Econ 102: Ch. 12 Inflation & Quantity Theory of Money

Inflation

an increase in the average level of prices

Inflation Rate

the percentage change in the average level of prices (as measured by a price index) over a time period

Inflation Rate Formula

((new - old)/ old) x 100

Consumer Price Index (CPI)

measures prices that consumers (households) face (fixed basket of goods)

PCE Price Index

measured prices that consumers (households) face (basket of goods changes)

Producer Price Index (PPI)

measures prices that producers (firms) face

includes intermediate goods

GDP Deflator

measures prices of all final goods and services

GDP Deflator Formulas

Y = C + I + G + NX

nominal GDP / Real GDP

Velocity

the average number of times a dollar is spent on final goods and services in a year

Quantity Theory of Money

Mv = PYR

M: money supply

v: velocity

P: price index

YR: real GDP

Why Does this Equation Work? Mv and PYR

Mv: nominal GDP (YN) - all the money in the economy times the number of times its used

PYR: nominal GDP

“Real GDP is ______ compared to the price index”

stable

“The velocity of money, v, is ______ compared to the money supply”

stable

“Changes in ______ generate changes in ______”

money supply; prices

Quantity Theory of Money in Growth Rates

M + v = P + YR

Real Rate of Return (real interest rate) Formula

r real = i - pi

nominal rare of return (interest rate) - inflation rate (pi)

How do We Interpret the Real Interest Rate?

negative real interest rates = you can buy less today than you could a year ago

positive real interest rates = you can buy more today than you could a year ago

Fisher Effect

the tendency for nominal interest rates to rise with expected inflation

Fisher Effect Formula

i = pi^E + r equilibrium

r equilibrium comes from the market for loanable funds

According to the Fisher Effect, What Should you do if you Expect Inflation to be Higher?

You’ll want to charge a higher nominal interest rate

Real Interest Rate (Rate of Return)

determined by the difference between expected inflation (pi^E) and actual inflation (pi)

Real Interest Rate (Rate of Return) Formula

(pi^E - pi) + r equilibrium

“When inflation is _______ , real interest rates can become _______”

high; negative

Money Illusion

confusion of change in nominal prices for real prices

Inflation Redistributes Wealth

its a tax that moves money from households to the government

pi^E < pi

lenders lose

real interest rate is less than real equilibrium

pi^E > pi

lenders gain