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The effects of inflation and money supply

Published:Wednesday | September 24, 2014 | 9:00 AM
Haughton

WHEN I was younger, a box of milk costed $5. Today, the cost of a box milk has moved to more than $200. This general increase in prices is referred to as inflation. The inflation rate in Jamaica moved from 13 per cent in 2010 to 7.5 per cent in 2011, eight per cent in 2012 and 9.7 per cent last year 2013. The Briefing will discuss the classical theory on the causes, effects and social cost of inflation. In classical theory, prices are fully flexible, adjusting in response to economic conditions. The inflation rate measures the average increase in aggregate prices and prices are really the rate at which we exchange money for goods and services.

Fundamentally, inflation and money are linked through the quantity theory of money.

What is the quantity theory of money?

The quantity theory of money outlines how money relates to inflation and output in the long run. As its name suggests, the amount of money circulating in the economy relative to the amount of goods determine the price level. People hold money to buy the goods and services they need. The more goods you need, the more money you hold. As such, the quantity of money in hand increases. If the number of transactions in the economy remains the same on average, then changes in the stock of money must be absorbed by either price or output. If the amount of money in the economy increases without an increase in what is produced, people will have more money to spend on the same amount of goods, therefore, the value of each good (the price) will increase (inflation). Much of my research is on the issue of money neutrality in the long term. A situation implied by the quantity theory of money where increases in the money supply only result in increase prices in the long run. Inflation could also occur through seigniorage.

What is seigniorage?

The Government of Jamaican must spend money to buy consumption goods, investment goods or to make social welfare transfer payments. The Government can finance their spending in three ways; by collecting taxes, by borrowing or by printing money. Seigniorage is the revenue the Government raises by printing money. If the Government decides to print money to raise revenue, it increases the money supply relative to the amount of goods in the economy which causes an increase in prices (inflation). By printing money, the Government imposes an inflation tax on the economy. When the Government prints more money, it makes the old money in your hand less valuable.Each good and/or service will now attract a higher price since more money is being circulated in the economy. The level of seigniorage varies from country to country; in low inflation regimes like the United States of America, seigniorage normally accounts for less than three per cent of government revenue. In countries like Italy and Greece, seigniorage is more than 10 per cent of government revenue. Seigniorage is normally associated with rapid inflation; inflation exceeding 50 per cent or more than one per cent per day is referred to as hyperinflation.

What is the cost of holding money?

The money you keep in your pocket does not earn interest. Instead, if deposited in the bank or invested in bonds, it will reap interest and increase in value. The interest rate it receives is the nominal interest rate, which represents the opportunity cost of holding money in your hand. Imagine you deposit your money in a bank account and you earn five per cent interest per year. When you withdraw your money, you might think that you are five per cent richer than last year, but this might not be the case if prices (inflation) increase from one year to the next. This five per cent interest you receive on the face value of your deposits in the nominal interest rate, which must be adjusted by the rate of inflation to give you a better picture of what true rate is (real interest rate). Therefore, the real interest rate is the nominal interest rate minus inflation. Taking an inflation rate of 9.7 per cent for Jamaica last year, the value of your money has fallen by 4.7 per cent (9.7 minus 5).What is the social cost of inflation?

The more prices increase, the less goods and services our given income can purchase. Therefore, the average person knows that as inflation increases, we become poorer if our income remains constant. In Jamaica for example, average salary increase has remain negligibly low over the last couple of years with inflation per annum average 10 per cent. The average person without a pay increase is 10 per cent poorer each year. The social cost of inflation is less in countries with low inflation rates.

n Dr André Haughton is a lecturer in the Department of Economics on the Mona campus of the University of the West Indies. Follow him on twitter @DrAndreHaughton; or email editorial@gleanerjm.com.