3 Money & Inflation Overview

A comprehensive set of 45 flashcards that review key concepts, equations, and traps related to Money & Inflation, based on lecture notes.

[HIGH] [Core Equations] Q: What is the Quantity Equation in economics? A: MV = PY

MV = PY

[HIGH] [Core Equations] Q: What is the growth-rate form of the Quantity Equation? A: %ΔM + %ΔV = %ΔP + %ΔY

With constant velocity and fixed output, prices adjust to money growth.

[HIGH] [Core Equations] Q: What is the Fisher Equation? A: i = r + \pi

%ΔM + %ΔV = %ΔP + %ΔY

[HIGH] [Core Equations] Q: What is the money market equilibrium condition? A: MS / P = L(r + \pi, Y)

Inflation rises by the difference.

[MEDIUM] [Core Equations] Q: How does real money supply relate to nominal money supply and price level? A: Real money supply is MS / P (nominal money supply deflated by price level).

No, real output growth must be subtracted from money growth.

[HIGH] [Mechanism Cards] Q: How does money growth cause inflation in the long run? A: With constant velocity (V) and fixed output (Y), prices (P) adjust proportionally to money growth (M).

i = r + π

[HIGH] [Mechanism Cards] Q: Why do inflation changes affect nominal but not real interest rates? A: Due to the Fisher Effect, nominal interest rates (i) adjust one-for-one with inflation ($\pi$) to keep real interest rates (r) unchanged.

Inflation changes nominal interest rates one-for-one.

[HIGH] [Mechanism Cards] Q: If inflation ($\pi$) increases, what happens to real interest rates (r) and nominal interest rates (i)? A: Real interest rates (r) are unchanged; nominal rates (i) rise to keep returns stable.

i rises by 2%.

[HIGH] [Mechanism Cards] Q: Why does a fall in money demand (L) raise the price level (P) if money supply (MS) is fixed? A: To maintain equilibrium (MS/P = L); if L falls, P must rise to lower real money supply (MS/P).

No.

[HIGH] [Mechanism Cards] Q: What happens in the money market when nominal interest rates (i) rise due to increased inflation ($\pi$)? A: It reflects lenders' demand for higher returns to match inflation.

MS / P = L(r + π, Y)

[HIGH] [Direction-of-Change Cards] Q: If money (M) grows faster than real output (Y), what happens to inflation (%ΔP)? A: Inflation rises by the difference (%ΔP = %ΔM - %ΔY).

The price level rises.

[HIGH] [Direction-of-Change Cards] Q: If inflation ($\pi$) rises by 2%, what happens to the nominal interest rate (i)? A: i rises by 2% (one-for-one).

Money demand shifts left.

[HIGH] [Direction-of-Change Cards] Q: If money demand (L) falls and money supply (MS) is fixed, what happens to the price level (P)? A: The price level (P) rises.

Reduce the money supply proportionally.

[HIGH] [Direction-of-Change Cards] Q: How do increases in inflation ($\pi$) affect nominal interest rates (i) in the long run? A: They increase proportionally (one-for-one).

No, if money supply is fixed, prices rise.

[HIGH] [Fixed vs Adjusting Variable Cards] Q: What is the fixed variable in the Quantity Theory of Money (growth-rate form)? A: Velocity (V) is assumed constant (%ΔV = 0).

Velocity (V) is assumed constant.

[HIGH] [Fixed vs Adjusting Variable Cards] Q: What critical assumption about real output is made when discussing long-run inflation? A: Real output (Y) is considered fixed in the long run.

It depends on money supply (M).

[HIGH] [Fixed vs Adjusting Variable Cards] Q: Does inflation ($\pi$) change the real interest rate (r) in the long run? A: No, r is fixed in the long run by real factors.

Calling %ΔM 'inflation' without subtracting %ΔY.

[HIGH] [Fixed vs Adjusting Variable Cards] Q: What adjusts to money growth (M) in the long run if velocity (V) is constant and output (Y) is fixed? A: Prices (P) adjust.

Money affects nominal variables while real factors determine real variables.

[MEDIUM] [Fixed vs Adjusting Variable Cards] Q: What is the central assumption about money demand (L)? A: It can change due to factors like financial innovations.

Nominal interest rates adjust one-for-one with inflation changes.

[MEDIUM] [Fixed vs Adjusting Variable Cards] Q: What key factors are typically stable vs changing in the money market equilibrium (MS/P = L)? A: MS can be set by the central bank, P adjusts to restore equilibrium, and L can shift.

Real interest rates are unchanged as nominal rates rise to keep returns stable.

[MEDIUM] [Graph-Decoding (No Drawing)] Q: What market shock corresponds to an increase in credit card usage? A: Money demand (L) falls (shifts left).

Nominal money supply (MS), price level (P), and real money demand (L).

[HIGH] [Graph-Decoding (No Drawing)] Q: When money demand (L) falls and MS is fixed, what are the fixed variable, adjusting variable, and direction of adjustment? A: Fixed variable: MS. Adjusting variable: P. Direction: P rises.

Price level must rise to maintain equilibrium.

[HIGH] [Central Bank Policy Cards] Q: What must the Bank of Canada do to keep prices (P) stable if money demand (L) falls? A: Reduce the money supply (MS) proportionally.

It can change due to factors like financial innovations.

[HIGH] [Central Bank Policy Cards] Q: How does the central bank stabilize price levels (P) if there is a drop in money demand (L)? A: By reducing the nominal money supply (MS) accordingly.

Price level needs to rise.

[HIGH] [Central Bank Policy Cards] Q: If money demand (L) falls and the central bank does nothing (keeps MS fixed), what happens to prices (P)? A: Prices (P) rise.

Velocity does not change, allowing for straightforward predictions of inflation.

[HIGH] [Classical Dichotomy Cards] Q: What is the classical dichotomy? A: Money affects nominal variables, while real factors determine real variables.

Real money supply is nominal money supply deflated by price level.

[HIGH] [Classical Dichotomy Cards] Q: What is the primary focus of classical monetary theory regarding money's influence? A: Money influences nominal variables, while output (Y) and real interest rates (r) are determined by real factors.

They increase proportionally.

[TRAP] [Exam Trap Cards] Q: Is money growth (%ΔM) equal to inflation (%ΔP)? A: No, you must subtract real output growth (%ΔY) from money growth.

It simplifies the relationship by keeping V stable.

[TRAP] [Exam Trap Cards] Q: What is a common exam trap regarding money growth and inflation? A: Calling %ΔM 'inflation' without subtracting %ΔY.

It prevents confusion between real and nominal interest rates.

[TRAP] [Exam Trap Cards] Q: Does lower money demand (L) automatically lower prices (P)? A: No. If money supply (MS) is fixed, prices (P) rise.

By reducing the nominal money supply accordingly.

[TRAP] [Exam Trap Cards] Q: What assumption should be avoided when money demand (L) shifts? A: Assuming it results in an automatic price level (P) decrease.

They decrease the demand for money.

[TRAP] [Exam Trap Cards] Q: What is a key insight from the Fisher Effect to avoid confusion? A: It prevents confusion between real (r) and nominal (i) interest rates.

Identify the correct relationships using established equations.

[FINAL CHECK] [Exam Trap Cards] Q: What general tip helps for inflation questions on an exam? A: Identify the correct relationships using established equations.

The growth rates of money supply and real output.

[TRAP] [Exam Trap Cards] Q: When analyzing inflation using the Quantity Theory, what must you consider? A: The growth rates of money supply (%ΔM) and real output (%ΔY).

Money influences nominal variables whereas output and interest rates are determined by real factors.

[HIGH] [Exam Execution] Q: When should you use MV = PY or its growth-rate form on an exam? A: When the question is about inflation, money growth, or nominal vs real output in the long run.

It typically suggests a need for stability in purchasing power.

[HIGH] [Exam Execution] Q: When should you use MS/P = L(r+\pi, Y)? A: When the question is about money demand, price level determination, or central bank policy.

It reflects lenders' demand for higher returns to match inflation.

[HIGH] [Classical Dichotomy] Q: Which variables are nominal in Topic 3? A: Price level (P), inflation ($\pi$), nominal interest rate (i).

By manipulating the equilibrium equation MS/P = L.

[HIGH] [Classical Dichotomy] Q: Which variables are real and not affected by money in the long run? A: Real output (Y) and real interest rate (r).

Real output is considered fixed in the long run.