macro exam 2- inflation and quantity theory of money

inflation definition

an increase in the average level of prices, at any point in time, some prices are rising, and some prices are falling

inflation rate equation

Π = P_t - P_t-1 / P_t-1 × 100

price indexes definition

gives us a measure of the average level of prices, 3 most common price indexes used are: 1. consumer price index (CPI)

2. GDP deflator

3. producer price index (PPI)

consumer price index (CPI) definition

measures the average price for a basket of goods and services bought by a typical american consumer, the index is weighted so that an increase in the price of a major item counts for more tahn an increase in the price of a minor item

GDP deflator equation

nominal GDP / real GDP x 100 (GDP deflator covers all final goods only)

producer price index (PPI) definition

measures the average price received by producers, unlike the CPI and GDP deflator, producer price indexes measure prices of intermediate as well as final goods

real prices equation and definition

used to compare prices over time, because real prices have been adjusted for inflation, Y real price in X dollars = CPI_x (base year) / CPI_Y x price in Y dollars

hyperinflation definition

monthly inflation that exceeds 50%

money definition

any good that is widely used and accepted in transactions involving the transfer of goods and services from one person to another, 2 types of money: 1. commodity money: a good used for transactions where the good also has consumption value 2. fiat money: paper money (like the U.S. dollar)

functions of money

1. medium of exchange: money is used in exchange of goods and services

2. unit of account: things are priced in terms of money

3. store of value: like many other assets, money retains its value over time

the quantity theory of money does 2 main things

1. sets out the general relationship between velocity, money, real output, and prices

2. helps to explain the critical role of the money supply in determining the inflation rate

velocity of money definition

the average number of times a dollar is spent on final goods and services in a year, refers to how fast money passes from one holder to the next

quantity theory of money and growth rate equation

quantity theory of money: Mv = PY_R

growth rate: M + v = Π = Y_R

what causes inflation?

inflation is caused by increases in M (money supply), given Y_R and v are relatively constant or fixed over time, then the quantity theory of money predicts that inflation must result from increases in the money supply

disinflation definition

a reduction in the inflation rate

deflation definition

a decrease in the average level of prices, a negative inflation rate

money neutrality definition

the quantity theory assumes that changes in M cannot change Y_R at least in the long run, increases in the money supply have no impact on real GDP (growth)

the costs of inflation

1. price confusion and money illusion: prices are signals and inflation makes price signals more difficult to interpret

2. unanticipated inflation can redistribute wealth: unanticipated inflation transfers wealth from lenders to borrowers

inflation redistributes wealth in 2 ways

1. nominal rate of return (i): the rate of return that does not account for inflation

2. real rate of return (r_real ): the nominal rate of return minus the inflation rate, the rate of return that does account for inflation, r_real = i - Π

the fisher effect

the tendency of nominal interest rates to rise with expected inflation rates, i = E [Π] + r_Eq

i = nominal interest rate

E [Π] = expected inflation rate

r_Eq = equilibrium real rate of return