CHAPTER 112
Money and Prices
Key Concepts Hyperinfl ation Monetarism Neutrality of Money Infl ation Money Multiplier Quantity Theory Infl ation Tax Money Supply Seignorage
Overview This chapter focuses on the nominal side of the economy: money and prices. We examine the historical behaviour of prices and the surge in infl ation that occurred in the twentieth century. We consider how to measure the price level and the rate of infl ation and compare their different meanings. We discuss why policymakers want to control infl ation and the costs of infl ation. Money is intimately linked to prices – after all, we quote prices of goods and services in terms of money. We review the historical development of money – from commodity money to paper money – and examine how governments and the banking sector create money and credit. We then consider the interaction between money and inflation. We first discuss hyperinflations – inflations of more than 50% per month – and show that they really always originate in fiscal policy, when governments print money to finance their activities. We review the concepts of seignorage and the inflation tax and compare them across countries. We then discuss a more general link between money and inflation and outline the quantity theory, which forms the basis of monetarism: the idea that inflation can be controlled by controlling the money supply.
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12.1 Rising Prices
THE HISTORICAL RECORD
Although historical evidence regarding the scale of economic activity is often obscure, we have much more evidence about the price of different items. The various receipts, invoices and advertising leafl ets that accumulate in pockets and wastepaper baskets amount to a substantial historical legacy. From these we can construct price indexes that refl ect the costs of buying a rep- resentative collection of consumer goods over time. For example, we could go to a supermarket on 1 January 2012 and buy a typical household’s weekly groceries for $120. When purchased on 1 January 2013, the same groceries might cost $125. With this information we can construct a price index that has a value of 120 in 2012 and 125 in 2013. This implies an infl ation rate (the annual percentage change in prices) of 4.2% [100 (125 – 120)/120]. Price indexes often are set at a value of 100 in a particular year – usually the year used to construct the average basket of goods. In our example, the index would have been 100 in 2012 and 104.2 in 2013. Figure 12.1 shows the behaviour of UK prices between 1264 and 2008.1 (A detailed examination and a cross-reference with UK history reveals many interesting events,2 but we want to see the broad characteristics of price behaviour.) Between 1264 and around 1930 prices showed no persistent trend, though there was a signifi cant increase in prices around the sixteenth century (primarily associated with the infl ux of gold and silver from the Americas). Prices sometimes rose sharply (e.g. during the Napoleonic Wars, 1790s to 1815 and the First World War, 1914–18), but then fell sharply. But after 1930 things changed and prices continued to increase – by 46-fold between 1930 and 2009. As Figure 12.2 shows, after 1945 annual infl ation was always positive. Before 1945 the United Kingdom had experienced extreme infl ation, large defl ations (falls in prices) and frequent small defl ations, which overall kept the price level reasonably constant over long periods.
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0.25 1264 1291 1318 1345 1372 1399 1426 1453 1480 1507 1534 1561 1588 1615 1642 1669 1696 1723 1750 1777 1804 1831 1858 1885 1912 1939 1966 1993
FIGURE 12.1 UK prices, 1264–2010. Until the twentieth century, prices showed no upward trend, experiencing both increases and decreases. In the twentieth century prices increased sharply. Source: Lawrence H. Offi cer, What Were the UK Earnings and Prices Then?, MeasuringWorth (2009), http://www.measuringworth.com/ukearncpi/.
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