07 Inflation, International Trade

Lecture from: 28.10.2025 | Video: Video ETHZ

The Classical Theory of Inflation

The long-run determinant of the price level is explained by the quantity theory of money.

The Value of Money and Price Level

Inflation is an economy-wide phenomenon concerning the value of the medium of exchange.

• Price Level ($P$): The number of dollars needed to buy a basket of goods.
• Value of Money ($1/P$): The quantity of goods that can be bought with one dollar. As $P$ rises, the value of money falls.

Like any asset, this value is determined by supply and demand:

• Supply: Controlled by the Central Bank (vertical curve).
• Demand: Determined by how much wealth people choose to hold as liquid cash. Demand depends negatively on the value of money (if money is worth less, more is needed for transactions).

The Quantity Theory of Money

When the central bank injects money (Supply shifts right):

1. Excess Supply: People have more cash than they want to hold.
2. Spending Increases: They buy goods or bonds, increasing demand for goods.
3. Prices Rise: Since supply of goods is fixed in the long run, prices are bid up.
4. Equilibrium Restored: A higher price level increases the demand for money until it matches the new supply.

Core Proposition: The quantity of money determines the price level; the growth rate of money determines the inflation rate.

The Classical Dichotomy and Monetary Neutrality

A cornerstone of classical thought is the theoretical separation of variables:

Type	Definition	Example
Nominal Variables	Measured in monetary units	Price of corn, nominal wage
Real Variables	Measured in physical units	Bushels of corn, real wage, real GDP

Monetary Neutrality: The proposition that changes in the money supply do not affect real variables in the long run. Doubling the money supply doubles prices and wages, but real output ($Y$) and real wages ($W/P$) remain unchanged.

The Quantity Equation

The relationship is formalized as:

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

Variable	Meaning
$M$	Quantity of Money
$V$	Velocity (rate at which money changes hands)
$P$	Price Level
$Y$	Real GDP

If Velocity ($V$) is stable, and Real Output ($Y$) is determined by factors of production (and thus unaffected by money), then a change in $M$ must be reflected one-for-one in $P$.

Implies: High inflation is always caused by rapid money growth.

Hyperinflation

Hyperinflation (inflation > 50%/month) occurs when governments print massive amounts of money to pay for spending, usually because they cannot tax or borrow. This acts as an inflation tax on everyone holding money.

The Fisher Effect

Monetary neutrality applies to interest rates.

$$\text{Nominal Rate}(i)=\text{Real Rate}(r)+\text{Inflation}(\pi )$$

Since money does not affect the real rate ($r$ is determined by saving/investment), an increase in money growth causes an equal increase in the inflation rate and the nominal interest rate. This one-for-one adjustment is the Fisher Effect.

The Costs of Inflation

Does inflation make people poorer? No. In the long run, incomes rise with prices. However, inflation imposes real efficiency costs:

1. Shoeleather Costs: Resources wasted when inflation encourages people to reduce money holdings (more trips to the bank = wasted time).
2. Menu Costs: The costs of changing prices (printing catalogs, updating systems).
3. Relative-Price Variability: If prices change infrequently (due to menu costs), inflation distorts relative prices, leading to misallocation of resources (consumers buy the “wrong” things).
4. Tax Distortions: Taxes are often based on nominal income. Inflation exaggerates capital gains and interest income, increasing the real tax burden on saving.
5. Confusion: Inflation changes the “yardstick” of value, making long-term planning difficult.
6. Arbitrary Redistribution (Unexpected Inflation):
   • Inflation > Expected: Borrowers win (repay with cheaper dollars), Lenders lose.
   • Inflation < Expected: Lenders win, Borrowers lose.

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International Trade

The focus shifts to how countries interact in a globalized world.

Microfoundations: Comparative Advantage

Why do countries trade? The answer lies in opportunity cost.

Consider two producers (Gardener & Farmer) and two goods (Meat & Potatoes).

1. Absolute Advantage: Who produces more with fewer inputs? (Productivity)
2. Comparative Advantage: Who produces with a lower opportunity cost?

Opportunity Cost of 1kg Meat	Gardener	Farmer
In terms of Potatoes	4 kg	2 kg

The Farmer gives up less to produce meat. The Farmer has the comparative advantage in meat.

The Gain: By specializing in the good where they have a comparative advantage and trading, both parties can consume outside their production possibility frontiers. Trade expands the total economic pie.

Welfare Analysis of Trade

Total Surplus (Consumer Surplus + Producer Surplus) measures economic well-being.

Exporting Country (World Price > Domestic Price)

• Price rises to world level.
• Winners: Producers (sell at higher price).
• Losers: Consumers (pay higher price).
• Net: Gains to producers exceed losses to consumers. Total surplus rises.

Importing Country (World Price < Domestic Price)

• Price falls to world level.
• Winners: Consumers (buy at lower price).
• Losers: Producers (face competition).
• Net: Gains to consumers exceed losses to producers. Total surplus rises.

Trade Restrictions

Governments often restrict trade to protect domestic industries.

1. Tariff: Tax on imports. Raises price, reduces quantity imported. Creates Deadweight Loss (inefficiency).
2. Quota: Limit on quantity. Similar effect to tariff, but revenue goes to license holders, not necessarily government.
3. Non-Tariff Barriers: Regulations, red tape, standards.

Arguments for Protectionism

While free trade maximizes efficiency, other goals compete:

• National Security: Avoiding dependence for critical goods.
• Infant Industry: Protecting new industries until mature.
• Unfair Competition: Retaliating against subsidies.
• Jobs: Preventing structural unemployment in specific sectors.

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Continue here: 08 Open-Economy Macroeconomics