Module 10 – Money Growth & Inflation

What is inflation?

A general increase in the price level and a decrease in the value of money.

What is the Quantity Theory of Money equation?

M × V = P × Y (Money supply × Velocity = Price level × Output)

What happens if the money supply increases rapidly?

Inflation rises.

What does it mean that “money is neutral”?

In the long run, changes in the money supply affect nominal, not real, variables.

What is the velocity of money and how is it calculated?

It’s how fast money moves: V = (P × Y) / M.

The velocity of money, denoted as V, measures the rate at which money is exchanged in an economy. It is calculated by dividing the product of the price level (P) and output (Y) by the money supply (M).

What is the inflation tax?

The loss in purchasing power when the government prints money.

What is the Fisher Effect?

The nominal interest rate rises one-for-one with the inflation rate. This principle states that real interest rates remain stable over time, as nominal rates adjust to anticipated inflation. Consequently, borrowers and lenders alike can maintain their purchasing power.

List 3 costs of inflation.

Shoeleather costs, menu costs, tax distortions. These costs refer to the expenses and inefficiencies that arise as a result of inflation. For example, shoeleather costs involve the increased costs of time and effort people spend to manage their cash holdings, menu costs pertain to the expenses incurred by businesses when changing prices, and tax distortions occur as inflation can alter the real value of tax liabilities.