17.1: The Classical Theory of Inflation

The Level of Prices and the Value of Money:

• When the overall price level rises, the value of money falls

Money Supply, Money Demand, and Monetary Equilibrium:

• The supply and demand for money determines the value of money

  • The overall level of prices adjust to the level at which the demand for money equals the supply

• The equilibrium of money supply and money demand determines the value of money and the price level

The Effects of a Monetary Injection:

• 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

The Classical Dichotomy and Monetary Neutrality:

• Nominal variables- variables measured in monetary units

• Real variables- variables measured in physical units

• 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 and the Quantity Equation:

• Velocity of money- the rate at which money changes hands

• Quantity equation- the equation M × V = P × Y, which relates the quantity of money, the velocity of money, and the dollar value of the economy’s output of goods and services

• 5 steps that are the essence of the quantity theory of money:

  1. The velocity of money is relatively stable over time.

  2. Because velocity is stable, when the central bank changes the quantity of money (M), it causes proportionate changes in the nominal value of output (P × Y).

  3. The economy’s output of goods and services (Y) is primarily determined by factor supplies (labor, physical capital, human capital, and natural resources) and the available production technology. In particular, because money is neutral, money does not affect output.

  4. With output (Y) determined by factor supplies and technology, when the central bank alters the money supply (M) and induces proportional changes in the nominal value of output (P × Y), these changes are reflected in changes in the price level (P).

  5. Therefore, when the central bank increases the money supply rapidly, the result is a high rate of inflation.

• Inflation tax- the revenue the government raises by creating money

The Fisher Effect:

• Fisher effect- the one-for-one adjustment of the nominal interest rate to the inflation rate

17.2: The Costs of Inflation

A Fall in Purchasing Power? The Inflation Fallacy:

• Inflation does not in itself reduce people’s real purchasing power

Shoeleather Costs:

• Shoeleather costs- the resources wasted when inflation encourages people to reduce their money holdings

Menu Costs:

• The costs of changing prices

Relative-Price Variability and the Misallocation of Resources:

• When inflation distorts relative prices, consumer decisions are distorted, and markets are less able to allocate resources to their best use

Inflection-Induced Tax Distortions:

• Almost all taxes distort incentives, causing people to alter their behavior

  • This change in behavior results in a less efficient allocation of the economy’s resources

Confusion and Inconvenience:

• Inflation makes investors less able to sort successful from unsuccessful firms

A Special Cost of Unexpected Inflation: Arbitrary Redistributions of Wealth:

• Inflation is volatile and uncertain when the average rate of inflation is high

  • Countries with low average inflations, tend to have more of a stable inflation

  • Countries with high average inflations tend to have unstable inflation

Inflation Is Bad, But Deflation May Be Worse:

• Deflation is rarely as steady and predictable

  • It often arises because of broader macroeconomic difficulties