Chapter 11: Money Growth and Inflation

Inflation

increase in the overall level of prices

Deflation

fall in the overall level of prices

Hyperinflation

an extraordinarily high rate of inflation

Quantity Theory of Money

a theory asserting that the quantity of money available determines the price level and that the growth rate in the quantity of money available determines the inflation rate

Overall Price Levels Rises

the value of money falls

Overall Price Level can be Viewed in Two Ways

1. as the price of a basket of goods and services
2. as a measure of the value of money

Determinant of Supply and Demand of Money

value of money

Money Demand has Several Determinants

interest rates

average level of prices in the economy

Demand for Money

reflects how much will people want to hold in liquid form

liquidity preference

Increase Price Level

increase money demand

Decrease Price Level

decrease money demand

Nominal Variables

variables measured in monetary units

nominal GDP, nominal interest rate, nominal wage

Real Variables

variables measured in physical units

real GDP, real interest rate, real wage, output production, employment

Classical Dicotomy

the theoretical separation of nominal and real variables

Monetary Neutrality

the proposition that changes in the money supply do not affect real variables

only effect nominal variables

Velocity of Money

the rate at which money changes hands

Velocity and the Quantity Equation

V = (P x Y)/ M

Quantity Equation

the equation that relates the quantity of money, the velocity of money and the dollar value of the economy’s output of goods and services

Inflation Tax

the revenue the government raises by creating money

Fisher Effect

the one-for-one adjustment of the nominal interest rate to the inflation

Six Problems of Inflation

shoeleather costs

menu costs

relative price variability

tax distortions

confusion and inconvenience

arbitrary redistribution of wealth

Shoeleather Costs

the resources wasted when inflation encourages people to reduce their money holdings

inflation reduces the real value of money, so people have an incentive to minimize their cash holdings

Menu Costs

the cost of changing prices

Relative Price Variability

because prices change only once in a while, inflation causes relative prices to vary more than they otherwise would

Unexpected Inflation

redistributes wealth among the population in a way that has nothing to do with either merit or need

these occur because many loans in the economy are specified in terms of the unit of account - money