Inflation and Monetary Policy

Vocabulary flashcards covering key terms and concepts related to inflation, monetary policy, and their economic effects.

Inflation

The percentage change in an economy's overall price level.

Hyperinflation

Extremely high inflation, greater than 500% per year.

Fiat Money

Modern currencies, such as the U.S. dollar, are not backed by physical commodities but are valued by social convention and government decree.

M0 (Monetary Base)

Includes currency in circulation plus reserves held by private banks at the central bank.

M1

Adds demand deposits (e.g., checking account balances) to currency in circulation.

M2

Includes M1 plus savings accounts and money market accounts.

𝑀𝑡

Money supply.

𝑉𝑡

Velocity of money (average number of times a dollar is used in transactions per year).

𝑃𝑡

Price level.

𝑌𝑡

Real GDP.

Nominal GDP

Represented by 𝑃𝑡𝑌𝑡, indicating the total value of goods and services at current prices.

Classical Dichotomy

In the long run, the real and nominal sides of the economy are separate.

Constant Velocity

Velocity of money (𝑉𝑡) is assumed to be constant (𝑉𝑡 = 𝑉̅).

Real Interest Rate (R)

Reflects the real return on an investment, adjusted for inflation.

Nominal Interest Rate (i)

The stated interest rate on financial products, expressed in monetary terms.

The Fisher Equation

Captures the relationship between nominal and real interest rates: 𝑖 = 𝑅 + 𝜋 where 𝜋 is the rate of inflation.

Unexpected Inflation

Creates winners and losers. Debtors can repay loans with cheaper dollars, benefitting them, while creditors lose out.

Shoe-Leather Costs

High inflation leads to reduced money holdings and increased frequency of bank visits to withdraw smaller amounts of cash more often.

Menu Costs

Firms need to change prices more frequently in high inflation environments.

The Inflation Tax

The revenue obtained by the government through issuing new money.

Central Bank Independence

Separates monetary policy from fiscal policy to avoid the temptation for governments to print money excessively.