Macro 9 - Money Growth and Inflation

Chapter 21 and 28

Inflation

rise in overall level of prices. determined by CB and the amount of money in the economy ( money supply)

Inflation Rate

the percentage change in the price level from the previous period

Measures of Cost of Living

Consumer price index and GDP deflator

Consumer Price Index

overall cost of the goods and services bought by a typical consumer, measured monthly reports by office of National Statistics. When CPI rises, typical family has to spend more to maintain same standard of living

1) Fix the basket

Determine what prices are most important to the consumer

2)Find the prices

find the prices of the goods and services in the basket for each point in time

3) Compute the basket's cost

use data on prices to calculate cost of basket at different times

4) Choose a base year

pick one year as a base year then compute price by dividing basket price in one year by the price in the base year and multiply by 100

5)Compute inflation rate

Percentage change in price index from preceding period

Producer price index

measure of the cost of a basket of goods and services bought by firms, expected to predict changes in CPI

Problems with CPI overtsating

substitution bias, introduction of new goods, unmeasured quality changes

Substitution bias

does not reflect consumer reaction to changes in prices as they may substitute towards relatively less expensive goods

Introduction of new goods

purchasing power of new products mean more variety so consumers need less money

unmeasured quality changes

if quality rises, value of a pound rises etc.

GDP Deflator

ratio of nominal GDP/ real GDP x 100

GDP deflator vs CPI

the GDP deflator reflects prices of all goods and services produced domestically however the CPI reflects prices of all goods and services bought. CPI is price of basket in base compared, GDP deflator is price of same goods in base year

If CB increases money in economy...

more money to buy goods and services, no better at producing, price rises and spending more on the same quantity so money is less valuable

Money supply and demand curve

supply is vertical, demand determined by interest rate and average level of prices

quantity of money available determines

price level

growth rate in the quantity of money available determines

inflation rate

nominal variables

measured in monetary units eg. exchange rate, affected by changes in money supply

real variable

measured in physical units eg. real wage, do not change with money supply

Monetary Neutrality

irrelevance of monetary changes for real variables

Quantity Equation

V = (P x Y)/M where (P x Y) is nominal GDP, M is money supply

Inflation tax

government raises revenue by printing money

Hyperinflation

inflation that exceeds 50% per month

Yugoslavia

75% a month in 1990s, Serbian province issued $1.5 billion loans, inflation reached 300million% a month. Income reduced by 50%. Replaced currency to German mark

Real interest rate

nominal interest rare - inflation rate

nominal interest rate

real interest rate + inflation rate

Fisher Effect

when CB increases rate of money growth, inflation and nominate interest rates increase proportionately

Costs of Inflation

shoe-leather costs, menu costs, relative price variability, tax distortions, deflation

shoe-leather costs

resources wasted when inflation encourages people to reduce their money holdings

menu costs

costs of adjusting prices

induced tax distortion

less efficient allocation of resources