Money Growth and Inflation

This set of vocabulary flashcards covers the classical theory of inflation, including the Quantity Theory of Money, the Fisher Effect, monetary neutrality, and the various efficiency costs associated with inflation and deflation.

Inflation

A situation in which the economy’s overall price level is rising; in the United States, prices rose an average of $3.5 \%$ per year from $1935$ to $2021$.

Deflation

A falling price level; common in the $19^{\text{th}}$ century, such as between $1880$ and $1896$ when U.S. prices fell by $23 \%$.

Quantity Theory of Money

A framework developed to explain the long-run determinants of the price level and the inflation rate.

Value of Money

Represented as $\frac{1}{P}$, where $P$ is the price level; as the price level rises, this value falls, meaning the purchasing power of the currency has eroded.

Money Demand

Reflects how much wealth people choose to hold in liquid form; its most important determinant in the long run is the average price level.

Monetary Equilibrium

The point in the long run where the overall price level adjusts so that the quantity of money demanded equals the quantity of money supplied.

Classical Dichotomy

The theoretical separation of nominal variables, measured in monetary units, and real variables, measured in physical units.

Nominal Variables

Economic variables measured in monetary units, such as dollar wages and the price level, which are influenced by the monetary system.

Real Variables

Economic variables measured in physical units, such as real GDP, relative prices, and real interest rates, which are determined by production factors and technology.

Monetary Neutrality

The principle asserting that changes in the money supply do not affect real variables in the long run.

Velocity of Money

The speed at which the typical dollar travels around the economy from person to person.

Quantity Equation

The equation $M \times V = P \times Y$, where $M$ is the money supply, $V$ is velocity, $P$ is the price level, and $Y$ is real output.

Hyperinflation

Inflation that exceeds $50 \%$ per month; historical examples include Austria, Hungary, Germany, and Poland after WWI.

Milton Friedman's Dictum

The assertion that "Inflation is always and everywhere a monetary phenomenon."

Thomas Sargent's Dictum

The assertion that "Persistent high inflation is always and everywhere a fiscal phenomenon."

Inflation Tax

The revenue the government raises by creating money; a subtle tax on everyone who holds money because the value of their cash holdings diminishes.

Fisher Effect

The one-for-one adjustment of the nominal interest rate to changes in the inflation rate, given that monetary neutrality implies money growth does not affect the real interest rate in the long run.

Inflation Fallacy

The public belief that inflation reduces purchasing power, whereas in reality, nominal incomes tend to rise alongside prices, leaving real purchasing power unchanged in the long run.

Shoeleather Costs

The resources wasted when inflation encourages people to reduce their money holdings, such as making more frequent trips to the bank.

Menu Costs

The physical and administrative costs firms incur to change their prices.

Relative-Price Variability

A cost of inflation where distorted prices interfere with the ability of market economies to allocate scarce resources efficiently.

Inflation-Induced Tax Distortions

Occurs when taxes fail to account for inflation, causing inflation to exaggerate capital gains and interest income, leading to higher real tax burdens on saving.

Arbitrary Wealth Redistribution

A consequence of unexpected inflation where wealth is shifted from creditors to debtors because the real value of debt falls.

Economic Allegory of The Wizard of Oz

A theory suggesting the story was an allegory for the $19^{\text{th}}$-century deflation and the free-silver debate, with characters like the Tin Woodsman representing industrial workers and the Cowardly Lion representing William Jennings Bryan.