysis.Yet, for now, we ignore short-run

price stickiness.As we will see, the classical theory of inflation not only provides

a good description of the long run, it also provides a useful foundation for the

short-run analysis we develop later.

The “hidden forces of economic law’’ that lead to inflation are not as mysterious

as Keynes claims in the quotation that opens this chapter. Inflation is simply

an increase in the average level of prices, and a price is the rate at which

money is exchanged for a good or a service.To understand inflation, therefore,

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4 Money and Inflation

C H A P T E R

There is no subtler, no surer means of overturning the existing basis of society

than to debauch the currency.The process engages all the hidden forces

of economic law on the side of destruction, and does it in a manner which

not one man in a million is able to diagnose.

— John Maynard Keynes

F O U R

User JOEWA:Job EFF01420:6264_ch04:Pg 76:25579#/eps at 100% *25579* Wed, Feb 13, 2002 9:08 AM

we must understand money—what it is, what affects its supply and demand, and

what influence it has on the economy.Thus, Section 4-1 begins our analysis of

inflation by discussing the economist’s concept of “money’’ and how, in most

modern economies, the government controls the quantity of money in the

hands of the public. Section 4-2 shows that the quantity of money determines

the price level and that the rate of growth in the quantity of money determines

the rate of inflation.

Inflation in turn has numerous effects of its own on the economy. Section 4-3

discusses the revenue that the government raises by printing money, sometimes

called the inflation tax. Section 4-4 examines how inflation affects the nominal

interest