Topic 5.3 Notes – Money Growth and Inflation

1. Inflation as a Monetary Phenomenon

Inflation is a sustained increase in the general price level.
Deflation is a sustained decrease in the general price level.

We are not talking about one good becoming more expensive. We mean overall prices rising across the economy.

The key AP claim comes from economist Milton Friedman:

“Inflation is always and everywhere a monetary phenomenon.”

That means if the money supply grows too quickly for a long time, inflation results.

How Money Growth Leads to Inflation

Here’s the chain reaction when the Federal Reserve increases the money supply using open market operations, lowering the reserve requirement, or lowering the policy rate.

In the AD-AS model, this shows up as a rightward shift of aggregate demand from AD₀ to AD₁, increasing both real GDP (Y₀ to Y₁) and the price level (PL₀ to PL₁) in the short run.

Expansionary monetary policy in the AD-AS model

Step 1: Money Market

• MS shifts right.
• Nominal interest rate falls.

Step 2: Interest Rate Effect

• Lower rates → more borrowing.
• Consumption (C) and Investment (I) increase.
• Aggregate Demand shifts right.

Short Run

• Higher real GDP
• Higher price level

If the economy was in a recessionary gap, this helps.

Long Run (at full employment)

• Wages rise.
• SRAS shifts left.
• Real GDP returns to potential (LRAS).
• Only the price level stays higher.

That’s the big idea:
Money affects output in the short run, but only prices in the long run.

When money growth continues year after year, inflation continues year after year. That’s what happened in the 1970s, when rapid money growth contributed to high inflation.

2. Demand-Pull, Cost-Push, and the Wage-Price Spiral

These explain how inflation shows up in AD-AS in the short run.

Demand-Pull Inflation

Start with an increase in aggregate demand.

Demand-pull inflation in the AD-AS model

Focus on the right-hand panel. AD shifts right from AD₁ to AD₂ while SRAS and LRAS stay fixed.

Cause: Increase in aggregate demand (C, I, G, or Xn).

• Often linked to expansionary fiscal policy (deficit spending).
• Or expansionary monetary policy.

Results:

• Higher price level
• Higher real GDP
• Inflationary gap

Long run adjustment brings GDP back to potential, but at a higher price level.

Cost-Push Inflation

Now hold AD constant and shift SRAS.

Cost-push inflation in the AD-AS model

SRAS shifts left from SRAS₁ to SRAS₂.

Cause: Higher production costs (wages, oil, supply shocks).

Results:

• Higher price level
• Lower real GDP
• Stagflation (inflation + unemployment)

Classic example: 1970s oil shocks. Oil prices spiked, SRAS shifted left, and the U.S. experienced stagflation.

Wage-Price Spiral

This is how inflation can feed on itself over time.

The economy starts with an inflationary gap. As nominal wages rise, SRAS shifts left, pushing the price level higher.

Process:

1. Prices rise.
2. Workers demand higher wages.
3. Higher wages raise production costs.
4. SRAS shifts left.
5. Prices rise again.

This cycle can repeat, making inflation self-perpetuating.

Contractionary policy shifts AD left to reduce inflation.

Breaking this spiral is painful. In the early 1980s, Paul Volcker, Chair of the Federal Reserve, sharply reduced money growth. Inflation fell, but a recession followed.

3. The Quantity Theory of Money

Equation of Exchange

$$M \times V = P \times Y$$

• $M$ = Money supply (often M1)
• $V$ = Velocity of money (how often a dollar is spent per year)
• $P$ = Price level
• $Y$ = Real output (real GDP)

Total spending equals total output measured in dollars.

Velocity of Money

$$V = \frac{P \times Y}{M}$$

If people spend quickly, velocity is high. If they hold money, velocity is low.

Long-Run Assumptions

• Velocity is stable.
• Real output is determined by resources and technology.

So changes in $M$ mainly change $P$.

In growth rate form:

$$\%\Delta M + \%\Delta V = \%\Delta P + \%\Delta Y$$

If velocity is stable, then
$\%\Delta M \approx \text{inflation rate}$.

Quick Calculation Example

Suppose:

• Money supply = 500 billion
• Velocity = 4
• Real GDP = 1,000 billion

Find the price level.

$$M V = P Y$$ $$500 \times 4 = P \times 1000$$ $$2000 = 1000P$$ $$P = 2$$

Be comfortable solving for any variable. On tests, they often hide one piece and expect you to rearrange the equation.

4. Monetary Neutrality

Monetary neutrality means that in the long run, changes in the money supply do not affect real variables.

If money doubles:

• Nominal wages double.
• Prices double.
• Nominal GDP doubles.
• Real GDP stays the same.

At full employment, increasing the money supply only increases the price level.

This is why long-run inflation equals the long-run growth rate of the money supply.