Chapter 12: Inflation and the Quantity Theory of Money

fiat money

money that has no intrinsic value

(money in the U.S.)

commodity money

money with intrinsic value. ex. gold coins

what are the functions of money?

medium of exchange

unit of account (common unit measuring economic value)

store of value (can be saved)

inflation

an inc. in the avg. lvl of prices (in general)

decline in money’s purchasing power

how are inflation rates measured?

by changes in a price index over yrs

deflation

negative inflation rate

dec. in the avg. lvl of prices

disinflation

a reduction in the inflation rate. even when prices r still rising

index

the avg. price from a large & representative basket of goods & services

consumer price index (CPI)

measures the avg. price for a basket of goods & services bought by a typical American consumer

covers 80,000 good & services. fixed market basket.

producer price index (PPI)

measure the avg. price received by producers. includes intermediate & finished goods and services.

used to calculate changes in the costs of inputs

what are the 3 reasons that the CPI’s fixed basket can lead it to overstate the true inflation rate?

new goods bias

quality change bias

commodity substitution & outlet substitution biases

GDP deflator

price index that tracks the price of all goods & services produced domestically

shows how much the overall price level differs from the real GDP’s base year. ex. how much % higher yr 2’s prices were

indexation

automatically adjusting wages, benefits, tax brackets, & the like to compensate for inflation

personal consumption expenditure deflator (PCE)

focuses on household consumption, not fixed (no substitution bias)

what monetary policy focuses on

the Fed sets its inflation target using this

what indicator do forecasters for inflation use?

core inflation, excluding food & energy (core CPI, core CPE)

real prices

prices that have been corrected for inflation

quantity theory of money

sets out the general relationship btwn money, velocity, real output, & prices

what do both sides of the quantity theory of money equal?

nominal GDP & total spending

what factors of the quantity theory of money do we assume are stable?

real GDP & velocity of money (NOT their growth.)

what does the quantity theory of money assume about inflation?

it is caused by increases in the money supply.

why does the growth in the money supply approx. equal inflation rate (quantity theory of money)?

real GDP & velocity of money are stable.

when there’s an increase in the supply of money, what happens in the long run?

inflation

what happens to money in the long run?

it remains neutral.

what are the four problems associated with inflation?

price confusion + money illusion

inflation redistributes wealth

inflation interacts with other taxes

inflation is painful to stop

money illusion

when people mistake changes in nominal prices for changes in real prices

A.W Philips

philips curve. identified the relationship btwn unemployment and inflation

what happens to resources when people are fooled by the money illusion?

they are wasted in activities that seem to be profitable and move slowly to more productive uses.

do people remain fooled by the money illusion forever?

no, eventually they begin to expect the inflation.

monetizing debt (govt.)

paying off debts by printing money

they benefit from unexpected inflation

what happens if lenders expect inflation?

they’ll inc. nominal rates

(this is why govts. don’t always monetize debts).

how does inflation act as a type of tax?

by transferring real resources from citizens to govt.

what do unexpected changes in inflation rates do to lenders & borrowers?

they transfer wealth btwn them by changing the real return on loans

formula for a lender’s real rate of return

nominal rate of return minus the inflation ratef

fisher effect

the nominal interest rate is equal to the expected inflation rate plus the equilibrium real interest rate

fisher effect equation

nominal interest rate = expected inflation rate + equilibrium real rate of return

what is the real rate of return largely determined by?

the difference between expected & actual inflation.

what happens when inflation is greater than expected? (π > Eπ)

lenders harmed, borrowers benefit

what happens when inflation is less than expected? (Eπ > π)

lenders benefit, borrowers harmed

when are few long-term contracts signed?

when inflation is volatile and unpredictable

corporations pay taxes on phantom profits, meaning..?

they pay when prices go up due to inflation (not real price)

do firms pay taxes on real or nominal incomes?

nominal

when inflation is expected, lower inflation may be misinterpreted as,,,

a reduction in demand (money illusion)

leads to reduced output + employment

can changes in the money supply influence real GDP in the short run?

yes