Chapter 17: Money Growth & Inflation

Price level (P)

The price of a basket of goods, measured in money

Quantity Theory of Money

Asserts that the quantity of money determines the value of money

Money Supply (MS)

In the real world it is determined by the Fed, the banking system, and consumers. In this model we assume the Fed precisely controls it and sets it at some fixed amount.

Money Demand (MD)

Refers to how much wealth people want to hold in liquid form, quantity is negatively related to the value of money and positively related to P

Nominal Variables

Measured in monetary units: nominal GDP, nominal interest rate (rate of return measured in $)

Real Variables

Measured in physical unites: Real GDP, real interest rate (measured in output)

Classical Dichotomy

The theoretical separation of nominal and real variables

Monetary Neutrality

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

Velocity of money

The rate at which money changes hands

Quantity Equation

Mx V = Px Y

Velocity Formula

(Px Y)/ M

Hyperinflation

Inflation exceeding 50% per month

Inflation Tax

Printing money causes inflation, which is like a tax on everyone who holds money

Fisher Effect

An increase in inflation causes an equal increase in the nominal interest rate, so the real interest rate (on wealth) is unchanged

Shoe leather costs

The resources wasted when inflation encourages people to reduce their money holdings: includes the time and transaction costs of more frequent bank withdrawals

Menu costs

The costs of changing prices

Misallocation of resources from relative-price variability

Firms don’t all raise prices at the same time, so relative prices can vary which distorts the allocation of resources

Confusion and Inconvenience from Inflation

Changes the yardstick we use to measure transactions, complicates long-range planning and the comparison of dollar amounts over time.

Tax Distortions

Inflation makes nominal income grow faster than real income, Taxes are base on nominal income and some are not adjusted for inflation, So inflation causes people to pay more taxes even when their real incomes don’t increase