macroeconomics chapter 17 (money growth and inflation)

Inflation

the overall increase in prices of goods and services

When does inflation occur?

When the government prints too much money

Two ways to look at the economy’s price level

1. Price basket of goods/services (think CPI) 2. Measure of the value of money (higher the price level \= the less money is worth, as it has less purchasing power)

Money supplied

policy variable fixed and controlled by the Fed

Money demanded

average price levels in the economy

How do higher price levels affect money demanded?

Increases money demanded (because the value of money decreased)

How do lower price levels affect money demanded?

Decreases money demanded (since value of money increases)

How is the money supply affected by an injection of money by the government?

1. Increase in the money supply 2. Decreases the value of money 3. Increases the price level

How are price levels and money demand correlated?

They’re proportional; as price levels increase, the money demanded increases as well (and vice versa)

Quantity theory of money

the quantity of money available in an economy determines the value of money

According to the quantity theory of money, what is the primary cause of inflation?

Growth in the quantity of money

Nominal variables

variables measured in monetary units

Real variables

variables measured in physical units

What is the separation of nominal and real variables called?

The classical dichotomy

Monetary neutrality

changes in the money supply affect nominal units but not physical units (applies in the LONG TERM, NOT in the short term)

Velocity of money definition

the rate at which money is used/changes hands (very stable)

Velocity of money equation

Price level * quantity of outputquantity of money

Quantity of money equation

quantity of money * velocity of money \= price level * quantity of output

What does the quantity of money equation explain?

Relates quantity of money to nominal value of output; reveals that quantity of money and price level are proportional (as one increases, so does the other)

Inflation tax

price level rises; the tax affects everyone who holds money

Real interest rate equation

real interest rate \= nominal interest rate - inflation

The Fisher Effect

a change in the inflation rate must cause a one for one change in the nominal interest rate (real interest + inflation \= nominal interest rate)

Change/increase in price level?

Inflation rate

Inflation fallacy?

The idea that inflation is bad because it takes away people’s purchasing power

Shoeleather cost

the time and convenience you must sacrifice to keep less money on hand (during inflation)

Menu costs

the costs to changing prices (i.e., changing price tags, catalogs, etc.)

How does inflation affect relative prices?

Inflation distorts relative prices, which is bad as that distorts consumer decisions, which leads to markets being less able to allocate resources to their best use

Negative effects of taxes?

Distort incentives, cause people to alter their behavior, and lead to a less efficient allocation of the economy’s resources

How does inflation affect taxes?

Raises the tax burden on income earned from savings (discouraging saving)

Capital gains

profits made by selling an asset for more than its purchase price

Tax treatment of capital gains during inflation

inflation exaggerates the size of capital gains (you actually gain less than you think you do)

How to resolve tax problems created by inflation?

1. Eliminate inflation 2. Index the tax system (tax laws could be revised to account for inflation)

What is the Fed’s job?

To ensure the reliability of a commonly used unit of measurement

What is an additional cost of inflation that arises when inflation is unexpected?

Arbitrary redistribution of wealth

Why does arbitrary redistribution of wealth happen during inflation?

Money loans in the economy are specified in terms of the unit of account (money), and inflation decreases the value of money

When is inflation especially volatile and uncertain?

When the average rate of inflation is high

Costs of deflation?

1. Isn’t stable or predictable 2. Induces menu costs/relative-price variability 3. Redistributes wealth toward creditors and away from debtors

The Friedman Rule?

A small amount of predictable deflation may be desirable, as it lowers nominal interest rate, minimizing shoe leather costs