6 3 6
PA R T T E N
M O N E Y A N D P R I C E S I N T H E L O N G R U N
The price level must rise, the quantity of output must rise, or the velocity of money
must fall.
In many cases, it turns out that the velocity of money is relatively stable. For
example, Figure 28-3 shows nominal GDP, the quantity of money (as measured by
M2), and the velocity of money for the U.S. economy since 1960. Although the ve-
locity of money is not exactly constant, it has not changed dramatically. By con-
trast, the money supply and nominal GDP during this period have increased more
than tenfold. Thus, for some purposes, the assumption of constant velocity may be
a good approximation.
We now have all the elements necessary to explain the equilibrium price level
and inflation rate. Here they are:
1.
The velocity of money is relatively stable over time.
2.
Because velocity is stable, when the Fed changes the quantity of money (
M
),
it causes proportionate changes in the nominal value of output (
P
Y
).
3.
The economy’s output of goods and services (
Y
)
is primarily determined by
factor supplies (labor, physical capital, human capital, and natural resources)
and the available production technology. In particular, because money is
neutral, money does not affect output.
4.
With output (
Y
) determined by factor supplies and technology, when the
Fed alters the money supply (
M
) and induces
proportional changes in
the nominal value of output (
P
Y
), these changes are reflected in
changes in the price level (
P
).
5.
Therefore, when the Fed increases the money supply rapidly, the result is a
high rate of inflation.
These five steps are the essence of the quantity theory of money.
Indexes
(1960 = 100)
1,500
1,000
500
0
1960
1965
1970
1975
1980
1985
1990
1995
2000
Velocity
M2
Nominal GDP
F i g u r e 2 8 - 3
N
OMINAL
GDP,
THE
Q
UANTITY OF
M
ONEY
,
AND
THE
V
ELOCITY OF
M
ONEY
.
This
figure shows the nominal value
of output as measured by
nominal GDP, the quantity of
money as measured by M2,
and the
velocity of money as
measured by their ratio. For
comparability, all three series
have been scaled to equal 100 in
1960. Notice that nominal GDP
and the quantity of money have
grown dramatically over this
period, while velocity has been
relatively stable.
S
OURCE
: U.S. Department of Commerce;
Federal Reserve Board.
C H A P T E R 2 8
M O N E Y G R O W T H A N D I N F L AT I O N
6 3 7
C A S E S T U D Y
MONEY
AND PRICES DURING
FOUR HYPERINFLATIONS
Although earthquakes can wreak havoc on a society, they have the beneficial
by-product of providing much useful data for seismologists. These data can
shed light on alternative theories and, thereby, help society predict and deal
with future threats. Similarly, hyperinflations offer monetary economists a nat-
ural experiment they can use to study the effects of money on the economy.
Hyperinflations are interesting in part because the changes in the money
supply and price level are so large. Indeed, hyperinflation is generally defined
(a) Austria
(b) Hungary
Money
supply
Price level
Index
(Jan. 1921 = 100)
Index
(July 1921 = 100)
(c) Germany
Price level
1
Index
(Jan. 1921 = 100)
(d) Poland
100,000,000,000,000
1,000,000
10,000,000,000
1,000,000,000,000
100,000,000
10,000
100
100,000
10,000
1,000
100
1925
1924
1923
1922
1921
Money supply
Money
supply
Price level
100,000
10,000
1,000
100
1925
1924
1923
1922
1921
1925
1924
1923
1922
1921
Price level
Money
supply
Index
(Jan. 1921 = 100)
100
10,000,000
100,000
1,000,000
10,000
1,000
1925
1924
1923
1922
1921
F i g u r e 2 8 - 4
M
ONEY AND
P
RICES DURING
F
OUR
H
YPERINFLATIONS
.
This figure shows the quantity
of money and the price level during four hyperinflations. (Note that these variables are
graphed on
logarithmic
scales. This means that equal vertical distances on the graph
represent equal
percentage
changes in the variable.) In each case, the quantity of money
and the price level move closely together. The strong association between these two
variables is consistent with
the quantity theory of money, which states that growth in
the money supply is the primary cause of inflation.
S
OURCE
: Adapted from Thomas J. Sargent, “The End of Four Big Inflations,” in Robert Hall, ed.,
Inflation,
Chicago:
University of Chicago Press, 1983, pp. 41-93.
6 3 8
PA R T T E N
M O N E Y A N D P R I C E S I N T H E L O N G R U N
T H E I N F L AT I O N TA X
If inflation is so easy to explain, why do countries experience hyperinflation? That
is, why do the central banks of these countries choose to print so much money that
its value is certain to fall rapidly over time?
The answer is that the governments of these countries are using money cre-
ation as a way to pay for their spending. When the government wants to build
roads, pay salaries to police officers, or give transfer payments to the poor or el-
derly, it first has to raise the necessary funds. Normally, the government does this
by
levying taxes, such as income and sales taxes, and by borrowing from the pub-
lic by selling government bonds. Yet the government can also pay for spending by
simply printing the money it needs.
When the government raises revenue by printing money, it is said to levy an
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