Chapter 31: Inflation and the Quantity Theory of Money

Inflation: An increase in the average level of prices

  • Inflation Rate: The percentage change in a price index from one year to the next.

    • Inflation rate= (P2-P1/P1)x 100

    • P2= The index value in year 2

    • P1= The index value in year 1

Price Indexes: Used by economists to measure inflation

  • Consumer Price Index (CPI): Measures the average price for a basket of goods and services bought by a typical American consumer. This measure of inflation corresponds most directly to daily economic activity.

    • The basket of goods and services bought by the average consumer is changing all the time.

    • New goods and better quality goods are taken into account when computing the CPI.

    • May be overstated by 0.9% every year.

    • Used to calculate “real prices”. Real Price: A price that has been corrected for inflation and are used to compare the prices of goods over time.

  • GDP Deflator: The ratio of nominal to real GDP multiplied by 100. GDP deflator covers all finished goods and services.

  • Producer Price Index (PPI): Measures the average price received by producers. Measures prices of intermediate as well as finished goods and services.

The Quantity Theory of Money

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

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

  • Total Yearly Spending Equation: M x v = P x YR

    • M= money you are paid

    • v= The number of times in a your that you spend (Also called Velocity of Money: The average number of times a dollar is spent on finished goods and services in a year)

    • P= Prices

    • YR= A measure of the real goods and services that you buy.

  • Total Yearly spending rate for the nation as a whole: Mv = PYr

    • M= the supply of money

    • v= The average number of times in a year that a dollar is spent on a finished good

    • P= Price level

    • Yr= Real GDP

    • Yr and v are stable compared with the money supply M

v: Is determined by whether workers are paid weekly or biweekly, how long it takes to clear a check, and how easy it is to find and use an ATM. These factors SLOWLY change overtime. v is not a plausible candidate for explaining large and sustained increases in prices.

When v and Y are fixed, increases in M must cause increases in P. Inflation is caused by an increase in the supply of money

M = Inflation rate.

Changes in v and Yr can have modest influences on inflation rates.

  • If M and v are fixed, increases in Yr must lower prices. This happens because Yr increases faster than M

M: Changes in the velocity of money will affect prices.

  • An increase in the velocity of money will affect prices