[fake] ECN 101 - Ch 5

What is inflation?

the overall increase in prices

What is the rate of inflation?

The % change in the overall level of prices

What is hyperinflation?

An extraordinary high inflation

What is the Quantity Theory of Money

links the inflation rate to the growth rate of the money supply.

What is the basic concept of Velocity?

the rate at which money circulates

What is the definition of Velocity:

The number of times the average dollar bill changes hands in a given time period

Velocity Formula

V\= T/M

What is V in the velocity formula?

V \= velocity

What is T in the velocity formula?

T \= value of all transactions

What is V in the velocity formula?

M \= money supply

What is Quantity Theory of Money Equation?

"Money × Velocity \= Price × Transactions

MV \= PT"

What is T?

"The total number of transactions in a given period of time,

ex: 50 loaves of bread exchanged in a year"

What is P?

"The number of dollars exchanged,

ex: The price of the bread, $2"

What is P × T?

"The total number of dollars exchanged in a year,

ex: 100 dollars exchanged in a year"

What is M?

"The quantity of money,

ex: Quantity of money in the economy \=$20"

What is V?

"The transactions velocity of money, number of times a dollar bill change hands in a given period of time,

ex: In order to do a $100 dollar

transactions with only $20 in the economy, have to change hands 5 times"

What is M*V

The total money that used to make the transactions

What would happen to the total number of dollars exchange in a year, if money remains constant and velocity decreases?

The total number of dollars exchange in a year will decrease.

New Equation

"Money × Velocity \= Price × Output

MV \= PY"

What is new V?

"Income Velocity of Money, the number of times a dollar bill enters

someone’s income in a period of time"

Real Money Balances

The quantity of money in terms of the quantity of goods and services we can buy

Real Money Balances Ex:

"Ex: The quantity of money is $20, the bread is $2, the real money

balances is 10 loaves of bread, which means that we can buy 10 loaves of bread using the 20 bucks."

What is the Money Demand Function?

Equation that shows the determinants of the quantity of the real money balances people wish to hold

Money Demand Function Equation:

"M/P )^d \= kY

or

(M/P) \= kY , where d \= 1, V \= 1/k"

k in the Money Demand Function

the proportion that people wants to hold for every dollar of income

What is the quantity of real money balances demanded proportional to?

Real Income

What is the effect of higher income on the demand for real money balances?

It increases the demand for real money balances.

Why is V \= 1/k? and what does it mean?

"The bigger the k value, the smaller the V value.

(The greater the amount that the consumer keeps, the smaller the exchange time of money.)"

The quantity of money M must be proportional to what?

"the change of nominal

GDP P × Y"

The quantity of money M determines what?

"the dollar value of the economy’s

output"

What determines the economy’s level of prices?

Real GDP, Nominal GDP, and GDP Deflator

Real GDP

"Factors of production and the production function determines

output of the economy, denoted as Y \= F (K, L)"

Nominal GDP

The money M set by the central bank determines the nominal value of output P × Y if V is constant

GDP Deflator

The price level P is then the ratio of the nominal value of output P × Y to output Y , denoted as P \= P × Y /Y

Why is the price level proportional to money supply?

"The change of P affects the change of M as the productivity determines

Y already so it is fixed. Given that V is fixed, the quantity theory of

money implies that the change of the price level P affects the Nominal

GDP: P × Y and therefore affecting money supply M as V is fixed."

Theory of Inflation Rate

%∆M + %∆V \= %∆P + %∆Y

%∆M

the change of quantity money, control by the central bank

%∆V

zero when V is fixed

%∆P

the change of the price, which is the inflation rate

%∆Y

"he change of output depends on the production function and

technolog"

The rate of the money growth determines what?

the inflation rate

The rate of the money growth determines the inflation rate - Ex:

For example, increase 1% of the money growth rate causing an increase of 1% of inflation rate

What is Seigniorage?

The revenue raised by creating money, central bank has a right to create money

Seigniorage Process:

"Leads to Inflation tax: Creating money -\>

Increasing Money Supply -\>

Leads to Inflation -\>

Purchase Power of Money Decrease of Money Holders (another form of tax)"

Nominal Interest Rate

The actual money you get when you deposit money after a period of time, i

Real Interest Rate

The increase of the purchase power, r

Inflation rate

The increase of price, π

Formula for showing the relationship between i, r, π

r \= i − π

Fisher Equation

i \= r + π

Nominal Interest Rate is determined by what?

Real Interest Rate and Inflation Rate

Nominal Interest Rate is determined by Real Interest Rate and Inflation Rate? - Ex:

For example, increase 1% of the inflation rate causing an increase of 1% of the nominal interest rate

Ex Ante

An real interest rate that both the borrower and the lender expect when the loan is made

E

\#NAME?

the formula for real interest rate

r \= i − E × π

Why can't nominal interest rates be adjusted to actual inflation rates?

Because actual inflation rates are already known by that time

What determines the nominal interest rate then?

Expected inflation rate

What happens when inflation goes higher?

People may predict higher inflation

What is the relationship between Ante and Post in terms of inflation?

They are related because people may predict higher inflation when it goes higher

Fisher Effect is determined by what?

The expected: i \= r + E × π

The cost of holding money is what?

the nominal interest rate

Why is the money demand depends on the nominal interest rate?

The quantity of money depends on the price of holding money, if the price increases, the quantity of money demand decreases

Money Demand Function

(M/P )d \= L(i, Y)

What is the liquidity of real money balances based on?

income and nominal interest rate

What happens to the demand for real money balances when the nominal interest rate (i) increases?

It decreases

What happens to the demand for real money balances when income (Y) increases?

It increases